Dentists Gamble on Inflation with Triple Net Dental Leases

Dentists Gamble on Inflation with Triple Net Dental LeasesI’ve been telling you about how my father developed shopping centers in the 1970s and how inflation hurt landlords in the 1980s.

The new landlords learned lessons from their bankrupt predecessors, and redrafted their lease agreements to transfer inflation risks to their tenants through the NNN Lease (“triple net lease”).

When long-term tenant agreements of the 1970s began to expire in the 1990s, the landlords revised the previous gross lease agreements to their current standard NNN Lease form.

The triple net lease incorporates rising rents set to Consumer Price Index (CPI) increases and direct flow through of all operating costs to their tenants along with hefty admin fees.

This will make managing through the next inflationary period considerably more difficult for retailers and other tenants, just as it did for the early mall developers in the 1980’s.

Dental Tenants Now Take the Risk

During the economic boom years of the 2000s, the typical landlord form lease agreement evolved in terms of both their complexity and sophistication, with the bulk of new risks being borne by the tenant.

However, few – if any – dental tenants really understood or appreciated the potential inflationary risks they were being asked to absorb should the economy enter into another inflationary period. For many, it wasn’t even a business consideration, as most dentists had not operated a practice through the period of high inflation of the 1970s and early 1980s, and those that did have since retired.

Further, the dentists could only secure good locations through a highly charged competitive environment, encouraged by the landlords, and often manipulated by the brokerage community.

Brace Yourself for the Coming Storm

The result, in my view, is the creation of conditions now set for the “perfect inflationary storm.”

How many times has a dental tenant heard that this is the landlord’s standard form lease and is not subject to change or modification? In the mid-2000s, it was generally a “take it or leave it” proposition for the dentists, with easy money provided to them by bankers to build new practices, and since patient traffic was strong, in most regions, expansion and the growth of new dental offices was everywhere.

However, little consideration was given to incorporating clauses which would have prevented the offloading of inflationary risk from the landlords to the dentists. The focus was on performance and expanding the practice revenues.

Big Changes Since 2008

Dentists post-2008 were spared the greatest risk from inflation, not by having the type of lease agreements their contemporaries of the 1980s had, but rather, by the most dramatic slowdown in U.S. economic activity since the Great Depression of the 1930s.

Staggering base rents, driven by the brokerage community, combined with dramatic declines in consumer sales activity, were directly culpable for the high bankruptcy rates among America’s dental community. At present, many indicators suggest that a slow economic recovery may be underway.

However, there continues to be skepticism among many economists, who believe the current rebound is unsustainable, driven primarily by massive – but temporary – fiscal stimulus promoted by the Federal Reserve. In the past three years, for example, the Fed has injected more liquidity into the U.S. economy than in the previous 25 years, combined.1

As a result, the Fed’s easy money policies may pose greater threats to the long-term health of the U.S. economy than it solves.

You may want to look at it this way: If you factor in the additional liquidity injected by other major central banks, such as the Bank of Japan (BOJ), the European Central Bank (ECB), and the Reserve Bank of England, there has been more new capital introduced into the world economy since 2008, than in all of the previous years, combined.2

Too Much Money?

Never before in human history has so much money entered the world’s economy so quickly, and certainly never before in American history have we tripled the money supply by 300% in less than 4 years. Like a powerful drug promised to cure a potentially near fatal disease, there will be unpredictable and powerful side effects.

History has illustrated, and many economists tell us, that the downside effects of printing money are often substantial. Nobel Prize-winning economist Milton Friedman, for example, has said that “inflation is always and everywhere a monetary phenomenon.”3

Simply put, inflationary pressures can result as much from the loss of a currency’s purchasing power (cost-push inflation), as it can when the demand for goods and services is constrained by limited supplies (demand-pull inflation).3

By increasing the supply of dollars since 2008, without a corresponding rise in Gross Domestic Product (GDP), you will not be able to stave off inflation, inevitably leading to the loss of the dollar’s purchasing power. Indeed, since 2008, GDP has risen by about 3%, while the money supply has risen by over 300%.4

According to best-selling author and economist David Wiedemer, the real cause of inflation is “increasing money supply beyond what is needed to keep up with economic growth.”3

In the past, raising interest rates was generally seen as the best way to control inflation. However, this can no longer be as effective a deterrent as previously used because the GDP in the United States is 70% consumer-driven. The Fed can temporarily delay inflation with a slow and steady rise in interest rates and claim that some inflation is actually good for the economy but cannot prevent it or control it as easily as in the past.

