Decisions, Decisions Medical Office Space: Buy, Lease or Walk Away?

Doctors often ponder whether it is better to own their medical office space (MOS) or rent from someone else. Ownership can range from an office condominium to a multi-practice office building. This article will outline several factors that should be considered before making a decision.

• Establishing clear objectives is the first step in the analysis. Keep in mind that this is strictly a business decision. It is not the same as buying a personal residence. This decision will impact your practice finances and may affect your relationship with associates. It is a significant long-term investment that can span several tenures of ownership.

Once you have compiled a list of objectives you need to identify and list the pros and cons of ownership versus leasing. This process may also bring to light issues not previously considered which could weigh heavily in the equation and may lead you to pass on a particular location and look elsewhere.

Here are some common objectives of owning and the related pros and cons:

Cost control: This is probably the most common-sense reason for wanting to own your office space. Leasing to yourself puts you in control and can be a hedge down the road to skyrocketing increases due to market conditions outside your control if you were leasing. Most practices that structured their real estate arrangements properly have saved money over the long run. On the flip side, the condition and age of the property may be such that will require substantial additional capital outlays in the near future for items such as roofing, HVAC, windows and repaving. These may not be readily apparent.

Location: It may be that there is no rentable space available in the most desired location, in which case buying or building is the only way to situate your practice where the patients are. Proximity and accessibility for patients and referral sources is one of the most critical factors to a practice and this may justify paying a premium over other locations. If, however, you are opening a new practice or are faced with having to practice in a less than desirable or uncertain location, you may not want to make a long term commitment. In this situation a lease arrangement may make more sense.

Expansion: Owning may make it easier to carve up or add onto existing office space to meet the growing needs of your practice. If you lease, you would need permission from the landlord for substantive changes and may find the cost of additional space prohibitive, if available at all.

Tax Advantages: The current tax laws significantly curtail the ability to shelter taxable income that was once enjoyed by real estate ownership. Write-off periods are now twice what they were in the 1980s and annual operating losses from real estate can no longer be indiscriminately used to reduce other sources of taxable income. These losses, however, can be offset against income from similar real estate ventures or carried forward and deducted against future income or upon the disposition of the property. Shifting income from your medical practice to your real estate entity can still save some taxes. Net income from real estate is not subject to Social Security, Medicare, and other payroll taxes that are payable on wages and self-employment income. Also, all or a portion of gains on the disposition of real estate may be taxed at capital gains rates that are lower then ordinary income tax rates. In short, there are still tax advantages of real estate ownership but they should be a secondary consideration.

Under a leasing arrangement, most rent and related occupancy costs are deductible currently against taxable income instead of deferred to future periods.

Return on investment: Although some doctors have amassed a large retirement fund from MOS ownership, they are the exception. Far more doctors have been very disappointed at retirement age to find not only that there is there little or no equity in the MOS, but no market for it. This could be due to several factors, such as overpaying up front for the property, over-leveraging the property, failure to adequately maintain the property, or general market conditions. If, however, the property is properly appraised, purchased at a fair value, and favorably financed, equity build-up should occur with every rental payment. By paying yourself and making monthly debt service payments, your equity in the property should increase at least equal to the reduction in the debt principal.

The following steps can help you make the proper decision of whether to buy, lease, or walk away:

Make inquiries of other doctors who own or have previously owned medical office space. You may benefit from their experience. Also obtain information from commercial brokers and agents as to the market rate for leased office space and the per square foot costs of buying or building in your area.

Engage an independent inspector to assess the property and to advise you on any structural or operational deficiencies and the related costs to repair.

Determine the adequacy of parking. Availability of parking is critical to patient volume and this factor is often overlooked or underestimated. Figure on the average number of doctors, employees, and patients that may be in the office at any one time and increase this by 10{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5}. Also, allow for practice growth. A patient who can’t find parking space adjacent to your office will likely visit less often and may look elsewhere for medical care.

Run the numbers. Have your accountant prepare a financial projection that will help you determine the costs and related rent structure that will be required to support the purchase or construction. This should show both the taxable income or loss that will be generated and a cash flow analysis of what level of rent is necessary to support the costs, debt service and taxes owed, if any, on reportable income.

Consult with your bank or other financial lender on rates and terms for financing. Getting the lending institution involved early on is important. They may be able to assist you in obtaining information relative to market conditions, contractors, and other information that may be helpful in making your decision.

Obtain the consensus of the members of your practice. This may be one of the most significant and long-term financial commitments your group will ever make. Obtaining a simple majority vote to proceed may not be enough. If you have partners who aren’t buying into this, you should understand their reservations and make every effort to bring them on board. Failure to do so could result in divisive issues resurfacing later on. For example, younger doctors saddled with educational loans and mortgage loans may not be able to afford the down payment required to finance the MOS. They may however, desire to buy in at a later date.

If leasing is determined to be a more viable option, engage an architect to design and estimate the costs of interior renovations required. Negotiate with the owner to share part of the cost. If the space has been vacant for some time, the owner may be willing to grant you several months of free rent to help defray some of your costs.

In Conclusion

Ownership of medical office space can be a prudent investment, but it is not for everyone. The adage “it is better to own than rent” is not conventional wisdom with regard medical office space. Establishing objectives, gathering information, and running the numbers will assist you in making an informed decision or whether to buy, lease or walk away.

In a follow-up article, we will discuss the entity structure, finances, and operational considerations of ownership.

James B. Calnan, CPA, is partner-in-charge of the Health Care Services Division of Meyers Brothers Kalicka, P.C., Holyoke, MA Certified Public Accountants and Business Consultants; (413) 536-8510