By Jeffrey B. Sansweet, Esq.
Most young doctors who join a private practice after completing residency or fellowship expect to become partners. After working as an employee for two to three years, the young doctor will often become a partner while buying in to the practice over another three to five years. The practice buy-in may be based upon the value of the equipment, furniture supplies, accounts receivable and goodwill. Some practices lease their office space, so no value is attributable to the bricks and mortar. However, with some practices, the partners own the real estate and the issue arises as to whether the young doctor will become an owner of the real estate as well, and if so, how. This article will explore the issues relating to buying in to practice real estate.
Most medical practices are structured as professional corporations. Typically, if practice real estate is not leased, it will not be owned by the practice corporation itself for both liability and tax reasons. Rather, the building or condominium unit will be owned by a separate entity. That entity is usually structured as either a partnership or limited liability company, or if only one doctor is involved, the real estate may be owned jointly with the doctor’s spouse. Thus, a doctor may become a partner (I use the term partner generically, as a doctor who becomes an owner of a professional corporation is really a shareholder) of the medical practice entity without becoming a partner (or “member” of a limited liability company) of the real estate entity.
Some young doctors have no interest in becoming a partner in the real estate entity. They may not feel it is a good investment. They may not have the financial resources to buy-in to the entity. They may not like the location or may feel the practice will outgrow the space and eventually need to sell.
On the other hand, some senior doctors may not want to allow new practice partners to become partners of the real estate entity. They may feel that they put a lot of time, effort and money into building the structure and may want to hold on to it as an investment even beyond retirement or death.
If you are a young doctor buying in to a practice but not the real estate, you must protect yourself from being treated unfairly. There should be a written lease between the two entities. The lease should be at a reasonable, not above fair market value rental rate, for a reasonable term. If the rent is too high, perhaps to provide tax benefits to the owners of the real estate (such as no payroll taxes), there will be less money left in the practice. If the term is too short, you will face renegotiation of the rent too often. In addition, if the real estate is owned by one or more senior doctors who are close to retirement age, the practice could end up having to relocate if the senior doctors sell the real estate to an outsider to cash in on their investment.
In order to avoid that situation, in addition to a long-term lease or a short-term lease with options to renew, the real estate owner(s) could give the non-owner practice partners an option to buy the real estate at an appraised value upon his/her/their retirement or death, as well as possibly a right of first refusal.
Now let’s assume that all parties wish to have the young doctor buy in to the real estate entity. That could either occur at the same time he or she buys into the practice entity or at the point the young doctor has completed his or her buy-in. If the latter option is pursued, the young doctor presumably will be more able to afford the buy-in to the real estate. In any event, the main issues are the buy-in price and manner of payment.
The price can be determined in a few ways. One is simply by mutual agreement of all parties. Another method is simply using the original cost of the real estate if it was recently purchased, or the original cost plus annual cost-of-living increases. The most common method, however, is by means of an appraisal by a qualified commercial real estate appraiser. Of course, any mortgage liability would decrease the purchase price.
Once the price is determined, the manner of payment needs to be dealt with. One option is for the young doctor to simply pay each owner his or her share up front. If that is not possible, the young doctor could sign a Note in favor of each real estate partner with payments made over time with interest.
The most common method, however, is for the existing partners to refinance the mortgage to as close to 100 percent financing as possible. The new partner could simply sign the new mortgage and thus be equally responsible for the debt without having to pay any out-of-pocket buy-in. The existing partners are able to pull out the cash equity at that time to realize a return on their investment. When interest rates are declining, refinancing is more likely to occur. However, if interest rates have increased, the existing partners may not be willing to go the refinance route. If the mortgage is not refinanced, the new partner should be added as a guarantor thereunder.
The buy-in to the real estate entity should be accompanied by a new Partnership Agreement (or Operating Agreement if the entity is a limited liability company). The most important issues to be covered by such Agreement involve the buy-out. Should a partner who leaves or retires from the medical practice be obligated to sell his or her interest in the real estate and should the remaining partners be obligated to purchase his or her interest? If so, at what price?
Often, the Agreement provides that each party obtain their own appraisal, and that an average of the two determines the price, less the mortgage balance. If the two appraisals are greater than 10 percent apart, the Agreement may provide that the two appraisers choose a third appraiser. Then, the third appraiser’s price prevails or the three appraisals are averaged to determine the buy-out price. The payment term also needs to be spelled out. If there is significant equity in the real estate, the payments may be over as long as ten years.
Jeffrey B. Sansweet, Esq., is a healthcare attorney with Kalogredis, Sansweet, Dearden and Burke, Ltd. in Wayne, Pa.