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How to build equity inside and outside of your practice with real estate
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I know many orthopedists who have planned and managed well and had some luck and good fortune during their careers. They have had the gift of health that allowed them to achieve their goals prior to retirement. In their later years, they have more outside income available through equity investments than from salaries. This is a nice position to be in and makes practicing much less stressful during your winding-down period. It allows you to do more of what you choose and say no to aspects you do not like.
If you set financial goals early in your career, it is easier to achieve them. It helps to determine what you feel will be the minimum income you want later in your career or during retirement. There are many investment instruments that can lead to financial independence and income before and after retirement. One methods is investing in real estate.
Any investing can have risks and volatility. In this Orthopedics Today Round Table discussion, I have asked two long-time friends, who are well-known clinicians, leaders and educators who have done well investing in real estate, to talk about how they managed to use this investment tool to build equity inside and outside their practices.
Douglas W. Jackson, MD
Moderator
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Douglas W. Jackson, MD 
Neal C. Small, MD
Lanny Johnson, MDDouglas W. Jackson, MD: Why should orthopedists invest in real estate to build equity in their practice?
Lanny Johnson, MD: It gradually increases in value in most geographic locations. There can be cash flow and appreciation. Such cash flow has occurred for me with office property and apartment houses. I have seen amazing appreciation with waterfront property in Michigan. I had one such property increase in value 18 times while the family continues to enjoy the compound. I enjoyed 50% appreciation in 1 year on a speculative purchase of a condo in California.
Neal C. Small, MD: Here is why I became interested in investing in real estate: During the early stages of my career in orthopedics, it became necessary to deal with landlords for leasing office space. I wondered why I was paying healthy rent and the landlord was making a profit every month. He was enjoying regular cash flow and building equity by paying down his debt on the building. This seemed to be a “no-lose situation.” In 1976, my partner and I bought our first medical building, which was about 25,000 square feet. While we only occupied about 5,000 square feet, we were able to rent the remainder of the space in the building.
In retrospect, we probably overpaid for that particular building. Because inflation was significant in the 1970s, our building became more valuable and eventually made up for the fact that we didn’t “buy it right.” With inflation not as much a factor today as it was then, we might not have made a profit in today’s tight real estate scenario.
Eventually, I acquired several medical buildings and sold them to a real estate investment trust (REIT) in the mid-1990s.
Jackson: What are the disadvantages?
Johnson: Real estate it is not as liquid as the stock market. It may be hard to sell at certain times. I had an office property that aged as the office market shifted to medical centers and adjacent to surgical centers.
Small: Just as in any type of investment, there are no guarantees that your real estate investment will succeed. Many things can potentially go wrong. Just as in equities and bonds, real estate is interest-rate sensitive. When the project is immature, often interim or gap loans are needed. These loans are difficult to get with a fixed interest rate.
If interest rates are in a rising scenario, your project costs can escalate dramatically because of the floating interest rate. Once the project is mature enough, permanent financing is usually desirable. Permanent mortgages most often have fixed-interest rates. Any run up in short-term interest rates usually gets reflected in increased long-term interest rates when you are ready to roll into permanent financing. Once a favorable rate is secured, the investor must be aware of the terms of the note. Be careful not to allow periodic “calls,” which allow the lender to readjust the interest rate after a shorter term than the full term of the note amortization.
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Be aware of prepayment penalties, which can be quite onerous if you want to refinance or sell. “Yield maintenance” clauses are particularly onerous because they allow lenders to recover the anticipated investment yield on your note for its full term even when you pay it off early. There are all sorts of prepayment penalty scenarios. Hire a good real estate attorney to represent you for any real estate transaction even if you think you know all of the angles.
There are potential problems in any region with overbuilding a certain product, thus causing an oversupply of space and declining property values. Given enough time, the excess space will usually be absorbed. But this absorption and recovery may take several years. The investor must be careful not to over leverage a particular property in order to wait out the recovery process after a downturn. The far-sighted and aggressive real estate investor will recognize that although the particular market is depressed, there are opportunities. Properties in this scenario can usually be “bought right” (ie, at a significant discount). If you have the liquidity and the “staying power,” you will usually come out ahead as a buyer in a depressed market.
