Why are practice premises good investments?
Practice premises usually make wonderful investments. This is because of the symbiotic relationship with the practice: good premises, in the sense of a modern, pleasant, efficient, well laid out and well located building that GPs and staff enjoy working in and patients enjoy visiting, have a significant influence on profitability.
The extra profit is normally much more than the market rent.
For example, better premises may help attract and retain non-owner GPs and better staff, and appeal to patients, particularly patients who can pay higher prices. More GPs, more patients and higher prices mean more profit. It’s hard to measure accurately but a good guess puts the extra profit in the hundreds of thousands a year. It’s certainly much more than market rent will be if leased to an arms-length tenant.
Extending and improving existing practice premises makes a lot of sense too. One practice had spare land and put in a new minimalist consulting room for about $200,000. A new GP joined and before long she had new billings of $400,000 a year. The practice charged a management fee of 30%, so it got $120,000 extra a year. There were not many extra costs, so that $120,000 was almost all profit.
There are not many investments where a GP can earn a low risk 60% per annum return, but that’s how much this investment created for this practice.
Practice premises create security of tenure
Practices that own their premises are more secure. They are not at the mercy of a landlord, and liable to be moved on at the end of the lease. They control their space and this adds to the security of the practice and everyone wins.
Practice premises are usually capital gains tax (“CGT”) free
Many GPs are surprised to learn that practice premises are usually CGT free. They are covered by the Federal Government’s small business tax concessions and, provided certain conditions, are met are usually CGT on ultimate sale (although specific advice should be sought before selling).
This makes practice premises a relatively more attractive proposition than a simple rental property. Two buildings may be virtually identical but if one is used as practice premises it’s after tax net return will be greater than the other, purely because of this CGT concession.
The CGT concession is part of the Government’s strategy to encourage small business.
Co-ownership of practices normally means co-ownership of the practice’s premises.
For example, four GPs may club together to buy a surgery costing $2 million. Each of the GPs puts in $200,000 of their own money (possibly borrowed from their bank against the security of their home) and then borrows the remaining $1,200,000 secured solely against the surgery and the four owners’ personal guarantees, limited to their share of the total debt.
The GPs then rent the surgery back to their practice entities. The net rents pay the interest and repay the principal. The repayment of principal and capital gains over time creates value for the GPs.
An advantage is that each of the four GPs has been able to access an investment that may have been beyond each of them individually. Risk has also been diversified, particularly if more than one property is bought using this method. As a practical matter for asset protection, the GPs will probably not own the surgery personally but will use a trust-based structure or own their interest in the surgery through their spouses.
The best structure is a company as a trustee of a unit trust or a hybrid trust, with the level of debt in the trust controlled so that the property will be cash flow-positive and the trust will have a net income for income tax purposes rather than a tax loss.
The position is depicted here:
This structure is:
- Income tax-efficient. There are no problems with losses being locked up in trusts and not available to the owners, and there is no taxing point until the net income flows through to the ultimate beneficiary, usually a low-taxed relative or possibly an investment company.
- Capital gains tax-efficient. The 50% capital gains tax discount on the sale of assets after 12 months applies, and this exemption amount can be paid out to the unit holders without a further tax charge.
- Easy and cheap to admit new owners and to exit old owners. This can be done either by a transfer of units, by an issue of new units or a cancellation/redemption of old units. There is no stamp duty on these admissions and exits (subject to one exception), whereas if the owners held the property in their own names there would be a stamp duty charge, and a cumbersome and costly transfer process each time a new owner was admitted or an old owner exited. The exception arises where the land-rich company rules apply, ie, where the net value of the land in the trust is more than $1 million and there is more than a 50% cumulative change in ownership. Separate legal advice should be sought if a proposed transaction could trigger this rule.
- Easy to administer. The trust has its own bank account and a profit and loss statement and balance sheet. There is no mingling of funds, apart from the distribution of net income. The trust registers for GST if its rent income is more than $50,000 a year, and it will have its own ABN and TFN. It will lodge its own income tax return each year, and the trustee company will lodge a return with ASIC and pay an ASIC fee every year.
