Does It Pay to Be Your Own Landlord?

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When it comes to a dental practice, is it better to own or lease the property? We spoke to a real estate expert and a financial adviser to help you decide for yourself.

Colin Carr, CEO of national real estate firm CARR, which represents healthcare tenants and buyers exclusively, said providers can benefit greatly from ownership because they increase their net worth every month by paying for an asset whose value is likely to appreciate.

Real estate markets go up and down, of course, but despite the inherent risk, commercial real estate is a solid investment that increases in value by a couple of percentage points a year over a period of 10 to 20 years. And when providers own the space, 75% of the time it sells for more than the practice itself. “You can have a practice selling for $1 million,” Carr noted, but “the real estate will sell for more than that, three-fourths of the time.”

Phil Roberts, CFP®, CLU®, ChFC®, RICP®, a financial planner at Capstone Partners, agreed, pointing to a dental client in California who sold his practice and building last year. The client had saved $400,000 in an IRA, sold his practice for around $350,000 and the building for $700,000. “That inserted…money into his portfolio that he otherwise wouldn’t have had if he didn’t own the building, and [it] made his retirement much more stable,” Roberts observed.

But dentists don’t have to sell. They can lease the space to the practice buyer to receive a monthly income and diversify their cash flow in retirement. “Having your Social Security income, asset-based income, and real estate income can create a strong retirement…position,” Roberts said.

What Is Happening in Commercial Real Estate?

Although real estate is a long-term investment, knowing what is taking place in the short term is also essential, and experts are forecasting a challenging 2023. In predicting a recession, JP Morgan cites several factors:¹

• Geopolitical issues, like the war in Ukraine and the sanctions against Russia, have driven up the cost of food, shelter, and energy.
• High inflation, as high as 7.75% in late 2022, resulted in rent increases of nearly 7% compared with 2021.
• Interest rates will continue to rise in 2023 and could have a negative impact on commercial real estate owners.

CBRE, a global leader in commercial real estate services and investment, says it will be a difficult year because of high interest rates and a looming recession. As the Federal Reserve raises rates to control inflation, the higher cost of capital lowers asset values.²

Capital costs are quite high, per Fundera by Nerd Wallet. Interests on commercial real estate loans range between 3.5% and 20%, and many factors affect those rates, like the property in question, the borrower’s creditworthiness, and the type of lender. Loans backed by the US Small Business Administration have the lowest rates, ranging from 3.5% to 6% for a 20- to 25-year term for amounts between $50,000 and $20 million and from 7% to 9% for 25-year terms on loans of $5000 to $5 million. Banks rates start at 3.75% for loans over $25,000 for 10-to 15-year terms.³

Don't Forget the Tax Benefits

In addition, Carr explained, ownership confers tax benefits, such as for depreciation. The IRS allows owners to take a deduction to recover the cost (or other basis) of a property’s wear and tear, deterioration, and obsolescence provided the deduction is only for the owner, the property is used for business or income-producing activity, it has a definite useful life, and is meant to last for more than a year.⁴

Owners can depreciate everything but the value of the land on commercial properties over a period of 39 years. The Hartford insurance company recommends working with an accountant on this, as IRS rules change frequently. Properly executing a depreciation schedule allows dentists to match expenses to revenue and keep an accurate record of the practice’s business costs for a given accounting period as well as a realistic idea of its assets.⁵

According to Carr, owners can also speed up or do a bonus depreciation through a cost segregation study. They can deem some of the improvements made to the property to have a shorter lifespan and write these off faster. For example, owners can depreciate some upgrades over 10 or 15 years and others over 5 years. “So, you can pick up even more tax deductions if you are inclined to,” Carr stressed.

In addition to the tax advantages of depreciation, owners can write off maintenance expenses, origination fees, and closing costs, said Austin Lee, CFPTM, founder of Lee Financial Group, LLC. When they need to move, they can sell the property and use the proceeds to invest in the next building within a year without paying capital gains or a 1031 exchange.

Some restrictions apply, however. A 1031 exchange works only with a building that will be used for the same purpose, and a third party must hold the proceeds in escrow until the new building is purchased. The properties must also be “like-kind,” that is, of a similar nature.⁶

Owning Isn’t Always the Answer

So, why wouldn’t every dentist buy a property? Sometimes, Carr indicated, there is nothing available in the area where they want to practice, they don’t have the down payment, or they have cash flow problems that make monthly payments unaffordable. Finally, some dentists may not want to worry about upkeep and management, like snow removal, landscaping, and maintenance.

“The cost of ownership is time and money,” Lee acknowledged. “You pay for…remodeling, repairs, and maintenance. On the time side, if a problem…needs to be attended to, you are the one to attend to it.”

There are also opportunity costs involved, he said; for instance, buying a commercial building is a significant investment. And spending money on a building means one cannot spend it on dental equipment, marketing, or staff salaries. “That opportunity goes away when you have to put…money into buying the building itself.”

In such cases, leasing might be the way to go, Carr said. With a lease, not only are there many more options available, but there are also fewer obstacles to entry and a much smaller startup cost—usually a security deposit and a month’s rent. Plus, many landlords offer incentives like free rent while the dentist builds out the space, which can offset moving costs, and sometimes even contribute money for build-out expenses in exchange for a longer lease.

Another significant benefit of leasing is flexibility. Those who lease can relocate in a few years if they need more space, something that’s not as easy for owners. “If you outgrow your space, you can always move on to a larger space or even work with the management company or the…own[er]…to see if you can grow into…vacant spaces nearby,” Lee pointed out.

