How to Maximize the Value of ASC Real Estate
Insights from an ASC Expert, by Scott Bacon & Chris Stai
This month’s "Insights from an ASC Expert" column is co-authored with Chris Stai, Managing Director of HREA | Healthcare Real Estate Advisors, a leading national healthcare real estate advisory group. As a former Director for a publicly traded healthcare REIT, Chris has immense expertise in healthcare real estate and unique insights for navigating complex transactions.
How do I maximize the value of the ASC real estate?
Or rather, how do you maximize not only an investment in an ASC, but also the underlying real estate? The value of the ASC real estate can create significant investment returns for the physicians, but only if the lease terms are structured properly. It’s a balancing act to ensure both investments, the ASC operating entity and the real estate holding company, are successful. With current real estate valuations for ASCs ranging from a 5% - 6% cap rate, which is the equivalent of a 16.5x – 20x multiple, it is important to consider and plan around a couple strategic variables in order to maximize value.
First Priority – A Stable Tenant
First, ensure the ASC partnership is a sound operating company (‘OpCo’). Without a stable OpCo and sufficient EBITDA, the investment in the real estate comes with considerable risk and is therefore less valuable. Institutional investors, such as REITs and Private Equity, look for certain EBITDA metrics since the investment relies on the lease payments from the ASC to generate income.
There are a few factors that ensure a successful ASC partnership. These include a diversified base of surgeon owners/utilizers, a narrow mix of specialties, in-network or a pathway to in-network contracts, a facility that is efficient and not over-built for the projected case volume, an appropriate capitalization structure (debt vs. equity), and a facility that is conveniently located near the clinical practices of the utilizing surgeons.
Then — Impactful Lease Terms
The ASC (OpCo) signs a long-term lease for the property, typically 12 – 15 years. In most cases, the same ownership group of the ASC will create a separate limited liability company (LLC) to own the property (PropCo) and serve as the lessor. When the ownership of the OpCo and PropCo are the same or similar, this provides the ASC with the flexibility to structure lease terms that impact the financial value of both the OpCo and PropCo, including the following:
- Lease rate per square foot – should be based on fair market value (FMV) which varies by market, but is usually $30.00/SF - $40.00/SF
- Tenant improvement allowance – PropCo can fund a portion of the ASC’s interior buildout, but not at a level where the rent exceeds FMV
- Term of the lease – typically 12 - 15 years, with multiple options to extend the lease
- Annual fixed rental escalations, typically 2 – 2.5%
- Adequate rent coverage from earnings generated by the OpCo
- Real estate operating expenses and maintenance – typically passed through to the tenant, known as a triple-net lease
Let’s walk through two scenarios to better understand how lease terms can impact both the OpCo and PropCo.
- 10,000 SF ASC
- Musculoskeletal specialties with a focus on outpatient total joints
- 10 surgeon owners each owning 7.5% equity in the ASC
- Management company owns 25% equity
- Same ownership structure in both OpCo and PropCo
- 12 - 15-year lease term
- Single-tenant building
Explanation: Impact to ASC (OpCo)
The primary difference between the two scenarios is whether the tenant funds 100% of the cost to build out the interior of the ASC, or whether the landlord entity funds a portion of the costs through a tenant improvement allowance. This is a common term negotiated when structuring an ASC lease. For the ASC entity (OpCo), it reduces the upfront start-up costs for the new ASC. A tenant improvement allowance is offset by a higher rental rate as detailed above. One trade-off to consider is the long-term impact of the increased rental rate on the cash-flow of the OpCo.
Explanation: Impact to Real Estate Investment (PropCo)
As outlined above, the cost for PropCo to fund the tenant improvement allowance in Scenario 2 is $400,000. This amount needs to be funded by the landlord prior to receiving any lease payments. In exchange, OpCo will pay an incremental increased rental rate of $4.00/SF (based on amortizing the tenant improvement allowance over 10-years at a 5% interest rate). At a 6% cap rate, the value of the lease increases by $666,667 (or $266,667 after considering the $400,000 of build-out cost to fund the T.I. allowance).
The additional benefit to the investors in the PropCo is that they are able to sell the real estate while maintaining their ownership interest in the ASC. Also, the proceeds in the real estate is taxed at a lower rate known as long-term capital gain vs. ordinary income, which is an additional benefit to the investor.
Overall, a successful ASC partnership can provide a real estate investment opportunity for the surgeon partners. The first priority is to ensure the ASC (OpCo) is designed efficiently, well capitalized, and sufficient case volume to ensure it is a profitable venture. You will then want to ensure the lease terms are based on fair market value. If structured appropriately, the real estate investment can help monetize the value of the ASC lease for its partners in a tax-efficient manner, which is another way of lowering the physicians’ overall cost basis in the ASC.
It is also worth noting that Chris Stai and his team at HREA have created a unique structure known as the Hybrid Sale-Leaseback®, which allows physicians to monetize the majority of the real estate value, but also retain ownership in the real estate in a tax-deferred manner. Other benefits include maintaining alignment in ownership interest between OpCo and PropCo, succession planning, reducing the equity buy-in for new physicians, and providing continued real estate distributions at an approximate 8% annual return.