Premises and Lease Terms in Healthcare Business Valuations

Why do premises matter more in a healthcare business?

Every business needs somewhere to operate. A healthcare business usually needs somewhere particular, and that difference runs through the valuation.

Three features set the sector apart. The first is regulatory: some approvals attach to an address rather than to a person or a company, so the premises form part of the ability to trade. The second is capital: a clinical fitout is expensive, purpose built and largely immovable, so leaving the site destroys much of what was spent on it. The third is behavioural: patients, participants and referrers form habits around a location, so part of the goodwill sits in the address rather than in the name above the door.

Goodwill is the value of a business over and above its identifiable assets: the sources of custom that keep people coming back. Where those sources include the site itself, the lease decides how long the business can keep using something that produces part of its earnings. What is goodwill in a medical practice sets out the wider idea.

Rent and tenure are two different questions

Premises enter a valuation twice, and conflating the two is the common error.

Rent affects earnings. Maintainable earnings are the profit the business can reasonably be expected to repeat under normal conditions, arrived at through normalisation, the restating of the reported result onto arm's length, ongoing terms. Rent is one of the largest items in that restatement for a clinic or a pharmacy, and the figure used should be the rent a buyer will actually pay, not the rent the current owner happens to pay. See what is maintainable earnings.

Tenure affects risk. The capitalisation multiple, the factor applied to maintainable earnings to reach a value, reflects how confident a buyer can be that those earnings continue, and security of tenure sits directly in that judgement. Earnings produced from premises with a short unexpired term and no options are not the same as an identical figure produced from a site with long secure tenure ahead of it. See EBITDA multiples for healthcare businesses.

Neither substitutes for the other: a below market rent flatters earnings without making the business safer, and a long term does not make an uncommercial rent sustainable.

Method choice follows the same split. Capitalisation of future maintainable earnings applies a multiple to a single sustainable earnings figure and assumes a broadly stable cost base. Where the rent path is known and uneven, a fixed step-up or an expiry with a likely reset, a discounted cash flow, which projects future cash flows and discounts them to a present value, carries that path explicitly. Market evidence needs the same care, because a reported price reflects the tenure that buyer obtained, so it is not a value for a business holding a shorter lease.

When the approval is attached to the address

Community pharmacy is the clearest case in Australian healthcare. The Pharmaceutical Benefits Scheme states that pharmacists are approved under section 90 of the National Health Act 1953 to dispense pharmaceutical benefits from particular pharmacy premises, described as approved premises, that a unique PBS pharmacy approval number is issued for each approved premises, and that an approved pharmacist may only supply at or from premises for which they are approved.

Two consequences follow. The scheme revenue is anchored to a street address rather than to the company that owns it, and moving is not a decision made with a removalist. At the time of writing the location based criteria sit in a legislative instrument, the National Health (Australian Community Pharmacy Authority Rules) Determination 2018, which governs when the Authority must and must not recommend approval and deals separately with applications involving cancellation of an existing approval.

For a valuer this turns an ordinary lease question into an existential one. A pharmacy whose landlord will not renew cannot simply reopen in the next block, so the analysis examines the remaining term, the options, the landlord and any redevelopment exposure before it examines the script numbers. Pharmacy valuations covers the sector in full.

Pharmacy is the sharpest example rather than the only one. Services Australia states that a health professional needs an additional Medicare provider number to work in a new practice location, or for a new service at the same location. Billing entitlements are therefore recorded against sites, so a relocation is an administrative exercise for every practitioner at the practice as well as a property decision. See medical practice valuations.

Fitout, make good and the cost of leaving

Clinical fitout is the second reason. Sterilisation rooms, plumbed dental chairs, shielded imaging rooms, consulting suites and dispensary joinery cost real money and are worth very little anywhere else. Some becomes a fixture belonging to the landlord at expiry, and most of the rest cannot be economically relocated. A valuation therefore reads the unexpired term against the remaining useful life of the fitout rather than in isolation.

The obligation at the other end of the lease is the make good: the tenant's commitment to return the premises to a specified condition, often base building or the condition at handover. In a clinical tenancy it can be substantial, because the fitout that has to come out is the expensive part.

