Medical office building questions

8 Replies

Hi all,

I recently purchased our second commercial building in Webster NY area which has about 6600 sqft. The 2 tenants both decided to stay and has a cap rate of 13% after all expenses, we calc the cap rate using the average income and all expenses(taxes, insruance, snowplowing, maintenance) during the past 3 years. The questions we have right now is about the leases. One of the tenant has a expiring lease on December  but already stated they will be renewing lease with us after we take ownership. Both tenants have been there for over 10 years.  Both leases are now gross modified. 

My questions are as follows. Hope anyone can share some insights with us.

1. Would i be able to do a NNN lease with the tenant when renewing the lease while the other tenant is gross modified?

2. Is it normal to use CPI as rent escalation or a fixed rate? When using the CPI to calculate the rent increase, if i am doing the new lease as of march 2018, do i simply use the rate increased from 2017 march to 2018 march for each year going forward?

3. We want to get a long term lease with the tenant, is there any strategies you experts can share when negotiating the lease with them? 

Thanks in advance!

Xaxuan,

Here are my thoughts on the questions you posed.

1. As long as the tenant does have a renewal option that specifically states the renewal terms you should be good to convert them to a NNN lease. One thing to note, make sure to see what their NNN rate would be on a gross basis, since it can be tough to get tenants to switch to that structure if their rent increase is substantial.

2. I would say CPI is a fairly rare escalation format. Depending on your market I would suggest fixed rate steps (ie. $0.50/YR or 3% increase/YR)

3. Do they have a lot of vested capital in their spaces? If so, that can make them more sticky and give you more leverage. You can throw them to Tenant Improvement dollars to sweeten the deal to get them to do a longer term deal.

Hope this helps.

Originally posted by @Grant Steiner :

Xaxuan,

Here are my thoughts on the questions you posed.

1. As long as the tenant does have a renewal option that specifically states the renewal terms you should be good to convert them to a NNN lease. One thing to note, make sure to see what their NNN rate would be on a gross basis, since it can be tough to get tenants to switch to that structure if their rent increase is substantial.

2. I would say CPI is a fairly rare escalation format. Depending on your market I would suggest fixed rate steps (ie. $0.50/YR or 3% increase/YR)

3. Do they have a lot of vested capital in their spaces? If so, that can make them more sticky and give you more leverage. You can throw them to Tenant Improvement dollars to sweeten the deal to get them to do a longer term deal.

Hope this helps.

 Hey Grant, thanks for your suggestions. 

1. The current expiring lease does not specifically state the renewal terms.  

2. We are more inclined to do a fixed rate increase as well also according to the #2 response of yours. 

3. All the equipments, medical tables, beds, are already there(considering they've been there for a long long time) but none of them seem to be impossible to move around if you hire the right pros with right money, but it will be definitely a hassle for both of us.  The existing lease already has  landlord-paid improvement dollars on it.  I know everything is negotiable, but i am trying to think of something more creative to peusade them to do a long term lease :)

Thanks again for your replies, appreciate it!

I think one of the strongest factors a landlord can do (outside of macro economics) is to demonstrate a commitment to the building. A budget and plan for major overhauls and re-surfacing. If you have pride in your building and show you are serious about taking care of it in the long term, they will be more inclined to sign long term.

You need to drive your area. Check around with planning and zoning and see what new projects are in the works for medical office types. By driving around you can see vacancy levels for buildings and also see similar buildings types for rent and what they are offering.

The tenant likely on renewal will be looking at other options as well. It will be very tough to move them to NNN if building is older. The main reason you got such a high cap deal is the leases were running out very soon. For long term tenant leases those cap rates do not exist. Developers build new at a cap rate to cost (break even) of about a 9 to 9.5 cap and sell for 5 to 7 caps.

For medical there is usually a lot of tenant build out so harder for them to move UNLESS a developer is courting them for a brand new building and offering a bunch of perks to move.

Originally posted by @Ronald Rohde :

I think one of the strongest factors a landlord can do (outside of macro economics) is to demonstrate a commitment to the building. A budget and plan for major overhauls and re-surfacing. If you have pride in your building and show you are serious about taking care of it in the long term, they will be more inclined to sign long term.

 Great idea, I will definitely take that into account when we do our planning with the building and then share that with the tenant.

Originally posted by @Joel Owens :

You need to drive your area. Check around with planning and zoning and see what new projects are in the works for medical office types. By driving around you can see vacancy levels for buildings and also see similar buildings types for rent and what they are offering.

The tenant likely on renewal will be looking at other options as well. It will be very tough to move them to NNN if building is older. The main reason you got such a high cap deal is the leases were running out very soon. For long term tenant leases those cap rates do not exist. Developers build new at a cap rate to cost (break even) of about a 9 to 9.5 cap and sell for 5 to 7 caps.

For medical there is usually a lot of tenant build out so harder for them to move UNLESS a developer is courting them for a brand new building and offering a bunch of perks to move.

Joel, thanks a lot for your replies. Our area is one of the odd ones - the 13% cap rate is actually not that high in my area. I've seen deals with 16% cap rate and sold next day when it is listed, even higher in the city area. Newer buildings are definitely around the 10% rate and the current market does not have that many medical offices for rent for the medium sized tenants, which is one of the main reasons we like about this deal. We can only find 2 other medical spaces for rent and they both are either for single individual practise or huge medical group. We can continue to do gross modified which is totaly fine for us but if its likely convert to NNN will definitely prefer to do that as well.

@Xuxuan Liang my answer to your questions was going to be, it's all negotiable. You need to balance the risk of them leaving with getting the type, term and rental escalations you want in the lease. It sounds like our area is just the opposite of yours in that there is lots of empty medical office here. So I would bend over backwards to get the tenants to stay. 

Since you're in a better position you can go in asking for everything you want. But be careful because they can always decide to just buy some land and build a new space. 

They may be confused by the moving to NNN idea because non-real estate investors often don't understand that and it may not be customary in your area/product type. So ask yourself how important that is.

I'll offer the advice I received from a very savvy RE attorney, one who has seen both successes and failures:  "Don't try to squeeze the last dollar out of a deal."  Determine what factors would cause the tenants to stay or leave, and determine the costs associated with finding replacement tenants.  Once a property is vacant, you really don't know how long it will stay vacant or what terms you will need to offer to put someone in that space.

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