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.