The appraisal gap
The appraisal gap is the disparity between the actual construction cost of a dental facility and the lesser value placed on that facility by real estate appraisers.
Jeff Carter, DDS, and Pat Carter, IIDA
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The appraisal gap is the disparity between the actual construction cost of a dental facility and the lesser value placed on that facility by real estate appraisers. The decreased value assessment potentially protects lenders in case of foreclosure and the need to sell the dental facility as generic office space to a nondentist buyer.
This disparity "gap" often limits a dentist's ability to obtain sufficient funding for a project due to lending practices based on typical 80% to 90% LTV (loan to value) ratios. If your project appraises for 80% of the actual construction cost and the lender funds 80% of the value of the construction cost, your equity requirement into the project to make up the remaining unfunded percentage is greatly increased and may be well beyond what you are prepared to invest.
Fortunately, for those pursuing a new dental facility in a lease space, no appraisal is required and lending is based on the value of your practice as a business entity and what it can generate in cash flow vs. expenses.
So, which dental facility types involve real estate and as a result are impacted by the gap?
- Ground-up construction building
- New construction facility in a condominium space
- New construction facility retrofitted into an existing building purchased by the dentist
The gap is mainly attributable to the enhanced infrastructure requirements for plumbing, electrical, and HVAC.
Plumbing - Plumbing costs for dental facilities typically range from $20 to $30 per square foot (SF) vs. $7 to $10 for generic office space. The addition of compressed air lines, vacuum lines, and multiple sinks partially account for the higher cost per SF. Another significant cost addition to the plumbing category is the inclusion of plumbed nitrous oxide. In a five-operatory facility, plumbed nitrous oxide (excluding manifold, connector panels, flowmeters, and rubber goods) can add up to $20,000 to the project.
For example, a 2,500 SF real estate agency facility with two restrooms and a kitchenette projects plumbing costs of $7 x 2,500 SF = $17,500. Contrast that with a 2,500 SF, five-operatory, dental facility with plumbed nitrous oxide. Plumbing construction costs for the dental facility project at $30 x 2,500 SF = $75,000, or $57,500 higher than the real estate agency space.
Electrical - Dental facility electrical costs project at $20 to $25 per SF vs. $10 to $15 per SF for generic office space. The addition is due to the equipment- and lighting-intensive environment required to deliver dental treatment. Our friends at the generic real estate agency facility have little need for air compressors, vacuum pumps, autoclaves, and computed tomography units.
HVAC (heating, ventilation, and air conditioning) -Dental offices are a complex mixture of static and dynamic activity zones with an overlay of psychological and physiological anxiety symptoms to complicate occupants' perception of adequate temperature control. A typical 2,500 SF, five- or six-operatory facility requires three HVAC zones in the cost range of $12 to $14 per SF vs. $6 to $8 per SF in generic office space.
In fact, the IRS has recognized the unique additional infrastructure costs of dental and medical facilities. In 1997, the Hospital Corporation of America won a landmark decision against the IRS making the case that additional plumbing, electrical, and HVAC infrastructure is "essentially" part of the equipment requirements to provide treatment delivery and thus should be in the short-term depreciation schedule along with the equipment.
Is there anything you can do to counter the appraisal gap?
Yes, there are three things you can do to prepare for the appraisal gap:
- Acknowledge there is a gap and don't be misled by novices in dental design and construction who assure you it won't be an issue.
- Prepare to inject up to 20% equity into your project. That equity can be factored in from a number of sources. No one, to our knowledge, has ever obtained 100% financing of a dental facility involving real estate.
- Search for lenders who analyze your project in terms of cash flow and the value of your practice as a business entity vs. equity lenders dependent on appraisals that compare your state-of-the-art dental facility to generic office space.