Four Current Issues in Real Estate Development

When starting an ASC, it's easy to get caught up in the construction side — after all the building structure is the tangible element surgeons, staff and patients will have to live with day in and day out. But the choices your group makes regarding the real estate can have an equally long-lasting impact, both directly and indirectly, on the financials of the ASC business.

"I think too often, people just say, 'I'm going to go ahead and build an ASC, and it's going to cost us a million dollars,'" says Mike Lipomi, MSHA, president of RMC MedStone Capital. "Not nearly enough time is spent in thinking through the real estate component of the equation."
Here is a discussion of four key current issues in real estate development.

1. Choosing a real estate model

When physicians join together to "own an ASC," this language generally refers to the business entity that owns the operations side of the ASC. With regard to the real estate, the physician group then has three options: own the building and land as part of the already-formed entity; own the building and land as part of a separate entity that may or may not include all the physicians who are owners in the operations entity; or lease space in an existing building from a landlord. Making this decision is the top issue.

• Own or lease. Here, there are pros and cons to both models and, when you look at the overall financials, the decision may simply come down to your group's risk tolerance.

"In renting, you have to be careful to include all the costs so you're comparing apples to apples," says Jeff Eckert, senior principal with Kalamazoo, Mich.-based Eckert Wordell. "One of advantages in renting over owning is that not having to invest capital in real estate. We have found over the last three to five years that although real estate investments perform very well, they don't have the same return on investment as the business sides of strong surgery centers. If you have to choose between the two, based on ROI, you're better off choosing the operations over the real estate."

Further, it's not an annual return (or quarterly or monthly distributions, as you may experience with the operations side once its running full-force); it's 10 to 15 years down the road.

"It's kind of a forced savings plan," says Jerry VanderVeen, president of MW Vanderveen in Kalamazoo, Mich. "Years later, when you look at what you owe and what the building's worth, there's some equity there that you can hopefully turn into cash. You can sell part or all of that interest to an outside investor and become a paid tenant at that point."

Mr. Eckert and Mr. VanderVeen stress that they're not negative on owning; in fact, they're "quite bullish on it. But we want to paint the right perspective," says Mr. Eckert. "Owning also has some tax advantages that renting doesn't present to the physicians. The important thing is to look at the full picture, not just the bottom line, with a 'quick, what's my return?' attitude."

For a sample pro forma comparing ownership and leasing, see "Lease Vs. Own: Cost Estimate Sample for 2-Surgery-Suite ASC Development" on p. 51.

• Own separately or as one entity. If you decide ownership is best for your group, there is a further choice that needs to be made.

"You actually don't have to separate the real estate and the operations ownership," says Mr. Lipomi. "You probably should have two separate, entities and the reason is the tax treatment on operations is different than the tax treatment on real estate. Whichever way physicians decide, they should make sure they have proper tax counsel on that issue."Further, if you do it as one, "you eliminate all the potential conflicts of interest and animosity of some of the physicians being the landlords for some of the others," he says. If you have a subset that owns the real estate, there will always be a conflict of interest: If you have higher rent, there's a higher cap rate, and the real estate is worth more — but the operations make less; alternately, with a lower rent, the real estate is worth less, but the operations will make more. Signing a long-term lease up front that everyone can live with is usually the solution."

The primary reason you would want to separate the business and real estate entities is financial, and lenders are more amenable to single-asset entities, says Mr. VanderVeen.

"You're starting an ASC that has capital needs," says Mr. Lipomi. "You're going to want to have some younger surgeons, but they are maybe still paying student loans and can't invest in both. The older, wealthier surgeons can own the real estate and a piece of the operations. Keep in mind that this will create inherent conflict of interest issues; a wellworded agreement from a lawyer is necessary to keep all the issues in check."

2. Deciding on a building type

The key question here is whether to build new or take up occupancy in existing space.

• Existing space. Your physician group may have found space in an existing office building that is ideally located for both surgeon and patient convenience. While location is important, existing space poses a whole cadre of potential challenges.

"Quite frequently, the office building won't meet code and therefore necessitates significant upgrades in order to become ASC space," says Mr. Lipomi. "One big concern is something that recently happened to one of our facilities, which leased space on the bottom floor of an existing multi-floor building. The tenant on the floor above had a water leak over holiday weekend, and the ASC suffered over $50,000 in damages. And it's not just the damages, it's the challenge of running your business when you've got water, mold and other issues to deal with as a result.

"There are also lease-term issues with existing space: If you do have a lease, you had better be sure, because you've just limited yourself for 10 or 15 years. If you didn't plan properly and need to expand at some point, you're in rented space. There's no place to grow. You need to carefully consider your needs and the possibilities for growth and expansion."
• New construction. While this gives you more control over the process and the future of your business, you need to step up your due diligence and be more involved in planning efforts to ensure success.

"When building a new ASC, it's easy to overlook the real estate issues that should be involved in the decision, such as zoning regulations, CON requirements, easements and the entitlement process," says Matt Kleymeyer an associate in the healthcare development department at Lauth Property Group in Indianapolis. "It takes all those factors to get the building approved, and it's going to add a considerable amount of time and money if the physician group misjudges," either with regard to the lead time on these processes or, worse, with regard to the purchase of the building site itself.

