By Robert Wade, Esq.
Sooner or later, every physician group must face an important tactical decision whether to own the office space in which it practices or continue renting. Believe it or not, this is not always an easy decision. To be sure, ownership has powerful attractions, namely, cost control, tax benefits and the opportunity to build equity. Even in today’s world of relatively modest inflation, rents continue to increase—particularly in many of the more urban and heavily populated suburban areas where office space is at a premium. And owning one’s building or suite is an excellent way of putting a lid on one of the larger expenditures for medical practices.
By buying one’s building, costs are held in check because the largest carrying cost, debt service, will be a fixed number. Of course, certain building expenses (e.g., utilities, maintenance, etc.), like all other expenses, continue to creep upward. However, ownership means not having to worry about market conditions driving up occupancy costs.
Furthermore, each debt service payment goes to increase equity in the real estate. Over the length of a professional career, investing in one’s office can turn out to provide a sizable nest egg for a physician. Moreover, real estate ownership is associated with all manner of tax benefits. Mortgage interest and taxes are, generally speaking, fully deductible. And, while principal payments are not deductible, depreciation on the building component is. All that having been said however, physician group ownership of practice offices has its share of potential problems. Those pitfalls can be categorized as follows: costs (including increased exposure to liability), tax concerns and “equity lockup”. In short, for every benefit offered by ownership, there is a corresponding risk.
A purchase (and especially one involving construction or renovation) always costs more than anticipated. From licenses and inspection costs to hidden defects, zoning issues, safety code regulations and ADA requirements, there are countless expenses. And there is absolutely no way to predict where and how one will have to spend money. Yet, that’s exactly what a potential new owner must do—prepare a realistic, detailed budget and then add 15 percent for contingencies.
After the purchase, repairs, taxes and other costs will still increase, to be sure. And landlords generally just pass those costs along to tenants. But when the physician is his or her own landlord those increases must be anticipated and reserves set aside so as not to be caught short. Without adequate planning and reserves, the owner will have to borrow, increasing debt service costs, which will only compound the problem.
Another potential cost is the exposure to greater liability. Owners now not only have their corporate assets at risk in case a patient slips and falls, but also their personal wealth. Obviously, it is important to have plenty of insurance, but the choice of legal structure is critical as well. For example, ownership of real estate in a separate legal entity outside of the practice distances it from practice-related liabilities. Additionally, the choice for that separate entity should be one that “limits personal liability” such as a Limited Liability Company, Limited Liability Partnership, or even an “S” corporation.
Owning real estate does have tax benefits, but it also poses traps for the unwary. Most practices are “C” corporations. As a general rule, the “C” corporation practice should not own potentially “appreciable” assets. Real estate falls squarely in that category. The problem (among others) is that, if the building is ever sold, there are two layers of tax to face and the equity one thought one had is reduced by as much as 60 percent or more, simply through bad planning. Practice real estate should always be held in a “flow through” entity such as a partnership, Limited Liability Company, Limited Liability Partnership or “S” corporation (separate from the practice) where tax attributes flow directly through to the owners, eliminating the “double-tax” exposure. As among the flow-through entities mentioned, treatment may be slightly different as to state franchise and capital stock taxes.
The pot at the end of the rainbow, equity, can become a very thorny matter as new physicians buy into a practice. Similarly, the payout of a senior physician’s equity can be troublesome for a group. If these concerns are not addressed appropriately at the time of the purchase, the result may be tremendous equity on paper only.
In buy-in situations, for example, young physicians are required to pay a substantial sum of money for practice tangible assets, accounts receivable and “good will” to the existing practice owners. Expensive real estate may make the price tag for some too costly. For example, assume a group bought a building for $500,000 with $100,000 down—$25,000 each—a considerable investment, but probably affordable. Years later, the building is worth $1,000,000, and debt has been reduced to $300,000, leaving $700,000 of equity. That’s good, right? Well, for a new doctor to purchase a 1/5 interest, he or she would have to come up with $140,000 in cash, plus the buy-in price for the practice. That may kill the deal. But, if the owners can’t convince the juniors to part with the money to buy-in, how are they ever going to get their equity out?
Some would suggest that the younger physicians merely buy into the medical practice and not into the real estate entity. To be sure, some groups have done this. However, this does not get equity to the owners. Moreover, this tactic can cause other problems. Lack of complete identity between owners of the real estate and the practice will invariably give rise to conflict. The practice entity “renting” the space from the real estate venture will want the lowest possible rent consistent with fair market value. The real estate venture is interested in maximizing its profit and tax benefits.
Many address this problem by refinancing the mortgage every time a new owner comes on board, allowing existing partners to take out equity. In the previous example, if the group refinances, leaving equity of 20 percent, new debt would be $800,000, with $500,000 being distributed out to the existing partners. A new 20 percent partner would only be required to come up with $40,000 in cash. This could, however, cause a new problem: cash flow from having to service twice as much debt as before.
Equity “lock-up” issues arise also when a partner wants to retire. Either the partnership has to come up with cash (which it typically doesn’t have) or the refinance route must be taken, again potentially causing cash flow issues. A partnership “split up” scenario is potentially even worse: not only is there the issue of how to pay someone out, one has to determine who leaves and who stays, where the factors of ego and real (and imagined) advantages of the location have caused many an “amicable” split-up to degenerate into litigation.
The answer? Appropriate documentation in the practice group agreements which, well in advance, set forth what happens upon a retirement, split-up, death or disability.
For a sole owner of the real estate there may be no fight over buy-ins or payments out of equity; however, the risk of equity “lock-up” is even greater. Today’s valuable parcel of real estate has a habit of becoming tomorrow’s white elephant. No matter how much a building is appraised for, the real question is whether there’s a buyer for it when needed. As in all business matters, this requires thoughtful planning and giving oneself as much lead time as possible to insure that a buyer can indeed be found.
But, for sole owners and group owners alike, “tomorrow” can come more quickly in this day and age of practice mergers. Often when practices merge, economization results in unwanted or unneeded assets, real estate included. Ownership of real estate (and long-term leases, to be fair) can “lock -up” not only equity, but one’s options as well. So much so, that it’s no longer unusual for real estate to become an early focus in merger discussions.
All of these concerns combine to make real estate ownership sometimes less of a promise and more of a peril. However, these concerns can be addressed appropriately through budgeting appropriately, appropriate choice of entity, good insurance and through planning and documentation.
Robert Wade, Esq., is a partner in the Berwyn, Pa.-based law firm of Wade, Goldstein, Landau, Abruzzo, Mackarey & Davidson.