How much does a trustee company and a trust cost to set and run?
It usually costs about $1,800 to set up a company and a trust. If a hybrid trust is used there is also a separate stamp duty charge of $200. The annual accounting costs depend on the time taken to prepare the accounts and the tax returns.
Time is determined by the number of transactions that occur. It’s fair to say the accounting costs will be at least $1,000 a year.
There is also an annual ASIC fee of about $240.
How is the debt structured?
Most commercial properties are bought and held using debt.
There are a number of ways to structure the debt, and each has advantages and disadvantages. Unit holders usually contribute equity of 30% plus transaction costs, including stamp duty, which comes out of their own resources or borrowings against other assets they hold, such as their home. This makes the total equity contribution about 37% of the purchase price.
This is contributed to the trust as capital, in return for an issue of units. If the total cost of the property is $1 million, including stamp duty, and there are four unit holders, then each unit holder would contribute $92,500 ($1 million times 37% divided by 4).
This $92,500 is paid into the trust before settlement. The trustee uses the capital of $370,000, plus the $630,000 of borrowings, to pay for the property.
It is best to aim for equity of 30% (plus stamp duty) because the larger banks will normally lend 70% of the market value of a commercial property without any collateral security other than directors’ guarantees. This means the four unit holders can buy and hold the property together without having to give cross-securities over their homes and other assets.
Each of the four owners may borrow this equity of 30% (plus stamp duty) if they wish to. They just cannot borrow against the security of the new property. It is not unusual for an owner to borrow their share of the owners’ equity, in this case $92,500.
Who should be the unit holder?
The GPs family trusts can be the unit holders. This enables the trust’s net income and net capital gains to be distributed to the GPs’ family members or other related persons.
SMSFs can be unit holders provided the GP does not control the trust, but specific legal advice should be obtained first.
Avoid losses in trusts
The trust should avoid incurring a loss. If the trust is expected to incur a loss the GPs should consider borrowing at the unit-holder level, increasing the trust’s capital, decreasing its debt, decreasing its interest to avoid the loss.
The trust’s profit and loss statement might look like this:
Less Costs Interest Depreciation Rates Repairs Other
$44,000 ($630,000 times 7%)
The net income of $20,000 will be distributed equally to each of the four unit holders. They will each include $5,000 as assessable income in their own tax returns. How this is ultimately taxed depends on each unit holders’ own tax profile.
Building practice premises can be a good investment. Once again, the expected return on the investment comes in the form of higher practice profits, and these are usually much more than a market rent. For example, one client case involved three semi-rural GPs clubbing together and buying land in a unit trust, and then building a surgery. It cost more than expected, and took longer than expected. The high fit out costs and the cost of new plant and equipment surprised them too.
When the new practice was up and running, with nine consulting rooms 80% full every day, the return from the practice was over $450,000 each. This was, of course, spread amongst their SMSFs (which owned the building through a geared unit trust) and their family trusts which owned their interest in the practice itself, via a hybrid trust.
Before the project started they each made about $200,000 a year in someone else’s practice, without much tax planning. Once the project finished they each made about $450,000 a year in their own practice, with some excellent tax planning.
They could not have made the $450,000 without the new practice premises, so in a very real sense they each earned $250,000 on their one-third share of the practice premises. They put in $300,000 each and borrowed the rest, so it was an unbeatable investment. It was virtually risk free: they are great GPs and the success of their practice was never in doubt.
Two practical tips:
- you are a GP, not a builder, and its smart to employ a project manager to manage the project and for you to stay working as a GP; and
- you are a GP, not a practice manager, and its smart to employ a practice manager three months before opening to handle to the huge number of tasks connected to creating a brand new practice, and for you to stay working as a GP.
You are a much better GP than you are a project manager or a practice manager.
Should the GP have to sell on leaving the practice?
Some practices link the interest in the practice premises to the ownership of the practice. This means if a GP leaves the practice they, or more probably their family trust, have to sell the interest in the practice premises.
This approach can make sense and suits many practices. But there is no rule that says the practice and the property must be linked. Some practices treat them independently, so even a retired GP can still receive a share of the net rent and enjoy the appreciation in the practice premises’ value.
