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The economic implications of developing your medical office Part 2
In the previous article on the economic implications of developing your medical office, we focused only on the project costs that constitute a typical development project. The total project cost is substantially more than the cost of the construction of your building; however, it is this total project cost on which you must focus. You will spend the dollars, so to manage them, you need to budget them.
It is important to point out that there are non-development costs associated with your project not included in the total project cost. These include costs such as furniture and fixtures for your new building, as well as new medical equipment. These are handled separately from your development budget and included under other budget categories.
Once you have completed your total project cost assessment, you need to develop the remainder of your economic pro forma. This article will touch on two aspects of that pro forma: project financing and annual costs. Again, we will refer back to our hypothetical 1 ft² medical office building.
Project financing
The total project cost of our theoretical medical building is $298. If you plan to spend that much, you have to have resources to acquire that amount of money. The majority of the money will come from your mortgage loan, and the bank will have a number of ways to compute how much money they will lend you. Typically, there are three analyses that may be performed:
- Percentage of total project cost – This is common in residential loans. The bank requires 20% down and loans you the other 80%. This is done with some medical office buildings. For the analysis in this article, it is assumed that the bank will lend you 80% of your total project cost.
- Bank appraisal – The bank may do its own appraisal and, based on that appraisal, loan you a certain percentage of their imputed value. This may reflect market value but oftentimes includes older building values that can drag the appraisal down and lower your loan proceeds.
- Market rents – The bank may look at competitive market rents, capitalize those rents and develop a value that reflects the amount of money they are willing to lend. Because this often includes older medical space at lower rents, this may yield fewer loan dollars than you would get with the percentage of total project cost approach.
Regardless of the approach, the difference between your total project costs and the mortgage loan you negotiate will be your equity contribution. The chart below illustrates this:
| Long-term loan | Loan/NRSF = $238.40 | $238.40 |
|---|---|---|
| Subordinated/leased land | $0.00 | |
| Owner equity | Land equity | $30.00 |
| Cash equity | $29.60 | |
| Total project finance | $298.00 |
In this case you will have to contribute an additional $59.60 of equity to have sufficient project financing to meet your total project cost. Since you spent $30 to acquire your land, the other $29.60 will be a cash infusion from you. However, the question then often arises: From where does this cash come? It can come from cash you have in the bank, investments you liquidate or borrow against, or from a secondary loan. Regardless, it represents an obligation you will assume outside of your mortgage loan. Sometimes banks will loan 100% of the total project cost, but we do not recommend that doctors rely on this as they create their project pro forma.
There is another item in the above chart that bears discussion: subordinated/leased land. In the chart, the cost is shown as $0. Most doctors won’t consider a subordinated land lease, even though it can be a powerful financing tool. The downside of a subordinated land lease is that you lease the land from someone (usually on a 65-year or 99-year lease) and build the building on that land. At the end of the lease, the land and the building on it reverts to the original owner. So, you lose the building; however, by that time you should have reaped all of the ownership benefits of owning a building. And who wants to own a 99-year-old medical building?
The advantage of a subordinated land lease is that you get the value of the land (in this case $30) to be counted as part of your equity contribution. So, you would only have to come up with the additional $29.60 cash in this case, not $59.60. Then, as part of your annual operating expense, you would pay rent on that land. This is an option and should not be ignored.
Annual costs
This is where you determine your annual rent. For our theoretical building, the annual costs are shown below. Please note that the costs shown are for the first year only; they will be adjusted annually.
| Year | 2012 |
|---|---|
| Debt service | $18.88 |
| Land rent | $0.00 |
| Equity return | $0.00 |
| Operating expense | $9.00 |
| Total annual cost | $27.88 |
In this case the debt service is figured on the mortgage loan of $238.40, based on a loan of 5% over 20 years. Because in our example the land was not subordinated and leased, there is no land rent. Equity return is also shown as $0.00; however, this is discretionary. You are contributing a lot of capital to the project and have a right to a return on that investment (if you were putting your money in some other investment, you would expect a cash return). However, you may also decide that to keep your rent down, you will get your return on equity as an improved medical practice and improved practice space.
Operating expenses constitute the costs associated with operating the building, including such things as taxes, utilities, funds for repairs and insurance. If you have your building professionally managed, there would also be a management fee. In this case, $9.00 has been allocated for operating expense, which brings your total annual cost in at $27.88. This represents your cost of occupancy.
It is important to focus on your cost of occupancy regardless of whether you own or rent. It is the only way to effectively compare one option with another. Many doctors assume that the rent paid to their landlord comprises their rent. Oftentimes they do not include additional monies paid to the bank to service the loan they acquire to finish off their space. They also may not include common area maintenance charges and other pass-through expenses that may come from the landlord. These all need to be added to the rent that you pay the landlord so you can effectively compare it to the “rent” that you would pay for you to occupy your own building.
When all is said and done and you have developed your economic pro forma, the total project cost, total project financing and annual cost will give you a very good picture of the implications of developing your own medical office. It will help you decide whether owning is a good option for you, or if you are better off renting. It helps you make an informed decision.
Richard C. Haines Jr. can be reached at Medical Design International, 2526 Mount Vernon Rd., Suite B-405, Atlanta, GA 30338; 770-409-8123; fax: 770-409-8662; email: haines@mdiatlanta.com.