By Larry E. Willey, CCIM
Medical practices, large and small, are faced with the question of whether to lease or purchase the building housing their practice. A variety of factors pertinent to the practice and the owner’s objectives, as well as local market factors, must be taken into account before an informed decision can be made.
Factors to be considered in making this decision are:
• Business growth in the near and long term
• Lease terms available in the market
• Access to capital
• Historically low interest rates
• Real estate investment opportunity
• Property management control
• Interior improvement costs
An important factor in this decision is whether or not the practice intends to grow in size in the foreseeable future. If significant growth is anticipated, leasing may be the better option. A major benefit of owning real estate is the appreciation in the property over the long term that may or may not occur over the near term. If the practice is required to relocate within three to five years, it may lose the benefit of appreciation.
During poor economic times, or periods when there is a large amount of vacant office space available in the market, landlords may offer attractive lease terms to entice prospective tenants into their buildings. Favorable lease terms such as base rental rate, annual rent escalations, operating expense reimbursement, build-out reimbursement, rent abatement, length of lease term and renewal options may impact the lease versus purchase decision.
The amount of money that is required at the front end will most likely be less in a lease transaction than it will be in a purchase transaction. For this reason, access to capital, readily available or borrowed, must be considered. In a lease transaction, funds may be required for a security deposit and first month’s rent payment, excess tenant improvement costs, furniture, fixtures and equipment and possible moving expense. In a purchase transaction, the total project cost will include the purchase or development costs of land, building and tenant improvements including furniture, fixtures and equipment. Depending on the credit rating of the borrower, the lender may require a down payment ranging from 0 % to 20 % of the total project costs.
We are currently experiencing historically low interest rates. The 10-year treasury notes, used as an index by many lenders, have been below 4% during the 1st quarter of 2008. The ability to obtain financing at low interest rates is generating greater interest in office condo purchases. Low rates, coupled with most lenders’ comfort levels of loaning money to medical practices, can make purchasing an office suite or building an attractive proposition.
Home ownership, as a long-term investment, is prevalent in the United States and many physicians and professionals are now looking at their office space in the same light. This new source of real estate ownership provides another alternative for personal investment and it gives the owner increased control over the management of their property. Since many lenders offer programs that amortize loans over a 20- to 25-year period, purchasing an office suite or building gives the owner the ability to stabilize occupancy expense by avoiding typical rent escalations found in most commercial leases.
Standard medical office build-out projects are generally more expensive than that for general office space. For this reason, leasing a space that is already built out for medical use, or leasing from a landlord who pays for the build out, will reduce the initial out-of-pocket costs associated with making tenant improvements to a building that is in shell condition. However, under the theory that there is no free lunch, both the physician-owner of a building and the landlord would expect to receive a return on and a return of the capital invested in the tenant improvements. Using the same interest rate, the annual cost to amortize the improvement costs will be less if amortized over the life of a 20-year loan rather than over a 10-year lease.
So, how does one analyze the lease versus purchase alternative if you have answered the questions above and come to the conclusion that is equally feasible to lease or purchase an office location? One objective analysis is to compare the after-tax present value of the projected cash flows of each transaction. Present value is defined as the current worth of a future stream of cash flows at a specified rate of return, also known as a discount rate. The scenario with the lowest present value identifies the best alternative because it signifies the sum of money, in current dollars, required to meet the future obligations of each transaction.
The following are the assumptions, after tax cash flows and discounted present values of a 10-year analysis of a medical project n Metro Atlanta in which a 3,000-squarefoot office, with standard medical build out, can be leased for $17.50 per square foot or purchased for $216 per square foot. In this analysis, the purchase alternative is better because it requires $88,841 less current dollars to satisfy the future obligations of the transaction. It is important to note that the upfront capital requirement is $75,000 in the purchase scenario and $0 in the lease scenario. However, there is a significant residual value of $325,746 in the purchase transaction assuming the office is sold for $832,000 at the end of year 10 using an annual appreciation rate of 2.5%.
Larry E. Willey, CCIM, is a principal with Weston Realty Services, LLC, an investment and development firm focused on health care real estate. Contact him at (404) 915-1722 or firstname.lastname@example.org.