Special Report: Physician Investment Webinar (January 2007)

Physicians want a piece of office pie


By Jessica Griffith


As insurance and Medicare reimbursements fall and expenses rise, physicians are considering the investment potential of the buildings in which they lease space.

On the real estate side, many owners and developers are willing to sell equity in their medical office buildings (MOBs) but the details of these deals can prove confusing to both parties.

“There are as many structures as there are flavors of jellybeans,” says Peter Kloepfer, senior managing director of Denver-based NexCore Group LP.

Healthcare Real Estate Insights recently hosted its fourth Web-based seminar titled, “Physician Investment in Medical Real Estate: What Hospital and Health Systems Need to Know.” In addition to Mr. Kloepfer, participants included: Donald R. Dunbar, executive vice president and chief operating officer of Indianapolis-based Bremner Healthcare Real Estate; and Henry A. Trost, project administrator of Franklin, Tenn-based First Colony Healthcare LLC.

The presenters outlined the physician investment trend and offered their perspectives on the various financial structures.

Doctors take notice

Prior to 1986, many physicians owned real estate, but President Reagan’s Tax Reform Act eliminated tax shelters that made such ownership worthwhile, Mr. Dunbar said.

Physician investment in real estate remained unpopular through the mid- to late-1990s, when investors preferred stocks to buildings. As the century turned and the stock market declined, doctors reconsidered real estate. The steady decrease in their take-home pay due to reduced reimbursements and high malpractice insurance rates prompted additional interest.

Income for all doctors declined by 7.1 percent from 1995 to 2003, adjusted for inflation. For primary care physicians, that figure is 10.2 percent, according to the Center for Studying Health System Change. Meanwhile, professional and technical workers received average salary increases of 6.9 percent during the same time period.

“Physicians believe, and they are right, that real estate can help offset some of their overhead expenses,” Mr. Dunbar noted.

Physician investment is the status quo, Mr. Kloepfer adds. NexCore has offered equity to physicians since 1988, but he says more doctors ask for a stake now than they did in the past.

“It is rare for us to build a new building without physician ownership,” he says.

The level of participation varies but generally is less than 50 percent. At First Colony Healthcare, physicians’ share of the equity typically is between 20 percent and 40 percent, excluding deals with free equity. NexCore agreements usually have a 49 percent cap and the average is 20 percent to 25 percent, although Mr. Kloepfer says the company has closed deals with up to 70 percent physician investment.

The standard model at Bremner Healthcare Real Estate calls for up to 40 percent as a pro rata share of building occupancy. If the physicians occupy 10 percent of the building, for example, they receive 4 percent of profits from cash flow, refinancing or a sale.

Property types

Doctors are investing not only in traditional MOBs, but also in ambulatory surgery centers, specialty hospitals, imaging centers and other specialized clinics, Mr. Trost said.

As with any real estate investment, the key is not so much the type of building as the location, he added. Doctors require a convenient and visible site with plenty of parking and amenities, such as a canopied drop-off area and security.

A large project can be a better investment for physicians than a small building designed for a single practice, Mr. Dunbar said. A single-tenant building might seem like a safe investment, but neighborhoods change and practices grow or shrink, and that perfect location or building could potentially turn into a burden, he added.

“Physicians will make more money in their practices than they will in real estate and we hate to see physicians stuck in a building and have the tail wagging the dog,” Mr. Dunbar said.

A large MOB on a hospital campus brings physicians close to patients. In addition, the multi-tenant lease structure creates more value than a single-tenant building, he added.

Another benefit to a large project is the ability to hire a third party to handle property management, leaving the doctors to care for patients instead of fixing toilets or hiring landscapers.

Medical condominiums are popular in some regions, Mr. Dunbar said, but he is not a fan of the property type because the exit strategy is not as flexible as it might appear to be.

“The resale market is limited to someone who needs that exact space in that exact location,” he said.

