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Medical Office Leasing Basics

August 18, 2014

Article

Understanding the principles of leasing medical office space will enable practices to negotiate a lower-cost and equitable leasing agreement.

Lucien W. Roberts is assistant administrator of Gastrointestinal Specialists, Inc., a 22-provider practice in Central Virginia; he is also a practice management consultant who works with practices in critical areas such as HIPAA compliance and payer negotiations.

Physicians Practice recently spoke with him about leasing medical office space and how to

negotiate an equitable and lower-cost leasing agreement. Aside from staff salaries, a large part of practice overhead is the cost of leasing office space. Contract provisions can vary widely, so it is important that practice managers understand what the needs of the practice are, and can negotiate a lease that provides for only those parameters and nothing else that could potentially add significant costs over the life of the lease.

Erica Sprey: Can you explain the difference between rentable square feet and usable square feet?

Lucien W. Roberts: Rentable square feet equal the basis for your rent. Usable square feet equals the actual square footage of your office. The difference between usable and rentable square feet is a pro rata share of the building's common area - like public hallways, the lobby, public restrooms, etc.

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By dividing your rentable square feet by your usable square feet, you calculate the load factor (or core factor), which is a way to assess what percent of the building is allocated to unusable space.

ES: What is a "rent escalator", and why is it important to negotiate a lower one?

LR: The term "rent escalator" represents the amount your rental rate will increase by an inflation factor, generally 2 percent to 4 percent. When negotiating a rental agreement, keep the escalator as low as possible, as rent escalation compounds.

In this example, this practice could save $44,639 over 10 years by negotiating a lower rent escalation.

Cost/Sq ft

Annual Cost

Annual Difference

Aggregate Difference

Year 1

21.00

105,000

Year 2

21.42

21.84

107,100

109,200

2,100

Year 3

21.85

22.71

108,242

113,568

4,326

6,526

Year 10

21.85

29.89

125,485

149,448

23,963

44,639

[Example of $21.00 per Sq ft for 5,000 Sq ft at different escalations.]

ES: Can you explain a "triple net" lease?

LR: It is important to know what is and is not included in your rental agreement when comparing and negotiating leases. In a "triple net" lease, the renter typically must pay the expenses of property taxes, common area maintenance (CAM) for items such as snow removal, landscaping, etc., and property insurance. It is critical to get an estimate of these expenses upfront; if possible, negotiate a cap on your CAM. It is also critical to understand the costs of items that may be excluded from the rental rate such as utilities and housekeeping. Housekeeping alone can cost $0.80 - $1.25 / square foot / year.

Converting a monthly expense to a cost/sq ft:

We pay $750/month for housekeeping at one of our offices. We rent 9,882 square feet. So:

$750/mo x 12mos = $9,000/year

$9,000 per year/9,882 sq ft = $0.91 / sq ft/year

So, if I wanted to compare the rental rate of this office to another where housekeeping is included in the base rental rate, I would need to add $0.91 to the cost of this office to make an accurate comparison.

ES: What is a tenant improvement allowance?

LR: Tennant improvement allowance, also known as a T.I. allowance or upfit allowance, is a payment from the landlord as part of the lease. With new construction, the T.I. allowance is used to build out the office: walls, cabinetry, ductwork, flooring, etc. It does not cover all of the costs of construction, but it does offset much of this expense. For lease renewals I try to negotiate a small T.I. allowance to pay for re-carpeting, re-painting, etc.

Tenant improvement allowances are expressed in square feet, so a T.I. allowance of $50 / sq ft for a 5,000 sq ft office would result in a payment of $250,000. T.I. allowances are larger for longer leases, as the landlord has longer to recoup this expense.

For new leases, I have seen T.I. allowances from $40 / sq ft to $65 / sq ft. The size of the allowance differs with the quality of the building project, the condition in which the space is delivered for construction (i.e., Is HVAC ductwork in place? Has the ceiling been "dropped"?)

For lease renewals, I have seen allowances from $2 to $10. Again, it depends on the length of the lease extension. And if you don't ask for it, it is seldom offered.

ES: Should a practice ever sign an agreement that includes an evergreen clause?

LR: Most leases include an automatic renewal, or evergreen clause. If you do not let the landlord know in writing of your intention to not renew the lease, the lease is extended automatically for another year or longer. Typically, you need to give the landlord 90 days' to 180 days' advance notice (spelled out in the lease) of your intent to not renew when an evergreen clause exists. I recommend practices keep a spreadsheet that includes basic tenets of each lease such as the evergreen renewal deadline so that dates do not sneak by in the busy-ness of everyday business.