Are You Sure You Want a Second Bite of the Apple?

Contrary to Snow White’s poison-induced slumber, the sale-leaseback’s second bite of the apple might keep you wide awake. This article will outline the typical structure, risks, and considerations of the "red delicious" of physician-owned real estate.

What Do Real Estate Buyers Mean by "Second Bite of the Apple"?

When real estate owners sell their buildings in a sale-leaseback transaction, the "second bite of the apple" is a commonly used phrase referring to owners rolling their proceeds into the purchasing entity's portfolio, thereby capitalizing on a future portfolio sale. The concept has gained steam in recent years as sellers look to defer capital gains tax to a later date and reinvest their sales proceeds. Unfortunately, this second bite of the apple can quickly transform an event which buyers would describe as "taking your chips off the table" into one more akin to "rolling the dice".

Considerations of Taking the Second Bite

A common misconception owners make is conflating the owner-occupied investment they have enjoyed with the investment they would make with a private equity buyer. Just because the buyer focuses on medical properties does not make these investments comparable. An important question to ask yourself: Would you make the same investment if you weren’t rolling your proceeds (and deferring taxes)? If not, then you probably shouldn’t be considering rolling your gain at sale. There are numerous variables to consider when investing in a real estate fund, including:

• What assets are included?
• What is the fund structure – debt vs. equity?
• What timeframe is the fund aiming to hold its assets?

Thoroughly understanding the investment is paramount to making a sound investment decision. Keep reading for an example of a group that may be hoping they had read this article a little sooner.

Case Study: Ophthalmology Practice Takes Second Bite

In 2021, a northeastern ophthalmology practice sold its building at a 6.25% capitalization rate. Enticed by promises of 10% cash-on-cash returns and historical fund performance, the partners opted to roll their proceeds into a new fund offered by the buyer. This all sounded appealing, and many of the partners decided to partake in the continued investment. Good returns and deferred taxes equated to a great deal … until they looked under the hood.

The private equity firm's strategy involved rapid aggregation and packaging of medical properties for institutional buyers, funded largely through short-term, interest-only debt. However, rising long-term interest rates (increased by approximately 300 basis points since acquisition) served to elevate cap rates, diminishing property values. Consequently, the partners found themselves with depreciated assets and limited refinancing options as debt maturity approached.

As of this writing, we are a couple of months away from the maturity of that interest-only debt. The ownership has limited ability to refinance because the loan-to-value is significantly higher now than at acquisition. An increase in interest rates means that even if financing were possible, it would cause negative cash flow. The only solutions are to sell the building at a loss or inject significant equity in the hope that interest rates decline.

Beware of Speculative Investments

This cautionary tale underscores the inherent risks of speculative real estate investments. CMAC provides clients with comprehensive advice on the complexities and implications of sale-leaseback opportunities. If you're considering such a transaction and seeking expert guidance, reach out to CMAC for assistance.