November 12, 2019
Windfall for Some Partners Leaves Other Partners Footing the Bill
I hate to admit it, but I am old enough to clearly remember The Steve Miller Band singing “Take the Money and Run”. I just didn’t know that it described the physician-partners who walk away from a debt obligation and leave the repayment for the rest of their partners or, worse, those that may be future partners.
The stage is set whenever a group of partners agrees to pay an above-market lease rate so that a REIT or some other buyer will pay a higher purchase price. The premise is simple. The buyer pays an increased purchase price in return for the seller agreeing to an increased rental rate over the lease term, which is often 15 years or longer. It is likely that idea is flawed from the beginning, as an analysis would show that the present value of the increased rental payments is greater than the premium received. However, there are much greater problems that may occur that can have very serious practical, ethical and even legal implications.
The problem occurs when one or more of the selling members leave the practice (tenant) prior to the maturity of the lease. Let’s remember that the retiring member received a premium payment in exchange for their promise to pay a premium rent over the term of the lease. However, when the member leaves the practice prior to the lease term expiring, that member is no longer repaying his or her portion of the rent premium that is still due. That partner or those partners have just ducked out from paying their portion of the tab that is due on the premium received and left that to be paid by those remaining in the practice.
That means the remaining partners’ original benefit from the incremental sales value will be mitigated or eliminated by the portion of the premium they now pay (through the practice) on behalf of the partner(s) that “took the money and ran”. It is likely that the increased rent will cost the remaining partners more than they received in the first place. Beyond the issue of the original partners is the valid concern of new partners who may question why the practice is paying an above market rent. Moreover, some attorneys feel strongly that the practice is obligated to disclose the over-market rent when recruiting a new physician with the expectation of a partnership. An astute doctor contemplating partnership will see that his or her income would be diminished by that rental premium that had been monetized earlier by the preceding partners.
Although there are methods of re-equalizing the benefits and obligations attached to an above market sale / leaseback, the best thing that a group can do is to recognize that whatever premium they receive will be paid back with interest to the purchaser over the course of the lease and to make sure that the sale / leaseback occurs at true market rates. If that’s not possible, talk to your attorney about claw-back provisions for those retiring prior to the lease term to avoid the outcome as described in this example.
A group of 10 partners sell their 40,000 sf building at what amount to a 6 cap. The market rent is $20 psf but the partners agree to pay a lease rate of $23 psf. That increases the rent / NOI by $120,000 and increases the sales price by $2 million. The lease is for 15 years with 2.5% annual increases. After 5 years, 2 of the partners retire from the practice and no longer share in the obligation to repay the inflated portion of the rent.
In this case, the partners who retire after 5 years will realize a gain of $140,156 while those remaining for the full term will suffer a loss of $17,952, a difference of $158,108.