In markets of old, selling or purchasing a veterinary practice was formulaic. It was customary for a practice owner to sell the practice and the real estate (or, occasionally, lease the real estate) to a buyer in the same transaction. However, it has become a bit more interesting in today’s market.
In addition to the doctor-to-doctor transaction, corporate practice consolidators have dovetailed with real estate investment trusts (REITs) and other similar investors that purchase the real estate and lease it to the veterinary practice. (For simplicity, we will refer to all commercial real estate investors as REITs in this article, though there are nuances that differentiate them.) While this may not seem significant on the surface, it does toss a new twist into the transaction.
This article will address common questions to help you better understand the nuances of real estate ownership and its potential impact on the practice sale transaction.
Should I purchase the real estate with the veterinary practice?
Although it is not essential to own the real estate in tandem with the practice, given the choice, ownership is advisable for several reasons. Assuming the rent is on a fair market basis, with today’s interest and loan terms, the mortgage payment on the real estate is about the same (or less) than a rent payment would be.
Also, typically, no additional down payment is required from the buyer. The commercial lender will often lend 100% of the price, or slightly less (80% or so) and the practice owner finances the balance. I emphasize here that very few private buyers have significant cash wherewithal. Commercial lenders have long recognized that veterinary creditworthiness is practically second to none (default rate among veterinarians is less than half of 1%) and are eager to lend. Other considerations include:
- Owning the real estate provides the added benefit of building equity and net worth at the outset.
- If you own it, there is no concern with a landlord and no fear of lease renewals, rent increases, etc.
- If the real estate is included, the transaction is more attractive to another buyer at the point of eventual future resale. (The exception would be a new buyer who has plans to relocate the practice.)
However, be mindful that when you own the real estate, it’s another business that has to be compensated. Ideally, the practice should actually pay the real estate business fair market rent. In the case where the practice does not actually pay rent, the appraisal process should include imputing fair market rent, as it is a real practice expense that must be accounted for.
Should I sell the real estate with my practice?
While this may be a matter of discussion with your tax advisor, there are several points to consider. For reasons shown above, offering the real estate for sale makes the deal more attractive to prospective practice buyers. Given two practices with the same features, the more salable is the one offering real estate ownership as well. Possible pitfalls in renting the real estate to your practice buyer include:
- Although remote, there is the possibility of the new owner failing in practice and closing, leaving an empty special use space.
- The new owner may not renew the lease and relocate the practice, again leaving an empty space.
- Rent is taxed at the highest rate as ordinary income. However, if the real estate is sold, most of the proceeds come to the owner as capital gain, which is taxed at a lesser rate.
Further still, the tax on the sale of the real estate can be mitigated by a 1031 exchange, through which you can take the gain proceeds from commercial sale and purchase another “like-kind” commercial rental property locally or in a commercial REIT, which provides comparable rental income and appreciates in value as before. The tax is postponed until you take the gain personally, presumably at a future lower income tax rate.
The object here is to avoid losing your practice sale by not offering the real estate but retaining and enjoying the same income and appreciation advantages. Obviously, there is more to a 1031 exchange, about which your tax and legal advisors can provide details.
In the end, however, some practice owners will find that renting to the buyer is the preferred choice in the transaction. Be mindful that the practice value, financeability and salability are determined by its profitability, which is affected by expenses, including rental. So, the actual negotiated rent charged to the buyer can be more or less, depending upon whether the seller’s goal is to monetize the transaction toward real estate value or practice value. This becomes a tax impact matter, and your tax advisor should be brought into play.
Should I sell my real estate to a REIT and keep the practice?
Different REITs purchase vast amounts of real estate in different markets. In recent years, REITs and other commercial real estate investors have discovered the safety and economic resiliency of the veterinary profession. So, a REIT may approach you to purchase your real estate while you keep the practice.
Let’s say you sell your real estate to a REIT while retaining ownership of your practice. As one of many expenses, the rent you now pay to the REIT becomes a significant factor in the practice value. Ideally, the rent should be less than 5% of revenues, and annual rent escalation should be considered. If rent exceeds 5% of revenue, it can have a negative effect on the practice value. In the future, when it’s time to sell, the rent will have an impact on value, financeability and salability. So, be mindful of what is negotiated in your lease if you sell the real estate prior to the practice.
By the same token, if you have sold the practice and kept the real estate but reduced the rent to maximize the practice value, a prospective REIT buyer will be deterred by the less-than-market-rent and will need to negotiate a commensurate lower price for the real estate. Additionally, if not done carefully, the lease negotiated at the time of practice sale could prevent the sale of the real estate altogether.
Furthermore, if you want to sell the practice to a corporate consolidator and you have already sold the real estate to a REIT, you may have trouble with your preferred practice buyer assuming the lease. Most corporate practice buyers do not buy the real estate but work in tandem with their preferred REIT who purchases the real estate and leases to the corporation. The REIT you sold to previously and the lease terms now play heavily into the practice price negotiations. Moreover it may turn out that the prospective practice buyer will not work with the REIT owner, and you have lost your practice sale to your ideal buyer.
All this is a complicated scenario, the long and short being advice to keep your real estate intact with the practice and sell both at the same time, or keep the real estate and sell the practice. Whether a private or corporate sale, the real estate can usually be sold after the practice, so we advise against selling it before the practice.
Should I lease space for my practice?
Whether you are starting a new practice or are purchasing a practice in leased facility, there are factors to consider that may not be of short-term significance but can have a negative effect on revenue, value, salability and financeability down the road.
- Your purchase or start-up lender will require the lease period to be coterminous with the finance period, typically 10 years. In the event of future sale, your buyer’s lender will require the same coterminous period for the new loan. Accordingly, you should have as many options to renew the lease as possible. Since the options are yours to exercise or not, the more the better for the tenant.
- Just as with all expenses, the amount of your lease payment is critical to your practice value since value is largely based upon some multiple of profit, and profit is determined by expenses. Accordingly, the rent should not exceed 5% of revenues. While this is not achievable at the outset of a start up since revenues are zero, your revenue proforma should anticipate a rent expense no greater than 5% at any given time.
- One of the most damaging effects we see on practice value and salability is the ability to grow. Clientele is there, but the accommodation space is not. Your appointment schedule is full, and you have no room for an additional doctor and staff. So, you are turning away revenues, and growth is stymied. While that may not be a major factor for you at your current financial stage, it will be for your eventual buyer who has many years ahead in their career. If your space is located within a business plaza or shopping center, try to negotiate in your lease the option, preferably first rights, to attain the adjoining space or any other if and when it becomes available. Assuming you are in a productive and growing demographic area, it is best to have too much space at the outset, though keeping the 5% rule in mind for long-term plans.
- Although you may not have control over this, it is wise to try to negotiate some influence over who your neighbor is. While you will know their identities at the outset, neighbors come and go, and you need someone who will attract prospective clients to the neighborhood, such as nice restaurants and other socially oriented businesses with similar demographics as your practice.
Selecting the best approach to real estate when purchasing or selling a veterinary practice can be complex. Learn more during our Hour with the Experts webinar, “Own, Lease, or Sell? Navigating the Ins and Outs of Veterinary Practice Real Estate” on April 22 at 7 p.m. EDT.
