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How Medical Real Estate can Thrive in a Low-Income City

Can Medical Real Estate thrive in a low-income city? A deal recently came across my desk from McAllen, TX, a town on the US-Mexico border across from Reynosa in Mexico. I’ve never been to McAllen, so I did my usual preliminary Wikipedia review to get a sense of the basics. In many ways, McAllen is an appealing place to invest. Properties are cheap, the population is large and growing, border trade provides employment, and it is considered one of the safest cities in Texas.

On the other hand, it there are some aspects of McAllen that might turn away investors. Over 25% of the population was below the poverty line as of 2016, and more than 29% had no health coverage. In the early 2010’s it held the top spot for poorest metro in the nation. Not in Texas, the poorest in the entire United States. Since then, other metros have overtaken it, but it remains near the top (or bottom, depending how you look at it) of the list.

For perspective, if you walked into an elementary school that accurately represented the population of McAllen, all the fifth graders and more would be living in poverty. The entire first grade plus half the second grade would never go to the doctor.

The deal didn’t make sense regardless of the location, but it was an interesting exercise to consider investing in McAllen. The population is just not going to be able to support the same tenants as a wealthier metro, like Phoenix. Is there still a good way for me to invest in medical real estate? If I cover my three basic questions, then the answer is yes.

-Is there a demand for the tenant (the medical service) in the community?

-Does my purchase price allow me to charge market rate so there isn’t incentive to leave?

-Can the tenant recruit employees (providers) to provide the service?

When the deal didn’t work at face value, I was left without a specific tenant to consider. That opened the question, what type of medical practice do I want as my tenant? It’s actually easier to start with who I don’t want as my tenant. I don’t want medical practices that focus on high-touch, high-end services, such as plastic surgery, fancy sports medicine facilities, private-pay dermatology, etc. They have more overhead costs supported by high fees for service, so may not do well in a low-reimbursement environment. That leaves me with tenants that provide efficient care that are profitable even with majority Medicare/Medicaid reimbursement.

McAllen holds another unenviable title. It is the most obese metro in the United States, with obesity rates in the high 30’s and diabetes in the low 20’s. People with diabetes can suffer long term kidney damage and end up relying on dialysis every day. Given the enormous diabetic population, dialysis centers would have plenty of patients. However, upon looking, I found out there are already 15-20 dialysis centers in McAllen. In my hometown of Eugene, Oregon, a relatively affluent and fit college-town with the same population as McAllen, there are 2.

So clearly other people have had that same idea. Even if there is not room for more dialysis providers, there are other medical services that have high demand and lower supply. Cancer treatment, vascular surgery, pediatrics, and adult primary care all can have efficient business models while still providing great service to low-income communities. They all have essentially immobile patient bases, meaning if the practice moves, their patients may switch providers. If I can partner with one of those providers—provide the real estate for their practice—it will be a stable investment in an otherwise challenging place to invest.

Is the rent market rate so I avoid tenants moving to cheaper office space? It shouldn’t be too much of a challenge to check this box. The cost of living in McAllen is in the ballpark of 10% below the national average. Property values are low. As long as I don’t let tenant improvement costs get out of hand (easier said than done), rent can be relatively cheap. Since medical reimbursement does not vary significantly by location, a medical practice in McAllen will be more stable in theory than a practice in a low-income part of a more expensive city. This was actually a big part of what killed the original deal—the seller wanted $250 per square foot for vacant space. In McAllen where rents are low, there is no way I can get a tenant for a fair rent and make money off the building if I start at that price per foot.

Can the practice hire providers? This question gave me pause at first since McAllen has a large percentage of Medicare/Medicaid patients. Medicare and Medicaid pay less than commercial insurance, practices may be less profitable and providers make less money. Lower pay doesn’t attract physicians.

However, McAllen and its associated metro area is large and growing. There are jobs, and there is solid age demographic diversity. I expect that if I take a more granular look, some areas will pop out as more desirable and more quickly growing. It might not be a Park City or a Jackson Hole where Orthopedic surgeons go to retire, but there will be doctors.

Partnering with physician groups in a place like McAllen has another benefit from my perspective: I am adding value to the community. When I invest, I want the community where I invest to benefit as well. By investing in medical real estate and working to enable physicians to provide their best care to as many patients as possible, I believe I am adding value to the community. This community already struggles with access to healthcare, partially due to lack of insurance coverage and partly due to a lack of access. I can help bring medical services to the community, either by partnering with local physicians or national providers.

