To Lease or to Buy?

February 1, 2004

How to make a lease versus buy decision

As buyers of big-ticket items, physicians have been in the eye of what consultant Robert James Cimasi calls an "almost perfect storm" during the past several years. Great commercial forces -- low interest rates, abundant medical real estate, and investments required by HIPAA -- seemed to align to make 2003 a very good time for practices to invest in themselves.

And 2004 looks to be much the same. As a result, quite a few practices are facing expensive decisions to invest in property and upgrade their practice's technology. According to some experts, low interest rates and a surfeit of supply mean that if physicians are not pondering such purchases, they should be.

Yet some troublesome details typically remain even after the decision is made. Chief among them, of course, is how to finance capital investments, especially medical equipment and real estate. Should physicians lease or buy? Does renting provide a better return on investment than buying?

The answers, unfortunately, are not clear-cut. "There's no one right answer for all practices," says Mike Andersen, senior vice president of Commons Medical, an Orlando, Fla., firm that works with practices to develop both leased and acquired space. "There are a lot of pros and cons to leasing and buying."

Many of the pros and cons, moreover, rest not only on each practice's financial condition, but on its expectations for the future. Not all the factors can be reduced to numbers. "Every physician has a threshold [for] what the minimum internal rate of return is on this stuff," says Cimasi, who is president of Health Capital Consultants in St. Louis. "That's easy to quantify, but taken together with other factors it's a complex set of circumstances that they need to consider."

Dollars in, dollars out

At first blush, the math is simple. "First you compare what it would cost if [you] were to lease with what it will cost to buy," says Paul Angotti, president of Management Design LLC, a medical practice financial consultancy in Monument, Colo. Those costs should include interest payments and depreciation expenses.

After comparing how many dollars would go out the door under a lease to how many would go out under a straight purchase plan, the next step is to add or subtract the tax consequences.

With leases, each monthly payment is an expense that can be subtracted from the practice's taxable income each time you make that payment. When you purchase items that are going to last longer than a year, on the other hand, the amount you deduct usually would not be the amount of your monthly payment. Instead, it would be how much the property depreciates, the amount you spend to maintain or improve it, and (sometimes) the interest payments you make.

The Internal Revenue Service allows you to decide whether you think you'll be using the new equipment for three, five, or seven years. Depending on what you decide, you can write off up to one-third, one-fifth, or one-seventh of these total "amortization and depreciation" expenses each year.

Yet there are still other factors to consider in deciding whether to lease or buy. When they buy, for example, practices can immediately write off up to $100,000 in office equipment a year, notes Brent Meyer, a partner at Physicians Accounting Management in Encino, Calif.  The rest would be depreciated over the five- to seven-year life of the equipment.

In Meyer's view, that often makes purchasing the best choice. "I would say that probably 90 percent of my clients will purchase their equipment," he says, "and the 10 percent who don't purchase ... are leasing equipment that is very expensive." They either did not have the cash to make a sizeable down payment, or they were getting high-tech equipment that would be obsolete by the time they paid it off in a few years.

"They don't mind just leasing the equipment, knowing at the end [of the lease] they just give it back because they're going to end up getting new equipment anyway," says Meyer.

Cimasi agrees that each decision ultimately depends on each practice's particular condition and need. "It has a lot to do with cash flow," he says. Leasing makes sense "if you can set up a lease where you can conserve capital, and you get lower monthly payments and avoid the technical risks of obsolescence."

Then there is a series of maddeningly subjective, educated guesses that need to go into each lease-versus-buy decision.

What's the life expectancy?

How long a piece of equipment or even a building will hold its value is often strictly in the eye of the beholder.

"There's a difference between the functional life of a piece of equipment and its market life," Angotti points out. A technologically obsolete imaging device might still work -- producing value for the practice -- long after faster, better devices are out in the market. Some physicians might not mind purchasing and holding it for as long as possible; others may worry that competitors soon will be using newer devices to take images faster, more cheaply and probably more profitably in the future. For them, leasing would be a better choice.