This is setting up our economy for what could be an inflationary period of time longer and more extensive than ever experienced before. Next week, I’ll tell you more… and how dentists can safeguard their practices during inflationary times.

Bibliography1 St. Louis Federal Reserve2 International Monetary Fund3 Widermer, David (2010) “Aftershock”4 GDP Statistics About.com Guide

Dentists: Protect Your Dental Lease from Inflation

Dentists: Protect Your Dental Lease from InflationHow an Inflation-Hedged Tenancy Agreement Can Save Your Dental Practice and Give You a Competitive Edge

Last week I started talking about what I see as the upcoming “perfect inflationary storm.”

While some indicators suggest that a slow economic recovery may be underway, there continues to be skepticism among many economists.

Some feel the current rebound is unsustainable and driven primarily by the massive – but temporary – fiscal stimulus promoted by the Federal Reserve.

In the past three years, for example, the Fed has injected more liquidity into the U.S. economy than in the previous 25 years, combined.1 Never before in human history has so much money entered the world’s economy so quickly, and certainly never before in American history have we tripled the money supply by 300% in less than 4 years.

Preparing for Inflation

This is setting up our economy for what could be an inflationary period of time longer and more extensive than ever experienced before.

Indeed, some business owners and financial analysts with whom I have consulted have commented that many policymakers are already well aware of this. However, many of them – as well as corporate executives and Wall Street bankers – often have vested interests, thereby making implementation of these policies difficult. Further, many have been trained as expert systems managers rather than generalists, and thus only see piecemeal solutions to these very complex problems and will be unable to replace a failed system with a new one.

What does all this mean for dentists? In my view, today’s dentist must both have the foresight to read the writing on the wall and create the tools necessary to effectively manage their dental practice during rising and high inflation. This may start with an annual inflation rate of 7% within the next 1 to 3 years, rising to double-digit inflation within 4 to 5 years.

Preparing to manage a dental practice through an inflationary period can be a daunting task when you stop to think about it. Imagine your costs going up significantly and not being able to pass those costs onto your dental patients at the same rate.

However, the good news – as the saying goes – is that you don’t have to outrun the tiger; you just have to outrun the person next to you.

Being One of the Survivors

Hedging your long-term business commitments today will give you the edge needed to outlast and outperform your competition. Many of today’s dentists opt to listen to the financial cheerleaders as if they’re financial planners because it “feels” good and because it “fits in” with their view of how the world works.

Instead, take this opportunity to be a reflective strategist and critical thinker about tomorrow. One of the greatest of these was Herb Kelleher, the former CEO of Southwest Airlines. He had a reputation for thinking outside the box, and his proactive risk management style – including his fuel-hedging program implemented in the 2000s, which allowed the airline to enter into aggressive fuel futures contracts – allowed them to better manage their costs.2

As the price of jet fuel rose dramatically during that period, Southwest emerged as the most profitable airline in the industry, driving out competitors and avoiding Chapter 11 bankruptcy – the fate that ultimately awaited all major U.S. air carriers. Southwest’s fuel-price inflation-hedging strategy provides a great lesson in how to compete in difficult economic times and emerge victorious.

Hedging against Inflation

America’s tenant-based businesses like dental offices should, in my opinion, act like Herb Kelleher by identifying the major expenses in today’s dollars, in order to hedge against future inflation.

As occupancy and tenancy costs remain top priorities in long-term lease contracts for dentists, these are critical costs to contain. As your tenancy leases roll over for renewal, avoid locking into existing options to extend the terms of the previous NNN Lease Agreement protecting the landlord against inflation by passing the costs on to you.

Be willing to “step out of the box” and renegotiate hard, both the base rent provisions, and triple net components of the lease, much like the hedging strategy employed by Southwest.

