Hospital Real Estate and Financing Q&A With Mike O’Keefe of Navigant Consulting

1. How has the recent tumultuous activity on Wall Street affected hospital real estate transactions? 

Mike O’Keefe: The aftermath of the current global credit crisis and “cratering” of equity values has meant that the days of easy access to low cost sources of capital are certainly over, and hospitals are no exception. In fact, virtually all healthcare bond issues in the queue as of mid-Oct. 2008 have been shelved and the credit markets are essentially frozen and not functioning for long-term bonds or variable rate demand bonds (VRDB). Existing issues of VRDBs are being “put” back to bank issuers, resulting in re-sets at higher interest rates for hospitals and amortization schedules being significantly shortened. The demise of the auctionrate securities market was an early casualty of the capital market debacle as well, further limiting the financing vehicles of choice for healthcare providers.

In addition to the difficulties healthcare organizations have experienced managing the liability side of their balance sheet as a result of the credit crisis, equity investment portfolio values have significantly deteriorated healthcare providers’ asset base and severely curtailed the use of investment returns as a source of capital to fund capital expansion programs and current operations. Philanthropic pledges have also dropped in lockstep with the market. These convergent events — combined with the expectation that reimbursement levels will continue to be squeezed — have forced many healthcare systems to suspend all planning for future projects until further notice.

As government leaders desperately search for the right prescription to thaw and stabilize the frozen global capital markets, the new world order for healthcare providers needing to access the capital markets in the foreseeable future will be severely tightened credit, a heightened scrutiny of business plans, and significant pressure placed upon hospital management teams’ experience in and approach to managing the significant risks inherent in large scale capital spends. Only healthcare providers with the most solid credit profile, business plans, management teams and risk mitigation plans and will obtain affordable financing.

2. As the bar continues to be raised in an ever-challenging credit environment, what can a hospital or healthcare system do to be well-positioned to secure the capital it needs to continue to fund its strategic capital initiatives? 

MO: First and foremost, capital sources will want evidence that providers have a good track record of being good stewards of their limited financial resources — and that starts with diligently “planning the work and working the plan.” With razor-thin margins in a highly competitive environment, there is no longer any margin for error. Hospitals need to get it right the first time. From a credit underwriter’s perspective, here are 10 critical components for a successful business plan.

1. Internal project management organizational structure in place; project leadership by a designated senior project executive and steering committee comprised of board committee members, physicians and department heads.
2. Project guiding principles that include operational/performance improvement metrics and objectives. (Note: This is an extremely critical step to offset the rising cost of capital with reduced operational costs from performance improvement initiatives.)
3. Independently validated market-based volume projections.
4. Cohesive physician integration strategy and “buy-in.”
5. Right sized facility plan; forecast inpatient and ancillary space capacity requirements based on service-line volume projections.
6. Realistic benchmark-tested “all-in” capital budget, inclusive of all hard, soft and financing costs, furniture, fixtures, equipment and medical technology as well as appropriate contingencies and cost escalation factors.
7. Independently validated financial feasibility study.
8. Experienced external team; program/project management, design, construction management and other qualified professional consultants.
9. Early guaranteed maximum price (GMP) and schedule in-hand from construction manager (at completion of design development drawings).
10. Project risk management tools and processes in place, including schedule and budget controls.

Hospitals that have well-conceived project-specific business plans that include realistic project budgets, schedules and an overall risk mitigation strategy are more likely to attract capital. Hospitals that bring forth fragmented plans will find themselves in a less creditworthiness position.

3. What alternative, non-traditional sources of capital can healthcare provider’s access to fill the void created by the current turmoil in the credit markets? 

MO: More healthcare organizations will consider monetizing non-core assets on their balance sheet such as medical office buildings, health and fitness centers, and ambulatory care centers, and use the proceeds to fund new acute care capital projects and technology.

Using third-party developers to develop, finance, own and operate medical office buildings, surgery centers and ambulatory care centers has become commonplace with healthcare providers. In fact, many healthcare providers are starting to use private capital to fund acute care projects including new hospitals, especially acute care projects that are for-profit joint ventures with physicians.

Healthcare providers should be cognizant that most traditional developers/investors rely upon highly leveraged transactions and therefore will not be able to secure required project financing until the credit crisis subsides. A few cash buyers — such as equity real estate investment trusts (REIT) — have remained open for business and have prospered by being able to fund with speed and certainty in this uncertain environment.

Healthcare REIT, the healthcare REIT with one of the highest investment grade ratings, and a strategic capital partner of Navigant Consulting, has seen a pronounced up-tick in deal flow and an improvement in the quality of projects after the credit crisis began to unravel. By having Healthcare REIT as our strategic capital partner, Navigant has ready access to over $1 billion of equity available for immediate funding of our development projects, which is especially critical in this uncertain credit environment.