Let’s make a deal

A developer’s role is to serve as a buffer between a hospital and the physicians, and to help those parties align their interests with each other and with any institutional investors, Mr. Kloepfer said.

In return, hospitals benefit from joint ventures with physicians because doctors are encouraged to stay on campus and are discouraged from competing with the hospital. As a result, physicians gain economic benefits, some control over their surroundings and pride of ownership in their facilities.

An MOB developer needs to understand the nuances of both real estate and healthcare, Mr. Trost said. In addition to doing traditional due diligence when looking for a development firm, a physician group should look for a company with a track record in healthcare, he said, adding that healthcare real estate is quite different than traditional office real estate.

Doctors typically lease smaller spaces but have higher costs for buildout and maintenance, according to Mr. Trost. They might not have experience in negotiating real estate deals.

“It can be hard to find the decision-maker,” Mr. Trost noted.

Add to that the complexity of organizing the deal. Physician investment can take a variety of forms, depending on several factors, Mr. Kloepfer said. Players need to consider whether the project is an existing or new building, what type of risk the physicians are willing to take and at what stage the physicians will invest.

Which structure is best?

The so-called pari passu structure is the preferred way to organize a physician investment deal, he said.  The term means that each player has an equal right to investment returns.

Typically, the hospital invests with the developer and then the doctors invest once the majority of the risk is removed. The primary risk period takes place after the groundbreaking, meaning that most physicians prefer to invest closer to the completion date.

Mr. Kloepfer said his second-favorite structure is preferred return, meaning the physicians get a better deal than other owners.

“That makes for a little more of a sexy sell,” he said. Like the pari passu structure, preferred return requires physicians to pay a market rent. However, they also get a higher percentage of the investment returns. To recoup losses, developers can cap the amount the physicians would receive if the building is sold.

Less attractive in Mr. Kloepfer’s eyes are free or partial-free equity deals, in which doctors are offered a stake in the building with little or no investment up front.

“You start to create a misalignment,” he said. “Any time you have a situation where physicians get something for nothing and that gets monetized through the sale of the building, you drive behavior toward a decision to want to monetize.”

He adds that these types of deals often result in above-market rents.

The topic of free equity inspired some debate among the presenters during the Webinar.

“The reason we promote free equity is because in a lot of the transactions, the physicians cannot pony up the equity,” Mr. Dunbar said.

Mr. Trost added that doctors are not willing to pay above-market rents, even if they receive a stake in the building.

“Our structure does not drive higher rent; it is based on market rent and shared equity,” Mr. Trost noted. “Our returns are ongoing; it is not a back-end pop. Everybody is going to make money on the cash flow and everybody is going to make money on the sale. That is not a misalignment.”

Rate of return

Investment returns vary widely across the markets, but a typical pari-passu deal for a stable building can deliver returns of 11 percent to 15 percent on leverage of 65 percent to 75 percent, Mr. Kloepfer said.

“Is it better than the stock market? Yes. Is it a good thing to do? Yes. Are [doctors] going to get rich from investing in real estate? Probably not,” he added.

NexCore has worked with 500 physician partners over the years and all 500 have made money, he said. But Mr. Kloepfer does not want to overstate the “sex appeal” of physician investment or underestimate the value of real estate expertise in these deals.

“I really feel compelled to point out that the money they’ve made does not compare to how much money they’ve made when we’ve been able to improving efficiency by, say, 10 percent, by designing a more effective layout of their suites,” he said. “Let’s not forget that while physicians want to be more involved in the business side of healthcare, they are primarily involved in the medical business, not the real estate business.”

The Webinar on physician investment was the last of four online seminars presented by HREIand HREI Executive Briefing in late 2006. Other topics were third-party development of medical real estate, the monetization of MOBs, and a look at the California healthcare real estate market.

A full 90-minute recording of each Webinar, complete with all presentations and supporting materials, is available on CD-ROM. For more details, please visit www.hreinsights.com. q

Jessica Griffith is a business writer specializing in commercial real estate.

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