Do you know whether to sell or lease at the time of a practice sale?
Although many practice owners own their real estate, this changed considerably over the past decade. The COVID-19 pandemic presented challenges many practices did not expect, but the challenges resulted in an increase in clients and business. Many practices have been sold to corporate groups or independents where the practice seller maintains ownership of the real estate, with the new practice owner being the tenant.
This structure is common because it allows the buyer and seller to focus on the primary transaction of the business, the sale. Also, many sellers like to separate the sale of the practice from that of the real estate to spread the tax liability over multiple years, with the added bonus of continuing to receive a regular income from the property.
Although these are compelling reasons to hold the associated real estate, there are some potential negatives. Many veterinary facility leases are for a 5-year term with an option to extend for 2 additional 5-year periods. Concerns arise if the tenant decides not to extend the lease beyond the first 5-year term. If the building is dated or the practice outgrows it, owners may want to move into a new one instead of paying to update the old facility. A move may also make sense if the area’s demographics have shifted. Bottom line, the landlord may end up with a facility with limited marketability because it is built primarily for veterinary usage.
The question frequently posed by practice owners is, “Does it pay to sell the real estate in tandem with the sale of the practice?” Although no one likes to hear “It depends” as an answer, the reality is that it truly depends on several factors. Corporate buyers typically prefer not to own real estate because they want to save their cash for practice purchases, which tend to have a higher return on investment (ROI) than the associated property. Based on this, they often push owners to hold the real estate, presenting it as a good way to keep the cash flow coming in without having to be a producer at the practice. However, most groups partner with real estate groups that specialize in veterinary real estate that often will purchase properties at market value, making it feasible to sell both the practice and real estate simultaneously should the practice owner want to part with both.
Cash from the sale of a practice may provide for retirement, but few like seeing the principal received from the sale going down each month. That’s why holding the real estate can be appealing to many sellers. Rent payments provide income that allows the practice sale proceeds to be invested rather than used for everyday expenses.
The sale or retention of the real estate should never be a deal breaker in the practice sale process. Sellers should consult their accountants, financial planners, and, potentially, a veterinary practice consultant to help determine whether it makes sense to sell or lease the property. It is worth noting that not all veterinary real estate is created equally.
There is no clear-cut yes or no answer for every seller. Several factors come into play regarding the decision, such as age. For example, a 50-year-old seller may need income coming in on a regular basis long term so they don’t deplete the principal from the sale prematurely. This may not be a significant concern to a 70-year-old seller, who is at a more traditional retirement age.
Risk tolerance is also important. If you are a seller who will worry about the new owner moving down the street when your 5-year lease is up, perhaps the closure of selling both is valuable.
Other key criteria need to be evaluated. For example, moving and building fresh is very expensive. Are there reasons a seller might want to leave the facility in the near term? Moving can make sense if the building is dated, doesn’t allow for growth, or has inadequate parking, or if demographics dictate a better location for the practice. That said, moving is more of a last resort as opposed to a first choice.
The profession is quickly moving toward state-of-the-art facilities that appeal to clients and team members alike. Investing in maintaining and updating facilities can add significant value to the ultimate sale of a practice. Owners of outdated facilities may benefit from a sale of the real estate in conjunction with the practice sale. At this stage, a corporate buyer will be more motivated to assist in finding a buyer for the real estate.
The alternative may be that in 5 years the seller will be looking for a buyer by themselves, while the practice has moved into an updated facility nearby. As Kenny Rogers famously sang, it’s important to “know when to hold ’em” and “know when to fold ’em”!
Lease terms are extremely significant and should be reviewed with an attorney who is familiar with the norms for your area. A 10-year lease, if obtainable, may give peace of mind to a 60-year-old seller, as opposed to a 5-year lease. Also, if the landlord is responsible for the roof, walls, HVAC, driveway, and so on, then they must realize that these items can potentially chew up a good part of a year’s rent, so rent will likely be higher to account for this.
Corporations are different because they make more money by owning multiple profitable clinics and usually do not want to deal with the less-profitable real estate pieces. Their main concern is negotiating a favorable lease.
Favorable and fair leases are achievable if both sides are flexible. Owners with a building in a heavily trafficked location may not care about a 5-year term on a lease, because if the hospital practice wants to move, it will be relatively easy to find a new tenant or to sell. Other sellers may want the certainty of knowing that they will have an income stream for at least 10 years, and at that point if the lease is extended, great. If not, then they can sell.
Perhaps of equal or greater importance than the length of the lease is what the landlord and tenant are responsible for in terms of maintaining the facility. Many are familiar with the term triple net lease, which implies the tenant is responsible for property taxes, building insurance, and building maintenance in addition to rent and utilities. A true triple net lease means the landlord is not responsible for any costs associated with the building. This appeals to landlords because if a roof or driveway needs replacing, that can eat up a good portion of the rent for the year. Most landlords seek a 6% to 10% ROI each year, with the additional benefit of paying down the principal owed on the building, which allows for equity to be built over the years that it is leased.
A corporate tenant may be OK with the terms above, but a longer-term lease and a true triple net lease will typically be reflected in a lower annual rent, which should provide for better practice profit. Corporations are motivated by increased EBITDA (earnings before interest, taxes, depreciation, and amortization) and will often be open to negotiation if it can improve the bottom line.
Independent buyers may have a different perspective. A shorter-term lease with an option to purchase can be appealing as buyers often see the value of owning the real estate vs being in a storefront lease in a property that they can never own.
Veterinary real estate can be an excellent investment, and demand for it has steadily increased over the past decade. Rent and mortgage defaults throughout the great recession and during the COVID-19 pandemic have been scarce, and this has only enhanced the value of these properties. In line with this, businesses that focus solely on veterinary real estate ownership are becoming prevalent.
As discussed, for practice sellers, the right lease terms, the right facility, and the right location help define whether it is worth keeping the real estate long term vs selling at the time of practice purchase. In addition, age, risk tolerance, and desire for closure may impact the decision to sell the property or not. Overall, the market remains very healthy for both the sale of veterinary practices and the associated real estate.
Jeff Rothstein, DVM, MBA, is the cofounder and president of Mission Veterinary Partners, headquartered in Novi, Michigan, which operates more than 250 veterinary hospitals in more than 30 states. He is a frequent presenter at veterinary conferences and veterinary schools and can be contacted at firstname.lastname@example.org.