Key Terms in Medical Office Building (MOB) Leases – Landlord and Tenant Perspective

With the advent of the Patient Protection and Affordable Care Act, it has been predicted that 45,000,000 more Americans will be seeking medical care. The demand for medical office space will likely increase dramatically as medical practices strain to keep up with such greater demand for medical care.

Landlords and tenants who can identify and quickly resolve critical medical office lease issues will be able to dramatically reduce the time period between signing a letter of intent and opening for business and, thus, more rapidly serve that increased patient demand.

Here now are some key lease issues facing MOB landlords and tenants.

Landlord Services and Tenant Obligations – Net Versus Gross Lease. Exceptionally cost conscious tenants will ask the landlord to maintain and repair not only the building and common areas, but also the premises, as well as provide basic utilities and all for one flat monthly rental payment. This is commonly known as a gross lease. Equally cost conscious landlords will prefer a net lease arrangement. Under a net lease, the landlord would maintain the building structure (foundation, walls and roof), common areas and utility facilities, and charge the tenant for its pro-rata share (premises rentable square foot area divided by the total building square foot area) of operating expenses (including maintenance, insurance, and real estate taxes) for the building and common areas. The landlord will also want the tenant to provide its own janitorial services, maintain its premises, and maintain the heating, ventilating, and air condition (“HVAC”) units and system servicing the premises.

The compromise most commonly seen is this: landlord maintains the building (foundation, walls and roof etc.) and common area, provides utility services and janitorial services to the building common areas and the premises (excluding tenant’s labs, operating rooms and excluding medical waste) and tenant pays its pro-rata share of operating expenses (for the building and common area). The tenant will nonetheless be required to maintain, replace, and repair the HVAC system (at its expense), pay its pro-rata share of building and common area operating expenses, and provide janitorial services to its premises labs, operating rooms, and handle all medical waste (all subject to landlord approval). Tenant may also typically be required to pay for after-hours utility services consumed by the tenant.

Rent and Rent Increases. Market conditions will usually dictate the initial lease year rent; however, subsequent increases are a matter of negotiation. While a tenant may prefer a flat rent rate during the term and landlord may prefer to adjust that rate (upward) annually based on market conditions, both positions are unrealistic. Also a tenant seeking a long term lease (seven to ten years or more) will expect to pay increased rent. The most typical rent increase structures are (1) a defined percentage increase each year varying between 1% to 4% or (2) the greater of a defined percentage increase each year or an increase based on changes in the consumer price index, but not to exceed a specified cap.

Tenant Improvements. While a tenant may prefer that landlord provide a “turn key” suite build out, at landlord’s expense and to tenant’s specifications, landlord may prefer to have the tenant handle such construction, but at the tenant’s sole cost (subject to landlord approval rights). Neither position typically prevails unless, with respect to the landlord, it is particularly eager to sign the tenant for an extended term (giving the landlord sufficient time to recoup its investment) or as to the tenant – it’s competing with other practices for space at a very desirable location (hospital adjacent for example).

The typical compromise runs as follows: landlord provides a set dollar per usable square foot space allowance, reserves approval rights over tenant’s architect, contractor, and subcontractor, funds the “TI Allowance” at completion of construction, and in some cases, requires the tenant to either post or prove it has sufficient funds to cover the full improvement cost before any construction begins.

Tenant Options. An experienced landlord will want to minimize the options its tenants may hold, particularly in a bullish market. Options a tenant may customarily seek include the right to extend the term, expand the space, acquire the space if it’s a condominium, go dark (cease active use), terminate the lease, and the right of first refusal on adjacent or nearby suites.

The compromise reached includes granting tenant an option to extend the term for one or more periods of 3 to 5 years each, and, infrequently, an option to cancel upon the death or permanent disability of the tenant’s principal practitioner.

Tenant Exclusive Use. Although a savvy landlord will want a mix of tenant uses, it won’t want to restrict its right to lease to whomever it chooses in order to bring in successful new practices so landlord can achieve maximum occupancy, maximum operating profit, and maximum value for its property. A savvy tenant on the other hand, will not want to have a competitor in the space next door, and may insist on the exclusive right to conduct its practice at the building. Here’s a compromise: grant the tenant an exclusive use, but allow another tenant to provide competitive services as long as the gross proceeds from such competitive services do not exceed a set ceiling percentage of such competitor’s overall gross proceeds at its premises.

Personal Guarantees. Depending upon tenant’s financial strength, landlord may or may not require personal guaranties from tenant’s principals. In situations where a guaranty is required, tenants often succeed in limiting the guaranty to a specific dollar amount or have the maximum exposure reduced yearly by some set amount. In Arizona, although a husband and wife must sign a guaranty to have that guaranty binding on the couple’s community property, often the tenant may successfully argue that the landlord’s credit decision to lease to tenant was based on the guarantor’s sole and separate assets so the guarantor’s spouse should not have to sign the guaranty.

Other Issues. Other issues involve parking (whether tenant will have reserved and/or covered reserved spaces, how many, whether parking space rental will be charged and the amount per space per month), signage (both monument signage on the adjacent streets as well as exterior building signage), exclusion, due to HIPPA laws, of tenant’s patient records and information data systems from the reach of a landlord lien, and subordination rather than waiver of landlord’s lien rights with respect to tenant’s medical equipment when the tenant has purchased such equipment pursuant to a purchase money security interest.

Conclusion

Therefore, going into a lease negotiation, landlord and tenant can both reach a common goal (a signed, mutually acceptable lease) more rapidly if they have identified their respective key issues and have thought through acceptable alternative resolutions.

About the Author

Roger K. Spencer received his undergraduate degree from the University of Michigan in Ann Arbor, graduated from Northwestern University School of Law in Chicago and for many years was a senior partner in the real estate department of Quarles & Brady (formerly Quarles & Brady Streich Lang) before starting his own firm in early 2005. Roger is an accomplished practitioner with more than 35 years of experience in commercial transactional real estate law with a heavy emphasis on commercial leasing, commercial acquisitions and sales, and commercial real estate finance. He is also an accomplished speaker and lecturer on real estate law topics.

From The Author

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