Prices are high, interest rates are low and doctors are doubling up in rentals. In a hectic medical real estate market, the right approach can still work out in the end.

We're happy with the price," says John Steinmann, DO, an orthopedic surgeon with Arrowhead Orthopaedics in San Bernardino County, discussing the 5,000 square foot medical condo in Riverside that the group bought recently. "Even though the market is most likely going to continue to go down, we feel like we got a price that is six months ahead of its time."

After about a decade working in a rented medical office in Riverside, the ten practitioners at Arrowhead felt it was time to settle in permanently once their lease was up. So, in a common transaction, the group bought a medical condo on Parkview Hospital's campus to rent to itself through a separate limited liability corporation. "The major criteria for this new location were proximity to referring physicians, proximity to the hospital and proximity to imaging services--and ownership," says Dr. Steinmann, a member of the San Bernardino County Medical Society.

This isn't the group's first brush with owning commercial real estate, however. Many years ago, Arrowhead bought land in Redlands where they built a 50,000 square foot facility. The group's practice in Redlands occupies about 60 percent of the building; they rent the rest of the space out through another LLC. "We've taken the opportunity in our Redlands office to bring in-house all ancillary services that are necessary for our patients, and that's what ground-up construction or owning your own office space can allow," says Dr. Steinmann. "We have constructed space for imaging--for MRIs and CAT scans--for physical therapy, for dedicated hand therapy, for a surgery center, as well as for our office. So, for almost all items, this facility now offers a one-stop location."

That drive for ownership gives Arrowhead advantages in cost control, patient throughput and eventual equity. And they should know--they also rent office space in San Bernardino and Banning. "I think the biggest thing for all of us is the ability to control our immediate destiny, and one of the biggest things with owning is that most of the time, at least when you build a structure like we did--from the ground up--we can design it in a way that fits our practice lifestyle the most," says James Matiko, MD, another Arrowhead orthopedic surgeon and SBCMS member.

With declining reimbursement and an uncertain commercial real estate loan market, that kind of freedom might be harder for physicians to attain nowadays. Rents continue to be high, but so do medical real estate values. The Federal Reserve has lately cut interest rates, but low-rate mortgages are harder to get, and may drift even further out of reach for some doctors. Still, there are a few things physicians can do to weather tough times, borrow intelligently and run property more efficiently.

Renting Versus Owning
Ownership certainly has its attractions--and few pitfalls. "We don't have to worry about what we're going to do in three years when our lease runs out and somebody wants to extort higher lease payments out of us," says James Matiko, MD, another Arrowhead orthopedic surgeon and SBCMS member. Also, "you're paying your monthly fees to your own group, and hopefully many years from now you'll have some nest egg," he continues.

But becoming a landlord won't automatically win you a place among the idle rich. "I think the perception by some in the community is that we've got this huge money-making and generating machine, and we all must be multi-millionaires who are just raking it in hand over fist," says Dr. Matiko. "We don't make any money off our building right now. It's a long-term investment," he says. "We're still deeply in debt from this place and will be for several years."

In addition to typical landlord concerns, such as water and power rates, the group is feeling the same pinch as physicians across the state. "None of us came into this saying, 'I'm making a great salary, so how can I squeeze more out of everybody?'" says Dr. Matiko. Instead, much of the group's interest in real estate came from a need to control costs. He says the group thought: "'What are we going to do? Our employees want more money, the cost of doing business is escalating, but nobody wants to pay us more.'"

For some people, however, renting may make more sense. With a recent start in medicine and a smidgen of bad luck, buying "is not financially feasible right now," says Adrienne Lara, MD, an obstetrician-gynecologist in Oxnard and a Ventura County Medical Association member. "I would love it to be, because I've been offered a place down the street at The Palms [medical plaza], and you're seeing a lot of doctors who are doing this building-buying together, and I just think it's wonderful."

But there are upsides to renting, Dr. Lara says. "I have everything included--all my utilities, water, gas, electricity, and the maintenance of the building," she says. "I pay one lump sum for everything. For doctors that's wonderful; you just pay it all and there it is. The downfall is that same dependency."

Dr. Matiko points out that it's probably not a good idea for a smaller group of physicians to jump into real estate when few of them plan to commit for the long term. Another factor is corporate stability. "If there are six or seven of you [in a group] and things aren't looking good and you're going to split up, that could be a big problem," says Ronny Ghazal, MD, an SBCMS member who also practices orthopedic surgery with Arrowhead. "You're not easily able to maneuver anymore when you own the real estate ... other than that I can't imagine why you would not want to do this," he says.

