Optometric Practice Real Estate
Before making any decisions, make sure you know the details of renting and buying.
ALLAN BARKER, O.D., ROCKY MOUNTAIN, N.C., GREG STOCKBRIDGE O.D., M.B.A., HOLLY SPRINGS, N.C.
We, as optometrists, can explain corneal cross-linking, fit complex bitoric lens designs and manage intraocular pressure. However, many of us cannot explain the difference between a warm lit vanilla shell (a minimally finished interior typically with ceilings, lighting, heating, cooling, plumbing, electrical) and a cold dark shell, which is the opposite. Signing a lease without the ability to discern between these shells can cost you, as the tenant, more than $50 per square foot. For a 3,000 square foot office, that’s a $150,000 mistake.
Something else to consider: Many doctors sign leases everyday that include terms such as “force majeure” (act of God), “balloon payments” and “loan irrigation fees” with little understanding of the ramifications of these terms. (For common real estate terms, check out www.realtor.org/ncommsrc.nsf/files/commercial%20real%20estate%20glossary.pdf/$file/commercial%20real%20estate%20glossary.pdf.)
Real estate decisions, as is the case with doctor skill and customer service, play a significant role in a practice’s financial success. Therefore, it’s crucial you not only familiarize yourself with common real estate terms before choosing a practice location, but also the details of renting and owning.
As the O.D. tenant, you cover the landlord’s bank payments for the property with your rent, while the landlord deducts the interest portion of these payments from their taxes. (See “How Much Rent Can an O.D. Afford?” below.) The building appreciates, while the landlord depreciates the property.
Also, the tenant usually pays for the Taxes, Insurance and Common Area Maintenance (TICAM) charges for the landlord. To avoid signing a Draconian lease, be aware of these top-10 landlord tricks:
|How Much Rent Can an O.D. Afford?|
The industry benchmark is 6%. Thus a $1 million practice should support a $60,000 facility cost ($1,000,000 x .06 = $60,000). If the $60,000 location houses a $2 million practice, this is quite positive, assuming no landlord percentage rent, as the facility cost now becomes 3% ($60,000 facility cost/$2,000,000 practice = .03). If the same $60,000 location contains a $500,000 practice, facility cost becomes 12% ($60,000 / $500,000 = .12). This low cash receipt production does not cost justify a $60,000 rent expenditure.
If the optometrist owns the property, we feel they can justify at least an 8% benchmark instead of 6% due to the desirable equity variable of becoming a property owner.
1. Long-term leases with personal guarantees and lack of short-term renewal options or bailout clauses. You want the flexibility to move eventually, if that is part of your business plan or if markets change. Too long a term lease may lock you into a location that you would prefer to vacate, such as one that does not allow for future expansion of services facilities. Also, a long-term lease by an overly frugal landlord may force you to renovate someone else’s property if your office becomes dated.
On the other hand, a short-term lease may force you to move before you are ready. Along these lines, make sure you have lease protection and the option to purchase the building and/or a right of first refusal.
2. Uncapped CAM and TICAM charges that contain built-in administrative charges that go to the landlord.
3. No ceiling on tenant HVAC repair charges and no ability to distinguish between major (landlord) and minor (tenant) repairs. Also, no prior landlord pre-inspection required of the HVAC system.
4. Annual consumer price index (CPI) increases rather than at-term renewal.
5. Failure to provide proper build-out costs for the tenant, which should be at least 10% of tenant outlay through the initial lease term and again at-term renewals.
6. Figuring square footage based on outside walls compared with inner walls, effectively increasing rentable square footage.
7. Automatic renewal clauses without sufficient notice of term expiration.
8. Oppressive holdover provisions with double and even triple rent charges.
9. Mandates for legal venues on contested matters in distant locations untenable to the tenant with no remuneration of legal costs even if the landlord is at fault.
