Medical Office Subleases Fair Market Rental Values

[Mike Maher]

We have a hospital group as a client who has been active in acquiring smaller practices over the years. Many of the medical practices have sublease agreements in place with other doctors. These agreements often grant use of one or two exam rooms in the office on a per session basis. These sessions are typically 4 hours, and include the use of furniture, equipment, supplies, and often of a receptionist and of a registered nurse or other medical professional. Some of the agreements are one offs, between two individuals, and some are at larger retirement communities - in any event rates are all over the place since the data is not transparent, and many of the agreements do not appear to be arms length transactions. I was wondering if anyone has encountered any similar requests from clients, or has been performing any of this kind of work?

Thanks in advance

Mike

 

[Big4Jim]

Determining the market rental rate for a sublease medical office shouldn't be that difficult. However, it doesn't seem to me that your agreements are real estate leases. It sounds like your client is looking for the market rental rate for the co-location contract similar to a data center co-location. Therefore, you should be looking for comparable agreements. I would assume that the agreements would vary depending on the level of service and amenities the medical practice provides, specialized equipment, location relative to medical centers, availability/"occupancy" of sessions at the office, etc.

 

[Joyce Potts]

Nemours is going crazy in the Orlando area with building out pediatric offices within established PO and retail centers.

 

[Financially Feasible]

We have a hospital group as a client who has been active in acquiring smaller practices over the years. Many of the medical practices have sublease agreements in place with other doctors. These agreements often grant use of one or two exam rooms in the office on a per session basis. These sessions are typically 4 hours, and include the use of furniture, equipment, supplies, and often of a receptionist and of a registered nurse or other medical professional. Some of the agreements are one offs, between two individuals, and some are at larger retirement communities - in any event rates are all over the place since the data is not transparent, and many of the agreements do not appear to be arms length transactions. I was wondering if anyone has encountered any similar requests from clients, or has been performing any of this kind of work?

Thanks in advance

Mike

Mike,

It looks like you are a "long time watcher; first time poster"... so welcome to the Forum!

I've read and re-read your post several times. There are a lot of unknowns in your post so I'm not sure if anyone can give an adequate answer. However, I have some questions which, upon seeing the answers, may be able to help shed some light for you (or give other posters adequate information to help formulate an answer). Here it goes:

1.) You mentioned "I was wondering if anyone has encountered any similar requests from clients...". In your post, you didn't mention what the request from the client was. Are you valuing a business? Real estate? Interest (fee simple, leased fee, leasehold, going concern)? Is this a rental study? Intended use/user? I'm unclear as to what information that the client is seeking.

2.) These sublease agreements... are they for any specific term? Do they have a minimum number of "sessions" that are required for a given term? Do they reimburse expenses? What makes you think that they are not arms-length? Do they have signed leases? Are such sublease agreements typical for your market? Do the historical operating statements show a stabilized level of income for these subleases?

I may have more questions but this should get the ball rolling. I'm just trying to get a better understanding of what you're looking for and what the situation is... and while I don't know if I can help you out directly, I may be able to help you out conceptually.

 

[Mike Maher]

Mike,

It looks like you are a "long time watcher; first time poster"... so welcome to the Forum!

I've read and re-read your post several times. There are a lot of unknowns in your post so I'm not sure if anyone can give an adequate answer. However, I have some questions which, upon seeing the answers, may be able to help shed some light for you (or give other posters adequate information to help formulate an answer). Here it goes:

1.) You mentioned "I was wondering if anyone has encountered any similar requests from clients...". In your post, you didn't mention what the request from the client was. Are you valuing a business? Real estate? Interest (fee simple, leased fee, leasehold, going concern)? Is this a rental study? Intended use/user? I'm unclear as to what information that the client is seeking.

2.) These sublease agreements... are they for any specific term? Do they have a minimum number of "sessions" that are required for a given term? Do they reimburse expenses? What makes you think that they are not arms-length? Do they have signed leases? Are such sublease agreements typical for your market? Do the historical operating statements show a stabilized level of income for these subleases?

I may have more questions but this should get the ball rolling. I'm just trying to get a better understanding of what you're looking for and what the situation is... and while I don't know if I can help you out directly, I may be able to help you out conceptually.

Ed,

Our client is a hospital group who is actively acquiring smaller medical practices. The client is looking for Fair Market Rental Value of the office space for regulatory reporting purposes. Intended user is the client, and most are as of a current valuation date. Whats happening is the client is buying the practice, but don't want to pay overly inflated rents to the landlords, who are often the same as the owner of the practice the client just purchased.

