The Beyond Multifamily series is hosted by non-residential commercial real estate investor and Best Ever Show host, Ash Patel. Ash’s goal for this series is to introduce you to the world of non-residential commercial real estate investing and teach you how to look at and underwrite different commercial asset classes.
In this episode, Ash highlights this often-overlooked commercial real estate asset, and why it provides an excellent opportunity to make money. He lays out the benefits of buying medical buildings based on cap rates, stability, diversification, and more — plus what to look for when buying a medical practice.
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Ash Patel: Hello, Best Ever listeners. Welcome to the best real estate investing advice ever show. I'm Ash Patel. This is an episode of Beyond Multifamily, where we dive into topics other than multifamily investing. Today we're going to dive into some of the benefits of investing in medical buildings. These are often overlooked assets by a lot of investors, and what prompted this talk was I just sold a medical building that I've held for a number of years for a 6.2 cap rate. And this is in mid-September of 2022. Interest rates are rising, cap rates are rising on commercial buildings, but there's a subset of people that really want medical buildings in their portfolio.
Why do medical buildings trade at such low cap rates? Let's explore some of the benefits of buying medical buildings. One is they're extremely stable. When's the last time you saw a medical practice, a physician's office go out of business? It just doesn't happen. You don't have to monitor the physician's or medical building's revenue like you would a retailer or a restaurant. After the Affordable Care Act, we now have the highest number of insured Americans ever. We also have an aging population, further securing the growth of medical practitioners.
As you look at the diversity of your portfolio, you now have to take into account things like essential services. I've got a number of bars, restaurants and salons that are tenants of mine, and during the COVID locked down, a lot of them were shut down for business, they're non-essential, and often it's detrimental to their long-term business, having a retailer that will have to lay off staff, or a restaurant that has to layoff bartenders. All of a sudden, when they reopen, they may have to rehire additional personnel. With medical practitioners, they're typically essential services, so they don't suffer the same in lockdown scenarios.
Medical practitioners also typically have a succession plan. So when a doctor retires, they don't just say "Out of business, thank you. Building's for sale." What typically happens is the doctor trains the replacement, and the replacement will end up buying into the practice. So all of the patients, all of the goodwill, the reputation that this doctor has established for many years now gets sold to the next generation of practitioners. And often, as the building owner, that lease is still upheld, and often, you can sign a new lease with the new practitioner.
If you think back, how many times have you had a dentist or your primary care physician that's retiring, and there's somebody waiting to take over that practice right away, and you as a patient just continue going to that same practice? When a bar or restaurant sells to a new owner, you don't know how that new owner is going to change things. They might disrupt the business. Customers may get alienated, business goes down, and that tenant has the potential of failing. With doctors and medical practitioners, it's often not the case.
And the rare scenario that a doctor just leaves or vacates their building, or moves or doesn't renew their lease, you can often fill that space very easily with someone in the same practice area. For example, if you have an orthopedic group in a building, and they decide to leave, every other orthopedic part practice in town is going to want that space for the residual patients. Dentists - same thing. Other practitioners - same thing. If you go to the dentist once every six months, and you're just used to going to that one location, you're gonna go back to that same location, maybe because it's convenient to your house, maybe because it's been a habit for so many years just to go there... And you'll absorb the fact that there's a new doctor, dentist, whatever, that's there, taking care of you.
Back to the example of restaurants. If you have one restaurant that chose not to renew their lease, and they vacated the building, you can have another restaurant tour come in, but they may want a completely new buildout, they're gonna want a different look and feel to the interior, and you've got to accommodate that often. With medical practices, they don't require a lot; they require a hand-washing sink in each exam room, they require a large reception area... Often, if they do X-rays inside, you have a lead line X-ray room. The buildings are typically ADA-compliant. For dentists, there's plumbing run underneath the concrete floors, or to the floor below, for all of their water supply drainage lines. Any medical practitioner that requires chairs with lighting, there's going to be power in the floors; each room typically has adequate power for all of the tools that they may use. You'll often find a nice break room area as well. Because of these commonalities, it's easy to transition from one practitioner to another, or to go from, let's say a podiatrist's office to a veterinarian.
Medical office space also commands a higher rent per square foot, which means more revenue, it means the value of your building is higher than the relative office or retail space around you. Another benefit is that the leases are often personally guaranteed by a doctor, or they're corporate-guaranteed by a group. So in a typical scenario where you lease out a restaurant, an office space, or retail space, if it is a national tenant - that's great; they'll sign a corporate-backed lease, and it's a very stable, secure lease. If it's a mom and pop tenant, let's say a hair salon, for example, they're going to sign a personal guarantee; you now have to do some digging, and make sure that this individual that signs the lease and the personal guarantee has adequate financials, so that if something happens to their business, they can continue to pay their rent, until let's say you find another tenant.
