The business model of medical centres in Australia has changed dramatically over the last decade. The incorporation of a range of specialist medical services, including Pathology, Diagnostic Imaging and Pharmacy under ‘one-roof’, offers a ‘one-stop shop’ for patients’ immediate medical needs.
The property relationship between the medical centre operators and the pathologist and diagnostic imaging owners is usually via a ‘sub-lease’. The medical centre takes a head lease from a third-party Landlord (some medical centres are owner-operated) and then sub-lets a small portion of the medical centre to a specialist operator for a specified term.
Some pathologists/diagnostic imaging owners may have equity in the medical centres, and several of the larger operators such as Primary Healthcare and IPN, own both the medical centre and the pathology/ diagnostic imaging businesses.
Medical centres often provide the fitout and a range of ‘shared services’ to the pathologist/ diagnostic imaging business including (but not always) bulk billing, reception area, waiting room, toilets, receptionists, lunch rooms, customer parking and a captive market of patients.
In return, the pathologist/diagnostic imaging business pays a “rent” to the medical centre for these services, facilities and captive patient market.
So, what’s the problem with this arrangement?
The problem is that sub-rental values of these specialist services has risen so dramatically, the pathologists/diagnostic imaging businesses argue that their business models are threatened, and the costs end up being passed on to patients and ultimately Medicare.
The Department of Health (DOH) have had guidelines on setting these rents since 1973. However, on 30 Jan 2018, DOH released their ‘Red Book’: Guidance on Laws Relating to Pathology and Diagnostic Imaging – Prohibited Practices, which will see steep and strict penalties enforced.
So, what has changed?
The DOH is strictly enforcing the setting of market rents with fines of up to $1.26 million for a company and/or criminal imprisonment of 5 years. The transition period is February to June 2018.
In the latest edition of the ‘Red Book’, the DOH has explicitly mandated that “the rental is not permitted if it is linked to the number, kind or value of requests made by the requester (pathology/ diagnostic imaging) even though it may not be substantially different from the market value”.
This type of rental agreement is referred to as a ‘profit rent’ in Valuation terminology.
So, going forward, how should these sub-leases be valued?
The ‘Red Book’ provides little guidance as to what should be taken into consideration in setting these ‘market rents’. It does however provide a clue in that a 20% buffer of the underlying ‘market rent’ will be accepted, provided there is ‘supporting evidence’.
From a valuer’s perspective, the business relationship between a pathologist/diagnostic imaging business and a medical centre is complex, may not be at arm’s length and may involve the provision of a multitude of shared services, facilities and even staff.
Valuers will need to carefully analyse a multitude of factors including:
- The undergoing medical centre rent (is at Market Rent?);
- The number and layout of consulting rooms and the ratio to support amenity areas;
- The provision of the fitout, who owns it and the obligations of each part in relation thereto;
- The provision and apportionment of outgoings and power between the parties;
- The provision and apportionment of shared areas such as reception, amenities, customer parking, lunch rooms, and others;
- The provision and apportionment of shared services such as receptionists, bulk billing, IT systems, and others (if applicable);
- The market value of standalone pathologist/diagnostic imaging premises in comparable locations to the subject medical centre adjusting for fitout, length of term, and provision of direct services utilised by the pathologist in comparison to the sub-leased medical centre.
There is little doubt that the market rental value for sub-leased pathology/medical imaging will fall and potentially dramatically, with much broader implications for the profitability and business multiples for medical centres and possibly changes to their overall business model going forward.
Written By: Simon Fonteyn, Managing Director of Intelligent Property Solutions