Tenant Improvement Allowances for Medical Space

Landlords often think about allowances as a figure per square foot that works across their building. A clinic does not use space the way the average tenant does. Attorneys at Winstead note that many medical tenants have sinks in each exam room and run x-ray, MRI and other equipment that use more electricity than standard office equipment. The New York Real Estate Journal's guide to medical leases adds that radiation-producing machines need lead shielding, and that medical practices usually require extensive and expensive equipment, which makes short terms impractical.

Size matters in a different way than it does in ordinary offices. A small suite with many plumbed rooms can use far more allowance per square foot than a larger one with open areas. Before you compare two offers, have an architect or contractor price your actual program in each suite. A higher allowance in a shell can leave you worse off than a lower one in a former clinic, which is why the condition of the space belongs in the comparison.

An allowance is defined by its work letter. Two offers with the same headline number can be worth very different amounts. Ask these questions before comparing them:

• ✓Does it cover design, engineering, permits and project management, or only hard construction costs?
• ✓Does it cover items such as sinks, casework, added electrical panels, dedicated circuits, medical gas piping and shielding?
• ✓Can any part be used for equipment, furniture, cabling, signage or moving costs?
• ✓Can unused money be taken as a rent credit, or is it forfeited?
• ✓Does the landlord charge a construction management fee, and is it deducted from the allowance?
• ✓Who pays for building-standard items or code upgrades outside the suite, such as an upgraded riser or path-of-travel work?
• ✓When is the money paid, and what paperwork, such as lien waivers, triggers payment?
• ✓What is the deadline to use it, and what happens if your project runs late?

Do the arithmetic on a total-cost basis, over the term. A larger allowance paid for through higher rent is a loan, not a gift. A rent concession or a reduced term may be worth more to a practice that already has capital for the build-out. TAG can model competing offers on the same basis so that the comparison reflects what the practice will actually pay.

When your costs exceed the allowance, a landlord may offer to fund the difference and recover it through additional rent. That can preserve cash for equipment and opening costs, but look at the terms the way you would look at a loan.

Hypothetical, for illustration: a landlord funds $120,000 above the allowance, repaid evenly over 120 months with no interest. That adds $1,000 a month to rent. Interest raises the payment, so ask for the rate and do the math on that basis.

• Interest rate. What rate applies, and is it comparable to what a lender would offer you?
• Early exit. If you leave or the lease ends early, is the unamortized balance due at once?
• Guarantee. Is the balance covered by a personal guarantee? Holland & Knight's attorneys warn that limits on a guarantor's liability may be subject to reimbursing the landlord for the amortized cost of improvements or an allowance.
• Escalations. Are annual rent increases applied to the amortized portion as well? Ask that they not be.
• Security. Does the landlord ask for a larger deposit or letter of credit in exchange?

Your lender's view is worth having at the same time. Compare a landlord's amortization offer with an equipment or leasehold improvement loan, and confirm the terms with your lender and CPA.

Separate the budget into two lists at the start: things that become part of the building and things you can take with you. The lease treatment, and often the tax treatment, differ.

• Improvements usually stay. Walls, plumbing, ductwork and shielding are generally part of the premises. Ask what the lease says about ownership and whether you must remove them.
• Equipment usually goes. Exam tables, imaging units, chairs and similar items are normally yours to take, but items that are bolted or piped in can fall into a gray area. List them in the lease as tenant property.
• Landlord liens. Ask whether the landlord claims a lien on equipment. An equipment lender may require a waiver from the landlord.
• Restoration. The New York Real Estate Journal's guide says a tenant will want to provide at signing that it need not remove lead shielding or other special installations, while a landlord may want to decide near the end of the term. Pin this down in writing.

Tax is a question for your CPA. IRS Publication 946 describes qualified improvement property as generally an improvement to the interior of a nonresidential building placed in service after the building was first placed in service, excluding enlargements, elevators or escalators and the internal structural framework. The IRS tangible property guidance also explains that a lessee of part of a building applies the improvement analysis to the portion of the structure and building systems it leases. Who paid for and who owns an improvement can affect how it is treated, and these rules change, so have your CPA review the work letter before you sign.

An allowance can be a compliance issue as well as a business one. If the landlord is a hospital, a health system or another party that could receive your referrals, a build-out contribution is part of the economic picture. The HHS Office of Inspector General says remuneration under the Anti-Kickback Statute includes anything of value and names free rent as an example. The Stark law rental exception and the Anti-Kickback space rental safe harbor both look for rent set in advance and consistent with fair market value. Ask healthcare counsel to review the whole package, including free rent, allowance, overage terms and any landlord-paid equipment, before you agree to it. Counsel decides whether it fits.

1. Write your clinical program: room types, plumbing, power, imaging, sterilization and any gas or vacuum needs.
2. Ask an architect and a contractor with clinical experience to do a test fit and rough pricing on your short list of suites.
3. Split the budget into improvements, equipment and soft costs, and mark which ones the allowance could cover.
4. Ask each landlord for its work letter and form language along with the proposal, not after it.
5. Compare offers over the full term, including free rent, amortization, escalations and restoration.
6. Have counsel review the package if the landlord or its owners could be a referral source.