By: Douglas Hughes, (Guest Blogger from CARR)
Conventional wisdom tells us that spending less money is the most effective approach to saving money. After all, a penny saved is a penny earned and the more you save, the more you have left over. That logic is hard to argue with, but it is not always fool proof. Saving money for your practice the wrong way can lead to diminished patient care, outdated equipment, the wrong location for your practice and additional negative results.
There are several critical factors often overlooked when a healthcare practice’s primary focus is paying the lowest rent vs. achieving the best combination of overall terms. Let’s look at three factors where paying higher rent could actually increase your profitability.
#1: The Cost to Build
Healthcare buildouts often cost two-to-three times more than a typical commercial real estate space. This is attributed to many factors that are unique to healthcare, including:
- More durable finishes
- Millwork and cabinetry
- Plumbing and sinks in exam rooms, sterilization centers and laboratories
- Increased electrical and HVAC requirements (heating, ventilation and air conditioning)
- And several more
Three of these costs alone: HVAC, Electrical and Plumbing, drive up the cost considerably for healthcare buildouts when compared to non-healthcare uses.
With buildout being such a costly expense, many healthcare professionals get themselves into trouble when they only focus on the lowest lease rate. The reason this can be such a costly mistake is because landlords often care the most about maximizing the property’s income, which is primarily driven by the lease rate.
The NOI (Net Operating Income) is the main number an appraiser or investor looks at when valuing an investment property; which again, is derived from the lease rate. Savvy landlords recognize this and would often rather invest more money into their space while providing other concessions such as free rent, lower annual escalations and tenant improvement allowance as opposed to lowering their lease rates. To a landlord, lower lease rates devalue capitalization potential should they decide to sell the property.
- A Landlord has a 2,000 SF vacant space listed for lease at $4,000 per month on a 10-year lease term
- A doctor wants to lease the space for the lowest lease rate possible
- The doctor offers the landlord $3,250 per month to get the lowest monthly rent
- The landlord proposes keeping the rent at $4,000/month but is willing to give the tenant $100,000 and 5 months of free rent to buildout the space plus 3 months of free rent upon opening for business
In this instance, the Doctor would be spending $90,000 more in rent over the 10-year lease term (assuming the landlord would agree to the lower proposed monthly rent). However, the doctor would be better taking the landlord’s higher-rent offer because they would be saving $100,000 on the buildout loan, receiving $12,000 in free rent (plus a free build out period)and saving an additional $27,000 on loan interest expense (assuming a 10-year loan term at a 5% interest rate). In this instance, the lower rent would have cost the doctor almost $50,000 more in total expenses!
Additionally, with the higher lease rate / monthly rent, the doctor would receive a higher level of tax deductions as rent is 100% deductible. Conversely, some of the additional loan costs are not deductible and a portion of what the loan was spent on would need to be depreciated over a longer period of time to account for the build out.
From the landlord’s perspective, this deal is more appealing with the higher lease rate and more concessions because the $112,000 tenant improvement and free rent allowance today will be primarily recaptured through rental income over the lease term. More importantly, it saves the Landlord from devaluing the property by over $128,000 when compared to lowering the lease rate (assuming a 7% cap rate which is a conservative rate in today’s commercial real estate market). This same approach and value carried over the entire property could save the landlord $500,0000 to $1,000,000 on an average sized property at the time of sale.
In this scenario, the landlord is much more likely to perform the transaction while the doctor would save well over $50,000 compared to seeking only the lowest monthly rent! Both the landlord and doctor win.
#2: Your Location
Another overlooked factor that could make paying a higher lease rate a better financial decision is a property’s location.
If you have ever worked with a commercial real estate agent, you have likely heard them say, “location, location, location.” This is the most cliché term in real estate for a reason. Location is one of the most important factors in a healthcare practice’s success. There are two factors regarding your location that need to be considered: the first involves demographics, visibility, access, signage, etc. and the second is the quality of neighboring or anchor tenants.
Having a strong anchor tenant, such as a leading grocery store or large national retailer can significantly impact the rate you pay. However, higher rent premiums can be worth the increased expense when you consider the amount of potential new patients a strong anchor tenant can attract. A space with a better location and higher rent has the potential to increase the number of new patients per month to the point where the increased profit would be greater than the cost of the higher rent. Thus, the value of your practice would arguably be worth more upon a sale, as most practices are valued and sold based upon a percentage of annual revenue. If you can take home more money and increase the value of one of your largest assets, paying more in rent could be seen as a strategic investment versus simply an expense.
The same logic can be said of paying more for increased visibility, traffic count, accessibility, signage, etc.
#3: The Condition of the Space
The condition of a space makes a large impact on the overall cost of a deal and is often overlooked when the primary focus is on achieving the lowest rent.
When was the building built or remodeled? When was the HVAC last replaced? Is there sufficient electrical service for your equipment and technology? Is the building up to code and ADA accessible? Has there been any recent roof leaks? What type of deferred maintenance is present? And the list goes on…
Any of these items could cost you thousands of dollars to remedy over the term of your tenancy. Whether the issue needs to be fixed on the front end, like installing new HVAC, or something else that adds up over time, like poor-energy efficiency, the extra costs of leasing an older space or poorly maintained property needs to be carefully considered.
Paying a higher rent upfront to avoid the above costs should be thoroughly evaluated prior to committing to a new lease in order to determine potential expenses and liabilities over the long-run. You can make the most informed decision for your practice when all the cards are on the table and no stone is left unturned.
There is a significant amount of money on the line when it comes to your healthcare practice real estate, and the vast majority of it is negotiable. It is vitally important to consider more than just lease rate and length of the term when evaluating your real estate options. Often times, landlords are only willing to move slightly off the lease rate when they would be willing to give significantly more concessions. The best strategy to achieve maximum profitability with your commercial real estate needs is to have professional representation with every transaction you are involved in. One of the best parts is that as a tenant, your representation does not cost you anything as landlords and sellers pay real estate fees in commercial real estate; just like in residential real estate.
Beyond having professional representation, it is equally important you have an agent on your side who only works with healthcare tenants and buyers and does not represent landlords or sellers. You want someone who understands and specializes in healthcare and is only on your side of transaction. An agent who understands the nuances of healthcare real estate can easily make a six-figure impact in your real estate negotiations. Additionally, having an expert agent who doesn’t have a single listing improves your ability to have a no conflicts of interest approach. Your agent’s specific strategy for maximizing your practices profitability through real estate should take all the guess-work out of the process and bring peace of mind in every commercial real estate transaction you are involved in.
CARR Healthcare is the nation’s leading provider of commercial real estate services for healthcare tenants and buyers. Every year, thousands of healthcare practices trust CARR to achieve the most favorable terms on their lease and purchase negotiations. CARR’s team of experts assist with start-ups, lease renewals, expansions, relocations, additional offices, purchases, and practice transitions. Healthcare practices choose CARR to save them a substantial amount of time and money; while ensuring their interests are always first.
Visit CARR.US to learn more and find an expert agent representing healthcare practices in your area.