In particular, ask for longer-term rents with locked-in fixed rents, which do not rise based on the Consumer Price Index (CPI), but rather, have set increases and thereby cap off the percentage increases year over year. Landlords will generally object to this, but given today’s real estate environment, they will often concede, as they are unlikely to want to lose a good, paying tenant.

An excellent window of opportunity still exists to take advantage of struggling landlords by implementing such a hedging strategy. Only agree to triple net provisions with a cap on increases of no more than 6% year-over-year. You’ll want to do this while most landlords are still operating in a non- or low-inflation mindset and remain insensitive to this request as they do not yet foresee a high-inflation period ahead.

Although putting in place an inflation-hedging strategy will take time, planning and effort, the pecuniary benefits would be a significant competitive advantage similar to the one Southwest had if you feel there is a reasonable risk that our economy will enter into an inflationary period of time.

Considering Your Risks

What do you have to lose? Ask yourself where the bigger risk lies: paying marginally more in rent on the front end, or not having the ability to stop landlords from loading you up with additional expenses, so that in the end your triple net charges begin costing you more than your base rents?

If we hit a period of 12% annual inflation – which many believe to be a real possibility – it will only take about 3 years, under most lease agreements, for your triple net charges to start costing you more than base rents.

More importantly, consider how it will affect your competition’s bottom line. Should they fail to heed the inflationary warnings allowing their landlords the unrestricted ability to pass inflationary risk on to them you’ll have the same advantage Southwest had on its competitors.

Bibliography
1 St. Louis Federal Reserve
2 Cobbs, Richard & Wolf, Alex (Spring 2004) “Jet Fuel Hedging Strategies”

Dentist Leases: Inflation Risks and a Changing Economy

Dentist Leases: Inflation Risks and a Changing EconomyBusiness leases were very different back when my father was a mall developer.

As I described last week, he opened a shopping center in Canada where he prioritized the landlord-tenant relationship. As a landlord, he worked hard to help his tenants achieve success.

Unfortunately, he was unable to cope with the rising costs of operating the shopping centers due to inflation in the 1980’s. Today, malls, strip centers and medical/dental buildings are primarily managed by institutional owners.

Tenants are no longer viewed as collaborating business interests; now tenants are commodities to be bought, sold, discarded or traded in favor of the mall owner’s and mall stockholders’ bottom-line.

Dental Leases Used To Be Simple

The most direct result of the inflationary period of the early 1980s was the advent of – and now widespread use of – the “net” form of lease, commonly referred to as the “net lease” or Triple Net Lease Agreement (NNN). In fact, many tenants cannot even recall a time when the NNN Lease wasn’t in effect.

However, prior to the 1980s, most dental leases were, in fact, of a “gross” nature. Under the Gross Lease Agreement the dentist paid one rent, which covered all of the costs a landlord might incur, including such things as parking lot maintenance, insurance, repairs, etc., leaving plenty of room for landlord debt service and profit. Most gross lease rents were set to rise by about 3.0% annually, because inflation for the previous 30 years averaged about 3.2% per annum during the post-War era,1 making such an agreement simple to manage for both landlord and his dental tenant.

But when the costs of operating malls and other commercial properties unexpectedly and quickly began to rise as a result of higher inflation, the mall and property owners were forced to absorb the additional expenses, thereby cutting into their profit margins.

This forced mall owners such as my father to pay both higher mortgage rates and rising operating costs. When inflation was finally contained at the expense of the mall owners rather than the retailers and shoppers, it forced many early developers into bankruptcy and malls into foreclosure.

The Triple Net Lease Becomes Standard

When the foreclosed shopping centers were ultimately resold to other interests, the new shopping center owners applied the lessons they had learned from their bankrupt predecessors, and redrafted their lease agreements to transfer inflation risks to their tenants through the NNN Lease.

As the long-term tenant agreements of the 1970s began to expire in the 1990s, the landlords would not renew the previous gross lease agreements unless they were revised to their current standard NNN Lease form, which incorporates both rising rents set to Consumer Price Index (CPI) increases and direct flow through of all operating costs to their tenants along with hefty admin fees.

The result will make managing through the next inflationary period considerably more difficult for retailers and other tenants, just as it did for the early mall developers in the 1980’s.

