February 17, 2022
Enzo Ferrari once said, “Aerodynamics are for people who can’t build engines.” He understood that it was the engines that made his Ferraris the fastest in the world.
Similar to Enzo Ferrari, it’s important for physicians to understand what’s driving their real estate investment. The engine is the medical practice and its ability to pay rent. But what does that have to do with leveraging your real estate?
Onboarding new physicians into the real estate investment could be likened to oiling your engine. It keeps the investment protected and adds to its longevity. Aligning real estate ownership with practice ownership also aligns the objectives of the practice with the interests of the real estate, and this, in effect, removes real estate investment risk. In this scenario, the real estate investment is enhanced because it is a further investment in the practice.
While most growing and progressive practices fully understand the importance of attracting new physicians into their property company, many struggle in finding a way to keep the investment attractive. Too many of those groups, however, fail to understand that "attractive" is not the same as "affordable" and, therefore, opt for solutions that don't really address the full issue. The practice ends up falling short of its objectives.
There are a number of ways to help fund buy-ins, including having the practice act as the bank and lend the money. But making a poor investment affordable doesn't improve an unattractive investment. It only masks the issue – like putting lipstick on a pig. The real challenge is for the current ownership to make the buy-in as attractive as it was when the initial group invested.
We often ask groups the following question: “If you were to buy this building again today, would you use 50% of your own money and only leverage the remaining 50%?”
Invariably, the answer is “No, why would we when we could get a much better return by leveraging.” The groups often remind us that this is a business investment and not their individual homes. This is exactly what is being asked, however, when a new physician comes on board an investment with reduced debt and high equity ... regardless of affordability!
The impact that leverage can have upon returns on equity is demonstrated in the graph below. While the "first-ins" borrowed 85% and saw an immediate return of nearly 20% cash-on-cash, the latecomers with 55% leverage show a cash-on-cash return that is about 1/4th of their predecessors’ return. Chances are those doctors will take a pass or look to another practice with a more appealing investment opportunity.
Allowing leverage to wane can be the single greatest cause of investor apathy, growth of tension between the practice and the real estate entities, and greater difficulty in funding buyouts. By looking at your investment as something new and fresh and maintaining reasonable leverage, it will truly remain attractive and benefit the practice and all of its partners.