8 Questions to Ask when Purchasing Medical Real Estate

While there are basic value criteria that should be applied to every real estate purchase, there are specific questions that should be asked when purchasing a medical building. I believe that the following list should be part of due diligence when approaching a property with a medical tenant.

1. 1. What is the location and condition of the building?

Physicians tend to stay in one place for a long time, a major advantage of the asset class. However, over decades, properties with long-term tenants can get rather shabby. At the end of the day, medical real estate is still real estate, and you need a fundamentally high-quality building or a price adjustment to account for that. Patients judge their doctors based on the emotional experience of their visit and the physical space and location influence this. As practices follow patients, medical tenants will move if the condition or location of the building is inadequate. Stable cash flow is enhanced by limiting unforeseen expense and the willingness of the tenant to sign a long-term NNN lease, both of which are strongly influenced by the condition of the building.

1. 2. Is the building well suited to housing a medical practice?

If you are purchasing a building with a tenant, talk to the physicians about the building. Does the layout work well for them? Do they have the waiting room space, exam rooms, and nurse’s stations, and workspace flow that they need? There will always be aspects of building tenants wish they could change, so you will need to determine if the tenants are at their wits end with a layout, or if their complaints are benign.

When purchasing a property to build-out for a medical tenant, don’t assume any building will do, as there may be specific plumbing, HVAC, or work-flow issues that impact the cost of the remodel. It would be wise to talk to a prospective tenant or medical-specific architect before committing to its purchase.

1. 3. How strong is the tenant (the physician practice)?

Consider the risks of single or two-person independent practices. Will the business vanish if one individual has an emergency or retires? Is the site attractive to a replacement tenant? Practices affiliated with larger groups or corporations might have stronger backing, but that depends on their long-term plans. In general, it is wise to ask about pending retirements and their plan for ongoing provider replacement. When possible, try to get financials. Look at competition in the area: is there a newer, more visible practice of the same specialty nearby that is a threat?

1. 4. Do the local demographics and demographic trends support the practice?

Understand the business model of your tenant and their demographic needs. A high-end surgery center focusing on expensive, elective procedures will likely be best suited for an affluent area, whereas other specialties can thrive in many neighborhoods. Unlike general practice, an obstetrics or pediatric practice could struggle in an older and aging community. Pairing a strong tenant with the right patients creates successful practices and happy landlords.

1. 5. How robust is the practice to changing insurance reimbursement rates?

It is helpful to understand the business model of a practice in terms of their revenue – that is how well they are paid by medical insurance. Medicare and Medicaid pay much less per procedure than private health insurance plans, and certain practices are unable to survive an unbalanced mix of these or cannot survive any significant shift towards more Medicare/Medicaid insured patients.

1. 6. Are there regulatory barriers to building new medical facilities of the same certification level?

Ambulatory surgery centers have rated operating rooms, with Class A allowing for the least complex procedures and Class C allowing for the most. Higher classifications require higher cost and regulatory burden to certify. Additionally, some states are “Certificate of Need” states, meaning new surgery centers cannot be built without proof they are needed. Other special designations include Rural Care Centers, which allow for higher billing per-patient. These can take months and hundreds of thousands of dollars to certify. It is important to recognize that while regulatory burdens add paperwork and cost, they can increase value by creating barriers to competition.

1. 7. Do the lease structure and price per square foot make sense?

As with any commercial real estate asset, the lease structure is important in medical buildings. I recommend finding a NNN lease or ascertaining with confidence that you can manage the building and budget for operating expenses. Also, it is important to ensure that the value of the lease is commensurate with the price of the building. Paying an above market price for above market lease rate can make sense with the right tenant and lease term. But factoring in the future risk of a tenant change or the decision to sell or refinance the property is always wise. It can be thrilling to make a purchase, but keeping your long-term strategy in mind from the outset - whether it is a change of tenant, the risk that your tenant will find cheaper space elsewhere instead of renewing their lease, or a decision to sell or refinance the building – will help you manage potential risks and avoid headaches.

1. 8. How do the tenants feel about the lease?

Whether your transaction is a sale-leaseback or purchasing a building with an existing lease, it is wise to assess the relationship with the tenant. Are they committed to the space? Do they resent lease terms over which they feel they had little control? While these questions are not unique to medical real estate, I have found it particularly relevant in this space. Physicians don’t often start practices with significant business acumen, and often have considerable debt combined with high income starting their careers. This leads to greater willingness to accept expensive leases in exchange for large initial tenant improvement allowances. Later on, when those physicians realize how much of their income is going towards an above-market lease, resentment might set in. Assessing your tenants’ relationship to a lease on which you are hoping for future renewals is an assessment of the future value of the property.

These are eight of the questions I have found helpful in assessing the value of medical real estate purchases. Hope they are helpful for you in your diligence. Feel free to contact me if you’d like to discuss these further.