The Cost of Doing Business
"The rents for medical office [space] in Southern California have been trending upward in the last four or five years, but more recently it's become more acute," says Chris Lewis, senior vice president at Wells Fargo Permanent Debt Finance. As property values increase, landlords are taking the opportunity to raise their rents. And, to be fair, building maintenance costs continue to rise--especially as those buildings age. "Also, I think there are more doctors out there," adds Lewis, "and that's creating supply issues."
Richard Held, president of Held Properties, a medical property owner and manager, agrees. "Rents are still going up; the vacancy rate is still too low," he says. "In all my buildings right now, I have no vacancies and a waiting list," he continues. That's a bad situation for both tenants and landlords, since it makes it difficult for a landlord to allow a trusted practice to expand.
Rents on Held's properties in the Los Angeles-metro area, such as 100 UCLA Medical Plaza, vary by geography, building age and surrounding market. "We're north of $4 [per square foot per month] on one building and at about $4 on another," he says.

Rents will continue at a high rate until the cost of construction drops and more new medical offices are created. "They will start slowing down a little bit, but my crystal ball only goes out six months, and not for the next six months," says Held. "With the cost of building materials escalating over the past years at a double-digit rate, rents have to go up a little bit more before it's feasible for medical buildings," he says.

But at the same time, medical real estate prices are creating barriers to doctors who would like to own their own spaces. In Southern California, medical office capitalization rates--the ratio between an asset's cash flow and its original price--have fallen abruptly from the range of about 8 percent in 2000 to about 5 percent today, he says. With low interest rates, "the financing market, up until recently, has been incredibly aggressive, which has basically caused prices to go up significantly," he adds.

"That lease-versus-buy analysis is a great question right now, because lease rates are up on the medical campuses ... and interest rates are down and [U.S. Small Business Administration loans] or owner-user financing is at historic lows for doctors," says Jeff Albee, vice president at commercial real estate advising firm Sperry Van Ness in Irvine. "The banks are really aggressively pursuing the medical community for financing for owner-user purchases, so right now is actually a good time for them to look at buying."

Asked what doctors should look for, Lewis points out that they "need a long-term financing source that's able to finance not only the building, but also the value of a lot of the improvements, because you have more sinks, more electrical, more cabinetry." Where a law firm can have a $40 tenant improvement allowance per square foot, medical buildings can need improvement allowances as high as $150 per square foot, he says.

But borrowing for commercial real estate is getting tougher in some quarters. "The [commercial mortgage-backed securities] market is in a self-induced coma," Lewis says. "I don't know when it's coming out--people say the second half of 2008, people say it's not going to be until 2009, but it's unresponsive. It's going to survive, but we're not sure when it's going to reappear," he says. "You're going to see an effect over the next year of doctors saying the financing is just not there, and if it is there, it's very conservative."

In commercial-backed mortgage securities, financing is now 50 percent to 60 percent, compared to the 70 percent to 80 percent financing of recent years, estimates Lewis. "Even though the interest rates are going down, the indexes, the spreads are dramatically increasing, the amortization periods are shorter, the underwriting is more conservative," he says. What that comes down to is that doctors will have to supply a larger down payment, as a proportion of a building's price, he adds.

Although banks may be pursuing doctors to finance user-owner purchases, it's a good idea to take a look at overall banking trends.

In a January survey of senior loan officers' views on bank lending practices, the Federal Reserve Board found that about 80 percent of domestic banks and about 55 percent of foreign banks had tightened lending standards on commercial real estate loans since October. At press time, the January report was the most recent available.

During 2007, the Fed survey reveals that about 55 percent of domestic banks and 45 percent of foreign banks reported higher debt service coverage ratios and lower loan-to-value ratios on commercial real estate loans. About 40 percent of domestic banks and half of foreign banks reduced the maximum loan sizes that they were willing to grant by the end of the year, and about 45 percent of domestic banks and 75 percent of foreign banks reported raising loan rate spreads over their cost of funds, meaning that they have tightened their lending standards for commercial loans.

Despite the gloomy credit news, there can still be a silver lining. "I think that the slowdown in the residential market has caused the owners of the current [Riverside] property to consider what the future had in store for them, and it didn't seem favorable to wait it out," says Arrowhead's Dr. Steinmann. "So, they were willing to make very significant concessions in price for us, which made the deal worthwhile," he says.

"Right now we're getting back to a more-normal market," says Tom McBride, a senior investment advisor and Albee's colleague at Sperry Van Ness. "People are actually buying and selling for real, valid reasons and you're seeing less of these inflated values and frenzied buying," he says.

Controlling Costs
Doctors have been adapting to the high cost of office space partly by pitching in together. "They're sharing space or sharing reception areas and that's been a big trend; they're consolidating their practices," says Lewis. "There was even some sub-leasing of additional space, extra space or intermittently used space."

"I'm actually renting for a large sum of money," says Dr. Lara, the Oxnard Ob-Gyn, discussing the recent departure--on good terms--of her medical office roommate. "I'm looking for a roommate right now. I have a great place next to St. John's [Regional Medical Center]--it's the doctors' pavilion adjacent."

Another way to control costs is to manage property properly. Historically, groups of doctors form legal entities to buy property, but that model has big drawbacks in the current real estate climate, Lewis says. In a typical group of physician real estate investors, "the ten people generally can't come to a unified opinion, and if they come to an answer, it takes too much time," he says. With extremely expensive medical tenant improvement costs of roughly $80 to $100 per square foot, "I've seen a lot of doctor-owned properties that have suffered because there's a time-lag in the decision process--you can't purchase effectively and efficiently and it ends up that your costs are out of control," he adds. "You really need a professional manager consultant who adds value, [one who] knows the most efficient way to run the business."

