Office Rent: How Much Is Too Much If I Own The Building?
Dear Dr. Hayes,
Occupancy costs for my practice are closer to 10% of my gross than the recommended 8%. However, I own the corporation that owns the building. Yes, my rent is a little high, but I am my own landlord.
How do you factor the true occupancy costs in this situation? I am building equity in a nice piece of commercial real estate which I will own free and clear in ten years. I am sure this is not a unique situation for other ODs.
Stephen Kepley, OD
Dear Dr. Kepley,
This is not easy to answer for the simple reason that none of us know what the real estate market is going to do over the next ten years.
But, it’s still a good question. In the absence of a crystal ball, let’s make some economic assumptions and I’ll show you and my other readers a process you can use to analyze the pros and cons of property ownership.
Renting From Yourself
First off, most accountants prefer to see doctors create an LLC or S Corp for the purposes of owning real estate and then rent office space to their practice in a separate agreement.
From a practice management standpoint, I also like this approach because it helps you keep the investment issue separate from practice overhead considerations.
Now, to your question. Can a practice owner justify paying more for rent if he owns his building versus renting from a third party landlord?
Cost To Own Versus Rent
You didn’t give me your overhead numbers, but let's assume that you are a solo practitioner grossing $500,000 and netting 28%, or $140,000 in your current office arrangement.
That means you currently pay 10% of your gross, or $50,000 per year, in occupancy costs to your personally owned corporation.
For purposes of this discussion, we will also assume that you could rent comparable space from a third-party landlord for 8% of your gross, or $40,000 per year, in total occupancy costs.
If all other practice expenses are equal, that means your net income would be $150,000 if you rent and $140,000 if you own.
The question then becomes: “Can you justify earning $10,000 less per year for ten years to make payments on your office building?” Or, would you be better off putting that $10,000 to work somewhere else?
Let's first look at your cost of ownership.
Out of the $50,000 (10% of your Gross) you spend each year on occupancy costs, we can reasonably assume that $40,000 goes to your mortgage and $10,000 goes to taxes, insurance and a reserve for future maintenance and repairs.
Real Estate Value
Next, we have to calculate what your $40,000 in annual mortgage payments will buy.
For ease of math, we’ll assume no down payment. In that case, 12 monthly payments of $3,330 (approximately $40,000 per year) over ten years at 6% percent interest will pay off a principle amount of $300,000.
What is your guess of how much a $300,000 office building in today’s dollars will be worth in ten years? The answer to that will vary dramatically depending on the economy and the real estate market in his local area.
Let’s say we come out of the recession soon and the building appreciates at 3% per year. It could be less, it could be more. But that is the approximate rate of inflation over the last ten years.
At that rate, the building will be worth $403,175 when you pay it off in ten years.
What Are The ‘Opportunity Costs’?
Now we have to consider the ‘opportunity cost’ of that $10,000 extra you spent on your own building. In other words, what else could you do with that money?
You could take it as salary and spend it personally. You could make lease payments of $10,000 per year for equipment.
Or, you could invest it. That is usually how economists measure opportunity cost — by what ROI (Return On Investment) you would have received if you had invested that money elsewhere.
Comparing The ROI
Who knows what the stock market is going to do over the next ten years? All we can do is look at historical returns. Long term, the stock market returns about 8% per year. Let’s use a more conservative 6.9%.
If you invested $10,000 per year for ten years at a tax free return of 6.9% per year, you would have a total of $143,445 at the end of ten years.
While that is not an unrealistic return for money put in an IRA or 401k, I have to point out that the stock market is actually down slightly on a total return basis over the last ten years. Not a good thing.
Assuming you are in the market during a period of average returns, the hypothetical value of the building after ten years would equal $403,175.
Compare that to the $143,445 you would have in your 401k for investing $10,000 per year in the stock market. The difference is $259,730.
In my opinion, that $259,730 is the premium you earn for owning your own building under the assumptions listed above.
Lessons, Caveats And Cautions
Lesson: Even if the numbers don’t work out exactly this way, and they won’t, this is a good process to use when doing your own investment analysis.
Caveats: We didn’t consider the difference of income tax deductions for renters versus owners. Nor did we calculate the value of the rental income after the building is paid off in ten years.
Caution: Until this current crash, most of us had never seen the value of well-located real estate decline over time. As we see, prices can go down.
But, these numbers do present a compelling argument. Given that you have to pay rent to somebody, owning the real estate you practice in can be an excellent long-term investment.
Regards,
Jerry Hayes, OD
Disclaimer: The information and opinions contained on this site are for discussion purposes only and are NOT intended to serve as legal, accounting or investment advice. ©2009 Jerry Hayes, OD. Not to be reproduced without written permission of the author.
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Dear Dr. Hayes, I am
Dear Dr. Hayes, I am currently the managing associate in a practice that is 2.5 years old. The practice is doing fairly well as we are on track for $500K this year with one doctor five day per week.
I am attempting to work thru a partnership proposal made by the two owners of the practice. One particular topic I am trying to ascertain is what is a fair market rent for the northern Virginia region where we practice?
One of the two practice owners also owns the current space for which we are paying $2,700.00 a month rent to him. The space next to our current office is owned by the other partner with plans to expand into that as we expand in 3-5 years.
I am now trying to figure out what would be a fair number to pay for future rent as we grow. Are rents a function of gross? Is there a formula to use per square feet? Any response would be greatly appreciated.
Sincerely,
Stephen W. Hinkle, O.D.
Dear Dr. Hayes I have few
Dear Dr. Hayes
I have few questions for you.
1. Net usually is 30% in a typical optometric practice-does this amount includes OD salary? If it is, what percentage should the net be if I am planning to hire a doctor?
2. My patients are mostly progressive wearers, and my lab bills are extremely high compared to the national average. Average reveune per patient is $300 and average sale is $650 per patient. Should I raise my progressive lenses prices even though the reveune per patient is not bad compared to national average? It is at 2.25 times of lab cost before discount.
Thank You
Dr. Ed Ling
All good points by
All good points by Jay!
Thanks for your input. Jerry
This is an eloquent scenario,
This is an eloquent scenario, Jerry, and illustrates opportunity cost well. There are, however, variable assumptions in every example. To further legitimize the act and comparison of owning your own building, I recommend that those of us who own our real estate, pay our separate LLC at the upper end of true rental rates for equivalent office space in our market area.
What that does is completely eliminate the variable of what you do with the income differential. Most CPAs will, as you say, provide a nice scenario with what that difference in payments COULD do if invested completely; but the truth is, people just spend it. I've found it's a pretty fair statement that "docs will live on what they make."
It becomes abundantly clear to own whenever it cash flows if you think the building will be easily sold when you are done with it, as any equity is far better than a stack of paid rent receipts at the end of 25 years. The current market will make those considering it NOW take pause, due to the economic times, but they will rebound and it again will be a viable option.
The time when it does not make sense to own is when you want more practice mobility. Perhaps your area of town may be changing, or there is a new hot area you may want to re-locate your practice to in the future. By all means, don't BUY real estate then. Or perhaps one simply cannot afford a mortgage note on a building, but can find an older property to rent where it can be remodeled, and commands a much lower rental rate because the building is often owned by the landlord free and clear.
I find it most advisable to own a building, and build MORE space that you need, so you can lease it to others. That's even better, since your tenants pay some of your bills. Again, being a landlord is not for everyone, but for those willing to take a little risk, the rewards are great. And CPAs can display their greatest creativity when they have two entities to play with!