Lease Negotiations | How Selling the Business Impacts Property Value

When selling a business, it is important to know and understand the different components of a real estate lease and the impact it has on overall property value. This is especially true for healthcare operators, who may not have the same level of real estate experience as seasoned investors. It is crucial to become well-educated about the various components of a lease and to pay close attention to the incorporated lease language. This article summarizes and explains the key clauses to include in lease negotiations, and the pitfalls to avoid to ensure maximum value after a healthcare practice sale.

Longest Lease Term Possible (10-15 Years)

For medical office buildings, lease terms typically range from 7-15 years, while longer terms are often preferred by investors. The longer leases are favored as properties with shorter lease terms or frequent renewal options require buyers to assume the risk of vacancy or renegotiation, reducing the overall asset’s value.

A longer lease term directly enhances the value of the property. Properties with lease terms of 10-15 years provide buyers with a predictable and secure income stream. These leases also reduce the perceived investment risk. Short lease renewal terms, on the other hand, can diminish investor confidence and can lower the property’s market value. Shorter leases can reduce the property’s value by 10%, while longer-term leases reflect stability and often warrant premium pricing.

Locations with 10-year leases in place also represent a secure property for the tenant and landlord. These properties often see greater returns and build a strong relationship with both parties. The dedication to the facility also creates a positive outlook as investors will see that the property is in a secure position.

Annual Rent Increases

Rent escalation clauses, or annual rent increases, are specified when signing a lease. This process allows landlords to specify how often rents will rise, together with how much they will increase by. It also ensures that income from the lease will keep up with inflation and market conditions. This is especially appealing as properties with 2.5% to 3% annual rent increases demonstrate consistent income growth, boosting the property’s value and appeal to investors.

The most preferred rental increases are annual compounding increases based on the Consumer Price Index (CPI), with a year-over-year cap of 3% or 4%. These set percentage increases fluctuate based on the CPI and provide investors with greater certainty that their rent growth will keep pace with inflation. Rent grows faster with a higher escalator, demonstrating the property’s strong performance over time. Therefore, properties with a rent escalator rate of 3% or higher will achieve a higher property value compared to those with a rent escalator of 2% or lower.

For tenants undergoing lease negotiations, signing a lease with set annual increases is also beneficial, as it provides predictable expense forecasts and guarantees that they will not face unexpected increases in yearly rent.

Full Corporate Guarantee for the Entire Term

A full corporate guarantee ensures that the parent corporation—not a subsidiary—is responsible for lease payments throughout the lease term. The guarantee typically involves the parent company’s assets backing the lease, offering stronger assurance compared to a subsidiary guarantee, which relies on the financial strength of a smaller business unit. Together, these factors provide added financial security for the landlord.

For investors leveraging the asset and purchasing with traditional financing, a full corporate guarantee typically provides more favorable lending terms. Traditional lenders, such as banks and credit unions, prefer the security offered by a strong guarantee and adjust their rates accordingly. This added security results in a lower interest rate, allowing investors to achieve a higher margin and overall rate of return.

Ultimately a commercial lease is only as strong as the financial strength and size of the tenant providing the guarantee. In the event of a tenant default, a stronger guarantee increases the likelihood of successfully collecting the owed rent payments.

Absolute NNN Coverage

An absolute net lease (NNN) transfers all property-related costs—including maintenance, insurance, property taxes, and structural repairs—to the tenant. Properties with absolute NNN leases offer a “hands-off” investment opportunity, which is highly desirable to potential buyers and particularly appealing to out-of-state investors, thereby widening the buyer pool. This lease type also gives tenants the flexibility to alter the property without purchasing the facility, allowing them to make adjustments to the building as their business model evolves over the long term.

Another benefit of a NNN lease is there are no caps on reimbursements. Avoiding caps on net lease reimbursements ensures landlords can recover all expenses, maximizing property profitability.

No Early Termination Clauses

Early termination clauses create uncertainty for landlords and can significantly reduce property value. If a tenant can break the lease prematurely, it limits an investor’s certainty and ability to make accurate future investment projections. For example, if a tenant signs a 10-year lease with an early termination option, the landlord is not guaranteed 10 years of rental income—only the early termination payout.

One of the most common early termination clauses for medical tenants is tied to the employment of key physicians. Lease language that specifically allows the tenant to terminate their lease following the employment termination of a key physician can drastically diminish the property’s value. An investor who purchases the property cannot reliably predict future cash flow based on the lease term if it is contingent upon a physician’s employment status. In the event the physician leaves the practice, the tenant could effectively cancel the lease at any time.

In Conclusion

Negotiating favorable lease terms is vital to enhancing property value when selling a business. Factors such as long lease terms, annual rental increases, full corporate guarantees, absolute NNN coverage, and the absence of early termination clauses contribute to increased investor confidence and higher property valuations. By addressing these elements strategically, property owners can maximize the appeal and profitability of their assets in the marketplace.

In addition to becoming self-educated about the different components of a real estate lease, it is highly recommended to seek the counsel of an attorney and a real estate broker to assist in negotiation.