To reach out about medical real estate investments or to learn about my upcoming book on medical real estate investing, reach out to Jacob@fallcreekpartners.com

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What Kills an Attractive Medical Deal? Resentful Tenants

A well-established Orthopedic specialty group in and office and surgery center from a hospital in a suburb of Austin, TX. An absolute triple net lease and 2.5% annual rent escalators on . 5 years left on the lease with a 5-year renewal for a decent price because the seller was older and wanted out. What could kill this attractive deal? Resentful tenants.

We walked away.

The property was right across from a hospital, and it was built out as a surgical center. Both details made the property very desirable and increased the chances a tenant would stay long-term. Even though a 5-year lease isn’t spectacular, we weren’t concerned. The chance a doctor group would move was very low, especially having already been there for about 20 years. Also, we really liked the lease terms. The doctors were responsible for everything on the inside of the units, and the condo association was responsible for everything else. The doctors were responsible for paying condo association dues, so the lease was effectively absolute NNN.

The group had partnered with a large ambulatory surgery center (ASC) operator to help manage the surgery center. Not only did this mean they had professional practice management involved, it would be a connection for us with the ASC operator. Additionally, the hospital across the street had talked about a joint venture with the doctors for some time. If that happened, the hospital would assume the lease (a win) or buy the units (a win).

We felt confident this was an excellent opportunity for our investors. There was minimal landlord responsibility, and the practice was stable and had great patient volumes. There was inherent value in a surgical center across from a hospital, and there were several potential exit options. Modeling suggested the building would cash-flow well throughout the holding period and sell for a profit after a lease renewal. It looked like a great passive income investment with a strong return.

Then we dug deeper.

The price per square foot was on the higher side and that rent was over market rate by about 10%. On its own, that’s not necessarily bad if the doctors like the place. Imagine your own apartment. If your rent is 10% higher than apartments nearby but it’s perfect for you—sectional couch just right, bedroom set up, office with good view—then you may stay anyway.

What really killed this deal was physician resentment. They hated the lease.

The doctors in the practice felt they had been pressured into signing the lease at above-market rates by the previous landlord, who was a partner in the practice at the time they signed the lease. They had not maintained the interior well, and those expenses loomed. The condo association created a new capital plan to be funded by greatly increased dues, which they would also have to pay. In short, the tenant’s financial burden far outweighed their perception of the value of the space.

The doctors made it clear they would not be renewing at the end of their term unless rent was decreased by around 30%. The cap rate was great, but not great enough to absorb a 30% drop in value in 5 years or cost of releasing and vacancy.

Did the property have intrinsic value even if the doctors left? Yes, but replacing above-market rent would be hard. If we bought the condo units at market-rate rent and knew the tenant would leave in 5 years, we could line up a new tenant in the meanwhile and potentially avoid a drop in rent or much downtime. That wasn’t the situation, though. The various possibilities of partnering with the hospital or upgrading the facility were speculative. Again, starting with above-market rent made repositioning harder.

The surgery center was adequate for the doctors at the time, but it would need to be updated for a new tenant. Where would that money come from? Either we would finance the improvements (more capital put into the project) or the new tenant would and might request a rent abatement (a decrease in income from the project). Either way, we hadn’t factored those expenses into the purchase price.

Would the doctors have even followed through on their threat? Maybe, maybe not. Either way, we didn’t want to spend the next 5 years with them resenting me for their lease. We like to build relationships with tenants, not hang for dear life and hope we can figure something out.

Let’s rewind to the important part: Despite the sticky appearance of the tenant and the property, there was a landmine. The only way to find the landmine in the deal was the have conversations with the tenant.

The agent involved limited the amount of contact we had with the tenant. In fact, if we had not gone in-person to the inspection, we would not have met the tenants. We had a nice conversation in which we learned more about the potential value of the property. The doctors told us about the partnership with the surgery center operator, the hospital’s interest, and the potential for upgrading the operating rooms, not the realtor. The doctors also told us about the problems, though.

We asked open-ended questions and listened to their answers. We didn’t zone out when they started complaining about various details of the practice. They were able to brag about what was great at the property and rant about what didn’t work. We did our best to speak to them as a friendly peers, not dismissive future landlords.

This deal may have worked out anyway. We could have re-run numbers and let investors know the sale price at the end would be lower, revising down the overall project return. They may have still been interested, but we would be taking more speculative risk than we wanted to put on our investor.