January/February 2008
Medical practices face an environment of declining Medicare and Medicaid reimbursements coupled with increased administrative costs to recover these shrinking revenues. Many medical practices are considering owning their own building as a way to increase their revenue and add an appreciating asset to their practice. Purchasing commercial real estate, however, is very different from purchasing your home and mistakes can result in the loss of hundreds of thousands of dollars. This article will discuss the three major aspects of the real estate transaction: the purchase contract, due diligence and securing the financing.
The purchase contract memorializes the essential terms of the real estate transaction between the buyer and seller. Unlike residential contracts, a commercial contract is typically not a standardized form agreement. Commercial form contracts do exist, however, these standardized forms never address the myriad of unique issues that come up in commercial real estate transactions. In a situation where a practice is looking to acquire a medical office building with existing tenants a vague form can have dramatically bad consequences. For example, these form contracts may only require a seller to make a good faith effort to obtain a letter from a tenant certifying that his lease is not in default. Most banks, however, will not fund a transaction unless they receive this documentation from every tenant. If this situation occurs once the buyer’s earnest money has become non refundable, the transaction will not close and the buyer will forfeit the earnest money.
The contract must also address how the seller will resolve any title problems that arise during the due diligence period. In certain contracts, the seller may choose not to remedy these problems, in such case the buyer should be able to terminate the contract and be refunded the earnest money. Alternatively, the buyer may choose to close the transaction and deduct the payoff of any of seller’s mortgages from the amount due to the seller. The goal here is to provide the buyer flexibility in determining how it wants to resolve title problems.
The due diligence process is really what separates the commercial transaction from the more familiar residential one. In a commercial transaction, the buyer should typically perform the following due diligence: (1) obtain a title report on the property; (2) perform a Phase I environmental survey; and (3) review a current survey of the property.
A commercial title report will describe all the issues that affect title to the property. Many issues can arise from a title report that will impact the ability to timely close a transaction. These issues might include, unsatisfied security deeds, defective chain of title, unpaid taxes, improper zoning or failure of the property to have all the proper easements for parking or utilities. The Phase I environmental survey is typically required to confirm there are no environmental issues related to the property. It is important to discuss the environmental survey with the bank as many banks will require that this environmental survey be conducted in order to finance the purchase of the property. If the report discloses any environmental issues, that will lead to a more detailed Phase II report. A Phase II report can significantly increase the cost of the transaction and delay the closing depending on what such report reveals about the property condition. Lastly, the survey is a critical component in the due diligence process as it reveals any encroachments on the property that come from adjacent properties. It also plots the location of all the easements that affect the property to confirm the property can be used for its intended use. A survey might also reveal the parking lot servicing the property is actually located on the adjacent property. It may also indicate that the water from the property runs off into a detention pond on an adjacent property and there is no easement permitting such water runoff.
The third important aspect in a real estate transaction is financing. Prior to obtaining a loan commitment from a bank, the bank will require that the medical practice submit financial statements, tax returns and the personal returns of the practice owners. In the current tightened credit environment, the lending institution will closely scrutinize this information. If the practice is aware of any financial issues it is best to work with the lending institution at the outset to resolve them. The medical practice does not want to forfeit earnest money because the bank will not fund the loan because the practice failed to timely inform them about a financial issue. Most traditional bank financing will require that the practice owners sign a personal guaranty to personally guarantee the loan by the bank. This can become a very sensitive issue if a practice owner wishes to retire but the bank will not terminate his personal guaranty. In such situations, the bank might be persuaded to terminate the guaranty if the practice pledges additional collateral or pays down the principal amount of the debt. The bank’s willingness to terminate the guaranty is directly related to the financial health of the practice and whether or not it needs the added protection of the continued personal guaranty.
Medical real estate continues to grow at a rapid rate in response to the continued trend of medical practices owning real estate. The purchase contract, due diligence and financing are key pillars to successfully concluding a commercial real estate transaction in a timely fashion. Medical practices who pay attention to the details of the real estate transaction will be rewarded with a timely closing while those who do not will find the lessons learned painfully expensive.
Justin S. Daniels is a health care partner at the law firm Wagner Johnston & Rosenthal, P.C. in Sandy Springs, and can be reached at (404) 261-0500.
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