Converting medical office building into small offices

[Bharath Raj]

I own a 5100 sq ft medical office space with no restrictions near the University of Houston. I have inherited a tenant who has 1450 sq ft for the next 5 years. This area is turning and there are new businesses sprouting everywhere. My current competitor is the guy next door with a similar building which is already built out fully (Texas children' outpatient office used to be here for a decade). My building is 1750 sq ft built out, and the remaining 1850 sq ft is shell space. I am not a stickler for putting in another medical office in this building. I wanted to explore the possibility of creating several small office spaces with a common reception area and CAM. In order to run my numbers right, I wanted to ensure that I count everything. Here is my list of costs. Please critique

1) Insurance: I have a insurance policy for the whole building. Do I need any other kinds of insurance?

2) I currently have a common area parking and access arrangement with my neighbor for the parking lot and landscaping that we share. I plan to pass the cost to my tenants, proportionate to the sq ft of their office spaces (variable per tenant) and the common area (fixed amount of area)

3) Electricity

4) Water

5) Internet

6) Receptionist fee

7) Telephone

8) Conference room maintenance: Do I need to set up a projector? What are the elements that go into a decent conference room?

9) Break room maintenance: How do I decide what to stock and how much?

10) Restrooms maintenance & common area cleaning

11) Is there a way to recoup the initial built out costs that I would have to absorb to make this work? 

12) Since this office space would be in the 3rd ward in Houston, I would appreciate any local input also. 

Thank you. 

[Joel Owens]

Is your end goal to sell the property or hold it for 10 or 20 years? If it is too hold for short term then quality of the tenant matters more for resale cap rate even if rental increases are not as large. If it is to hold then maybe a more mom and pop tenant with higher rental increases per year for maximum cash flow. Tenants should absolutely have their own insurance and some landlords add on to their insurance as additional insured. In all your leases generally the tenant should have recourse against the one property and entity set up only instead of you personally. Have in the lease where tenant is required to give updated ongoing business and personal financials.

Is the daycare operator a franchisee of a large chain like the learning center or mom and pop start up?

I like medical tenants better. When economy gets tough people cut back on daycare but medical people need services to live. Make sure if mom and pop tenant that you DO NOT give blocked rent meaning if 3% annual increases it does not happen with a 15% jump every 5 years of a 10 year lease. Instead it goes up every year so if they go out in year 4 of the 10 year lease you have extracted maximum return. Also get a personal guarantee on the lease as well as the corporate. If they have decent net worth and liquidity then if they want to shut down the business early they will be looking at a settlement with you or you could go after their personal assets if they try to liquidate the remote corporate entity. Generally with the settlement to try and break the lease you are trying to get lost rent for the months before re-renting to another tenant, tenant improvement amounts, and leasing commissions expected. This way for the new tenant you are not out a bunch of money.   

No legal advice given.