Make good is a real liability rather than a formality, and Australian accounting practice recognises it as one. AASB 16 Leases states that the cost of the right of use asset a lessee recognises at the commencement date includes an estimate of the costs of dismantling and removing the underlying asset, restoring the site, or restoring the asset to the condition the lease requires.

Many practices prepare special purpose accounts, or use the election in AASB 16 not to apply those requirements to short term leases and low value assets, so the obligation can sit outside the financial statements altogether, and a valuation asks for the clause rather than searching for a provision. Where a net asset method is used, which values the business as its assets less its liabilities with each item restated to market value, an unprovided make good obligation belongs among the liabilities. See healthcare business valuation methods.

Where AASB 16 has been applied there is also a comparability trap. Rent leaves operating expenses and reappears as depreciation and interest, so EBITDA, being earnings before interest, tax, depreciation and amortisation, is higher than on the previous treatment. A figure prepared on one basis cannot be read against a multiple derived from the other.

Lease term, options and the valuation date

A valuation is a conclusion as at a stated date, and the lease position is read as at that date.

The unexpired term is the period left to run. Options are the tenant's rights to extend, and they matter in two ways: how many remain, and whether the tenant can still exercise them. An option is not tenure. It is a right that has to be exercised on time and in the manner the lease specifies, and options are lost through inattention more often than through dispute.

Retail lease legislation recognises the problem in some states. The Victorian Small Business Commission states that where a lease contains an option to renew, the landlord must give the tenant written notice of the renewal deadline, the proposed rent and other key details no later than three months before the date the option is no longer valid, and that if the landlord does not, the date is extended by three months from the day the notice is given. It also states that a landlord must renew where the lease contains an option and the tenant has exercised it.

Three further terms matter as much as the length.

• Rent review mechanism. Fixed, index linked and market reviews produce different cost paths, and a ratchet clause that stops a market review reducing the rent is a one way risk.
• Outgoings. Who carries land tax, owners corporation levies, insurance and maintenance decides the real occupancy cost, which a headline rent per square metre does not show.
• Permitted use. A narrow use clause can stop a buyer adding a service line, a dispensary, an imaging room or a second discipline, or require consent before the practice changes what it does.

Where the lease is close to expiry at the valuation date, the valuation states its renewal assumption and prices the uncertainty rather than assuming it away.

Can the lease be assigned to a buyer?

A sale that leaves the tenancy behind is not a sale of the same business, so assignment, the transfer of the lease from the outgoing tenant to the incoming one, belongs in the transaction analysis rather than the settlement paperwork.

The Victorian Small Business Commission describes the process for retail leases in that state. It states that a transfer occurs when a lease passes from the outgoing tenant to a new one, for example on a sale of business, that the request must be in writing and include information about the financial resources and business experience of the proposed tenant, and that the landlord is taken to have agreed if no written response is given in the 28 days after the request. It also lists grounds for refusal, including a use not permitted under the lease, a proposed tenant without sufficient financial resources or business experience, and failure to follow the lease's reasonable assignment provisions.

For a valuation the questions are narrower than the law.

• Is landlord consent required, and on what grounds can it be refused?
• Does the outgoing tenant remain liable after assignment, and are personal guarantees released?
• Is there a bank guarantee or security deposit, and who funds its replacement? Cash securing a bank guarantee is restricted rather than available working capital, so it is usually a completion matter.
• Does the lease contain a change of control clause? A sale of shares or units does not assign the lease at all, but such a clause can still give the landlord rights, so a share sale can trigger the same consent process by another route. See valuing a healthcare business for a shareholder exit.

Where consent is uncertain, that uncertainty is itself a transaction risk. Preparing a healthcare business for sale treats it as something to resolve before a sale process begins.

Retail lease legislation is a state based flag

Whether protective retail leasing legislation applies at all is a question of state law and of what the premises are used for, and healthcare premises fall on both sides of that line.

At the time of writing, the Victorian Small Business Commission states that retail premises are premises used wholly or predominantly for the sale or hire of retail goods, the provision of retail services, or a business the Minister determines, and that the Act may apply where those goods or services go to other businesses rather than consumers. It is a use based test, and many clinical tenancies meet it.