There is no right or wrong .. Linking is a good idea because it creates a commonality of interest and symmetry of ownership between the practice and the practice premises. This usually makes for a more harmonious life and takes away any concerns or arguments about what rent should be paid.
However, a GP who is interested in buying into a practice may not be interested in owning a share of the premises as well. With GPs in short supply, it is not wise to limit your options.
Should the GPs own the premises in the same proportions as the practice?
Ideally yes. This has a number of advantages including simplicity, equality and fewer arguments about what is, or is not, market rent. But it is not necessary.
It’s not uncommon for one or more GPs in the group to be unable or unwilling to invest in the practice premises. Provided the tenant entity (ie, the practice) pays a market rent to the landlord entity (ie, the trust) there is no problem here.
Ideally the GPs will be able to agree on what is a market rent. If they can’t a valuation from a local real estate agent may help. Otherwise, a sworn valuation is needed, but these are costly and should be regarded as a last resort.
One advantage of symmetry of ownership is that it does not matter whether the rent is a bit high or a bit low: it’s from one pocket to another. Preferably the rent should be a bit high, and the excess paid back to the bank as extra principal repayments. This is OK from a tax point of view provided the rent is within the band of “arms-length” rents experienced for commercial property. Eight per cent of value is about as high as you should go unless there is clear evidence supporting a higher rent.
What if someone wants to leave?
The procedure for someone leaving should be set out in a unit-holders’ agreement. The procedure will typically be:
- Related party transfers are permitted without the consent of the other unit;
- However, transfers to non-related parties are only permitted if a procedure is followed. This procedure involves:
- offers to sell to the other unit holders at market value, in their proportions;
- If unit holders fall to take up the offer to buy, those units are then offered to the remaining unit holders in their proportions; and
- if after three months the offer is not accepted, the units can be sold to others.
If a GP is leaving it may be agreed that one of the other GPs will buy the units in the property trust. The fact that the unit holders’ agreement prescribes a contrary set procedure can be ignored if all the unitholders wish to do so. We always stress the prescribed procedure is a last resort, to be fallen back on if the owners cannot work out something better as circumstances arise. Remember, parties to an agreement can all agree to vary or not enforce that agreement, and keeping things on friendly terms is typically the best way to go.
How are renovations dealt with?
Renovation issues are much the same as ownership issues. However, if equity has been built up (borrowings repaid and/or values increased) the bank may be prepared to lend 100% of the renovation cost. If this is not the case, the unit holders may have to contribute a further amount to create additional equity to allow borrowings for the renovation to proceed.
The bank may be persuaded that the renovation will increase value by more than the renovation cost. But banks normally take a conservative view and discount the value back.
The rent should be increased post-renovation to reflect the increased value. This will create cash flow for the trust that can be used to service the renovation debt.
What if the renovations cost more than the increase in value?
This happens often. Building costs are high and a renovation costing $300,000 may only add say $200,000 to value. This means net value falls by $100,000 even before the angst factor is considered. This may be a good reason not to renovate a building that you do not occupy, but when you occupy it the decision is more than just a financial analysis. The synergy between the practice and the premises has to be considered. When a GP and the staff spend such a large part of their waking time in the practice premises its amenity and aesthetics are important.
If four GPs spend $100,000 “too much” and “over-capitalise” the building, what does it matter if they each intend to spend at least 10 years working there? That adds up to about $50 a week each – a small price for being in better quality space, not to mention the effects on staff and patients.
GPs can of course invest in commercial property other than the practice premises.
Commercial property is any property other than property used for residential purposes. This includes shopping centres and malls, shopping strip retail stores, farms, tourism assets, offices, factories, some sporting facilities and medical and dental surgeries. Defining commercial property as “any property other than property used for residential purposes” emphasises purpose over form, so a GP’s surgery in a converted residence is classed as commercial rather than residential property, even though it may still have a potential function as a residential property.
Commercial property covers a wide range of property types that have quite different risk/return characteristics and will follow different trends and cycles, further compounded by geographic factors. For example, rural land in South Australia will increase in price after a good grain cropping season at the same time as sugar cane plantations in Queensland are dropping in value.
