Physician partnerships are often one of the most unique groups of individuals found in business today. These highly trained partners with dynamic personalities come from a variety of backgrounds, and work in a high stress environment. They often greet us in meetings after they’ve performed 35 cataract procedures or completed a full day of hip replacements; these individuals having a tight schedule is an understatement.
In many non-healthcare businesses, when the founders or owners retire, they can continue to hold their ownership into retirement. For physician partnerships, the physicians must typically relinquish their ownership position when they retire.
Private practices are comprised of physicians with a wide range of ages and different career timelines, a result of proper succession planning. While all partners are aligned toward the overall success of their practice, they must also keep their own interests in mind. When a practice operates from a physician-owned building, the real estate is commonly owned by a separate legal entity. Even though ownership in the real estate entity can only be held by partners in the practice, the real estate is very rarely owned directly by the practice. Instead, it’s owned by some or all the partners. This unique dynamic has the potential to create inequity between partners and fosters uncertainty in their exit strategies.
In this article, we’ll examine the various players in a physician real estate partnership and establish a better understanding of their individual circumstances and objectives.
The senior partner has likely been with the practice for more than 20 years and was probably one of the founding members. If not a founder, at minimum they were likely part of the group that took the risk to build the practice’s current facility, applied for the Certificate of Need to start their surgery center, and played a hand in recruiting many of the other partners. This partner has been receiving cash flow from their real estate investment for a long period, enjoying the benefits of depreciation, and is looking to retire in the next one to five years. The partnership is presumably set up so that when the senior partner retires, they will be required to sell their real estate shares to the rest of the partnership at an appraisal value.
The new partner joined the practice within the past few years and worked as an employed physician with the eventual goal of becoming a partner. To secure partnership status, they had the opportunity (truthfully, were required) to buy into the practice, buy into the surgery center, and as a last priority, to buy shares of the real estate at appraisal value. They likely took out a loan with personal guarantees, and because of the higher appraisal value of the real estate, the return on investment is not as attractive as it was for the partners who bought in much earlier or developed the facility from the ground up.
Middle of the road partner
The middle of the road partner is in the most unique position. This individual has been with the practice for five to 15 years and likely has more than 10 years remaining on their career timeline. Each time a new partner joins the practice, they are required to sell a few real estate shares to the newer partner at a higher appraisal value compared to the time of buy-in. At the same time, each time a partner leaves the practice, they are required to buy their shares, requiring more cash or debt and raising their basis in the investment. This partner’s exit strategy is based on the practice’s ability to continue recruiting physicians who want to buy into real estate. With continued headwinds in physician recruitment, cashing out of this investment will become increasingly more difficult.
Newly recruited employed physician
The newly recruited employed physician is on a path to partnership with an anticipated timeline of 18 to 24 months. In the recruitment process, this individual was courted by health systems and private practices all over the country. They likely have a large amount of medical school debt, so they chose to join a growing private practice where they will have the opportunity to buy into the practice, the surgery center and the real estate. Based on this timing, they will likely have to buy into the real estate when interest rates are at a short-term high and when appraisal values could plateau for the foreseeable future. Once the recruit becomes a partner and completes the buy-in process, each time a physician retires, they will have to come up with the capital to buy those shares. If the practice never raises its rents, the cash flow on the investment is marginal. This physician and other newly recruited physicians are also the exit strategy for each physician partner senior to them. If this individual buys in when the building is 25 years old, they will likely still be an owner when the building is 50 years old and aging, unless the practice vacates the current facility or strategically executes a sale and lease back. The newly recruited physician’s exit strategy is riddled with uncertainty.
A slippery slope
From an outside perspective, it is clear which position you would prefer to be in (hint: the partner with the most certain exit strategy). As time passes and ownership in the practice real estate transitions from one partner to another at higher appraisal values, is it realistic that the property value will always continue to increase, providing an exit for every future partner? If the practice isn’t raising its rent, but every partner buys in at a different appraisal value (with higher monthly debt obligations), isn’t the investment better for the older physicians than the younger ones? Eventually, there will be a partner who made a poor investment or is receiving a subpar return.
So, is there a way the practice can make every player a winner?
There are only two ways for physicians to exit their owner-occupied real estate investment:
- Sell to a younger partner (as described above).
- Sell to an institutional investor.
With option one in mind, it’s critical to understand the increasing difficulty of recruiting physicians into private practice. Exacerbating the problem is the follow-on obligation of buying into the practice, then the surgery center, and eventually into the practice’s real estate. On top of these debt obligations, remember that medical school debt is at an all-time high, and many physicians are recruited from an outside market and might be taking on debt when purchasing a new home. Considering these new recruits are the exit strategy for senior partners on the verge of retirement, it’s important to note the trends. In 2018, 51% of all physicians were employed as opposed to being a partner in private practice. Today, 74% of physicians are employed.1
When selling to an institutional investor (option two), the most important variable to understand is the length and structure of your lease. A properly structured lease is the primary value driver in selling to a third-party investor at a premium value. As a rule, and among many other parameters, the lease should be at least 10 years long to achieve optimized value. With a shorter lease length or other inferior terms, the buyer must account for the potential risk of non-renewal, resulting in poor pricing for the physician owners.
Now, let’s examine how every player wins if they sell their real estate to an institutional investor.
The senior partner will be bought out of their real estate at a premium-to-appraised value, higher than any incoming partner would pay. The lease the practice signed will be 10 to 15 years, even though the senior partner may be retiring in the next five years. They are no longer making payments toward overheard, has certainty in their exit strategy, and will cash out at an optimal value.
The new partner will be bought out of their real estate at a premium to appraised value. The greatest benefit the new partner has over the other partners is a far shorter investment timeline, not 20-plus years like for the founding partners. Because of this accelerated timeline, the new partner will experience the highest return on investment. With immediate liquidity and plenty of career runway, the new partner can make other investments and compound the profits over time. Additionally, this player doesn’t have to constantly buy out the retiring physicians in a time when appraisals have plateaued and interest rates have risen.
Middle of the road partner
The middle of the road partner will be bought out of their real estate at a premium-to-appraised value. They likely have five to 15 years remaining in their career, and if the practice signed a lease for 10 to 15 years, this aligns nicely with their work timeline. This partner benefits from having received rental cashflow for a long period of time up until the sale. They have certainty in their exit strategy at a premium value and a seamless transition to retirement.
Newly recruited physicians
The newly recruited physician will benefit from not having to buy into an investment with uncertainty in their exit strategy. The path to becoming a partner only involves buying into the practice and surgery center; meanwhile, if the practice continues growing, this individual can use their capital to invest in a new location and benefit in the same way as the senior partners when they began their careers.
For a partnership that has physicians with a variety of career timelines, there will never be a perfect time to sell the practice’s real estate — but there is a time to sell when everyone can win.
From a demographic perspective, 2023 could be an ideal time to sell to an institutional investor, primarily because a sale to younger physicians could be difficult. Many partnerships have physicians on the verge of retirement, and interest rates have increased, which increases buy-in costs. It’s becoming more difficult to recruit younger physicians, and real estate is another burden of debt that recruited physicians must consider before joining a practice.
Armed with an understanding of the players involved in a physician partnership, along with their various objectives and exit strategies, you can plan for a strategic real estate sale at the best possible time for your partnership.
- Gooch, K. “74% of physicians are hospital or corporate employees, with pandemic fueling increase.” Becker’s Hospital Review. April 19, 2022. Available from: bit.ly/42rXXIS.