With most doctors, you often don't have to do a lot of digging. You know that they're a doctor, you can look at what assets they have, where they live, the car they drive, and typically, a doctor is not going to go out of business again. But if they decide to break their lease, that personal guarantee is enforceable, and you know that they have the assets to back it.
Now, Best Ever listeners, one of the gold standards in retail leasing is a Starbucks. If a Starbucks signs a fresh 10-year lease, those can trade at a four cap, four and a half cap. When a physician group signs a lease - now, let's say this is a regional physician group that maybe has 10 practices. They're not nationally known. They're not known by out of state investors. But if you have some local knowledge, you know that this is a regional optometrists group, let's say, that has 10 locations, they're expanding rapidly, and they sign a corporate guarantee lease; it is very secure. The only way they're getting out of that lease other than carve outs in the lease is if they declare bankruptcy at the parent corporation level. And again, medical practitioners, medical groups - they just don't declare bankruptcy very often.
What do you look for when you're looking to buy a medical practice? I'll give you a quick story... I was recently approached by a medical broker. As a matter of fact, the same broker that sold my building at a 6.2 cap. He put me on his list and he sent me a listing that's very close to my house... And he wanted three and a half million dollars for it. And it was an eight and a half cap. The problem was the location isn't great, and there's only three years left on this lease. So when you couple the two things together, I've got to think in the back of my mind that if this physician group ends up leaving, because the location is so bad, it might be very difficult getting a tenant into that building. If you have to repurpose that into just regular office space, or co-working space, that building's not going to be worth three and a half million dollars. You're going to be really upside down.
This was a missed opportunity. I initially dismissed it because of the location, because of the cap rate, and because of the three years remaining on the lease. I got another call from that same broker a few weeks later, saying, "Hey, if you're still interested, we signed a 10-year lease with this group, and we're now asking a seven cap." So where did I go wrong? What I should have done is gotten the property under contract. In due diligence, I could have negotiated and renewed that lease the same way that this broker did. If I had signed that 10-year lease, I would have made a one and a half point spread on that deal. What does that mean in numbers? It means I could have made over $700,000 within 30 days of due diligence. So definitely a missed opportunity.
Break: [00:10:42.12] to [00:12:40.15]
Ash Patel: Best Ever listeners, I want to dive into that example, because I want to make sure you all understand what happened here. So the risk of this physician group not renewing caused that cap rate to be at eight and a half percent. Now, when you sign a fresh year lease, you're good for 10 years, so you can command a much lower cap rate. A lot of people are good with just parking money into that deal. A lot of 1031 buyers that want something very safe and stable know for the next 10 years this property is going to pay them rent, and they can sell in year five. They're going to sell at a lower price. Why is that? The highest value of a typical property, whether it's retail, office, standalone, medical practice, is when a fresh lease is signed. As the years go by, the risk of that tenant not renewing becomes more apparent, and you've got to weigh that into your underwriting. You've got to start playing with the numbers and the what-if scenarios, just like I thought about "What if this tenant doesn't renew?" I owned some very expensive dirt in a building that I'll likely have to repurpose; not worth the risk. With a 10-year fresh lease, there's not much risk that you're going to incur. And if you sell in year five or six, you milk the profits for four or five years and you can still sell at a decent amount of value.
How do you find these deals and what do you look for? There's brokers that specialize only in medical space. So you can get on their lists, talk to them, have conversations with them, and see if you can add value to them as well. Let them know exactly what it is that you're looking for. You can look for physicians that are selling their practices or physicians that are getting ready to retire.
What happens is a lot of times physicians or medical groups, they'll own their practice, they'll own the building as well. And when it comes time to retire, they're more concerned with the value that they're gonna get for their practice, and the real estate - they often don't know what to do with. The person buying the practice may not have the deep pockets to finance both the cost of buying the business, as well as the cost of buying the real estate. Often, these are young people that are coming out of medical school, with six figures in debt from schooling... And maybe they just bought a house, a car... They're probably not the ideal candidates to take on a multimillion dollar real estate loan. And for that reason, you can interject and talk to the physician, and say, "Look, I'm happy to buy the building, so you're not risking all of your eggs in one basket. Let's say you sell your practice to a new chiropractor, right out of school; if they run the practice into the ground, and you're holding the note on the practice, as well as holding the note on real estate, or maybe they're paying a lease to you, or your seller finance some of it - you want to diversify some of that risk. So why don't I buy the building from you, you will continue with the same lease that you have, or this new physician can sign a lease with me, and they make lease payments to me, they make business acquisition payments to you." And that's often a win/win scenario.