10. Provisions to relocate the tenant to another location without their permission.
The good news: As a “clean” medical specialist with a destination business, you’re a desirable tenant. In addition, landlords know that health care’s percentage of G.D.P. is expected to grow from its current 17.8% to 19.6% by 2021, says CMS, and that medical office vacancy rate generally runs 4% less than all office space. In fact, the September 2013 issue of Pensions & Investments sites the ACA as a “shot in the arm” for commercial real estate investing. Thus, you’re in a great position to negotiate a positive lease.
Generally, real estate appreciates fast vs. the inflation rate. Also, it is full of tax breaks. However, real estate is not a get-rich-fast scheme. It is a means of getting rich slow, so patience is required. Let’s look at some numbers.
Dr. “Renter” occupies 3,000 square feet, paying $20 per square foot, which includes TICAM. That means the landlord receives $60,000 in rent per year (3,000 sq. ft. x $20 per foot = $60,000). Many leases require a 3% CPI increase per year. Through 15 years with these terms, Dr. “Renter” pays the landlord $1,115,935.
Now, let’s look at Dr. “Owner.” He buys a similar 3,000 square foot facility down the street from Dr. “Renter.” Property in that area has an 8% CAP rate. (CAP rate is a measurement of a building’s value relative to the yearly rent amount.) For example, if the CAP rate is 8% and the rent is $60,000, dividing the rent by the CAP rate gives you the approximate cost of the building ($60,000 / .08 = $750,000). Thus, the 3,000 square foot building that Dr. “Owner” rents for $60,000 should cost approximately $750,000.
|Renting Vs. Owning: A Financial Breakdown|
|Dr. Renter||Dr. Owner|
|Square feet - 3,000||Square feet - 3,000|
|Rent + TICAM = $20 per square foot||Interest rate 4% fixed|
|Yearly Rent CPI increase – 3%||Term – 15 years|
|Rent year 1 - $60,000||Loan payment year 1 - $66,572|
|Rent year 15 - $90,755||Loan payment year 15 - $66,572|
|Total rent paid - $1,115,935||Property appreciation - 5%|
|Equity value year 15 - Zero||Equity value year 15 - $1,484,949|
Dr. “Owner” obtains 100% financing fixed at 4% for 15 years to buy the building. So, he’ll pay the bank $66,572 per year. Initially, this is more than Dr. “Renter” pays. However, due to the 3% annual CPI increase, Dr. “Renter” surpasses Dr. “Owner”’s annual outlay after five years. At the end of year 14, Dr. “Renter” is paying $90,755 in annual rent, while Dr. “Owner” continues paying the bank $66,572 per year.
Dr. “Renter” has zero equity and is still paying rent. Dr. “Owner,” assuming a 5% annual appreciation rate, now owns a building worth $1,484,949. Also, Dr. “Owner” is able to not only deduct interest payments to the bank, but can also depreciate the property. Of course, depreciated tax savings must be recovered when the building sells. However, these taxes can be temporarily avoided via a like-kind exchange if Dr. “Owner” purchases another similar investment property within a certain time period utilizing the same property partner owners.
Dr. “Owner” does have to make major repairs when needed and pay taxes on equity pay downs. But, none of these fees even approach the $1.5 million in equity owned by Dr. “Owner” vs. the zero equity for Dr. “Renter.” Also, Dr. Renter may not have the security of keeping his space at the end of his lease when a national chain tenant with a balance sheet more favorable to a bank mortgage holder approaches his building’s landlord. (See “Renting vs. Owning: A Financial Breakdown,” page 20.)
Though the comparison between Dr. “Renter” and Dr. “Owner” is compelling, it’s important to remember that sometimes, especially in metro areas, investors own the best locations. So, you may have to rent before buying. OM
Dr. Barker is president of Eyecare center and serves as vice president of Optometry Cares and is on the Essilor ECP Advisory Panel. In addition, he is an investor in more than 30 commercial real estate buildings. E-mail him at email@example.com.
Dr. Stockbridge graduated from New England College of Optometry and received his M.B.A. from Duke University in real estate and is VA residency trained in hospital based optometry. E-mail him at firstname.lastname@example.org, or send comments to email@example.com.