In our area, which is central NJ and eastern PA, many of the physician practices are owner occupied, and the Dr has a lease with himself, so leases like that are clearly not arms length, which is why the client wants the FMRV. But many of the practices also have these session subleases, which are among friends, and upon interviewing the Dr they inform me that this was an agreement between two people who were acquaintances, and that no market research was done to arrive at the price per session. So its not really arms length, and neither party appears to be well informed.

The type of agreement seems to be somewhat typical for medical offices in that we are coming across it more and more frequently, but since most of the parties are small individuals there is no income/expense data for the sublease. The signed agreements we see are usually very vague, outdated/expired, or terms have changed and a new document has not been signed. Typically a Session is 4 hours, includes use of one or two furnished exam rooms, may or may not include staff support, and is a flat fee, so while the main tenant may have a NNN lease, the subleases on a per session basis are gross.

So maybe an example will help. Mike Maher Medical leases 5,000 square feet of office space from Office Space Corp at $25.00/PSF NNN. It's an arms length transaction, signed lease, everything typical of the market. We can easily look to the market for recently signed leases of medical office space, as well as listing of office space, and determine that that lease is at fair market rents. However, Mike Maher Medical also has a sublease signed with Dr. X. Mike Maher Medical informs us that Dr. X uses 2 exam rooms in Mike Maher Medical's office suite once a week, for a single 4 hour session. Dr. X pays Mike Maher Medical $200 per session.
Since 4 hour session leases are not advertised as a typical lease term we have no market data, and the majority of data we have been collecting is either one offs, not arm's length, or not done by well informed parties, we're looking for other opinions as to how we should handle trying to value these session leases.

 

[Financially Feasible]

Ed,

Our client is a hospital group who is actively acquiring smaller medical practices. The client is looking for Fair Market Rental Value of the office space for regulatory reporting purposes. Intended user is the client, and most are as of a current valuation date. Whats happening is the client is buying the practice, but don't want to pay overly inflated rents to the landlords, who are often the same as the owner of the practice the client just purchased.

In our area, which is central NJ and eastern PA, many of the physician practices are owner occupied, and the Dr has a lease with himself, so leases like that are clearly not arms length, which is why the client wants the FMRV. But many of the practices also have these session subleases, which are among friends, and upon interviewing the Dr they inform me that this was an agreement between two people who were acquaintances, and that no market research was done to arrive at the price per session. So its not really arms length, and neither party appears to be well informed.

The type of agreement seems to be somewhat typical for medical offices in that we are coming across it more and more frequently, but since most of the parties are small individuals there is no income/expense data for the sublease. The signed agreements we see are usually very vague, outdated/expired, or terms have changed and a new document has not been signed. Typically a Session is 4 hours, includes use of one or two furnished exam rooms, may or may not include staff support, and is a flat fee, so while the main tenant may have a NNN lease, the subleases on a per session basis are gross.

So maybe an example will help. Mike Maher Medical leases 5,000 square feet of office space from Office Space Corp at $25.00/PSF NNN. It's an arms length transaction, signed lease, everything typical of the market. We can easily look to the market for recently signed leases of medical office space, as well as listing of office space, and determine that that lease is at fair market rents. However, Mike Maher Medical also has a sublease signed with Dr. X. Mike Maher Medical informs us that Dr. X uses 2 exam rooms in Mike Maher Medical's office suite once a week, for a single 4 hour session. Dr. X pays Mike Maher Medical $200 per session.
Since 4 hour session leases are not advertised as a typical lease term we have no market data, and the majority of data we have been collecting is either one offs, not arm's length, or not done by well informed parties, we're looking for other opinions as to how we should handle trying to value these session leases.

Thanks, Mike - your post does offer clarity!

My initial thought is this (and this assumes that subletting is permissible under the lease) - unless the landlord requires a percentage rent for any subleases or a flat additional rent for any subtenants (and I'll assume that neither of these are applicable for your situation unless otherwise informed as such), why would the presence of a possible sublease have any impact at all on the derivation of a fair market rent between a lessor and lessee? Why would the landlord care whether the tenant or subtenant occupies the space (and this assumes that the landlord would have to approve the subtenant prior to occupancy) as long as they are getting their market rent? Further, would a tenant pay any level of "premium" to market rent for being allowed to have subtenants if they are, from what I can tell, a "come and go" type of tenant with irregular cash flow?

These questions are meant as a conceptual guide on how to answer your questions (as I don't have any actual market data to give you for the type of problem you are looking to solve).

