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6 key trends affecting healthcare real estate in 2017

1. Repeal of the Affordable Care Act

On January 20, 2017, President Trump signed an executive order indicating "prompt repeal" of the Affordable Care Act (ACA) and instructed federal agencies to use "all authority and discretion available to them to waive, defer…or delay the implementation of any provision … that would impose a fiscal burden on any State or … individuals." Republicans have made efforts to repeal the ACA since its enactment, but Congress has not yet acted in 2017 to make significant changes to the law. One may only speculate as to the extent to which the ACA will be unraveled and how it will be done. Republicans have circulated multiple plans to replace the law, and Republican leadership has indicated that a replacement plan should reverse the expansion of Medicaid, strengthen Medicare, and give taxpayers "more control and more choices" in selecting plans, while maintaining the ban on preexisting conditions. Rep. Tom Price, M.D. proposed a bill last year which would fully repeal the ACA and replace it with a plan which includes individual health pools, expanded HSAs and elimination of the healthcare exchange. This legislation passed in Congress under budget reconciliation rules but was vetoed by President Barack Obama.

There is a wide range of forecasted financial impact related to repeal of the ACA. The American Hospital Association (AHA) commissioned a report which estimates the impact on hospitals if the ACA is repealed, using the Price bill as a model. Should Congress pass legislation similar to this bill, the AHA report estimates that healthcare coverage would return to pre-ACA levels and further suggests that the result would be a rise in uncompensated care and a decline in revenue for hospitals, as the number of uninsured patients would increase. Furthermore, a report released by the Robert Wood Johnson Foundation (RWJ) estimates that if a reconciliation bill similar to Price's was passed now, the result would be an increase in uninsured people by 29.8 million in 2019. The RWJ report suggests that even partial repeal of the ACA, which would eliminate the Medicaid expansion, the individual and employer mandates and the Marketplace tax credits, while maintaining the ACA's insurance reforms including prohibition on pre-existing conditions exclusions "could lead to a fourfold increase in the amount of uncompensated care providers finance themselves compared to current levels." Avalere Health has also released the results of its research on the effect of block grants and per capita caps which would decrease funding to states for Medicaid. Avalere projects that Medicaid spending would be lowered by $150 billion and per capita caps would lower spending by $110 billion. According to Avalere's President, block grants and caps operate to shift power from the federal government to the states in determining covered services and program eligibility.

To date, the current climate of uncertainty does not appear to have significantly altered strategic planning on the part of health systems, as market participants indicate that real estate projects in planning phases continue to move forward. However, some caution within the industry is noted; for instance, Colliers International's 2017 Healthcare Marketplace Report predicts delayed decision making as healthcare providers grapple with implementation of site-neutral payment legislation and with potential repeal of the ACA. The potential repeal of the ACA and the implementation of site-neutral legislation will significantly impact inpatient hospitals. Instead of expanding existing inpatient facilities, we predict that acute care providers will continue to look for off-campus opportunities within their community. In particular, we predict an increase in the construction of micro hospitals and other ambulatory facilities.

2. Value Based Reimbursement and Changes to Healthcare Delivery Setting

As noted above, significant uncertainty exists surrounding the potential repeal of the Affordable Care Act. However, healthcare industry consensus is that the trend to value based reimbursement will continue to accelerate, regardless of what reform ultimately looks like. HHS' goal is to shift 50% of Medicare payments away from fee-for-service and to value-based payment models by 2018. This point was reiterated at the 2017 JP Morgan Healthcare Conference in January, where it was noted that the "focus on value – high quality affordable care and health for a population – has to continue." Executive pay is increasingly linked to quality metrics, as outlined in a February 2017 feature in Modern Healthcare. The drive to value has influenced the ongoing convergence of payors and providers, as evidenced by UnitedHealth Group's acquisition of Surgical Care Affiliates (SCA) for more than $2 billion, which will combine OptumCare and SCA to form a comprehensive ambulatory platform. Within the post-acute sector, programs such as the Quality Incentive Payment Program (QIPP) for nursing homes in Texas provide financial incentives for nursing facilities to improve quality.

