How to invest in medical office? How to find your tenants? What's the average TI (tenant improvement) for a small to medium size office? William Pozo, a podcast listener that has been investing in medical offices for several years, shares his knowledge.
Tell us a little bit about you.
I'm just a small business guy, I don't have tons of properties, I've never done a syndication before. I seeded a small building many years ago and have slowly turned it over the course of many years with a bit of help of my father who had a medical office and helped me get into a medical office by removing some of those fears that I think a lot of owners have, or a lot of entrepreneurs have about getting into the business.
You said that you've grown in the medical office, did you grow by selling or just buying more?
I initially seeded some money to a friend who was a contractor who needed to buy a piece of land, he didn't have any money. With that little seed capital, I was able to get involved in a few duplexes, and I'm not afraid to talk about it, I love duplexes because I think that's an easy way for small investors to get started. That capital eventually led me to be able to buy land, develop or entitle, sell, and then roll it eventually into a medical office. I don't try to sell, I'm not a flipper. I find that there are a lot of people who are looking to return that capital back to them, but I try to withstand it and hold for the long term. When I say I grew up in a medical office, it took me many years to get there, but it's to buy and hold, I try not to sell, I want to pay down the mortgage, and eventually buy bigger buildings.
Have you been refinancing the ones that you have and cashing out to buy other properties?
Yes, I have leaned on this tide in the last 10 years. This has been very good for us with low interest rates. The debt-to-equity ratios are definitely on my side because I'm quite conservative in my investment approach, especially now with these high interest rates environments, we're all going to feel it, and with the insurance rising. You're in California, you probably have similar insurance issues going on in California. Florida is on fire with the insurance right now, so our costs are escalating along with the interest rates but the debt to equity is low, it's in my favor so I've been able to buy and hold. And even though I typically don't pull a lot of money out, I don't try to maximize it, but I have done it over the last 5 to 10 years in order to buy a small building.
There's nothing wrong with not doing syndications, that is a way of growing and it's perfectly amazing. I would love to be able to do that, it all depends on what your goals are and you know how much additional complexities you're willing to enter.
I probably should be borrowing money in different forms, not just from a traditional bank. There's nothing wrong with it.
Medical office is one of the few offices that has been very stable during COVID. I have a friend who owns a huge medical office building and I think 98% occupied. It didn't have one dip during COVID.
The medical office buildings performed really well initially during the first few months of COVID. We were very nervous about the situation with the rents and luckily, the doctors, especially these small format doctors, in the 1 to 5000 square foot range, most of them continued to pay their rent, there were a few that asked for additional time. If you're in a good location, generally speaking, the medical office has been excellent. You need to have good parking, you need to have ideally close proximity to a hospital, or a network of doctors, doctors love to be near each other. For new real estate opportunities, we initially identify the hospital and we branch out from there. That usually drives your traffic for open spaces. Obviously, if you're fronting a street, or you're near a major intersection, that's to your advantage. The actual vacancy rates have been near zero over the last 10 years. The rates have continued to rise. It's suffering a little bit now with the interest rates because of inflation, I don't think the doctors truly understand inflation. A lot of these doctors are unsophisticated, they don't truly know how to do that CPI calculation. Have you done the CPI escalations on any of your commercial rents?
Yes, I have however, I heard that they removed the housing and food items from it. So, it's not real.
We're suffering that now. Those tables are built into my contracts, the name of the table, the type of table, and where you get it. As a result, the interest rate looks lower than reality so it's very difficult for a landlord to raise the rent using the CPI but the space itself remains leased and we've been very happy with it. That's why I thought it'd be a great topic for the audience here. People should seriously consider medical office, or a conversion for an existing office building which a lot of buildings you see out there can, depending on the city and the zoning.
How do you find your tenants?
First, it's the size of the space. Larger spaces tend to be more sophisticated tenants that want to have leasing agents. Tenant reps inflate all my costs so they're dangerous from a landlord's perspective. As a matter of fact, I joke around that when I see a broker and I see a tenant rep, usually the deal can be very difficult, but the size of the space warrants it, or the sophistication of the tenant, because their build-outs can be complicated and the doctors don't really know what they want. Their spouses tend to be the ones making some of these decisions, it's very difficult when you have a very expensive lease combined with a sophisticated build-out and there's an education process. I've done the leasing with reps, and I've done it with brokers. If the broker is a good broker, you won't have an issue, and I'll be happy to pay their fee.
Anything less than two or 3,000 square feet, I'm advertising it in front of the building. I'm putting the word out with existing doctors. There's a small group of community folks, these doctors tend to have a point person at their front desk, and they have a few important business people. If you put out the word out to a few of the larger ones, all these doctors, if they like your building, they bring those doctors with them because if you're an orthopod, or a pediatrician, or one of these sophisticated cancer doctors, they're looking for those physicians to be very close so they'll spread the word. But the larger ones that require hundreds of dollars per foot in additional capital tend to go to the reps or the brokers that can deal with that level of sophistication. I've done a few of those.