Long-term worth

When it comes to real estate, "the biggest point in the [lease or buy] issue is estimating the value of the building 10 years down the road," Angotti says. A typical mortgage on medical office space will go 10 years, with a balloon payment at the end. A balloon payment is the amount you still owe for the property after making all your payments. Practices can either pay it all at once or, if you and the property qualify for a new loan, refinance it by borrowing the remaining amount as a new mortgage.

The trick is in guessing whether the building will be worth more than the amount of the balloon payment when it comes due. If it is, it will be easy to refinance. If it is not, the physician may well end up making another sizeable cash payment in order to get a new loan for the remainder of the original purchase price.

"That's what people are banking on -- that property is always increasing in value," Meyer says.

They are often correct. "Overall," Andersen observes, "medical buildings appreciate as fast as if not faster than others." Cimasi notes that, when buying a medical office building, you're also accumulating equity that you don't get when renting. Real estate often outperforms other kinds of investments, too. A stock that would generate as much cash as a building that has appreciated over 10 or 20 years would need to be distributing "a whole lot of dividends during that time." There are not many stocks that have done that recently, he says.

Yet owning medical real estate is not always a slam-dunk profit. There is genuine risk involved.

"It's not always appreciating," Meyer maintains. "Property [value] goes in cycles just like the stock market does ... ." Timing matters. Buy at the top of the market just before one of the cyclical slumps, and it's eminently possible that the building won't fully regain its value by the time the balloon payment is due in 10 years.

Angotti is even more dubious about the wisdom of buying instead of leasing office space. "I've been doing this 21 years, and I can tell you medical office space does not appreciate like a house." Buyers often may devalue it because they will have to do a lot of renovation in order to accommodate their own specialty. "An orthopedic group may have to blacken an area. A family practice needs a casting room. Different specialties and kinds of practices all have different kinds of space configuration needs. That tends to deflate the value."

Medical office owners' properties can suffer in other ways that homeowners' properties do not. Often dependent on their proximity to hospitals, certain specialty practice space can lose value if, for example, the hospital downsizes, does away with its NICU, downgrades from a Level I to a Level III trauma center, or if it merges with another, Cimasi adds.

Angotti has "seen war stories where [a practice] is at the 10-year point, and each of the partners had to reach into their pocket and take out an eighth of a million dollars each because the building wasn't worth what they thought it would be."

"To be very, very conservative," he says, Angotti counsels his clients to figure the building will be worth only 80 percent of its original value in 10 years. If the deal does not look advantageous when it includes that assumption, it's probably best to keep leasing space.

Andersen and Cimasi generally use less conservative calculations. "In all cases, it is a case of trying to leverage your available capital," Cimasi advises. "The most optimal investment is to find a property that you're going to sell for more than what you paid for it." If you can't, buying probably is not a viable option.

What's in the practice's future?

Still other factors that don't fit into a neat mathematical equation need to go into any lease-versus-buy decision. The most important factor, Andersen points out, is to have a good idea of where the practice is heading. Do you plan to take on new partners, retire, grow, or merge with another practice during the time you'd be paying off the equipment or the building?

For example, one of his clients, Asheville Cardiology in North Carolina, wants to be paperless in five to seven years. It thus needed space flexible enough to turn a chart room into a clinical pod, and needed financing that would allow the current chart room to pay for itself in five years.

Another client "in five years might want to add a partner or two, or at least PAs," he reports. Those kinds of considerations greatly influence the kinds of equipment, office space, and financing that would be best for the practice.

In the end, the experts agree, deciding whether to lease or buy inevitably extends beyond financial statements, the educated guesses, the practice's likely development, and even the specifics of the deal to the individual physician's personal investment and risk tolerances. "Your personal risks, your financial comfort zone, how much aggravation do you want to deal with; all these are factors you want to consider," Cimasi says.

William Litt can be reached via
editor@physicianspractice.com.

This article originally appeared in the February 2004 issue of Physicians Practice.