What questions should you ask to find the best medical real estate investments? There are basic criteria that every real estate purchase should meet. I believe there are specific questions that you need to ask when purchasing a medical building, though. The first three are the most important, and I use them as my first look at a property and tenant before moving on to the next five.
1. Does the practice business model make sense in the context of the the local demographics?
Even though medical practices do very well in general, you want to find a tenant with the best chance of success. In order to do so, you need to understand the business model of your tenant and their demographic needs. What do I mean?
A high-end, high-touch plastic surgeon, sports medicine facility, or dermatologist is going to struggle in a low-income area. Their business model relies on expensive, elective procedures to remain profitable given their significant overhead. With a less-affluent patient base, they will have fewer patients available who can pay their out-of-pocket fees or who have commercial insurance that pays well for procedures.
Not all practices do well in an affluent area. A primary care practice focused on no-frills efficiency that performs well in a low-income, Medicare/Medicaid dominated area might struggle in a wealthier area. Patients will rather pay for the high-end appearance and potentially more attention from the doctor per visit.
Similarly, an obstetrics or pediatric practice could struggle in an older and aging community. Why would you place a pediatrics practice next to a retirement community in Florida? Kids don’t visit the doctor when they visit their grandparents unless it’s an emergency.
If you find a tenant catering to the patient population near them, you will most likely have a successful practices (and be a happy landlord).
2. What is the location and condition of the building?
At the end of the day, medical real estate is still real estate, and you need a fundamentally high-quality building or a price adjustment to account for that. Patients judge their doctors based on the emotional experience of their visit, and the physical space and location influence this. Is it dingy and unpleasant inside? Was it hard to find or hard to get to? Was it a pain to find parking? Physicians tend to stay in one place for a long time, a major advantage of the asset class. Medical tenants can and will move if the condition or location of the building is inadequate.
Some locations, locally and regionally, struggle to attract physicians to provide services, no matter how great the business practice is. Where does this happen? Anywhere there is already a lack of healthcare services, it’s hard to attract doctors. Rural areas and poor inner-city areas suffer most. Reimbursement tends to be predominantly through Medicare and Medicaid, so practices are less profitable, and physicians may make less.
A practice that cannot hire replacement doctors will not renew a lease, leaving an empty medical property. Worse, you already know it will be hard to attract a new tenant.
3. Do the lease structure and price per square foot make sense?
Medical tenants will leave a property if the lease is too expensive. The specialized and expensive medical build out often brings a higher price per square foot than average commercial tenants, but there is still a market rate. Paying above market price per square foot for a property that carries above market lease rate with the right tenant and lease tempts many and can even make sense. Factor in the future risk of a tenant change or the decision to sell or refinance the property, though. Can you release at the same price per square foot?
It is thrilling to make a purchase, but it is not thrilling to realize you have created a problem for yourself. Keep your long-term strategy in mind from the outset. Is there a risk that your tenant will find cheaper space elsewhere instead of renewing their lease? How does that impact your decision to sell or refinance the building?
As with any commercial real estate asset, the lease structure is important in medical buildings. I recommend finding a NNN lease or determining that you can manage the building and budget for operating expenses.
Those are my first three, most important, questions. If any of them raise red flags, I am probably walking away unless the price is incredible. Still, I can ask more questions to find the best medical real estate investments.
4. How strong is the tenant (the physician practice)?
Is the tenant going to stay in business? Most medical practices stay in business forever, but I believe it is valuable to consider the biggest risks.
Consider a single or two-person independent practice. Will the business vanish if a single doctor has an emergency or retires? This goes back to Question 2: can they attract a new doctor if need be? Having multiple practice locations, even with only two doctors, suggests a large patient base. If the doctor retires, they can probably sell the practice to a strong buyer.
Practices affiliated with larger groups or corporations might have stronger backing, but that depends on their long-term plans. Is the specific site so weak the larger corporation will close it down? Try to get financials for the practice location. Ask about pending retirements and plans for ongoing provider replacement.
Look at competition in the area: is there a newer, more visible practice of the same specialty nearby that is a threat to business? The population might be large enough to support two of the same specialty practice, but that’s an analysis I want to do before buying a building.
5. Is the building well suited to housing a medical practice?
If you are purchasing a building with a tenant, talk to the physicians about the building. Does the layout work well for them? Do they have the waiting room space, exam rooms, and nurse’s stations, and workspace flow that they need? Are they able to use the space efficiently, or do they pay for space they don’t use. There will always be aspects of building tenants wish they could change, so you will need to determine if the tenants are at their wits end with a layout, or if their complaints are benign.
When purchasing a property to build-out for a medical tenant, don’t assume any building will work. There may be specific plumbing, HVAC, or work-flow issues that impact the cost of the remodel. It would be wise to talk to a prospective tenant and a medical-specific architect before committing to its purchase.
6. How robust is the practice to changing insurance reimbursement rates?
If health insurance companies pay less for certain procedures, will a practice survive? This goes beyond the location-business model concept of question 1. Medicare and Medicaid pay much less per procedure than private (commercial) health insurance plans. With healthcare costs sky-high in the US, it is not impossible that commercial plans will pay less in the future or that single-payer insurance will extend to more people.
Some practices would be unable to survive, some would. Business models that primarily serve Medicare/Medicaid patients may not be flashy and high-end, but they are likely to weather changes in reimbursement. They already get paid the least a medical practice can. On the other side of the spectrum, super highly paid specialties, like dermatology, will probably do fine even if their pay is cut in half.
This is a relatively low risk in my view. The physician lobby is very strong, preventing decreases in reimbursement. Regardless, medical practices are strong business and can take more hits that you would expect before failing.
7. Are there regulatory barriers to building new medical facilities of the same certification level?
Buildings with special designations can take months and hundreds of thousands of dollars to certify. These regulatory burdens add paperwork and cost, and so increase value of existing, certified properties by creating barriers to competition.
Ambulatory surgery centers are incredibly costly to build and certify. They have rated operating rooms, with Class A allowing for the least complex procedures and Class C allowing for the most. Higher classifications require higher cost and regulatory burden to certify.
Most states are “Certificate of Need” states. Capital expenditures to build new medical care facilities must go through a state oversight committee. The restrictions vary between facility types, from surgery centers, to assisted living facilities, to hospitals themselves. The process can take months and cost hundreds of thousands of dollars, and there is no guarantee that a certificate will be granted.
Rural Care Centers allow for higher billing per-patient in rural areas with low access to healthcare. They are meant to incentivize medical operators to offer services in communities with poor access. These too can take hundreds of thousands of dollars and months to license and open, making tenants less likely to move.
8. How do the tenants feel about the lease?
Whether your transaction is a sale-leaseback or purchasing a building with an existing lease, does the tenant feel good about the lease? Are they committed to the space? Do they resent lease terms over which they feel they had little control?
These questions are not unique to medical real estate, but I have found them particularly relevant in this space. Physicians don’t often start practices with significant business acumen, and often have considerable debt combined with high income starting their careers. This leads to greater willingness to accept expensive leases in exchange for large initial tenant improvement allowances. Later on, when those physicians realize how much of their income is going towards an above-market lease, resentment might set in.
Assessing your tenants’ relationship to a lease on which you are hoping for future renewals is an assessment of the future value of the property.
I have found these are the eight questions to find the best medical real estate. They have helped me find value and avoid deals with serious pitfalls. To reach out for questions or to argue about these, send me an email at jacob@fallcreekpartners.com