4. What are some of the implications hospitals need to be aware of when considering utilizing third-party capital? 

MO: Although transactions with third-party developers and investors can be structured as off-balance sheet operating leases, hospital providers need to understand what impact such transactions will have on their debt capacity. Some credit rating agencies have taken the position that even though a transaction may be structured to achieve off-balance sheet treatment, each transaction will be evaluated on a case-by-case basis to determine its impact on a hospital’s debt capacity.

Depending upon the level of materiality, a typical approach is to convert a hospital’s scheduled rental payments to an equivalent of debt service to determine the level of debt it would support and therefore its impact on debt capacity. Credit rating agencies also have taken a more conservative position recently. They are stating that though the underlying debt financing utilized by a third-party developer/owner may be non-recourse to the hospital, if a project is located on a hospital campus and may house key hospital physicians and outpatient operations and if the developer/investor defaults on its mortgage, the hospital would have the “moral obligation” to step in and cure a loan default. Therefore, developers/investors that do not place mortgages on properties offer healthcare providers the potential advantage of lessening the impact a project may have on the organizations debt capacity.

5. What risk-management and control-related questions should be asked by hospital executives and board members when considering monetizing non-core assets or using a third-party developer to finance and own a project? 

MO: Here are 16 different sets of questions hospitals executives and board members should consider asking themselves before monetizing their non-core assets.

1. What financial and other criteria should we establish to pre-qualify developers/property investors?
2. How well-capitalized is the prospective investor? Are they highly leveraged? What is their funding source? Do they have financing contingencies that must be satisfied to close? Can they fund with speed and certainty? Do we have controls in place for the maximum leverage that can be placed on property assets?
3. Do we expect the development or sale transaction to be treated as an offbalance sheet operating lease? If so, has our auditor reviewed the ground lease and hospital tenant lease documents and provided an opinion that the transaction will be treated off-balance sheet?
4. What impact will the transaction have on our debt capacity? Have we obtained our credit rating agencies perspective on the proposed transaction? Do we know what level of off-credit treatment we expect to receive? What variables will impact this level?
5. Have we conducted a compliance review to ensure the proposed transaction complies with all Stark, private inurement and other regulatory requirements?
6. Has the developer/investor ever defaulted on a ground lease or property loan? Have they ever been involved in litigation with a hospital or project team member?
7. What pre-leasing levels need to be achieved before they will commit to start construction? What commitments do we have from our developer to complete the project by a date certain? Has the appropriate level of liqui dated damages been set if delivery dates are not met?
8. Are the necessary controls over permitted uses and tenants in place? Are we protected from allowing a potential competitor to occupy the building in the future?
9. Are the use-restrictions structured to protect the organization in the future as the rapid pace of technological advancement changes what services and procedures can be performed in a physician’s office?
10. Does the firm have the necessary experience in developing and operating healthcare facilities?
11. How will the property be managed? Does the firm provide property management in-house or outsource to a local firm? Do we have the right to perform certain building services? What management fees and other fees will be passed through to tenants?
12. How will we and our physicians be treated as tenants, especially when leases are renewed? What is the investor’s reputation and track record on increasing rents on lease renewals? Did we talk to other hospitals and tenants that have a history with the firm?
13. What correlation will the sale price of monetized assets have on the investor’s ultimate value creation strategy? Do we have a commitment from the investor regarding caps on future rent increases? Are we at risk of alienating our key aligned physicians if the investor’s strategy is to aggressively increase rents to “market” to create value?
14. Does the investor intend to hold for the long-term or do they typically sell in 3–5 years? Do we have a commitment from the investor to hold the property for a minimum term? Do we have the right to purchase the property when the investor decides to sell? Are we protected from the property being sold to a potential competitor in the future? Have we established criteria future owners must satisfy to be qualified to purchase the property?
15. Do we have the right to approve other project team members, includ ing architect, contractor and property manager?
16. Is the investor prohibited from owning competing buildings that could pose a conflict of interest?

Healthcare providers that conduct the appropriate level of due diligence on prospective capital partners and establish an appropriate level of controls will be in a much stronger position to manage the risks and rewards of accessing capital through private third parties.

Mr. O’Keefe (mike.okeefe@navigantconsulting.com) is a director in the healthcare real estate group of Navigant Consulting (www.navigantconsulting.com). Prior to joining Navigant, Mr. O’Keefe was a vice president of development and principal of AMDC Corp., which was acquired by Navigant in 2007. Since 1985, Mr. O’Keefe has played an integral role in the planning, development, financing, and leasing of more than $1 billion of healthcare projects ranging from medical office buildings, ambulatory care centers, surgery centers, cancer centers, medical fitness centers and new hospitals.