Given the market forces in motion which are driving the push toward value based reimbursement, what are the implications for healthcare real estate? For starters, outpatient migration will continue, as outpatient settings are generally lower in cost and preferred by consumers. However, the January 2017 implementation of the site neutral payment legislation may cause health systems to modify their real estate strategy to ensure the financial viability of proposed projects that will be subject to decreased reimbursement. Nonetheless, incentives and patient preference will continue the multi-decade shift away from the acute care setting. As of 2014, the national average occupancy for hospitals was 61%, per MedPac. This was down from 64% in 2008 and from 77% in 1980. Large, older hospitals can be outdated or oversized, requiring innovative real estate strategies to determine how best to utilize these structures. An increasing number of hospitals are seeking to use unused floors or wings by leasing this space out to another provider for uses such as long-term acute-care, inpatient rehab, skilled nursing, hospice, or behavioral health. These arrangements can be complex, as many factors outside of a typical real estate lease must be taken into account. The challenges facing the acute care industry have also contributed to consolidation, as hospitals seek greater negotiating power, scalability, and improved access to technology. A 2013 academic study found that 60% of hospitals are now part of larger health systems.

3. Tax Exempt Hospitals Under Pressure

Nonprofit hospitals that have long relied on the benefits of tax-exempt status have begun to feel pressure from municipalities in recent years. Public pressure has prompted judicial and legislative scrutiny into the tax-exempt status of nonprofit hospitals across the country. In 2011, the well-known Provena case in Illinois sparked an intense debate as to the legitimacy of hospital-based property tax exemptions. Following the decision, stakeholders crafted legislation that was passed by the Illinois legislature in an attempt to clarify the scope of property tax exemptions for hospitals and health care providers. The legislative fix has also been challenged in recent years, which resulted in an Illinois appellate court declaring the statute unconstitutional. The Supreme Court of Illinois agreed to hear the dispute and a ruling is expected in 2017. In the meantime, property tax exemptions for hospitals and health care providers in Illinois are on hold and the debate continues. In New Jersey, AHS Hospital Corp., d/b/a Morristown Memorial Hospital, settled a property tax dispute with the Town of Morristown for $15.5 million. In the wake of the Morristown settlement, over 35 nonprofit hospitals have been sued by municipalities in New Jersey. The Morristown case disputed the nonprofit status of many nonprofit hospitals, arguing that their operational profile was more typical of the for-profit sector. Other municipalities in other states have begun scrutinizing nonprofit hospitals and health systems, compelling hospitals to defend their charitable nature in terms of dollars given away, rather than focusing on the scope of benefits given to the communities in which they serve.

In 2017, we believe that tax-exempt hospitals and health care providers will continue to face headwinds in terms of pursuing and preserving property tax exemptions. Tax exempt hospitals should be aware of these challenges and should be prepared to clearly demonstrate the benefits that they provide to the communities that they serve. Additionally, tax-exempt providers need to be vigilant in terms of complying with state law requirements and Internal Revenue Code and regulations including IRC Section 501(r) in order to maintain exemptions and demonstrate that they are providing a high level of charity care.

4. Capital Markets

In the last decade, healthcare real estate has become a more widely recognized asset class by both the domestic and international investment community. With this rise in potential buyers combined with reimbursement pressures on the operational side, many health systems and physician groups have elected to "monetize" their real estate assets. In 2016, the healthcare real estate industry's largest single sale/leaseback occurred, when Catholic Health Initiatives sold 52 medical office buildings to Physicians Realty Trust (a Milwaukee-based REIT) for $724.9 million.

Though the Federal Reserve increased interest rates in December 2016 (and has indicated that three more rate hikes are likely to occur in 2017), investor optimism in the commercial real estate sector has not diminished, as cap rates and interest rates are only moderately correlated. However, health systems may be affected by increased borrowing costs and a rise in inflation. These factors create an incentive for healthcare providers to lock in occupancy costs, though the overall uncertainty around healthcare may create caution in the market in evaluating long term leases or acquisitions.

Within the healthcare real estate investment community, the consensus forecast is for a slight uptick in overall cap rates in 2017. Investors remain bullish overall, due to the fundamental demographic drivers which underlie the sector's growth. Nonetheless, given the current state of the market, health systems evaluating a potential monetization may wish to accelerate their decision timetable.