"In a situation I recently saw, a group of docs bought a site for an ASC, and didn't do their due diligence on the land," recounts Mr. Lipomi.

"They found out after purchase that there is a six-foot easement along the front of the property, meaning they could only have and build access to the property from a side road. In this case the realtor should have informed the physicians and the easement should have been on the title policy — now they are delayed for months in court trying to get a settlement."
He recommends working with a real estate agent who has healthcare clinical real estate experience.

"Seeking professional guidance with a reputable firm is key," says Mr. Lipomi. "If you haven't been through this before, there will be a lot of questions you might not think to ask, and a quality Realtor can be of tremendous assistance."

Further, says Mr. Lipomi, when choosing a site and entering into new construction, you need to take expansion into account — do you buy a bigger piece of land than you need at present to accommodate that potential? Generally speaking, the answer is yes.

"What I usually recommend should be done is to buy the land in order to build the ASC according to the requirements you think you're going to need later," says Mr. Lipomi. "If you think you're only going to need two or three ORs now, but will need four or five later, don't landlock yourself or build the ASC and shell it out for expansion. If you're landlocked, you're stuck. If you shell the ASC, when you do undergo the expansion, you need to retrofit the entire facility to bring it up to all the new code requirements that have been enacted since the initial construction.

"My advice is, if you think you're going to want to expand, buy accordingly, build it and license it — just don't equip it."

3. Obtaining financing

The biggest issue in real estate development — and one of the biggest industrywide (not to mention outside healthcare) — is obtaining financing to purchase the real estate.

"Financing is major challenge that many physician groups are dealing with today," says Mr. Kleymeyer. "As the capital markets continue to really tighten, lenders are more concerned with financing capacity, secondary use — who's going to occupy that facility if the ASC fails — and what supports you have in place in the business plan. Oftentimes, an ASC is a unique, single-use type of asset, so if the ASC fails, it's going to be hard to convert that center to opportune use.

"If you build the ASC to be the anchor tenant within a medical office building, that can strengthen your case with the lenders. As a result, there is a greater, more optimal mix of tenants with physician offices occupying much of the building; there's greater potential for referral sources than just among the physicians who own the standalone ASC; and because you can open up building ownership to others, you don't have to put up as much out of pocket. Lenders like to see that kind of distribution and minimization of the risk."

The terms of financing are also changing, notes Mr. Lipomi.

"You really have to work with your lenders and know where you're at," he says. "It's important that you get a real understanding of lending requirements for each potential source. Things have changed: You may end up having to give personal guarantees, whereas in the past this wasn't the case. If you have a good project, and you're smart, I think this is a good time to be buying and taking advantage of the opportunities presented by the commercial real estate market."
Finally, the experts advises, have a thorough understanding of the costs and process, or you may end up needing even more money — which the lender might not be willing to give you.

"If you are looking at a standalone ASC, work with a real estate lawyer to help with zoning and regulations, as well as with a consultant, accountant or even an attorney to guide you with respect to all the financials," says Mr. Kleymeyer.

Mr. Lipomi agrees.

"People think it's the same as buying a piece of land to put a house on, but when you take into account the cost plus the intricacy of the regulations, it's far more complex than that," he says. "This is a high-margin industry; if you make a mistake and the project is delayed, you don't just have to pay to fix the mistake, but you lose on revenues projected by the business plan. A three-month delay can cost you $600,000 of EBITDA — don't let that happen because you didn't want to spend a couple hundred on expertise."

4. Determining an exit strategy.

"Warren Buffet once said, 'The most critical question I need answered before I make an investment is how I get out,'" says Mr. Lipomi. "That's a critical question physicians need to ask on real estate development side — what is the exit strategy? Things will happen in the group as time goes on, and you need to know how you and others can get out, so you don't end up with a non-functional investment."

A good operating agreement for the real estate entity will cover various exit strategies, says Mr. Lipomi. Here are some of the options:

• The partners will buy out the physician who is moving/retiring/cashing out. This means you will have to be prepared to invest more if and when this happens.

• A new physician partner (or partners) will be found to buy out the physician who is moving/retiring/cashing out. "Ultimately, having physician partners on the real estate is generally a good thing, because then you essentially control your own environment," says Mr. Lipomi. "Just imagine a big player's coming in, he doesn't want to pay rent to the group, and three of the owners are retired and moved out of town. This guy could bring you $1 million in operations revenue, but they don't want to lower the rent. It's a big deal — you need to have a way to bring him in."

• Sell to a real estate investment trust or other real estate investor. "That's an excellent exit strategy, to develop then sell to an REIT; it makes the asset liquid," says Mr. Lipomi. "But when you're no longer the landlords, you might not have the flexibility to control the property the way you want to. What happens if you need to expand to keep up with the competition? Or a doctor with a great reputation comes along, and adding services would necessitate expansion? If you're not the owner, you're ultimately subject to whatever they want to do with the building."

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