Business

Secure your financial future

The lease terms agreed to when you sell a practice but keep the property can make a big difference in the final proceeds.

Secure your financial future
In situations where a practice owner is selling and leasing to an associate, the seller must make sure to receive personal guarantees of the lease payments from all partners of the entity signing the document.

Thirty years ago, nearly all veterinary practitioners owned or wanted to own the real estate where their hospitals were situated. But times are a-changin’. Today, as institutional capital flows into the veterinary industry and clinics continue to be purposely built for specialized care, the decisions that practice owners make related to their real estate are having larger impacts on their overall financial well-being.

Let’s explore the impact of institutional capital on the veterinary real estate space and identify certain business decisions that can hurt or improve a practice owner’s financial health.

An Overview

The veterinary real estate marketplace has shifted substantially over the past decade because of the influx of corporate practice groups. The primary driver for the shift is that most corporate groups do not buy the real estate associated with the practice. This results in a larger percentage of practice sellers holding on to the real estate and signing leases with the new operators.

As multiples on practices climb due to increased competition, sellers often become blinded by the practice valuation and fail to address lease terms in the letter of intent, resulting in far less leverage with the purchaser. This can depress the future value of the real estate since the lease instrument will be a large factor in determining the value of the property when the time comes to sell the real estate asset.

Here’s what should be addressed when negotiating a letter of intent so that the future real estate value is preserved.

Lease Terms

Understand that initial lease term and lease extension options are separate concepts. It cannot be stressed enough that while lease renewal options are nice, the future value of the real estate asset will depend largely on the number of years the tenant has committed to occupying the property.

Too often, for example, veterinary real estate owners report having a 20-year lease with the tenant but then find out after reading the document that they approved an initial five-year term and three five-year extensions at the tenant’s option. While veterinary practices infrequently move locations, banks will underwrite real estate debt based on the initial lease term, so a shorter term will impair a purchaser’s ability to obtain market financing and ultimately might affect the price a purchaser can pay.

Tenants in the current market environment are more willing to sign longer initial lease terms, real estate experts say. These experts recommended that, at a minimum, a 12-year initial term be sought. A term of 15 or 20 years, if agreed to, will result in significantly higher proceeds at the time of sale.

Landlord Responsibilities

Veterinary real estate is a unique asset class and is considered a hybrid of medical, specialty and office real estate. The real estate is almost always occupied solely by the veterinary practice, and as such the lease should most closely resemble what is considered the “market” for a single-tenant, net-leased facility.

One of the most attractive aspects of net-leased real estate is the lack of landlord responsibilities over the term of the lease. Traditionally, net leases make the tenant responsible for insurance, taxes and general upkeep and maintenance. Among the few responsibilities the landlord will sometimes assume is maintenance of the building’s structural components and replacement of the roof. Although buyers might accept these responsibilities, they and their lenders will build replacement reserves into the underwriting and offer a price based on the reduced net operating income.

Because of this, leases that contain landlord responsibilities for the roof and structure are slightly less valuable than those deemed “absolute triple net,” where the landlord has zero responsibilities related to maintenance. Also note that leases that include landlord responsibilities for anything else — parking lot maintenance or heating, ventilation and air conditioning systems, for example — can meaningfully impair the value of the real estate.

Tenant/Guarantor

The lease is a long-term financial agreement that should be approached in the same manner as if someone is lending money. After all, the real estate owner is essentially lending the land and the building to someone for a long period. The potential tenant should be scrutinized in the same manner as a bank would vet a borrower.

One of the more overlooked aspects of the veterinary lease is which entity is on the hook for payments over the course of the agreement. In many instances, landlords know their practice inside and out and are comfortable with the business being able to support the rent. However, the broader net-leased marketplace is not as familiar with the operations of a single practice and instead will analyze the property in a way a bank would a loan.

In the bank analogy, a bigger and stronger borrower will receive better terms and a lower interest rate. The same applies to the net-leased marketplace. A bigger and stronger entity backing future lease payments will result in a lower required return for prospective purchasers, and therefore, they will be willing to pay more for the property and its future lease payments. This is extremely important when negotiating any lease.

In situations where a practice owner is selling and leasing to an associate, the seller must make sure to receive personal guarantees of the lease payments from all partners of the entity signing the document.

In situations where a corporate group is buying the practice and leasing the real estate, the seller must make sure the “tenant” as defined in the lease is the corporate entity that owns all the veterinary operations of the corporate group. If it is not, a guaranty of payment rider should be executed to name the corporate entity as an additional guarantor of the lease payments.

What is important in these situations is that the co-signing entity is not a subsidiary of a corporate group and that the corporate parent is on the hook.

Final Thoughts

Animal medicine has become extremely sophisticated over the last 20 years and has attracted significant investment from the corporate world. As the treatment of animals has become more complex, so too have the tangential aspects of the industry, such as real estate.

Much like it is paramount to adapt a practice’s operations to be at the forefront of animal medicine in order to provide optimal patient care, it is equally important for independent practice owners to secure their financial future by arming themselves with the knowledge necessary to make the right choices about their real estate assets.

Graham Garrison is managing editor of Veterinary Advantage, a Today’s Veterinary Business sister publication.

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