July 21, 2022

For a Physician-Owned Real Estate Portfolio

(As seen through the eyes of a British Bachelor)

As a failed repurposed engineer, I like to consider complex problems either as open-loop or closed-loop systems. Obviously, this makes me eminently qualified to opine on what it takes to create a proper operating agreement, right? What do you mean, you don’t see the connection? Well, let me elaborate…

If you’re not familiar with open-loop and closed-loop systems, consider a saucepan simmering on a stove. When you remove the lid, it becomes an open-loop system where mass and energy can escape in the form of steam. When you replace the lid, it becomes a closed-loop system, where all the steam and heat stay inside the pan. (Are you starting to understand why I’m still single?)

What on earth has this got to do with real estate operating agreements, you ask? Well, humor me a moment while I stretch this comparison even further. Most physician groups who own their real estate will unknowingly participate in an open-loop system. Just like steam won’t stay in an open saucepan, partners aren’t going to stay put throughout the life of the investment. Instead, some will retire and others will join the practice to replace them.

Of course, a real estate operating agreement is a little more complicated than a saucepan. So let’s look at a more apt example, using every American’s pride and joy: the automobile. (You guys really do love cars. ESPECIALLY big ones.)

Cars are also open-loop systems, but they’re much more complicated. Air and fuel enter the system through intakes and create combustion. Combustion drives pistons that, in turn, create torque. The byproduct of that combustion is filtered and cleaned before leaving the system. Are you seeing the link yet? The similarities are clearly undeniable.

The three key economic elements of the real estate operating agreement are similar to those of a car’s open-loop system:

Air and Fuel Intakes – Affordable and Attractive New Partner Buy-ins

A car isn’t going to move without fuel and air creating combustion. So how do we move our real estate engine? By creating a sustainable mechanism – the operating agreement – that allows shareholders into the real estate investment partnership.

To make sure this mechanism is successful, you need to create a structure that is both AFFORDABLE and ATTRACTIVE to new shareholders. Without new practice partners entering the investment, the practice starts to stall, potentially even coming to a standstill.

Many real estate operating agreements are uncommunicative about how and when new partners should enter. That’s why a more thoughtful and forward-looking methodology allows for a steady intake of new shareholders throughout the life of the investment. And just like different types of fuel work best for different cars, it may take some testing and fine-tuning to get the right combination of affordability and attractiveness to appeal to new partners.

Throttle – Valuation Methodology

The harder you put your foot down, the faster the car goes. (Unless you’re driving the Fiat Punto I was when I passed my driver’s test: That “washing machine” of a car barely made it out of second gear.)

Using a lever to consistently control a car’s speed makes it easy for the average (non-Floridian) driver to effectively navigate from place to place. But when you look at real estate operating agreements, it’s easy to see the issue: Too many have had their “throttle” removed. With no basis for measuring the investment, it is difficult to tell “how fast” the practice is going.

Most agreements stipulate that the building should be valued at “fair market value,” or FMV. But depending on the calculation method used, that value can change significantly. When a practice relies on an outside party to determine how much their real estate is worth, are they truly in control?

There are other valuation methods that may be utilized, and many groups are now opting for these alternatives.  For example, some practices predetermine their real estate value based on the value created by their leases. In doing so, they strike the right balance when they’re “putting their foot on the gas,” making buyouts manageable and creating an attractive return for the existing owners.

Exhaust – Forecast and Managed Buyouts

Thirty years ago, the conversation about curbing vehicle emissions was just getting started; it wasn’t until 1990 that the Federal Clean Air Act was amended in an effort to greatly reduce air pollution. Part of the problem was that, back when cars were popularized, we understood very little about the environmental implications, and it took companies a long time to seek out sustainable alternatives, such as the electric vehicle.

Likewise, it’s taken a long time for operating agreements to develop sustainable mechanisms for buying out physicians. Twenty years ago, nearly all operating agreements were silent or unclear on the methodology for buying out retired partners. The few methods that were in place generally didn’t use appropriate partner succession modeling, making them unsustainable over the long term. The implications of this are significant; it becomes a Pandora’s Box that, once opened, or executed, is hard to close, or fix.

Nowadays, the exhaust is generally the most expensive part of the car. Its most important component is the catalytic converter, which reacts with pollutants to convert them into less harmful gasses. When you look at an operating agreement, the partner succession model is our version of a catalytic converter: it allows groups to forecast and manage physician buyouts such that the real estate entity is properly capitalized to sustain those obligations. Without it, the entity is likely to cause more harm to the practice than good!

It takes an experienced engineer to design a modern, reliable, and sustainable vehicle that reflects all the evolutions that have occurred. Likewise, it takes a specialized team -- with knowledge of the nuances, challenges, and evolution of real estate financing – to craft a real estate operating agreement that can serve your practice for the long term. If you’re looking for a specialist to help your practice, get in touch with CMAC at solutions@cmacpartners.com or schedule a meeting.