Use obsolescence to lower hospital property taxes

Property taxes based on excessive valuations are smothering traditional hospital owners.

All too often, tax assessors ignore functional and economic obsolescence that increasingly afflict hospitals, instead treating these assets as financially productive institutions that hold their value. Hospital owners, however, can leverage obsolescence to reduce taxable values and property tax bills.

A murky outlook
The uncertain future of the traditional hospital model creates obsolescence. Traditional hospitals face serious profitability challenges as consumers and their insurance plans look to more convenient and less costly healthcare delivery models. Hospitals today commonly have fewer “active” beds than “licensed” beds. Some have even closed entire sections of their facilities, reducing once busy patient floors to storage, or have postponed interior construction, leaving patient floors as idle shell space.

The traditional hospital’s diminishing appeal is creating obsolescence and clouding the model’s outlook. As the Wall Street Journal recently reported, “The sprawling institutions we know are radically changing—becoming smaller, more digital, or disappearing completely.”(https://www.wsj.com/articles/what-the-hospitals-of-the-future-look-like-1519614660)

Today’s consumer wants accessible and convenient healthcare. Instead of visiting a hospital campus, many would prefer going to a retail clinic, an urgent care center, or a freestanding emergency room. They are also accessing micro-hospitals, which are small, highly efficient facilities offering imaging, labs and even inpatient care in a small footprint; as well as outpatient surgery centers, which allow patients to receive care but recuperate at home.

Technology has advanced to a degree where fewer healthcare services need to be delivered in an expensive hospital setting. “The hospital’s role as the epicenter of healthcare has been shifting”, says, John Trabold, MAI, managing director of VMG Health.

“The advancement of technology has caused many services to be provided in an outpatient setting, which can be more cost effective and more convenient to patients and physicians alike,” he says. “We can expect this trend to continue as we see occupancies continue to decline for traditional hospitals.”
According to statistics from MedPac, the federal commission that advises Congress on healthcare matters, hospital occupancy in 2015 was only 62 percent, down considerably from 77 percent in 1980. (http://www.medpac.gov/docs/default-source/reports/mar18_medpac_entirereport_sec.pdf?sfvrsn=0 See page 73) (https://www.cdc.gov/nchs/data/hus/2011/116.pdf)

The sterile, clinical feel of most traditional hospitals also contributes to obsolescence. Patients prefer new and modern construction with good amenities, providing both excellent service and a rich experience.

This has given rise to a high-end hospital type that seems more like a luxury hotel than a medical institution. These upscale facilities boast large, private rooms with modern finishes, artwork, beautiful views and even gourmet meal service. Importantly, the payer mix for these facilities is more attractive, consisting mainly of private-pay insurance as opposed to Medicaid or other government entitlements. This usually translates into an affluent patient population that produces increased revenue and benefits the bottom line.

For hospital systems, this means that their large hospitals no longer serve the public at intended levels or within desired profit margins, creating economic obsolescence. Expenses for operating these institutions continue to rise, often outpacing revenue from declining patient populations. This is problematic.

Some hospital systems exit markets to cut their losses. Others see an opportunity to gain market share by purchasing struggling facilities. Either way, the value of traditional hospital real estate is declining as demand for traditional hospital services drops.

Taxpayer strategies
Hospital owners can use obsolescence to challenge assessed values. For example, assessors traditionally value hospital properties based on total square footage. Although this is usually appropriate for other property types, this technique will often inflate the market value of a traditional hospital.

This is especially true when a hospital has unused wings or unfinished shell space. This “dead” space does not contribute value. Instead of valuing the total square footage of the facility, assessors should focus on usable square footage – the space that actually generates revenue. If they are unwilling to do this, adjustments in their valuation analysis must be made elsewhere.

Here is another example. Because healthcare properties are regularly rented, the income capitalization approach can be an important and appropriate valuation method for hospitals. Rental rates and capitalization rates extracted from the market and used in the income approach must be adjusted to properly reflect the financial performance of the facility, however.

If the hospital is underperforming, its net operating income will be down. Investors will sense an increased level of risk with the property, which will drive up capitalization rates to reflect this perceived risk and reduce the value.

Since some assessors consider hospitals to be special-purpose properties, they often use the cost approach to value in addition to, or in conjunction with, the income capitalization approach. When using the cost approach, assessors must account for the functional and economic obsolescence that affects traditional hospitals. These buildings were not constructed to meet the market demand and efficiency needs of the modern healthcare environment, so appropriate downward adjustments must be made to the estimated replacement cost of the facility. This will account for the correspondingly reduced value.

These issues facing traditional hospitals are here to stay. The rapid pace at which healthcare is evolving must be factored into any analysis of the market value of facilities where healthcare is delivered.

For hospital owners, this presents the uncomfortable realization that many of their real estate assets have become obsolete or even exhausted. This obsolescence, though, serves as a strong tool to control taxable values and to protect hospital owners from excessive property tax burdens.

Daniel R. Smith, Esq., is a principal with and general counsel for Austin, Texas law firm Popp Hutcheson PLLC, the Texas member of American Property Tax Counsel, the national affiliation of property tax attorneys. Kevin Shalley, CMI, is a tax consultant and manager with Popp Hutcheson PLLC, specializing in healthcare properties. Contact Daniel at daniel.smith@property-tax.com and Kevin at kevin.shalley@property-tax.com.

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