 

[Big4Jim]

Ed,

Our client is a hospital group who is actively acquiring smaller medical practices. The client is looking for Fair Market Rental Value of the office space for regulatory reporting purposes. Intended user is the client, and most are as of a current valuation date. Whats happening is the client is buying the practice, but don't want to pay overly inflated rents to the landlords, who are often the same as the owner of the practice the client just purchased.

In our area, which is central NJ and eastern PA, many of the physician practices are owner occupied, and the Dr has a lease with himself, so leases like that are clearly not arms length, which is why the client wants the FMRV. But many of the practices also have these session subleases, which are among friends, and upon interviewing the Dr they inform me that this was an agreement between two people who were acquaintances, and that no market research was done to arrive at the price per session. So its not really arms length, and neither party appears to be well informed.

The type of agreement seems to be somewhat typical for medical offices in that we are coming across it more and more frequently, but since most of the parties are small individuals there is no income/expense data for the sublease. The signed agreements we see are usually very vague, outdated/expired, or terms have changed and a new document has not been signed. Typically a Session is 4 hours, includes use of one or two furnished exam rooms, may or may not include staff support, and is a flat fee, so while the main tenant may have a NNN lease, the subleases on a per session basis are gross.

So maybe an example will help. Mike Maher Medical leases 5,000 square feet of office space from Office Space Corp at $25.00/PSF NNN. It's an arms length transaction, signed lease, everything typical of the market. We can easily look to the market for recently signed leases of medical office space, as well as listing of office space, and determine that that lease is at fair market rents. However, Mike Maher Medical also has a sublease signed with Dr. X. Mike Maher Medical informs us that Dr. X uses 2 exam rooms in Mike Maher Medical's office suite once a week, for a single 4 hour session. Dr. X pays Mike Maher Medical $200 per session.
Since 4 hour session leases are not advertised as a typical lease term we have no market data, and the majority of data we have been collecting is either one offs, not arm's length, or not done by well informed parties, we're looking for other opinions as to how we should handle trying to value these session leases.

Mike - In your example, I don't think the Doctor X is a real estate lease. It is a business contract. Now you could FV a business contract much like a real estate lease, however there are a few subtleties.

 

[Mike Maher]

Mike - In your example, I don't think the Doctor X is a real estate lease. It is a business contract. Now you could FV a business contract much like a real estate lease, however there are a few subtleties.

Yea that's sort of how we're leaning. I mean in actuality its most like reserving a room at a hotel, or renting out a bowling alley for a party. Its just that the Doctors tend to write the the agreements up and try to fit them into real estate sublease agreements. Idk, it started out as a one time thing for the client and is now turning into a lot of the same requests, so we weren't sure if there were other appraisers out there being asked to value these medical session leases. Its really ramped up in the last year so we're also not sure if its a new requirement to check FMRV in the healthcare reform bill, or if just this hospital has decided they want to double check everything.

 

[Financially Feasible]

Yea that's sort of how we're leaning. I mean in actuality its most like reserving a room at a hotel, or renting out a bowling alley for a party. Its just that the Doctors tend to write the the agreements up and try to fit them into real estate sublease agreements. Idk, it started out as a one time thing for the client and is now turning into a lot of the same requests, so we weren't sure if there were other appraisers out there being asked to value these medical session leases. Its really ramped up in the last year so we're also not sure if its a new requirement to check FMRV in the healthcare reform bill, or if just this hospital has decided they want to double check everything.

You're speaking about the going concern. That brings me back to my point about looking at the historical operating data... if there is a stabilized level of rent received for this type of business arrangement (both at the subject and in the market), then there may be value of it into perpetuity. However, with full acknowledgement of my limited knowledge of these arrangements, I would hesitate to compare this income with things like ADR/ADO at hotels.

A colleague of mine recently appraised a specialty hospital and may have encountered the same issues... I'll reach out to him to see if he has any input.

This makes for an interesting discussion!

 

[Michael P Jacobs MAI]

You're speaking about the going concern.

Almost certainly. It only gets complicated if the sublease is for a specific term AND survives the lease in the event it is terminated, since that is a leasehold. Otherwise, it's a business service.

This is very different from hospitality, ALF/Senior Care and self storage where going concern is implicit. In this case the business is so specialized that there may be few buyers for the economic unit of business and realty.

This could change as the practice becomes more common, or the lender may be making a business loan partially secured by realty.

This is not uncommon here in SE Florida with all the medical office space we have. It's also seen around MIA cargo districts where the rent roll consists of dozens of "tenants" with small or no-suites and their cargo is moved in and out by the "landlords" employees.