Physicians Realty Trust, a healthcare real estate investment trust (REIT) with a strong focus on medical office buildings (MOBs), reported 99% rent collection in Q2 2021, an incredible achievement especially during a difficult economic environment and that is certainly the envy of real estate investors in any other asset class. Considering this, are healthcare providers negotiating the best terms they can on third-party deals?
Reputation capital is the value of the intangible assets of a business such as reviews, word of mouth, brand identity, and stakeholder trust. Reputation capital can increase the perceived value of products and services, stock price, and company valuation.
Not many health systems realize that their brands can translate into favorable real estate development terms when negotiating a build-to-suit deal with a developer for an outpatient project.
When a health system signs a long-term (typically 15-year) lease and puts its investment-grade credit behind the lease, it significantly increases the value of the building. A typical multi-tenant medical office building may sell at a cap rate of 6.5%, but a development with a large, established health system as the master tenant can realize a cap rate of 6% or less. This often translates to hundreds of thousands, if not millions, of dollars in increased value that would typically be realized solely by the developer. But now, healthcare systems are starting to claim a share of the value that they create.
The health system is conserving capital by letting someone else put up the money to build the property. However, in most cases, the tenant is sometimes on the hook for the tenant improvement (TI) costs above market. For example if the typical market TI allowance is $50 per square foot but the tenant's buildout costs are $125 per square foot. The tenant is then investing an additional $75 per square foot into the building and those improvements will remain with the property after the lease expires.
The tenant saves money because they received a building as well as $50 in tenant upgrades. The landlord, on the other hand, benefits from the tenant's additional capital invested in the building, the tenant's creditworthiness if and when they sell, and the landlord may be able to charge a higher rent if the additional tenant buildout was specialized in use and is left in place after they vacate.
Strategies for Capturing Reputation Capital
Health systems can negotiate with the developer to capture this reputation capital in a variety of ways. Deals can be structured with one or a combination of the following arrangements:
- The health system receives a free equity position in the building, typically 5-10%.
When the building is sold or refinanced, the health system receives a percentage of the proceeds. This tends to happen when there are approximately 10 years remaining on the lease.
- The health system receives a percentage of the cash flow distribution, typically 5-10%.
The health system’s brand equity means they get a percentage of the cash flow distributions the developer/landlord makes to its investors.
- The health system might also be able to leverage their reputation to negotiate a higher TI allowance, or below-market rent increases. If market TI is $50, perhaps they can secure $75 based on their brand and credit strength. If the market rent increase is 3% per year perhaps they can negotiate 2% or 2.5% per year.
- The health system has the opportunity to acquire an equity interest in the development
The deal can be structured to give the health system the opportunity to buy in as an investor, earning them the right to receive proceeds through both items 1 and 2 above. Known as Pari passu, a Latin term defined as “equal footing," or “whatever you get, I get” means that each investor will be paid on a pro-rata basis in accordance with the level of their percentage of equity.
The Risk/Reward Rationale
The developer/landlord is often willing to give the health system reputation capital because it reduces their risk and increases their upside rewards. Commercial buildings are underwritten upon achieving a certain percentage of preleasing prior to the start of construction. When a health system master leases the building, it eliminates the developer’s vacancy risk. Vacancies translate to financial risk. The assurance of a health system master leasing the building is so valuable to the developer that they are willing to give up a portion of the equity in return.
In real estate (and life to a certain extent) profit flows to the person taking the risk. Sophisticated healthcare clients have planning, design, and construction (PDC) relationships that may allow them to be the developer, especially if they own the land and even if they are going to flip it to an investor once it is fully leased. Or perhaps they hold and become the landlord – healthcare draws reliable foot traffic and that’s valuable to coffee shops, bookstores, and restaurants.
The brand name of the health system is helping the system lower its overall investment in the property. As a health system leader, it’s an ever-present reality that dollars need to stretch as far as they can. Our team enjoys finding new ways to advise your team on low-risk, win-win opportunities to succeed in today’s sophisticated real estate environment.
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© Copyright 2022. The views expressed herein are those of the author(s) and not necessarily the views of Ankura Consulting Group, LLC., its management, its subsidiaries, its affiliates, or its other professionals. Ankura is not a law firm and cannot provide legal advice.