Arm your leases against inflation

Today's veterinary practice owners wisely are devising short-term strategies for managing operational expenses such as payroll and supply costs. However, it's also important to think about long-term cost-cutting tactics. Why? Because there's a good chance that inflation will eventually return as interest rates are adjusted upwards and the costs of goods and services rise.

Savvy stewards of veterinary practice finances are anticipating interest-rate hikes and working hard to renegotiate loans to fix long-term interest rates at today's historically low levels. But what about other contracts, such as real estate, that might be affected by inflation?

Real estate rental

A veterinary practice lease agreement on real estate can have different flavors depending on who owns the building. Many practice owners rent real estate from the same individuals who own the practice in what might casually be termed a self-rental.

For example, Dr. Jane owns 100 percent of the veterinary practice's equity as well as 100 percent of the land and building the practice occupies. Or Dr. Jane and Dr. Bob own the practice, but only Dr. Jane owns the real estate, which she rents to the jointly owned veterinary hospital.

Another scenario entails real estate that is rented from related parties. For instance, Dr. Jane doesn't own the real estate; her DVM grandfather, who sold the practice but not the building, rents to her.

A final scenario — an "arm's length" arrangement — involves a practice owner renting from a third party completely unrelated to the practice owners. Shopping center rentals are a classic example.

No matter the housing situation, though, the real question is: How is the agreement structured, and is it favorable for all parties?

Lease agreement structures

Lease agreements for rented veterinary practice real estate usually include escalation clauses. These provide for a regular recalculation of rent. They're usually tied to a monetary inflation indicator, such as the Consumer Price Index (CPI). Other indicators include the Consumer Price Index for all Urban Consumers (CPI-U) and the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). (Visit bls.gov/news.release/cpi.nr0.htm for a recent summary of CPI calculations.)

Often, a lease agreement requires an annual adjustment for the change in the CPI during the prior year, but it can be calculated as often as monthly or as infrequently as every five years or longer. The longer a practice delays a rent adjustment, the less compounding of the increase. So from a renter's prospective, the longer the period of change between increases, the better.

Inflation and the CPI

A substantial CPI increase can have immediate ramifications for a practice whose rent is adjusted periodically for inflation. The chart "Consumer price index for urban consumers" spans 1970 through 2010 for changes in the CPI-U. You can see that during the past 15 years, we have enjoyed relatively low increases, with the most recent spike occurring in mid-2008 as energy prices soared in conjunction with variable prices. Even so, the highest annual increase in recent years was roughly 5 percent in July 2008.

Table1: Consumer price index for urban consumers

Prior to that, the index breached 5 percent in October 1990. Those sorts of changes are manageable for many business owners, but look back a bit further into history at other post-recession periods. For example, in March and April 1980, CPI peaked at about 14 percent, demonstrating that escalations happen rapidly. And in 1974 and 1975, peak increases of greater than 10 percent were recorded.

Indeed, contracts tied strictly to the CPI could be seriously challenging in the future. Using 1980 as an example, a lease agreement of $50,000 per year would increase to $57,300 in 1981. History suggests that jumps in CPI could cause significant cash flow problems when contracts are tied to the index.

Look ahead

In today's economy, consider renegotiating your old contracts or entering into new ones. And carefully choose the specific index cited, if one is used.

For instance, regionally based indices use a smaller sample size and thus may have increased variability. Consider specifying use of the CPI for all items less food and energy. Another option is to establish CPI adjustments limited by a ceiling such as a five-year adjustment not to exceed a set percentage that is made at the beginning of the sixth year of the contract. Or consider, in the case of an annual CPI adjustment, a calculation that would be the lesser of the calculated change in the CPI or an X percent ceiling.

Be aware that a landlord may ask for a floor when you ask for a ceiling. For example, the landlord may ask that in no case would the rent be lower than last year's base rent. Ask whether it's possible for the CPI to go below a 0 percent change. This recession has proven it can, with a decline of 2 percent in the most recent 12-month period. So in reviewing your contract, does it allow for a negative adjustment or a reduction in payment?

For new practice owners

Despite the economy, the veterinary practice purchase market is relatively healthy. Potential buyers should examine real estate occupancy requirements early on in the vetting process.

Ensure that your lease agreement extends for a long period of time. In general, I recommend a lease agreement of at least 10 years for a new practice owner, with two options for five-year renewals under terms as favorable as the original agreement.

Final thoughts

Think about your strategy for guarding your practice's profitability and cash flow. Carefully study any agreement that includes an adjustment based on CPI or another index. Negotiate ceilings and floors to protect all parties. And structure a fair rent arrangement that protects both your and your landlord's interests, if possible. Ensure that your rent payments are made in accord with the agreement.

As with all contracts, a lease is a legal document that should be written carefully. Contact your attorney to ensure preparation of a rock-solid agreement.

Dr. Heinke is owner of Marsha L. Heinke, CPA, Inc. and can be reached at (440) 926-3800 or via e-mail at MHeinke@VPMP.net