Conventional wisdom says that spending less money is the most effective way to save money. After all, a penny saved is a penny earned. That logic is hard to argue with, but it is not always foolproof. Saving money for your practice the wrong way can lead to diminished patient care, outdated equipment, the wrong location for your practice and additional negative results.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 factors often overlooked when a healthcare practice's primary focus is paying the lowest rent instead of achieving the best combination of overall terms. Let's look at three factors in which paying higher rent could actually increase your profitability.
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
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 Net Operating Income, which is a function of the lease rate, is the main number an appraiser looks at when valuing an investment property. 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 five months of free rent to buildout the space plus three 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 five percent interest). In this instance, the lower rent would have cost the doctor almost $50,000 more in total expenses.
Additionally, with the higher lease rate, the doctor would receive a higher level of tax deductions as rent is 100 percent 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. This same approach 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 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.
Another overlooked factor that could make paying a higher lease rate a better financial decision is a property's location.
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 can significantly impact the rate you pay. However, higher rent premiums can be worth the increased expense when you consider the number 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.
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? 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 needs to be considered.
There is a significant amount of money on the line when it comes to your healthcare practice real estate, and most of it is negotiable. It is important to consider more than just lease rate and length of the term when evaluating your real estate options. While landlords are often reticent to move off the lease rate, they can be willing to give significantly more concessions in other areas.
Richard Tidwell is an agent with CARR Healthcare Realty, a provider of commercial real estate services for healthcare tenants and buyers. He can be reached at firstname.lastname@example.org