Tourism assets, rural land and sporting facilities are generally not owned by GPs. This chapter will deal with offices, factories and shops, ranging from small local facilities to the huge CBD and industrial-zone complexes.
Returns from commercial property comprise rents and capital gains (or losses).
Commercial property rents are generally high relative to residential property rents, but capital gains tend to be less. Exceptions can occur, as can losses, but generally the capital gain is determined largely by the inflation rate, since this tends to determine rent increases.
If a property’s annual rent increases by 3% then, all things being equal, its value should increase by 3% too. But things are rarely equal, and this will be reflected in the change on yield. Value is an inverse function of yield, so falling yields mean higher values and rising yields mean lower values.
Yields are determined by a number of factors. Some apply to the general economy, some apply to the property’s location, some apply to the type of property and others apply to the particular property. The factors include:
- General economic conditions. Favourable GDP forecasts normally mean that businesses will need more space;
- Local geographic/demographic conditions. For example, the new ring road in Melbourne led to higher values in surrounding suburbs due to increased accessibility;
- The property’s particulars, including lease length, the timing of rent reviews, whether the lease allows for automatic increase, and the financial strength of the tenant.
Why don’t more GPs invest directly in commercial property?
GPs have a strange reluctance to invest in commercial property other than the practice premises. Possible reasons include:
- a lack of knowledge. Most investment books and magazines barely discuss commercial property, and if they do it is to stress how risky it is (taht said, most investment books and magazines are published by people who are involved in residential property);
- most financial planners are not qualified to advise on commercial property;
- high entry prices relative to residential property;
- low liquidity, although this is mitigated by line of credit loan facilities;
- relatively smaller re-sale markets; and
- high stamp duty and, often, land tax.
An example of a great buy
A GP buys a factory in Moorabbin, Victoria, for $2 million, including stamp duty and transaction costs. It is leased at $160,000, or 8% yield, for the next five years. The tenant pays all outgoings including land tax (on a single holding basis). The tenant is stable and has operated from the site for more than 20 years.
The GP borrowed 70% of the total cost of the property and contributed the remaining $600,000 as equity. The interest rate is 5%pa. The term of the loan is 10 years.
The figures look like this:
|Net rent||$ 90,000|
The net rent of $90,000 represents a return of 15% on the GP’s $600,000. If an unrealised capital gain arises each year of 3% (ie, about the inflation rate) this generates a further 10% return on the investment, taking the total return to about 20%pa.
Of this 20% return, 10% (the unrealised capital gain) is not taxed and about 3% is sheltered from tax by depreciation claims and building allowances. This makes the investment very tax-effective.
The investment is cash flow-positive. This means it generates more cash than it costs to hold it. This excess cash is paid back to the bank. The investment is so cash flow-positive it is also covering the principal repayments.
The big risk is something will happen to the tenant, or the tenant will not renew the lease at the end of the lease. This means a big part of due diligence is finding out about the tenant and forming a view of the property’s attraction to alternatives tenants if for any reason it became vacant. In this example, a valuer’s report gave comfort, indicating that historically the Moorabbin area had experienced only 3% vacancy rates, and the vacant properties tended to be the lower quality older properties. Local real estate agents confirmed this view.
Not all commercial properties behave this way. The more fashionable retail areas sell on much lower yields. These were as low as 5-7%, but recently have fallen as low as 3-4%.
What about dealing with estate agents?
Negotiating the actual purchase of commercial real estate can also be a treacherous process. It is a good idea to engage someone else to do the evaluation and purchase negotiations for you. It is a tad presumptuous to think that a novice property investor can out-negotiate a seasoned real estate agent. When a professional buyer gets involved the price usually falls.
It is a good idea to choose a bank that no GP has any other borrowings with. This way there is no risk of the GPs’ private affairs becoming tangled up with the practice premises.
You should choose the bank that offers the lowest interest rate. With commercial property lending, the concept of service does not really apply. Once the loan is in place and the property is settled there will be automatic repayments for the term of the loan.