“If you know the exact location and the exact square footage you’re going to need and want for the next 20 years, then…purchasing can make sense,” Carr observed. “But often it makes sense for a startup or a younger practice to lease for a season and, once established, look at purchasing.”

Newer dentists “can generally lease in a nicer area” than the one they can buy in, Lee noted, “so, depending on what type of clientele you’re trying to attract, that could boost the practice.” Plus, “a higher cash flow does help your credit rating.”

There are drawbacks to leasing as well, Carr added. Dentists who lease forfeit the asset building and increased net worth that results from owning. They cannot control rent increases, although they can negotiate, particularly with the help of a professional, but they often don’t have a say in who else leases nearby.

A pediatric dentist, for example, wouldn’t want a vape shop or liquor store next door. Professional guidance during lease negotiations can prevent these situations with stipulations in the lease as to who can be next to you, Carr said.

Lee concurred, adding that owning the building means the dentist decides who the neighbors are. “You get to choose…your tenants. So, if you are an endodontist, maybe you want a general practitioner in the building,” he explained. “You also have control over what happens to the property if you want to make improvements.”

In contrast, when leasing, dentists have little control. The rent can increase, and sometimes the property manager or owner decides not to renew, which means having to move. If there’s nothing available within the dentist’s price range, there can be a lot of uncertainty as to the future. “You are also at the mercy of the landlord for timeliness and quality of…repair[s],” Lee added. “So, if there’s something wrong, it’s only fixed when the landlord wants to fix it.”

How Do You Know What’s Right for You?

According to Lee, there are 3 questions a dentist should consider when deciding whether to lease or own. First, how long can he or she commit to the building or the location? In the short term, leasing is more cost-effective. However, if a provider can be in the same place for more than 7 years, buying might make more sense.

“If you are planning on staying put for at least that long, your business is very well established, and you don’t see yourself retiring in the next 7 years, then you ought to look at buying,” Lee said.

Next, dentists should determine how fast their business is growing. If the practice size is relatively stable, the dentist can probably buy a space that will accommodate it for years. But if the plan is to grow significantly in the short term, leasing is best until the projected goals are reached.

Finally, a dentist should get a feel for the local economy. A great location can become a poor one over time, whereas established neighborhoods are safer places in which to put down roots. “If it’s an up-and-coming community, it might be hard to tell,” Lee said, so “it may make sense to lease and…stay flexible.”

Roberts begins the decision-making process with clients by reviewing financial models that show the numbers for both options. However, psychology also comes into play. When dentists buy real estate, they “save” money each month by paying the principal on an asset that is appreciating.

“You don’t have to make a new decision every month to put money into savings because you just pay your mortgage every month,” Roberts said. “Then, over time, you build hundreds of thousands of dollars of equity in the property because you paid the mortgage and the property appreciated.”

Another way to accrue net worth is to lease and invest the difference between the mortgage and the rent. The amount saved could be similar or higher, depending on the return on investment and the appreciation of real estate in the area where the practice is located. However, Roberts noted, most people don’t save the difference; they spend it. Therefore, owning is more likely to build net worth.

“At some point, we all have to come to grips with our human nature and our proclivity to spend [the] money we have,” he remarked.

Carr agreed that professional advisers should discuss the pros and cons of each situation, including the property itself, its benefits, expenses, and the effects on the bottom line. “You’re going to start with a plethora of information that will help you narrow your options,” Carr said. “It’s got to make sense esthetically and emotionally, meaning you want to be there for the next 15 or 20 years, but then it also has to make sense financially.”

Roberts’ advice? “Sit down with a professional, do the math, and model out the lease versus purchase. Talk to your financial person or find a good financial person that…can simulate, if you were to buy this property, how that will look over the next 10, 20, and 30 years and [how it will look] if you were to lease it.”

Carr cautioned against taking a do-it-yourself approach with what could be a multimillion-dollar transaction. A bad decision, he pointed out, can have serious financial implications. “You want to go into any transaction with that amount of money on the line with a team of people who can help you across the board,” he said, “It will save you time and a significant amount of money and help you avoid costly pitfalls and complications.”

Roberts thinks leasing is excellent for dentists who are still building their practice. However, once a dentist has enough for a down payment, he or she should consider investing in real estate.

“If you’re somebody that wants to build equity and net worth with the things that you’re doing…you might as well build that equity and net worth in your real estate, too, rather than letting someone else build equity and net worth off of your back.”

References

1. Brooks, A. 2023 commercial real estate outlook. JP Morgan Chase & Co. December 2, 2022. Accessed 7 March 2023. https://www.jpmorgan.com/commercial-banking/insights/2023-commercial-real-estate-trends
2. Barkham R. U.S. real estate market outlook 2023: opportunities amid a slowing economy. CBRE.com. December 7, 2022. Accessed March 7, 2023. https://www.cbre.com/insights/books/us-real-estate-market-outlook-2023
3. Prakash P. The best commercial real estate loan rates. Fundera by NerdWallet. January 23, 2023. Accessed March 7, 2023. fundera.com. https://www.fundera.com/business-loans/guides/commercial-real-estate-loan-rates
4. Publication 946 (2022), how to depreciate property. Internal Revenue Service. Updated February 24, 2023. Accessed March 7, 2023. https://www.irs.gov/publications/p946
5. Depreciation defined. The Hartford. Accessed March 7, 2023. https://www.thehartford.com/business-insurance/strategy/depreciating-assets/depreciation-defined
6. Wood R. What is a 1031 exchange? Know the rules. Investopedia. Updated July 19, 2022. Accessed March 7, 2023. https://www.investopedia.com/financial-edge/0110/10-things-to-know-about-1031-exchanges.aspx