There are two basic ways in which the property element of a dental practice can be owned; leasehold or freehold.
By Leasehold, I mean that no capital sum has been paid for the property and that a full market rent is paid for the property on a monthly or quarterly basis. By freehold, I mean that the capital sum has been paid for the property and that no regular payments in the nature of rent are required to be made.
I recognise that it is possible to have leasehold property that is virtually freehold, such as a 99 year lease subject to a nominal annual ground rent, but it serves no real purpose to examine these fine differences in this article.
It is worth noting that, in respect of almost any given target practice, the availability of the freehold will be pre-determined. For example, if a practice forms part of a larger building, it will inevitably only be available on a leasehold basis. It follows that in the vast majority of cases, the Buyer will not be able to choose whether to purchase the freehold relating to a given practice. That said, a Buyer can decide, before looking at practices generally, whether he is prepared to consider leasehold, freehold or both.
So which to choose? Having been involved in this industry for some 20 years, I can confirm that this issue is a much debated issue, with strong and polarised views held by dentists and other professionals across the board. I summarise the views as follows:
The case for Leasehold Property
The purchase of a dental practice is a capital investment and when a capital investment is made, the investor must look to his return on capital. In broad terms, this is the profit that is made by the business that is being purchased.
Strictly speaking, in a single chair practice, the profit should be calculated after the principal has retained 50% of the gross in his capacity as the associate who carried out the work. The overheads of the practice must be met out of the remaining 50% and the profit is the resultant figure.
It is argued by professional investors, particularly in the dental industry, that the return on capital employed in the purchase of goodwill and dental equipment is materially higher than the return on capital employed in property.
If the return on capital is 20% on goodwill and equipment and 5% on freehold property, it is unwise to invest capital in freehold property. A prudent investor would buy goodwill and equipment on two practices for £100,000.00 each and make a profit, each year, of £40,000.00. A less sophisticated investor would buy a single practice, goodwill and equipment for £100,000.00 and the underlying Property for £100,000.00. It would then make a return of £25,000.00 on the goodwill and the equipment and save rent, showing a shortfall of £15,000.00 from the return of the sophisticated investor.
The case for Freehold Property
In terms of the original purchase price, the difference between the rental value of a property and the annual cost of repaying interest and capital is rarely significant. That said and depending on interest rates applicable from time to time, it is fair to say that, at the outset, the total of repayments and interest probably exceed rental payments. Repayments are usually constant, assuming constant interest rates. Rent will rise on each three or four year review and, depending on the market, are likely to rise quite substantially at the date of each review.
Standard leases contain a number of constraints on the tenant. For example, you will not be allowed to make alterations to the property without the consent of the landlord and probably his solicitor and surveyor too. This can lead to frustrating delays and significant wasted costs.
The landlord will invariably insure the building and pass on the cost to the tenant. Because the landlord is not personally footing the bill for insurance, he will not have huge concerns as to the cost of the insurance.
As I mentioned above, I have heard strong arguments over the years, for and against. I recently heard an argument from a leading dental accountant, which is possibly the most balanced view that I have heard. She said that she viewed the purchase of freehold property purely as an investment in property. If the dentist in question wishes to invest in property, it was as good an investment as any. If the dentist in question did not wish to invest in property and, for example, preferred to invest in the stock market, he should feel free to do so.
I personally believe strongly in investment in commercial property and as such, could only recommend the freehold option, if available.
A long standing client of mine purchased a practice some 20 years ago. The practice occupies the whole of a terraced house on a high street in the Home Counties. He purchased the goodwill and equipment for approximately £100,000.00 and he took a lease over the Property from the Seller of the practice, who owned the freehold, at approximately £10,000.00 per year. It emerged that the Property was in fairly poor condition.
The practice was fairly profitable and, apart from essential repairs, my client made numerous improvements to the Property. He felt slightly aggrieved at spending so much money on a property that he did not even own. It also upset him that his expenditure would almost inevitably lead to an enhanced rental value. At the time, the Property was worth some £200,000.00.
My client approached his Seller, the owner of the building and his current landlord, who was indeed quite happy to sell the freehold to my client. The freeholder said that, in his view, the Property was worth some £200,000.00 but that he would not sell it for less than £400,000.00. In the event, the freehold was made available at some £300,000.00, an obvious commercial compromise. The moral of that tale is that the client should have purchased the freehold at the time that he was purchasing the leasehold.
Russell Abrahams, Solicitor, Abrahams Dresden LLP
Abrahams Dresden articles and guidance notes are for general information purposes only and generally state the law as at the date of publication. The information may not be relied upon as legal advice. We are of course always happy to advise directly on specific issues arising.