Millions gained through lease extension at closing.

Oftentimes, we have witnessed all the focus of a private equity sale being cast onto the practice, with no consideration of the real estate investment which is usually the same set of owners. Let’s look at the following example as to why that can be economically disadvantageous.

In 2022, an Orthopedic practice in Alabama had four years left on its current leases. Those leases were producing roughly $3MM in Net Operating Income. At a 6 cap (their anticipated building value), the portfolio was worth $50MM. Luckily, before they closed the sale of the practice, they engaged a local real estate broker who had told them that based on the short length of their current leases, their portfolio would be valued at only $35MM. MOB and ASC Properties are primarily valued on the amount, length and reliability of the rental income produced. That reduction in value came as a shock to the group and as a result, they negotiated new 12-year leases (at the same starting Net Operating Income) to be put in place prior to the sale occurring. This resulted in a $15MM enhancement in value, which far outweighed any negotiated enhancement they had received during the practice sale and did not cause any loss in value as part of the PE sale.

Non-Owner-Occupied Structure

In addition to the negotiation of a lease extension, the real estate ownership provisions should be re-evaluated during a private equity sale. When a practice private equity sale occurs, the buildings are no longer considered owner-occupied. Not only does this have implications for the current or future financing (practice guarantee removed, rates adjusted & generally cash flow reduced), it also has long-term effects on the value of the investment.

Most private practices that own real estate are best suited to ownership structures that mirror the underlying practice. When physicians join the practice, they generally can join the real estate investment and when they retire there are provisions to be bought out. In addition, most groups will adopt a real estate valuation approach that is consistent over time to enable the ingress and egress of partners. Typically, that valuation is derived from the anticipation of a perpetual lease obligation being applied to the building.

But suddenly, as part of the private equity sale, the lease renewal is no longer guaranteed. At the end of the current lease there is a significantly greater possibility that the practice lease will not be renewed, and the group of owners will need a new tenant. That creates risks to income and a possible deterioration in value that makes it problematic to continue the buy in and buy out of partners based on the owner-occupied structure that was originally adopted. There is much more volatility in the building value which will now be a function of the remaining lease length. This should be considered as part of any entry or exit to the investment.

We believe the most important question to ask is the following: If you were repurchasing the building, under what valuation and structure would you do so? Having a real estate advocate on your side can be essential to help navigate the many moving parts that need to be addressed during a PE sale, with the real estate being one component that should be given the care and attention it needs.