But some groups find a way to make it work. "I think that's one of the things that's made our practice unique," says Arrowhead's Dr. Matiko about their approach to real estate endeavors. "Surgeons," he says, "tend to be fairly driven and fairly motivated guys--and somewhat opinionated--so you need to have collegiality. It would've been very difficult to engage in a project of this magnitude if people weren't cooperating."

Another cost-controlling recommendation that Wells Fargo's Lewis makes to doctor-owners is to hire a financial consultant with a law background. "Not a loan broker or a mortgage broker, because they'll tell you everything you want to hear and when the fee is paid they're gone," Lewis says. The right expert can do a better job than most physicians when it comes to replacing business partners, transfers of partnership interests, estate or tax planning, and loan prepayment penalties, he says. "There are some revisions to the prepayment method that makes it cheaper for borrowers to prepay with, say, government obligations, versus treasury securities," he adds. "Treasury securities add a higher price than other government obligations--that's a big issue that can save a lot of money."

Also, an external financial expert helps when it comes to impound accounts, such as rollover tenant improvement impound, where a lender takes a certain amount of money every month. "You have to know someone who can negotiate with the lender so it's not in perpetuity," says Lewis. "But more importantly, the method of getting your impounds back from a lender can be very complicated, because they want paper documentation, they want cancelled checks they want lien releases," he continues. "All those procedures need to be followed to a 'T' in order to get money back. Obviously if you're a doctor group you don't have time for that."

Location, Location, Location
If professional managers or investors can run larger properties more efficiently while improvement costs are high and credit tightens, then medical condominiums might be in ascendance. "Doctors obviously want to own their own building, but medical condos [in Southern California] are selling for $450 to $500 per square foot," Lewis says. "So if you have a 10,000 square foot floor [of a building] ... that's $4.5 million," he says. "That's pricey, but it's not as pricey as buying the entire building for $10 million and having to lease out the other space. [Condo ownership] is a trend that is picking up."

Medical property owner and manager Held is not a fan of condominium ownership. "A lot of doctors are thinking that owning condominiums might be a great idea, but I think that's one of the most foolish things they can do," Held says. If you want to expand or contract your space, there is no flexibility, he explains. "You have to either buy out the guy next door, which is probably too much space for you, or try to sell yours at a fire-sale discount, so that you can get moving," he adds. "The way a doctor should invest is in a limited liability partnership so that the doctor can get all the advantages of ownership with advantages of flexibility, and having a professional manager take care of everything for you."

Because the market is affecting other commercial real estate adversely, such as retail buildings, the medical community can take advantage. "A lot of the time, they will go [off-campus] to retail buildings," says Albee, noting that he feels that technology, such as the availability of electronic medical records that are easy to transfer quickly, is driving a trend toward off-campus sites.

When you're in the market for real estate, he strongly recommends working with a mortgage broker that specializes in medical building sales and leasing.
When considering whether to buy or not, Albee says a great deal depends on geography. "If you found a building for sale around Tarzana Hospital right now-today-buy it," says Albee. "But the same couldn't be said next to West Hills--it really depends on where you are," he says "For everything that's closer in to the density of the center, like West Los Angeles and the [San Fernando] Valley, it's still a good time to buy the right property, but as you get out to the secondary or tertiary markets, it's maybe a good time to wait--it probably has a little softness to go."
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SIDEBAR: The Rise of Ambulatory Surgery Centers
While reimbursement rates continue to shrink, doctors have been increasingly interested in owning or working at Ambulatory Surgery Centers, which have taken over many of the functions once relegated to hospital outpatient departments.

Between 2000 and 2006, the number of Medicare-certified ASCs in the United States increased about 55 percent, from 3,028 to 4,707, according to Healthcare Spending and the Medicare Program, a data book produced in June 2007 by MedPac, a Congressional advisory agency on Medicare issues. Medicare payments to these overwhelmingly for-profit, urban-based centers increased over that six-year period from $1.4 billion to $2.9 billion.

Bruce Wallace, CEO of Congero Development, which develops and runs ASCs, is bullish about medical real estate. "It's a great time to be a surgeon, it's a great time to be doing medical development, because of the fact, if you look out there, all we hear about in these debates is healthcare," he says.

For doctors wanting a stake in an ASC, ownership run the gamut, depending on the size of a group and its involvement in running the center, Wallace says. These include: "mom-and-pop shops" featuring a small procedure room attached to a physician's office; small ASCs with two to four operating rooms run by a physician group; generally larger ASCs run by a professional manager, who might handle several buildings; ASCs in which the manager, such as Cogent, owns a stake of less than 51 percent; corporate-owned centers, in which the manager owns an ASC outright and physicians are syndicated into an operating company; and joint-ventures with hospitals, where the hospital tends to own a majority.

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