SAN DIEGO—Repositioning smaller, aging medical-office buildings for condo-ization and including that option as part of the marketing package can help fill the gap created by renovation costs and interim lost rental income that often come with the process, HemphillSolutions senior advisor Ralph Hemphill tells GlobeSt.com.

Hemphill has more than 25 years of real estate experience that includes ground-up development, adaptive reuse/repositioning, portfolio management and advising businesses and hedge funds on all things real estate. After reading about ways to reposition larger aging MOBs, Hemphill spoke with us about an alternative solution for smaller buildings.

GlobeSt.com: What's your view of the exit strategy for owners of aging medical office buildings that we presented recently?

Hemphill: I completely agree; the sale-leaseback strategy can be a wonderful solution for a hospital system or medical association that occupies a large medical-office building its entirely. But what about a smaller property (say 13,000 square feet) owned by a sole practitioner or members of an independent medical practice that occupies, say, 20% of the building. Then what?

GlobeSt.com: What are the issues unique to these smaller properties or sections of properties?

Hemphill: Remember, the smaller the proportion of the building seller occupies, the more difficult it may become to adjust the lease economics to accommodate a buyer's desired purchase price and the leaseback seller's desired renovation scope contemplated in Mr. Barnes's example.

For example, a seller occupies 100% of the property (13,000 square feet), and the delta between the buy/sell price is about $125,000, representing mainly the renovation costs and maybe some interim lost rental income. In this example, the difference can be made-up by simply increasing seller's post-closing 10-year leaseback rent by +/- 4%, a manageable figure.

Unfortunately, if seller occupies only +/- 20%, to fill that same $125,000 gap, seller's post-closing 10-year lease back rent will have to increase by a deal killing +/- 20%.

GlobeSt.com: What do you propose as a solution?

Hemphill: One way around this barrier is repositioning the property for condo-ization and including that option as part of the marketing package. The condo option reduces purchase-price risk some, by giving the buyer three different exit strategies: a straight invest and hold, hold and sell for condos at a future date or, if the market is ripe, buy and flip as condos after closing.

With this program, the buyer may feel safe closing the price gap by paying a little more for the property (say +/-$65,000), knowing it has more than one exit strategy. The seller can take the “edge” off the deal by agreeing to close the gap (say the remaining +/-$60,000) by paying +/- 9.5% more in rent (versus 20%) or in the case of an immediate buyer/flipper, agreeing to purchase its unit for a favorable price and making up the gap by selling it later at a higher price, once the buyer sells all its inventory.

GlobeSt.com: What are the economics behind this system?

Hemphill: The economics behind the condo-ization plan are fairly straightforward and are governed by the following five basic principles:

Keep it small—Properties of no more than 20 units greatly reduces the length of the sell-out period, making the condo option more desirable.
Obviously, the bulk purchase price must be significantly less than the aggregate sale price of all the condo units. For example, a buyer may be happy to purchase a building for, say, $270 per square feet if it is confident it can sell individual units at, say, $425 per square feet to either an occupant or an investor of single-family rentals and by doing so, double its money.
The price of each individual condo must equate to a mortgage payment less than market rent or current rent, whichever is lower. With banks eager to lend to medical professionals at historically low rates (+/-4%) it may not be that hard to make a mortgage with a 10-year fixed-rate seem financially attractive compared to a market-rate 10-year lease with escalations. Pricing the units for less than a comparable single-family rental will attract small investors, too.
The building must be easily adaptable (i.e., in-unit restrooms, individually metered utilities (at least for gas and electric), individual HVAC systems and hot-water tank for each unit, coupled with sufficient parking).
Even though commercial condominiums typically do not have the regulatory hurdles and upgrade requirements to clear as do residential condominiums, bring the municipality's building, planning and zoning departments alongside early in the process to make sure there are no surprise requirements that could financially complicate conversion.

Condo-ization has worked well for me, so if someone runs into difficulty executing a sale-leaseback, I encourage them to consider the prospects of re-aligning its market program to accentuate the property's potential value as a condominium.

Instant Insights /

A Smart Exit Strategy for Smaller Aging MOBs

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