by John K. McGill, MBA, CPA, JD
Current rental market
We have long recommended that doctors own their office space to take advantage of substantial tax and economic benefits. While the vast majority of doctors (probably 65% to 75%) own their space, a substantial percentage do not. In some cases, the doctor’s practice is located in a multitenant office building where ownership is simply not available.
In other cases, the doctor’s current leased location is so optimal that moving, even to a building owned by the doctor, would harm the practice. Finally, in other situations, the doctor receives such a “sweetheart lease” deal that building ownership just doesn’t make economic sense.
Now is a tremendous time for these doctors to renegotiate or extend their office leases to realize incredible savings. Office vacancy rates remain high in most areas, as failed businesses and layoffs have reduced the need for office space, and rental rates have dropped.
In the fourth quarter of 2010, annual rental rates on commercial office space averaged $23.20 per square foot, down $1.82, or 7.3%, from $25.02 during the same period in 2008. Meanwhile, vacancy rates on commercial property rose from 11.8% to 13.4%. Moreover, commercial lenders are now “turning up the heat” on landlords to cut deals to get their office spaces leased in order to avoid or cure loan defaults.
Landlords don’t want to see long-term tenants walk out the door, particularly those occupying substantial space. Providing lucrative renewal/extension offers reduces the landlord’s risk, since the costs associated with a renewal are probably half of what’s required to secure a new tenant.
However, doctors can’t wait too long to take advantage of these leasing opportunities. As the economic recovery gains steam, rental deals will vaporize. In fact, rents in some markets, such as Washington, D.C., and New York City, are already starting to rise.
Our recent experience
Recently, a long time tax and business-planning client contacted us to assist him in renewing his office space lease of 2,453 rentable square feet. His practice was located in a high-rise commercial office building, downtown in a major metropolitan area, where building ownership was not a viable option.
We first assisted this doctor in negotiating a 10-year lease with substantial leasehold concessions back in 1991, when he first moved his practice there. We also assisted him in renewing the lease for another 10 years when it expired in 2001. He contacted us recently seeking only a short-term renewal, since he planned to sell his practice and retire in three years at age 65.
The landlord’s representative proposed a five-year lease at the current lease rate ($25.30 per rentable square foot), along with a lease concession of one-half month’s rent due for each of the first four months of the renewal term.
We first advised him that any bank financing the purchase of his practice by a potential buyer would require that the lease cover the practice purchase loan repayment period (typically seven years).
Accordingly, we recommended that he secure a lease extension for a term of 10 years, rather than five. The landlord would provide more concessions (free/reduced rent, etc.) with a longer lease period.
Upon researching the commercial rental market in his area, we discovered that other space in the same building was being offered at substantially lower rates due to high vacancies. We then helped the doctor engage a commercial real estate broker with intimate knowledge of the market to represent the doctor in “hardball” negotiations.
The result?
The doctor secured the recommended lease renewal term (10 years) at an extraordinarily favorable rate ($18 per rentable square foot). Moreover, the doctor received six months of free rent and six additional months at one-half of the normal rent. In addition, the doctor also received new paint and carpeting in the space and a $5 per rentable square foot allowance for a midterm retrofit (painting, carpeting) halfway through the lease term.
How much did the doctor save? More than $250,000 during the 10-year lease term compared to the landlord’s initial offer! Of this, more than $34,000 of the savings will occur during the initial year of the lease renewal, when the doctor is enjoying the free and reduced rent.
This drastic reduction in the doctor’s rent expense will fatten the practice’s bottom line during his remaining period of practice ownership. Moreover, this will also increase his practice sales price by another $30,000 to $50,000 due to the increased annual profits.
Editor’s Note: Reprinted with permission from “The McGill Advisory” newsletter through John K. McGill & Company, Inc., a member of The McGill & Hill Group, LLC. Visit www.mcgillhillgroup.com for more information.
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