Don't be afraid to look for medical buildings in rural areas. Often, doctors in rural areas have higher reimbursement rates, because of some government programs where they encourage doctors to set up shop in those underserved areas. The overhead for rural physicians is often much lower than urban locations. The competition is also much less than in other locations. All of these factors contribute to the long-term success of those medical practitioners.
If you are near a hospital or medical center, or just a large medical campus, buy whatever you can. I turned down a building a long time ago that was 1,200 square feet. I thought, "Oh my god, what practitioner could possibly go in there?" And when I walked away from that deal, it sold for a much higher price than what I would have offered. And I don't remember what practice went in there, but it's always been tenanted... And I've learned, if you are within the proximity of any medical campus, large hospital system, or standalone hospital, buy whatever you can. For independent physicians that are renting space inside the hospital, they're paying through the roof just to be in the hospital. Imagine how many chiropractors, dentists, other practitioners would want to set up shop right outside of the hospital for a much lower lease rate. People don't have to park their cars, walk across the parking lot, take an elevator and try to find where your office is amongst the sea of other offices. They can park right in front of your building, go right in, and be waited on
When it comes time to selling a medical building, we talked about this earlier, Best Ever listeners - they trade at much lower cap rates. The fresher the lease, the more stable the tenant, the lower the cap rate. However, even if it's a standalone physician, the highest and best purchaser is going to be that tenant. This is very similar to a scenario where years ago I sold a mixed-use building. It had a grocery store on the first floor and four college apartments above it. The market price for that property may have been around $360,000, but I was able to sell it to the store owner for about $450,000. Why is that? The reason is that store owner was paying about $2,500 a month in rent, and by them purchasing this building at a higher than market rate, they were able to essentially have their store rent-free. So they save $2,500 a month, and they're paying down the mortgage of this building.
Same thing with physician offices... If you sell the building to the doctor, it's worth more to them than it is anybody else, because now they no longer have to pay you rent. They can start depreciating the building, they can start paying down the mortgage on the building, and they benefit from all of those.
Best Ever listeners, there's also a lot of merger and acquisition activity in the medical space. Large hospital systems, large physician groups are always trading; they're always either acquiring or being acquired by other systems. And because of that, you'll end up with a lot of tenants that consolidate. And what that means is your tenants - if there's three physician offices within a close proximity, and one hospital group ends up buying all of them, they're going to consolidate their offices. And what that means is your tenant is now going to vacate, and you now have an empty building that you need to re-lease; but they are going to continue paying the lease until the end of their lease term is over. How do you deal with that?
So ideally, the person that signed the lease or the group that acquired that physician practice is going to want to present a buyout of that lease; they're gonna want to say, "Look, I know we've got five years left, and it's at $10,000 a month." If my quick math is right, that is 60 months times $10,000. So it's a $600,000 lease value. They're gonna say, "Hey, why don't we just give you $500,000 upfront, call it a day, and we're out of the lease?" That number you can negotiate. Or you can just sit there with the empty building, they have to continue to maintain it; if it's a triple net lease, they pay the taxes, they make sure the temperature is an adequate level, whatever is specified in the lease, and you just sit on a building. But if you can take that buyout, it's a huge win. Take the buyout and re-lease that to another practice.
And that's a wrap. Best Ever listeners, I hope I was able to add some value to you. I hope you will start looking at medical buildings as investments, start underwriting them, talk to some brokers that are in the medical space, and run some numbers; just see what you can find. And you know me, I always do value-add, so I'm not encouraging you to buy a medical building that has a fresh lease. You're going to pay top dollar. If you just want to park money, get some depreciation, have at it. But if you want to grow your wealth, you're going to want to buy value-add medical buildings, maybe something that has vacancy in it; a physician practice that no longer needs the entire building, and you could bring in an accompanying specialty. For example, if there's an orthopedic group or a podiatrist, and they don't need their entire building, a perfect companion to that practice would be a physical therapy location. So put the two together, they complement each other. If it is a standalone primary care physician's office, try to get a pharmacy next door. A mom and pop pharmacy, where they can call prescriptions in right next door. It makes it so convenient for the patients. So again, keep your eyes open for medical practices. They trade at such low cap rates, and there's a lot of opportunity to make a lot of money there.
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