Real estate investing is rewarding in many ways. It is usually financially rewarding. It is enjoyable and stimulating. It forces you to know your geographic area and financial arena, and the potential pitfalls. I look at real estate investing as gambling, with me as the house. If I have done my homework, the odds are in my favor.
Jackson: What is your philosophy on investing in real estate?
Johnson: I prefer the land bank over money in regular banks. I only buy opportunity. I have bought apartment housing at 40% on the dollar in down times, only to see it quickly appreciate to greater than full value. I invest without partners. I know cash buys more. I only borrow when money is cheap. Borrowing is like buying two things, the money and then the property. I always buy the property next to my present property. It has the most value to me. I did this on my homestead, which eventually was 300 acres while we lived there all these years prior to selling for a golf course development.
Small: Buy low and sell high — I wish it were that easy. The real estate market today is more challenging than 30 years ago. There are many investors with a lot of cash chasing fewer and good deals. Because inflation is relatively tame, the property must be bought correctly. If the investor wants a steady return, he or she may want to buy on a capitalization rate (Cap Rate), where a building or property makes a certain amount of income annually.
If the purchase can be structured so expenses are less than rents, there is an amount left over annually — net operating income (NOI), or income before debt service. If the annual debt service is less than the NOI, the building is profitable.
To determine whether you will make a certain return on your invested equity (ie, cash in the deal), divide the NOI by the return you want to make (ie, the Cap Rate). This will give you the amount you should pay for that particular building if you want to make a certain return on your invested equity.
Jackson: What and where should one buy?
Johnson: The answer is simple. Initially one buys a place to live and perhaps a place to work. For investment, I only buy opportunity. It is recognizing a property with upward value potential. It may be a distressed property in foreclosure.
Buy the property next to what you own or what you drive by on the way to your hospital each day. I read this in Medical Economics in 1966 and have done just this with great benefit. I will know these properties and recognize changes and opportunity better than anyone else because I focused on these properties. It may be waterfront property — in Michigan it never goes down.
Jackson: How can one maximize profits from real estate?
Small: The potential upside for these types of real property investments can be much higher. There is also substantially more inherent risk. For those willing and able to take a more aggressive posture, properties can be purchased which for various reasons do not produce cash flow.
It may be a building which is not well leased and needs rehabilitation, or a piece of raw land. For these investments, it is even more important to know what you are doing. You must understand the dynamics in play: Is the neighborhood turning around? Is the building only in need of simple cosmetic rehab to make it attractive for leasing? Are the leases turning over soon with the potential to increase rents significantly?
Remember, these investments do not produce cash flow, and you must invest substantial equity and structure your debt accordingly. You must be certain that you can continue to hold a property like this for a given period of time and then some.
Jackson: What is the easiest investment in real estate for a surgeon who is planning to practice at least 10 more years, who is averse to risk and has little time to spend analyzing a real estate investment?
Small: You are best investing in your practice’s real estate needs. With opportunities to invest in practice ancillary facilities manifest in most practice areas, often including some form of real estate …why not invest?
I used to pound the drum for practice independence (ie, build your own practice-owned ambulatory surgery center and imaging center). Many practices around the country have done that and are making significant profits from the facility fees generated. There are obviously real estate decisions to be made when contemplating these facilities.
Single-specialty hospitals are another area where real estate should be a consideration. If the practice alone can’t build the facility, joining together with colleagues may be necessary. In the rare case where partnering with a hospital or other medical development and management company is necessary to facilitate practice ancillary service, go ahead. A diluted piece of a practice ancillary and the incumbent real estate is better than having no piece of the pie.
For more information:
- Douglas W. Jackson, MD, can be reached at Memorial Orthopaedic Surgical Group, 2760 Atlantic Ave., Long Beach, CA 90806-2755; 562-424-6666; e-mail: jacksondw@aol.com.
- Lanny Johnson, MD, can be reached at P.O. Box 975, Okemos, MI 48805-0975; 517-285-1812; e-mail: lljmd@aol.com.
- Neal C. Small, MD, can be reached at OASC Inc., 5956 Sherry Lane, Suite. 1200, Dallas, TX 75225; 214-987-6133; e-mail: ncsmall@cypressmail.com.