Dentists Now Take the Risk

During the economic boom years of the 2000s, the typical landlord form lease agreement evolved in terms of both their complexity and sophistication, with the bulk of new risks being borne by the tenant.

However, few – if any – dental tenants really understood or appreciated the potential inflationary risks they were being asked to absorb should the economy enter into another inflationary period. For many, it wasn’t even a business consideration, as most dentists had not operated a practice through the period of high inflation of the 1970s and early 1980s, and those that did have since retired.

Further, the dentists could only secure good locations through a highly-charged competitive environment, encouraged by the landlords, and often manipulated by the brokerage community.

The result, in my view, is the creation of conditions now set for the “perfect inflationary storm.” I’ll describe what I mean – and what you can do to protect yourself – next week.

Bibliography1 Rattner, Steven (January 5, 1981) “Federal Reserve Sees Little Growth in ’81 with Continued High Rates,” New York Times

Dental Tenants and Changes in the Landlord Relationship

Dental Tenants and Changes in the Landlord RelationshipGrowing up in the 1970s, as the son of a Shopping Center Developer, I became acquainted early in life with leasing terms such as Percentage Rent, Natural Break Point, NER and so forth.

My father spoke highly of his tenants and took a genuine interest in helping them succeed in their business. When a tenant had trouble paying rent, he would spend time with them trying to understand the reasons, and when possible, made concessions such as rent reductions.

In close collaboration with his tenants, my father appreciated that his success was dependent upon theirs. This is a contrast to the manner in which landlords operate today.

Looking Back

It takes me back to 1978, when I was a 10 year-old boy, watching my father prepare for the grand opening on the first expansion wing of what was, at the time, one of Western Canada’s first regional shopping centers.

He would walk the corridors of the mall with a bullhorn, directing construction workers, ensuring that the opening would be on time. Located in Red Deer, in the Province of Alberta, a town of 50,000 and a trade area of a quarter-million consumers, the mall was comprised primarily of local retailers who generally made a prosperous living.

Helping Retailers

The day before the mall was to open to great local fanfare, my father noticed that the new optometry store had almost no inventory, as their expected shipments had not yet arrived.

He immediately went into action, contacting optometrists at other locations he owned, and asked them to forward as much of their excess stock as possible. In return, my father gave them various concessions, such as future rent reductions.

By the end of the evening, over 40 boxes of frames, glasses and other eyeglass products had arrived at the new mall, and the optometrist was able to open his store, fully stocked. My father understood that a retailer never gets a second chance to make a good first impression.

1980s Inflation

Unfortunately, several years after the mall opening, in June 1982, Canadian interest rates similar to those in the United States had risen to 21.5%1,2. These higher interest rates were the result of the Bank of Canada’s and Federal Reserve’s attempts to contain spiraling inflation, which over the same period, had risen by more than 13 percentage points in both countries1,2.

Sadly, my father was unable to cope with the rising costs of operating the shopping centers, hurting his malls, his business and his pride. As visionary as he and many other developers at the time were, they were unable to foresee the business-altering impacts of inflation and the consequent rise in interest rates.

Tenants as Commodities

Today, malls, strip centers and medical/dental buildings are primarily managed by institutional owners, where tenants are viewed not so much as collaborating business interests, as they are commodities, where they are bought, sold, discarded or traded in favor of the mall owner’s and mall stockholder’s bottom-line.

When the costs of operating malls and other commercial properties unexpectedly and quickly began to rise as a result of higher inflation in the early 1980s, the mall and property owners were forced to absorb the additional expenses, thereby cutting into their profit margins. Many properties were foreclosed and resold to other interests. The new owners applied the lessons they had learned from their bankrupt predecessors, and redrafted their lease agreements to transfer inflation risks to their tenants through the “net lease” or Triple Net Lease Agreement (NNN).

This will make managing through the next inflationary period considerably more difficult for retailers and other tenants. Next week, I’ll explain why some dental leases can be so tricky.


Bibliography
1 US Business Cycle Expansions & Contractions (undated)
2 Bureau of Labor Statistics, Consumer Price Index, All Urban Consumers – (CPI-U)

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