The process of transferring a practice lease to a new owner can be an intricate and impactful piece of the dental transition.
In the beginning of a dental transition, the initial focus tends to be on a handful of key areas, such as practice price, timing and seller workback. While the lease is not typically the focal point at the starting line, it certainly shouldn’t be left until the end. Most people are familiar with residential leases for an apartment or house, but transferring a practice lease can be more complex and filled with different stipulations. Moving to a new practice space isn’t quite as easy as moving homes.
For the buyer preparing to take over the lease, or for the seller preparing to make the transfer to the buyer, this piece of the transition is about preparing for both the financial implications and the decisions ahead. The rent of a space is often the largest contributor to overhead and can make a big impact on the patient base. Additionally, the lease agreement typically sets the expectations for not just one year but multiple years, so negotiating the proper terms up front while keeping the long-term goals in mind is crucial.
Here are a few significant factors to understand and common negotiated areas when it comes to the lease agreement.
Triple Net vs. Gross Lease
Simply put, the type of lease for the practice determines who pays for future expenses. There are two basic types of leases: triple net and gross.
Triple Net: In a triple net lease, the tenant is responsible for property taxes, insurance, utilities and base rent. Generally, triple net leases are the most common in dental practices.
Gross: A gross lease is where the tenant pays a higher base rent, but they are not responsible for property taxes and insurance (and sometimes not utilities). Those expenses fall on the landlord. This type of lease is less common and is often seen in small practices in rural areas.
Note that there are certainly hybrids of these two leases.
Overall, the key here is to understand what type of lease is being considered when analyzing the practice financials and the proposed lease itself.
Lease Term and Escalations
Understanding the length of the lease is not only about knowing how long the tenant will be at the office, but also recognizing how the following factors will affect both the seller and the buyer (the soon-to-be new tenant) in the short- and long-term.
Lease Term: The lease term is the duration the tenant is expected to stay in the space. This is considered to be when the tenant is “locked in” to the lease. Note that the lease term does not necessarily mean the length in total, but rather the initial duration, as this may not include the years of renewal options.
Renewal Options: Options to renew involve additional years that will extend the total length of the term. Therefore, if the tenant is on a five-year term with three two-year options to renew, that means they have the ability to stay in the space for 11 years total.
Keep in mind that if an outside lender is involved in the practice transition or purchase process, the bank will require the new buyer to have a lease for the length of the financing. This means if a buyer receives a 10-year term for lending, the bank will require the lease length to be 10 years, which includes the initial term and renewals.
Rent Escalations: Rent escalations involve increment increases of the tenant’s rent based on a certain time period or based on the initial term. The rent may increase a small amount each year, or it could be a fixed rate for one or two years and then begin escalating every year thereafter or at the term renewal. The amount of escalation will likely depend on the local market, initial terms and overall transition terms.
Whether it’s the buyer or seller, they should understand their obligations in relation to the term and renewals. For buyers in this situation, they should be mindful of the long-term goals and if the terms are restricting or locking them in for longer than they’d like. If the neighborhood or the office space isn’t amazing, the space doesn’t have room to expand and bring in an associate in the future or if the buyer wants flexibility to relocate in the future, then they may not want to confine themselves to a long initial term lease.
HVAC Repair and Replacement
The heating, ventilation and air conditioning (HVAC) system, is an area of the lease that is often heavily negotiated. The question is who takes on the financial responsibility and execution of repairs and maintenance and who pays for the replacement. Does the responsibility fall on the tenant or the landlord, or are the responsibilities split?
There isn’t necessarily a standard structure for negotiating the HVAC, but there are a few different ways to go about it.
In some instances, the tenant may be responsible for the repair and upkeep, while the replacement is on the landlord since they own the asset and the building. In other instances, the tenant may be required to pay for the repairs up to a certain dollar amount, or maybe the building is shared with multiple tenants, so they’ll need to split the amount.
Buyers, if you disagree with the HVAC terms in your deal, be sure to look at the full picture and understand the deal as a whole. For example, if you’re required to pay for the HVAC replacement, but it was just replaced in the previous year, consider that the chance of needing to replace it in the next few years is fairly low. Additionally, if you’re receiving a great deal out of the practice, and all of the transition pieces line up except for the HVAC terms, know that the overall big picture still works in your favor.
Option to Purchase and Right of First Refusal
While the option to purchase and the right of first refusal (ROFR) clauses pertain more to the overall real estate rather than the lease, this language impacts the buyer’s purchasing rights. If the buyer has any desire to purchase the real estate in the future, this is pertinent language for the lease agreement.
Sometimes, the buyer loves the real estate, but they can’t afford a down payment at the time of the transition. If that’s the case, it’s ideal to have an option to purchase clause in the contract, which is language that says the buyer can purchase the real estate when they’re financially ready.
Even if the landlord desires to sell the real estate to the buyer at the beginning of the new practice ownership, they may change their mind in the future and choose not to sell. Giving a buyer the option to purchase clause will keep the opportunity open for the future regardless of if the landlord changes their mind or not. This frames the option to buy as a tenant’s choice (not the landlord).
The right of first refusal clause differs from the option to purchase clause. If the seller chooses to sell the real estate, a ROFR gives the buyer a chance to purchase it before anyone else does. The ROFR is very common in dental transitions, especially in sole owner locations.
The key difference between the right of first refusal and option to purchase is that a buyer can exercise their option to purchase anytime during the option period for a specific price, whereas in a ROFR, the buyer has the opportunity to purchase only if the seller chooses to sell.
For buyers who don’t receive the contractual option to purchase, they should assess and determine if this is a firm deal breaker. Be sure to consider the deal overall and understand the ultimate end goals before taking a quick pass. The practice may still be a favorable one despite the inability to purchase the real estate.
Review Your Unique Situation with a Dental Transition Advisor
Looking at the terms of the lease agreement may not feel as exciting as the other aspects of the transition, but that doesn’t mean they should be overlooked. Take the opportunity to review the details early on to ease any concerns and minimize stress when transferring a practice lease.
Utilizing a dental transition advisor like NDP to look at the nitty gritty details can help ensure your bases are covered. Reach out today as our team can walk you through your situation and answer your questions.