The surgical center you're planning is going to need a home. But how big should that home be? Should you rent or buy? And what do you need to do to plan for future expansion? This article is based on my experience developing about 50 surgical centers over two decades. I don't have answers to all the questions, but I can help you get the conversation started. Here are seven key questions to consider before making your surgical real estate decision.

1 How large should your surgery center be?
Many people surprise me by starting the development process with facility design - "I've already leased a 10,000-square-foot building!" It's easy to get caught up in the details early, but restrain yourself. You need to wait on the size of your facility until you've performed the necessary analyses to determine your center's case volume, specialty mix and number of physicians.

2 Where should your surgery center be located?
Like other real property, location is everything. But what makes a good location? The obvious considerations include price, zoning, parking availability, compatibility with surrounding land uses and so forth. But when it comes to surgery centers, there's more.

In my experience, the key consideration is surgeon convenience. Your facility needs to be as close as possible to the practices of the primary surgeons who'll be using it. If the center is "just another venue" that's difficult to get to and adds unnecessary travel time, then the surgeons won't use it and it'll struggle to build case volume. It's usually best to select a site close to the surgeons' offices. Think carefully before choosing a compromise location that's "halfway between two major hospitals." While a location like that might sound ideal on paper, in reality it may end up not being close to anyone.

3 Should you allow for future expansion?
Now we're getting into issues of business strategy and economics. When examining a question like this, there are three basic things to consider: What does "expanding" the surgery center mean? How does the decision affect site selection? And what are the carrying costs?

Expanding a surgery center requires more than just building on additional operating rooms. It also usually requires enlarging admitting and pre-operative support areas, post-anesthesia recovery areas, and key building systems such as heating, ventilation and air conditioning, for example, or medical gas delivery. These changes are extremely disruptive and expensive to accomplish in centers that are already up and running.

The best way to ensure your surgery center is prepared to expand is to allow for additional space on the front end. This is easiest when the initial facility is built on a greenfield - or bare land - site. ASCs that choose medical office buildings or shell buildings will find it more difficult and expensive to expand down the line. The cost of expansion will always be less in a greenfield setting than in a pre-existing building.

Expansion is more complex when the facility is constructed in a building that includes neighboring occupants under the same roof. In a scenario like this, somebody may need to be relocated to accommodate future ASC expansion - unless the center leases additional space at the outset.

Either way, the initial enterprise is burdened with a carrying cost. If the base rent in a multi-tenant building is $24 per square foot per year and if it's anticipated that 5,000 square feet of future space may be required, then the carrying cost will be more than $120,000 per year, since rents typically increase each year pursuant to changes in the Consumer Price Index.

The vast majority of ambulatory surgery centers never expand their physical plant. Consequently, I'm not a big advocate of providing for future expansion beyond that which can be economically incorporated into the initial facility design.

4 Should you put your surgery center in an existing building?
Time is the enemy of development projects. Anything you can do to accelerate the development process deserves a hard look. A common strategy is to locate new surgery centers in existing, "high-quality" buildings. The key to this strategy is knowing the difference between high-quality buildings and those that aren't so great. The key difference lies in building "type."

Our industry characterizes Type B buildings as those suitable for general business uses. These buildings are often constructed over wood frames and usually not equipped with fire sprinklers. Type I buildings, on the other hand, might be characterized as suitable for institutional uses. These buildings are often constructed over steel frames and usually have sprinkler systems.

These are lay definitions, oversimplified and only partly accurate. But this much is certain: Not every building type can accommodate a surgery center. Successfully constructing an ASC in an existing building usually requires a Type I building. A qualified architect or engineer with a healthcare background should verify the ability of an existing building to accommodate an ASC.

5 How much will the surgery center cost?
This is one of the first questions people ask. Unfortunately for most of us, the answer is rather startling. The dissonance occurs because we don't always have the same understanding of the question. Surgery center cost is composed of more than construction cost. It includes the following:

• Direct construction costs
  • cost of constructing the building shell
  • cost of constructing the interior space
  • cost of off-site improvements (like utilities)
  • cost of on-site improvements (like parking)
  • contingency allowance
• Non-construction costs
  • architectural and engineering services
  • accounting fees
  • development fees
  • cost of land
  • interior design fees
  • municipal permits and fees
  • state permits and fees
  • inspections and testing
• Financing costs
  • loan fees
  • construction period interest

As substantial as construction costs may seem (ASCs must meet structural requirements beyond those of ordinary buildings as well as Life Safety Code requirements and contain redundant power systems, enhanced mechanical systems and more), non-construction and financing costs will typically add 30 percent to the overall costs. A surgical center can easily cost more than $400 per square foot to design, site, finance and construct. The key drivers are the cost of land and the size of the facility. These costs don't include fixed and movable medical equipment, office equipment and furnishings. Plan on equipment and furnishings costing somewhere around $400,000 to $500,000 per OR.

6 Should you own or rent the building?
This is one of the most significant and far-reaching strategic decisions facing de novo surgery centers today. The upside of combining the ASC and real property ownership is a reduction in occupancy cost over the long term, coupled with future financing flexibility. The downside is diminished annual cash-on-cash return on investment because the project requires substantially more equity.

In our example, the building owner contributed $120 per square foot to project equity (a 30 percent "down payment" in order to secure financing). If that center were 10,000 square feet in size, the down payment would be $1.2 million. The physician-investors in a moderately sized center might find that hurdle difficult to overcome - after all, that capital is in addition to the equity necessary to capitalize the facility's operational needs. The degree of difficulty confronting physician-investors seeking to raise equity capital for centers is the key driver underlying the decision to rent or to own.

7 How much rent should you pay?
With all the medical buildings out there and the competition for tenants, why aren't rental rates lower? Rental rates are driven by project costs and bank underwriting criteria, not market forces. Using our example facility with the $400-per-square-foot price tag, we can compute a rental rate based on typical bank underwriting criteria. Here are a couple key assumptions:

• The bank will likely limit its mortgage to 70 percent of project cost, meaning the landlord will need equity of $120 per square foot to secure financing.
• The bank will require the rental income from the property to exceed the debt service. The typical ratio is 1.3 times the debt service.
• The bank will likely limit its mortgage to 75 to 80 percent of total project value. Value will be based on an appraisal that depends heavily on rental rates.

Market rental rates haven't entered into the equation because new construction always commands higher rent than existing buildings. The mortgage holder protects itself against the market by requiring that the building be substantially leased before making the loan and by requiring continuing rent guarantees from the building's tenants.

If our $400-per-square-foot ASC were being constructed in a greenfield setting, the monthly base rent would be about $4 per foot per month, or $48 per year. Low interest rates could bring down the rent slightly, and if the landlord were satisfied with a lower return on investment, a slight drop might be possible. Even with those favorable conditions, the changes in the rental rate will be marginal.

Property management
ASC real estate issues can seem overwhelming, so take time on the front end to carefully consider and answer each of these questions before your next project. Thoroughly understanding the benefits and drawbacks of all your options will help ensure your center's upfront and long-term success.