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Orthodontic Practice Lease Considerations – Part 2

We previously discussed some of the issues regarding an office lease that need to be considered when buying an orthodontic practice and the selling doctor owns the office. In this article, we will discuss lease issues to be considered when the office is leased from a third party.

The first item to consider is when you can contact the landlord about lease terms once you purchase the practice. Quite often, the selling orthodontist wants the sale of the practice to remain confidential as long as possible. The seller may not want the landlord to know that he/she is selling the practice until many of the other sale and financing terms are agreed to by the buyer and seller. Thus, the buyer’s conversations with the landlord may not begin until later in the negotiation process.

Just like when the selling orthodontist owns the real estate, the lease terms must be considered. The buyer generally has to get at least a 5 year lease term, inclusive of renewal options, in order for a bank to provide financing for the transaction (the bank wants assurance that the buyer will have an office to treat patients and earn income for a reasonable amount of time in order to repay the purchase loan). The landlord generally prefers a longer lease term, and the buyer has to consider how long he/she plans to stay in the office and whether another office or location in the city is better for the practice. If the buyer’s plans are to relocate the practice soon, he/she should try to negotiate a shorter initial lease term with options to extend the lease for one year periods (to satisfy the lender’s requirement).

The lease rate also needs to be considered as we have seen some instances where the seller has been in a tenant in the office for a number of years without a rate increase, or without a formal lease agreement, and has a very good relationship with the landlord. When the seller is no longer the tenant, the landlord may see this as an opportunity to increase the rental rate to fair market rates, which has an impact on the practice’s profitability. Similar to when the seller owns the office and the fair market lease rates should be considered when the practice valuation is prepared, if it is fairly certain that the lease rate will be increased in the future, the practice valuation should take this into account and the buyer should be made aware of this early in the process.

Finally, one of the biggest issues we often face is the landlord’s reluctance to release the selling orthodontist from personal liability related to the lease (particularly when the lease is assigned to the buyer). The individual doctor often personally guarantees that his/her professional corporation will pay the lease.  The selling doctor usually has been a tenant in the building for a number of years, is financially well established, and may have a great relationship with the landlord. With the sale of the practice, the buyer will be required to personally guarantee the lease payments, but the buyer usually doesn’t have substantial personal assets as does the seller. More than likely, the buyer has minimal liquid assets, a lot of student debt, and very little or no experience running a practice. Understandably, this makes the landlord nervous and the landlord may refuse to release the selling doctor from his/her personal guarantee of the lease. This is an issue for the seller, which may require additional negotiations with the Landlord as to how long the seller will remain a guarantor.

There are many items to consider when selling and transitioning an orthodontic practice, and the lease agreement is just one of those items. However, the lease can often turn in to a multi-faceted negotiation process that can take longer than the parties anticipate.

Orthodontic Practice Lease Considerations – Part 1

Whenever dealing with a practice sale or transition, the buying and selling orthodontists have a lot to consider throughout the process, such as purchase price, length of the doctors working together before and after the sale, staffing issues, etc. However, we often see that one of the most important issues takes a back seat in the transition negotiations – the office lease! Whether the office is owned by the selling doctor or by an unrelated third party, we have seen numerous transactions be delayed due to lease issues not being resolved timely.

In the case where the selling doctor owns the real estate, the selling doctor often does not know what the fair market rental rate of the property is. The selling orthodontist often sets the lease rate he/she pays to himself/herself based on tax considerations or mortgage payments, which may be significantly higher or lower than fair market rental rates. We often have sellers tell us during the valuation process or transition negotiations that the rental rate should be $XX per square without really knowing the market, getting advice from a real estate expert, or understanding if this is a gross or net lease rate (“gross” meaning that the landlord pays most or all expenses, such as real estate taxes, insurances, maintenance, and “net” meaning that the tenant pays such expenses). The buyer, often inexperienced in these types of transactions, is generally advised to get the opinion of a local real estate expert to help evaluate the lease rate. The problems arise when the buyer’s expert says the rental rate should be significantly lower than the seller’s expectations. After much more time and research by the seller, it may be discovered that the rental rate he/she can receive from an actual tenant is much less than what he/she initially thought would be paid (or, often worse, if the seller realizes that the lease rate should be increased, which, if requested by the seller, creates other trust issues for the buyer). This situation can create a stumbling block in the transition negotiations and delay the closing of the transition.

The seller doctor, acting as the landlord of the property, has to understand that most buyers will do some research on what the fair market rental rate should be for similar spaces in the area. So, ultimately, the seller has to be reasonable and agree to lease the office at (or very close to) fair market rental rates. Otherwise, it may mean that the seller has to go through negotiations with multiple buyers to either: (1) find the buyer willing to pay a higher than reasonable rental rate, or (2) eventually understand that qualified buyers demand a reasonable rental rate and the rent must be set at market rates. Unfortunately, the latter often occurs after one or more qualified buyers have walked away.

Our advice to selling orthodontists that own the real estate is to do some research on the fair market rental rate for their office spaces when they first begin to consider selling their practices. The sooner these rates are established and supported by actual market research, the smoother and quicker the transition negotiations will go. It also helps in the valuation of the practice because the practice’s value is largely dependent on the income/profit accruing to the owner. If the income/profit used in the valuation is not correct (due to incorrect lease rates), the buyers may also challenge the valuation.

In our next blog post, we will review lease issues that can arise when the office is owned by a third party rather than the selling orthodontist.

Chris Bentson Article Featured in Orthodontic Products Magazine

GREENSBORO, NORTH CAROLINA— At least once in their lives orthodontic practice owners will go through a practice transition. Whether they are buying into a practice, adding a partner, or selling their practice for retirement, Chris Bentson of Bentson Clark & Copple advises orthodontists through every step of the process.

In the latest issue of Orthodontic Products Magazine, Bentson explains practice transitions in five main steps.

Begin by Gathering Information
The transition process starts at least two to three years before an orthodontic practice is put up for sale. Begin by learning as much as possible about the transition process. Talk it through with financial advisors, spouses, and other orthodontists who have gone through a transition. Make sure you consult several colleagues and sources of information, as experiences can vary. Word of mouth can also be a valuable asset when choosing a company to conduct an orthodontic practice valuation. Being well informed can minimize any pitfalls or surprises that come with the transition process.

Have A Valuation Performed
Before selling a practice, an orthodontist needs to know exactly what it’s worth. Like selling a car, or a house, appraisals must be done before any transactions can occur. An orthodontic practice valuation is much like having an orthodontic appraisal done before you sell. Valuations allow an orthodontist to know exactly where their practice stands financially before undergoing a transition.

Find the Perfect Partner or Buyer
In the current market there is a ratio of 3:1 seekers to opportunities, which is good news for those looking for another orthodontist for their practice. While residents tend to move to coastal states or high-density areas, it’s important to look for a candidate that can transition into your practice in the time frame you had in mind. Consider listing your opportunity with a transition specialization firm that has resident/doctor matching services. Transition firms often match doctors with buyers or partners free of charge.

Finalize all Transaction Negotiations
This period is where a transition will really kick into gear. During transition negotiations, buyer and seller will agree on a price, a financing plan for the orthodontic practice sale and work out any other details of the sale in writing. Generally, finalizing all the paperwork can take up to 90 days.

Official Ownership Transfer
This final stage of transition is essentially nothing more than finally signing official documents, and changing stationary and nameplates. Done properly, ownership transfer day will seem like just another day in the office.

These steps are an outline of the transition process to prepare orthodontists for the future. Proper research, planning and patience will allow for a smooth and rewarding transition.

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