Leasing vs. Buying Medical Office – The Upsides & Downsides
By Tracy Altemus, CCIM Executive VP, Healthcare Brokerage Services Agent, Arizona, Nevada & California, Ensemble Real Estate Solutions and Marina Hammersmith, Senior VP, Healthcare Brokerage Services Agent, Arizona, Ensemble Real Estate Solutions
As you might imagine, there are many factors to consider when making a decision about whether your business should buy or lease real estate. If you’re hoping for a simple “one-size-fits-all solution” we’re sorry to disappoint—you won’t find one. Every business is different, with varying needs, requirements and objectives.
It’s always recommended that you create a separate entity for the purchase of real estate and have your practice sign a lease from the ownership entity. Ensemble’s approach to the question of ownership is to break it down into two parts: 1) Does this purchase make sense as an investor? and 2) Is the lease rate you will have to charge your practice competitive with comparable lease rates for a similar product? It’s important to consider each point independently and arrive at a consensus if you want to secure the best long-term outcome.
We have developed economic models to assist our clients in these assessments so we can compare outcomes with lease versus buy options, thereby arming our clients to make the best decision. Of course, there are other variables, besides just the economics, to consider. Let us break down some of the pros and cons of each approach:
Leasing offers greater flexibility than owning, so if you’re unsure if your business is going to expand or contract in the coming years, this option may be your best bet. Leasing also makes sense if you encounter the following prohibiting factors:
- A short time horizon—a purchase can take three months or longer to close, and then you need time for any necessary improvements to make the office suitable for you.
- Costs are high for building or buying when you’re ready to make a move—as purchase prices pick up, interest rates rise and/or construction costs increase; they can create a barrier to entry for ownership.
There aren’t many unforeseeable costs with leasing since your lease dictates what your costs will be and most high-ticket capital items fall to the landlord. Typically, the only variable is operating expenses, but these are the same on both sides of the lease-or-buy discussion, so they aren’t too important to the overall decision as whether to lease or buy.
Of course, when you’re leasing you’re exposed to changes in the market at the end of each lease term. If the market has risen considerably during your lease term, you could be faced with a significant increase in rent. It’s also important to recognize that if the market declines during your term, you will likely be able to negotiate a lower lease rate. In short, when leasing you are always riding the market.
Every market is different, but we’ve seen a very tenant-friendly atmosphere in the Phoenix area over the last five years—with attractive lease rates, paid tenant improvements, free rent and more. Phoenix is just now beginning to tighten up, with less supply in the market, rates inching up a bit, and more and more tenants now need to contribute out of pocket towards the cost of their own improvements.
One of the most important elements of leasing is that you have optionality at regular intervals. Nearing the end of each lease term, you are afforded the opportunity to evaluate all your options with your practice, your real estate needs and the market in order to make any necessary adjustments at that time.
Are you landlord material?
Although leasing offers more flexibility in your short-term future, owning lets you control your own destiny and potentially build personal wealth. Want your name on the building and the freedom to do whatever you want within the space? Then you might want to consider ownership. But with that control comes all the costs of ownership. Those high-ticket capital items that are covered by your landlord when you sign a lease become your responsibility when you’re the owner.
Owning—whether buying an existing building or constructing a new one—involves risk. When looking at ownership options you need to make some assumptions (i.e. guesstimates):
- What do you need to invest now for the base building and any necessary tenant improvements?
- What will you need in the future—are there deferred maintenance items, parking lot repairs, etc.?
- If you have excess space to lease, how long can you carry the vacancy, what are the leasing costs and what rent can I achieve?
- Most importantly, what will you sell the building for at a later date?
With “assumptions” comes risk. You can control some of the risk with insurance and warranties, but many things are out of your control, like the market in general, time delays and cost escalations. And if you’re looking at a condominium as an ownership option, some of your “freedom” to do what you want will be limited by the association restrictions, rules and regulations.
The market might hit a downturn, we might have a recession, and suddenly you might find that your building isn’t worth what you paid for it, or what you were expecting when you started. We’ve all seen it happen before, and it can happen again. That said, even if appreciation doesn’t meet your projections, ownership might still be more financially advantageous than leasing because low interest rates and/or the tax benefits ownership provides could offset some market blips. Since those are based on an individual’s overall situation we always advise our clients to talk with their CPA.
Most building owners will tell you the best reason for buying is no longer paying rent to someone else (and watching them make money off of you). As we alluded to above, we advise our clients to have their professional corporation/LLC sign a market lease with a separate ownership entity which is presumably owned personally by the principal(s). This way, the tenant entity’s “rent” is a business expense to the practice and the profit is returned to the individual, and tax deferred until the investment is recouped. Ideally with ownership, if you’re paying market rent to yourself, and paying your expenses and mortgage out of that rent, you pocket the amount left over as your return. Then a few years down the road—market willing—the building appreciates in value and you sell it for a sizable profit.
Should I build?
If you decide to build, there are a multitude of things to consider: finding the land, loan costs, construction costs, the possibility of rising interest rates, and a time period of no less than 18 months to two years from the time you start your search until you occupy. You have to ask yourself “can we wait that long to take occupancy?” And “what will the market and interest rates look like when you have to lock the loan in?” Also “how big should I build”? In any ownership scenario you also have to consider your exit strategy and what happens if your practice needs to expand or contract over time. Are you willing to possibly be a landlord to other tenants or sell and relocate?
TO LEASE OR TO BUY?
That is the question, and there’s no general rule-of-thumb for the answer. Except this: make sure you work with the right real estate advisor who has the tools and experience to help you make a decision you are confident in.