5. New Rules Impact Leasing Arrangements

In recent years, several regulatory bodies have promulgated new rules that will impact how hospitals and healthcare providers own, operate and manage their real estate. In early 2016, the Financial Accounting Standards Board issued new lease accounting rules that will change how leases are treated for accounting purposes. Under current rules, leases for real estate assets are classified as operating leases or capital leases. Operating leases typically don't impact the balance sheet of the lessee. On the other hand, capital leases are treated as debt on the balance sheet of the lessee. In years past, healthcare providers have been able to classify long-term leases for healthcare facilities as operating leases. Existing rules have allowed providers to monetize non-core assets like medical office buildings through sale-leaseback arrangements with little impact on their balance sheet. The new rules, which take effect in two to three years (depending on whether a provider is a public entity or private entity), are not as generous. Providers will be forced to classify real estate leases as either operating leases or financing leases. With the exception of short-term leases (term of 12 months or less), real estate leases will be treated as financing leases. This will have a significant effect on providers' balance sheets going forward.

In late-2015, the Centers for Medicare & Medicaid Services (CMS) finalized a new exception to the Stark law for timeshare arrangements. Timeshare arrangements are often used by providers to attract physician specialists to underserved areas on a part-time basis. For example, a hospital may allow a cardiologist to use several furnished exam rooms in its medical office building for several days per month to see patients in the community. Under the existing rules, the hospital and physician are required to structure the arrangement as a lease with a term of one year, include a fixed schedule, and provide exclusive use of certain space and equipment. The new exception is designed to increase patient access to specialists in underserved areas by relaxing the requirements for part-time arrangements between providers. Under the new exception, providers are no longer required to structure the arrangement with a term of one year, include rigid occupancy schedules or provide for the exclusive use of space and equipment.

These new rules are already having an impact on how providers structure leasing arrangements. In light of the new accounting rules, providers have recognized that leasing arrangements will likely be classified as financing leases in years to come. As a result, providers looking to construct new facilities are carefully analyzing whether to own the facility or to engage a third-party developer to own the facility. Recent market trends suggest that an increasing number of providers are selecting the ownership model. Developers will continue to provide services to the healthcare industry, although an increasing number of developers are being engaged on a fee-for-service basis. Additionally, developers are offering alternative, creative solutions, such as credit-tenant leasing arrangements, whereby the healthcare provider will receive the benefits of ownership upon the expiration of the lease term. Finally, we believe that the new timeshare exception will cause providers to reconsider how timeshare arrangements are currently structured, which may result in an increase in the use of timeshare arrangements along with potential changes in facility design to more easily accommodate shared space and equipment.

6. Continued Regulatory Scrutiny

Hospitals and healthcare providers continue to face government scrutiny on multiple fronts. In December, the Department of Justice issued a press release that summarized its annual collections from false claims act litigation. It indicates that that the federal government recovered $4.7 billion dollars in fiscal year 2016 from cases involving fraud against the government. Some of the largest recoveries involved claims against hospitals and healthcare providers ($360 million in collections), followed by cases against a lab services provider ($260 million), skilled nursing providers ($160 million) and a rehab provider ($125 million). According to the press release, $2.9 billion of the $4.7 billion collected were the result of claims filed by whistleblowers. In fact, the Department of Justice noted that approximately 13.5 new cases were filed every week by whistleblowers in fiscal year 2016.

Government investigations also made headlines within the healthcare real estate sector in 2016 due to the negative financial impact that it had on providers. Healthcare REITs like HCP and Sabra took steps to reduce their exposure to facilities operated by Genesis and facilities operated by HCR ManorCare, both of which suffered financially as a result of government investigations.

In addition to fraud and abuse investigations, providers are also facing significant regulatory scrutiny from the Office of Civil Rights (OCR) in terms of implementing and protecting health information. In 2016, the OCR collected over $23 million dollars from settlements, with numerous providers paying over $1 million to settle claims. Additionally, providers looking to merge or consolidate are also likely to face government scrutiny. Last year, we saw the Federal Trade Commission challenge a number of mergers. While the new Republican administration has vowed to cut regulations, healthcare providers are likely to continue to face significant regulatory oversight in 2017, regardless of what path healthcare reform ultimately takes. We believe that the regulatory scrutiny will impact providers and real estate investors alike. Providers will be forced to implement and maintain robust compliance programs in an attempt to avoid government investigations and whistleblower actions. The cost of implementing and maintaining these programs will influence the real estate strategies pursued by health systems, including the calculus of whether to lease or to own certain real estate assets. Real estate investors may pursue assets occupied by providers who serve a higher concentration of private pay patients due to a decreased perceived likelihood of their tenants facing government investigations or whistleblower actions.

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