The largest lease I have is about 13,000 square feet of medical office, which is very expensive installing equipment, and very specific requirements. It's not small in a dollar sense, it's small in a square footage number but the expense per foot is very high. I prefer to do it on my own, I prefer to just manage the doctors’ expectations, and draw them out, I hire from time to time somebody who can do CAD drawings quickly and lay out the medical offices for them. As a landlord, if you go to the doctor's office, and every time you walk in you see the size of their waiting room, you see the size of their existing exam rooms, you will quickly know what doctors are looking for, and that applies to almost all specialties; pediatricians have specific requirements; lung doctors have more separation. When the doctor sees that you know what you are doing, they get a level of comfort, they calm down and they let you lead the way in terms of design. Minor modifications usually in the under 3000 square feet and then I'm able to push the brokers out of the way and manage it myself without necessarily having to list it on Loopnet. Crexi I've tried many times but it just doesn't have enough traction. I'm hoping it does soon because the more the merrier.
What's an average TI for a small office and the largest office that you have given?
If the doctor is willing to sign a long lease, and it's a reputable doctor, a desirable doctor, there is virtually no limit that I would not put them in, I will draw the tenant. In other words, I'll start at 10, I'll start to drive down at $20 to $30, but I'll go all the way up to 150, within reason. But if it's a reputable doctor that I know will draw his own clients and other doctors, it's worth it. The leases should not be less than three years, and that would be with no build-out or with near zero build-out. In the 5-10 years leases, I'm starting to spend money on the build-out. You'll have odd requests, special MRIs, or special PET scan scanners and those cost the building a lot of money, not the machine, I'm only talking about the build-out around the machine (the copper or the or the radiation field) that cost is very expensive. But once they've installed that equipment, it’s like a carwash, you can't take the carwash, it's the same thing for a doctor. Once a practice installs a machine, they will stay for 10 to 20 years, they're not willing to give up on their equipment.
It's similar to self storage. They won't move. And I will ask questions such as how old is the equipment? If they're moving equipment from another location, I will ask that question. I need to know because if you abandon that equipment, it will cost me money to move that. That has happened. You stick an old X-ray machine or a mammography machine that's bolted to the ground and you can't hire a handyman to remove that, they all look at it and run away. You want high-quality machines with high-quality doctors, but the reason to do that is for the term of the lease and it becomes almost like an excellent tenant, long term.
Is there anything that we should keep in mind with regards to medical office leases?
A lot of smaller guys are afraid of the lease, they're afraid of negotiating or structuring the lease. Don't be afraid of that, especially if you have direct contact with a doctor, you won't really have an issue. You just come up with a form, go to the area's market and see if anyone has the forms. Don't let that be a challenge. That's the number one reason people don't invest in medical offices, they see it as something scary that they have to have these contracts, it's not an issue. Let's face it, these doctors are unsophisticated and straightforward. The bigger your space, the more complicated it can get. That's one thing to keep in mind.
Number two, talk to your local jurisdiction before you buy a building, and make sure the zoning is in place. Even if the building is built, they may not have the water or the certificates of use available. You need to have those conversations with people in the county or whoever's managing it. Before I buy a building, I actually go to the city and ask those questions, if the front clerk doesn't have an answer, you have to pay a fee to get a zoning verification form, it's a nominal fee and it's worth it. Do the homework of verifying the location like that speaker that you had who talked about the development cycle. You can put something under contract but then you have to do all your homework, it's the same thing. When you're buying something you almost have to put it in a contract and then go see if you can do a certificate of use change. From an office use that was used by a CPA that you know is going to move as soon as you buy it, can you turn it into medical? You go to the zoning office and you have those conversations. There's usually an impact fee here locally even though the building is not changed. They consider an additional consumption, whether it's parking or water or whatever, they're always taxing us here, so do your homework before conversions. For existing space to be medical is totally possible.
Look out for parking. What's the typical parking ratio on commercial? Three spaces for every 1000 square feet. What are the typical requirements in a small medical office? In South Florida, it's different because we're a little tighter, we don't have the space. Doctors don't want to go to places that don't have a lot of parking, that is the biggest single amenity. They don't even look at the bathroom, they do need to wash their hands, they need to have sinks, but the parking is number one. Typically, I look for anything above four spaces per 1000 sf. And if it's not above four, I will start discounting the price in my head. If it gets below three spaces for 1000 sf, it's typically not a medical building because a pediatrician will bring the grandmother when the baby is born, they will bring the grandmother with the dad, the grandfather, they all might show up in different cars. And the joke is in the medical world, for the pediatrician, that's five cars for one baby. But for the OBGYN it's one, and the lung doctor has one per patient. It has a lower impact on your parking ratio. So, if you have a doctor that only sees two to three patients an hour, generally speaking, that's going to be the calm tenant from a parking perspective. When you evaluate medical office buildings, don't be afraid of it, just keep all these things in mind.
What would keep you from investing in a medical office? Nothing, it's just more about the opportunity. A lot of people don't drive around thinking about medical offices, because they see it as something that hospitals do. Hospitals do like to control their doctors, but there's a good 20-30% of doctors that are on their own. When you see a decent building, even a smaller one with a couple of different tenants, make sure you hedge your risk with the income. Check the parking, and the distances between all the doctors, and typically your medical doctors are going to be paying 10 to 15, 20% more than office use. It's not the same thing. People ask me, how are your office buildings going? They're great because generally speaking, I've been lucky and that medical use has continued unabated, so I always encourage investors just like you. We have to keep medical on, even if it is expensive, but conversions are out there. A lot of office buildings are empty right now. There's nothing wrong with going to the city counter and asking for the process to change it from general office to medical office.
Whenever I hear all that negativity about office, oh no, it's an opportunity. Just like the interest rates, we're entering an era of opportunity, and to me all these empty office buildings are a pure opportunity.
William Pozo
williampozo@gmail.com