Queensland takes a different route. The Queensland Small Business Commissioner states that a lease is a retail shop lease if it is for a shop of less than 1,000 square metres used to carry on a retail business, or for a non-retail business in a retail shopping centre, and it names medical centres among the premises it lists as not retail shops. The same clinic can therefore sit inside the legislation in one state and outside it in another, though a Queensland medical centre in a retail shopping centre can still be caught by the shopping centre limb.

This is a flag rather than a conclusion. Where the legislation applies the tenant has statutory disclosure, assignment and dispute resolution rights that reduce risk; where it does not, everything turns on the lease itself. Which applies to a particular lease is a legal question for the business's lawyer.

Relocation and demolition risk

Two clauses can turn a long lease into a short one.

A relocation clause lets the landlord move the tenant elsewhere in the centre. A demolition clause lets the landlord end the lease so the building can be redeveloped. Both appear routinely in shopping centre leases and older strip retail buildings, and both hurt a healthcare tenant more than a general retailer, because the fitout cannot follow and, in a pharmacy, the approval will not follow without a fresh application under the location rules.

Relocation risk has a quieter form too. A business co-located with the source of its work, a pharmacy beside a medical centre or a physiotherapy practice inside a general practice, is exposed to another party's lease as well as its own, so the lease that matters may not be the one the business signed. Patient, participant and referral concentration deals with that wider dependency.

When the owner also owns the premises

Many healthcare owners hold the practice premises personally, in a family trust or in a self-managed superannuation fund. The structure is common, and it has to be untangled before either asset can be valued properly.

The valuation separates the two. The business is valued on the earnings it produces while paying a market rent for the space it occupies, whatever related party rent has actually been charged. A below market rent overstates reported profit, so earnings are reduced; an above market rent understates it, so earnings are increased. That is normalisation rather than criticism of the arrangement, and it lets the conclusion be compared with evidence from businesses that lease at arm's length. The rent adopted is often contested where the valuation is prepared for family law, a shareholder dispute or a tax matter, so a valuation typically states the rent used and the evidence behind it. See valuing a healthcare business for tax purposes.

The property is then dealt with on its own. Where it sits inside the entity being valued it is treated as a surplus asset, an asset the business does not need in order to earn its normalised profit, and valued separately, usually by a property valuer. Adding it to a business value already struck after a market rent would double count it; leaving it out of the equity calculation would lose it. That is the difference between enterprise value, the value of the operating business, and equity value, what the owners hold once surplus assets and debt are accounted for.

The two assets also have different buyers, different risk profiles and often different timing, and an owner selling the practice while keeping the building needs to know what the building earns as an investment property with a new tenant. Arrangements of this kind carry tax and superannuation requirements that should be confirmed with your accountant and lawyer.

What a valuer asks for

Lease documents do more work in a healthcare valuation than most owners expect. A complete premises file usually includes:

• the executed lease and every variation, extension and side deed
• the options, and the dates by which each must be exercised
• the rent review mechanism, and the outgoings reconciliation
• the make good clause, and any negotiated cap or agreed position
• the bank guarantee, security deposit and personal guarantees
• assignment, change of control, relocation and demolition clauses
• the fitout schedule and what the landlord owns at expiry
• for related party premises, evidence supporting a market rent

See what information is needed for a business valuation.

How premises risk reaches the conclusion

Premises rarely appear as a separate line in a valuation. They move three things: maintainable earnings, through the rent adopted and the occupancy cost a buyer will bear; the capitalisation multiple, through security of tenure, assignability and redevelopment exposure; and the assessment of transferable goodwill, being goodwill that passes to a buyer, as distinct from personal goodwill that leaves with an individual, because goodwill attached to a location transfers only if the location does. See does a medical practice have transferable goodwill.

Much of this can be improved before it is tested. Exercising an option on time, settling a make good position, negotiating a longer term and confirming how assignment works are typically available well before a sale, a shareholder change or a dispute makes them urgent. To have the premises position assessed as part of a valuation of your own business, request a valuation, or read how medical practices and dental practices are valued.