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Should Real Estate Be Part of a Practice Buy-In?

MANAGED CARE June 1996. © MediMedia USA

Should Real Estate Be Part of a Practice Buy-In?

When physicians invite a new partner into a practice, it raises the question of whether he or she should be required to invest in the practice's real estate holdings. Here's what to consider in making that decision.
Daniel M. Bernick, J.D., M.B.A.
MANAGED CARE June 1996. ©1996 Stezzi Communications

When physicians invite a new partner into a practice, it raises the question of whether he or she should be required to invest in the practice's real estate holdings. Here's what to consider in making that decision.

Daniel M. Bernick, J.D., M.B.A.

A group of physicians is looking for a new partner to join the practice. They interview a slew of candidates and find a prospect they like. But there's one hitch: The prospective physician doesn't want to get involved in the group's practice real estate, feeling that it's not a wise investment. The present partners insist that a real estate investment be a part of the agreement. An impasse ensues. What to do?

Many practitioners have made substantial investments in their practice offices, whether a condo unit in a medical office building or perhaps a free-standing building that houses the practice. Should this practice-related asset be included in a medical practice buy-in?

Normally, the real property is held outside the medical practice corporation, and it has its own set of books and financial statements as a venture separate from the medical practice. Thus, practically, it is easy to exclude the real estate from the medical practice buy-in if this is desired.

A special kind of investment

Some practitioners want to recoup their substantial investment in the real property, and feel that a new partner, as a partner, should participate in the real estate as an important practice-related investment. Financially, the property may not be a great investment, the senior partner reasons, but owning it is critical to the practice's success, as it allows the doctors to maintain control over the practice location. With the doctors as the office owners, no unfriendly landlord can kick the practice out of its current location or raise rents to exorbitant levels.

The new partner, however, may resist buying into real estate. The cash return on investment may be small or nonexistent; there may be few prospects for appreciation, and the asset is expensive, requiring substantial commitment of cash and debt. Furthermore, the investment is illiquid, a fact that may be troubling to a new partner not sure of his or her long-term commitment to the practice or the geographic area in which it is located.

A difference of perspective

Thus, while the older doctor reasons that "what's good for one is good for all," the new partner may view the real property as the senior doctor's problem. "Why throw good money after bad?" may be the thought — though it is unlikely to be expressed so baldly.

While circumstances vary, in general older practitioners should not insist on a real estate buy-in. If the practice office is an appealing investment, the new partner will most likely want to buy in. If not, little is gained from making a major issue of it, and in fact much may be lost if the negotiations over the buy-in to the medical practice are soured as a result. Older doctors should recognize that it is harder to find a buyer for the practice than it is to find a buyer for the real estate. Anyone can own real estate, but only a doctor can buy into a medical practice.

The new partner may not be able to afford a buy-in to the real estate, even if he or she has the desire. In the early years of partnership, the young doctor's share of the medical practice income may be modest, and this modest portion is perhaps further depleted by payments for the new partner's share of the practice stock or equip-ment values. To add a buy-in to the real estate may turn a deal that is "doable" from the young physician's perspective into one that is onerous and unacceptable.

With no buy-in...

If there is no real estate buy-in, the doctors should agree on a rent for the office, and then incorporate their agreement into the medical practice partnership documents. The issue is important, because often the current rent is above market rates. This wouldn't matter if the senior doctor owned all of the practice and the property, because what came out of one pocket would just as quickly go into the other. Furthermore, there are potential tax savings to the older doctor from shielding the excess rent with depreciation deductions on the real property or from reducing the amount of salary he or she takes from the practice corporation, which saves payroll taxes. But if the new doctor doesn't buy into the real estate, the math changes entirely. Now 50 percent of the excess rent paid to the older doctor as sole owner of the real estate is being subsidized by the younger doctor as a partner in the medical practice.

With a buy-in...

If there is a real estate buy-in, the transaction can be done with a straight down payment and promissory note. The doctors have to determine a price for the property and go from there. A separate partnership agreement should be established for the real estate. Placing real estate into the practice corporation can become a tax disaster if the property is ever sold, or if the corporation is liquidated. If the practice is unincorporated, it's still best to keep the real estate separate in terms of financial accounting and legal documentation. The real estate and the medical practice are two separate businesses, and tracking the financial performance of each will be impossible if their finances are intertwined.

An alternative approach for real estate buy-ins is to eliminate the payment of cash and notes to the senior doctor in favor of a capital contribution by the younger doctor directly to the new real estate partnership. This eliminates the tax to the senior doctor that results from the payment of cash and notes directly to him or her. However, this will probably result in the young doctor's acquiring a smaller percentage interest in the partnership, as dollars contributed directly to the partnership increase its value. That reduces the percentage of the partnership that those same dollars can buy.

The author is a consultant for The Health Care Group Inc., of Plymouth Meeting, Pa., who works extensively with buy-in and payout arrangements and with practice mergers. Mr. Bernick holds an M.B.A. from the Wharton School of the University of Pennsylvania in Philadelphia and frequently writes about health care issues.