Excerpted from The Biggest Legal Mistakes Physicians Make: And How to Avoid Them
Edited by Steven Babitsky, Esq. and James J. Mangraviti, Esq. (©2005 SEAK, Inc.)
Download Free 646 Page E-book: The Biggest Legal Mistakes Physicians Make and How to Avoid Them
Executive Summary
Their earning ability allows many physicians to invest in the real estate market and own interests in land, office buildings, retail properties, and single- and multifamily developments. When making those investments, physicians, because of the enormous time constraints many of them are under, often focus almost exclusively on the bottom line return they hope to achieve and fail to pay adequate attention to details. Inattention to details can, at a minimum, cause an investment to underperform and, in certain circumstances, spell financial disaster for the physician.
Mistake 1 Not Reducing the Purchase Agreement to Writing
Physicians are extremely busy and, as a result, sometimes fail to ensure that all of their agreements are reduced to writing, relying instead on a handshake. In the real estate investment world, however, all promises and discussions should be reduced to writing because of the amount of money and risk involved. A well-drafted purchase agreement should cover topics such as purchase price, earnest money, contingencies, closing, prorations, title insurance, representations and warranties, and casualty and condemnation.
Action Step Physicians should not make any assumptions or believe any assurances. Even the best intentions can be misinterpreted. If it is not in writing, the seller can easily argue that it does not exist. Physicians should have a purchase and sale agreement prepared that covers all of the important issues and allows them an out if the results of their due diligence are not acceptable.
Mistake 2 Investing Blindly
Even though real estate is one of the few investments in which risk is directly proportional to knowledge, physicians often invest in real estate based on questionable advice or without doing any real investigation at all of the property. Since the rule in commercial real estate is still largely caveat emptor (“let the buyer beware”), performing adequate due diligence is extremely important.
Action Step Physicians should avoid unpleasant surprises. They should not rely on puffery that the property is a “steal” or “hidden gem.” As needed, they should hire professional inspectors, engineers, and environmental and other consultants. It will be money well spent.
Mistake 3 Buying Into an Unknown Location
Even though the principal real estate maxim is “location, location, location,” physicians often invest in real estate without knowing much about the area in which the property is located. A “good” location depends on the real estate sector involved. For example, the corner of two major streets may be an ideal spot for a shopping center, but not for a single-family residential development.
Action Step Physicians should research the property’s location carefully. Are the demographics (i.e., population and income) sufficient to support the use to be conducted on the property? Are zoning changes planned? Is the site well suited for the intended use?
Mistake 4 Not Doing a Realistic Financial Analysis
Not doing or having done a realistic financial analysis of the proposed investment property can lead to financial disaster for physicians. One of the biggest mistakes first-time investors make is paying too much for a property whose rental income stream cannot support the price. Physicians should not rely on the seller’s statements regarding value and income.
Action Step Physicians should always thoroughly analyze the financial situation of a potential investment property. They should have the property professionally appraised and have their accountant review the property’s books and records. One way to determine an acceptable purchase price for the property is to use the income capitalization approach. This can be done by estimating the net operating income for the property (gross annual rents minus operating costs such as taxes, insurance, maintenance, and utilities) and dividing that number by the rate of return experienced by real estate investors in the area (the capitalization or “cap” rate).
Mistake 5 Making an Inadequate Title Investigation
Physicians often assume that title to the investment property is merely a perfunctory legal issue that need not concern them. Nothing could be further from the truth. The title documents, which constitute liens on the property, could be critical to the physician investor’s ability to develop and operate the property. Things such as easements, licenses, reciprocal operating agreements, and covenants, conditions, and restrictions may impose significant financial and nonfinancial obligations on the investor.
Action Step Physicians should have the state of title carefully reviewed by an experienced real estate lawyer before agreeing to the purchase.
Mistake 6 Ignoring Section 1031 of the Internal Revenue Code
Many physicians are unaware that Section 1031 of the Internal Revenue Code enables them to defer taxation and effect a tax-free exchange if they exchange an existing investment or business property for like-kind property. This enables them to dispose of an unwanted property and acquire a different property without a tax effect. Doing so, however, involves very strict timelines within which a replacement property must be identified and closed on.
Action Step Physicians should determine upfront whether their transaction might qualify for Section 1031 treatment. If so, they should consult an expert to ensure that the transaction is structured and carried out in a manner that complies with that section.
Mistake 7 Using the Wrong Ownership Structure
Physicians sometimes invest in real estate in their own names, even though there are a variety of much more advantageous investment vehicles available to them. When deciding whether and which entity to use, the two major issues physicians should consider involve tax and liability. Ideally, depending on the circumstances surrounding an investment, an entity should be selected that provides the physician with both limited liability and a pass-through of the profits and losses generated by the property (i.e., no tax at the entity level), such as a limited liability company or a subchapter S corporation. However, each entity has advantages and disadvantages that must be weighed before deciding which best satisfies the physician investor’s need.
Action Step Physicians should not invest in property in their own name without first obtaining expert advice about the other structures available to them. Those structures may enable them to realize significant tax and other benefits.
Mistake 8 Having an Inadequate Capital Structure
Physicians often invest in property without first ensuring the availability of reasonably priced financing or without having enough capital to sustain themselves if there is a market downturn or unexpected vacancies. To stay in real estate for the long term, cash reserves are needed. Operating from a lack of cash puts pressure on the physician to defer maintenance, do substandard repairs, accept less-than-qualified tenants, and give in to tenant demands for fear of vacancies.
Action Step Physicians should explore financing alternatives as early as possible with reputable lenders and then finance conservatively. They should ensure that they have sufficient cash reserves to survive in case the unexpected occurs.
Mistake 9 Not Spelling Out Details When Purchasing With Others
Physicians often enter into common ownership investments with other physicians and friends without spelling out each owner’s rights and responsibilities with respect to the property. Most deals that go sour have this in common: The investors/co-owners did not have a clear understanding of what they were buying. They didn’t think through the details and potential downside of their relationship and how to deal with those issues.
Action Step Physicians should prepare an agreement that clearly spells out each co-owner’s rights and responsibilities. They should deal specifically with issues such as ownership interests, financial responsibilities, management, repairs and maintenance, the death of a co-owner, and the desire of a co-owner to sell his or her interest.
Mistake 10 Procrastinating
Some physicians try to time their real estate investments by waiting for the “perfect” market or situation. There are no such markets or situations. History proves that the prices of good commercial real estate will increase, regardless of when one buys, as long as the owner holds on to the property for a reasonable period of time. Hoping that a better deal may be out there if one waits may very well mean missing out on market upturns.
Action Step Physicians should act now by identifying their goals, the kind of property they want, the areas that have such properties, and everything for sale in those areas. They should continue to do so until they find a deal.
Conclusion
Physician investors who take these mistakes into consideration when acquiring investment real estate and take steps to avoid them will be able to take advantage of the tremendous opportunities and upsides available in the U.S. commercial real estate market.
Additional Resources
- Auger, Pure Profits: Pinpoint Winning Properties, Think Like an Investor, and Succeed in Commercial Real Estate (Cameo Publications 2003)
- L. Manning, Commercial Real Estate: The Ins and Outs of Making Money in Investment Properties (Cypress Publishing Corp. 2002)
Written by:
Robert J. Horvat, Jr., Esq.
Peer reviewed by:
Jonathan V. Barg, Esq.
Download Free 646 Page E-book: The Biggest Legal Mistakes Physicians Make and How to Avoid Them