Hospitals today are experiencing severe cost-containment pressures brought on by actual and threatened cutbacks in third-party payments from both private insurers and government-funded programs such as Medicaid and Medicare. Meanwhile, the movement away from fee-for-service payment models is challenging the predictability of hospital revenues.
As hospitals consider whether to expend scarce capital to acquire physician practices that could enhance outpatient revenue, they face a critical need to identify alternative sources of capital to fund strategies in non-acute care settings. Real estate investment trusts (REITs) are one nontraditional source of capital that hospitals should explore.
REITs offer hospital CFOs a cost-effective option for meeting a portion of their organizations’ capital requirements. Considering the average hospital holds as much as 60 percent of its existing balance sheet in real estate assets, hospital CFOs have a substantial “bank account” from which to raise a major portion of their organizations’ capital program funding.
REITs are tax-efficient vehicles formed to acquire real estate and lease it to third parties with the objective of passing along most of their net income to their shareholders. Eleven REITs, with a capitalization of approximately $67 billion, are focused on health care. Healthcare REITs have proved to be attractive entities for investors, returning more than 20 percent in 2012. They also are exempt from taxes at the entity level, with some minor exceptions. Healthcare REITs include publicly traded vehicles as well as some public, but not publicly traded, vehicles. They currently have excellent access to low-cost capital through the public equity and debt markets.
The healthcare REITs actively seek to acquire non-acute care hospital real estate. They prefer on-campus or off-campus hospital-affiliated real estate, ranging from medical office buildings and ambulatory care facilities to clinics, cancer centers, and the like. Many also acquire long-term care facilities and specialty hospitals.
REITs provide a means for hospitals to secure capital for new development without requiring that a hospital take on debt or use its bonding capacity in exchange for a substantial leasing commitment on the part of the hospital or its affiliated physicians. REITs also offer hospitals a way to increase the balance sheet value of their real estate assets from book to market, which is often a multiple of book value. In addition, the sale and leaseback of some or all of the hospital’s real estate allow the hospital to liquefy a material segment of its balance sheet. Such balance sheet engineering also enhances bond ratios and may facilitate an increase in a hospital’s bonding capacity and rating.
By transferring certain real estate assets to a REIT, the hospital also is relieved of the requirement to invest further capital into its real estate and can instead focus its available capital on its acute care portfolio, the acquisition of physician practices, and the funding of operational requirements.
The larger, publicly traded REITs in this space are interested in acquiring stabilized existing medical office buildings and ambulatory care facilities affiliated with hospitals or hospital systems. Although they have development capability in some cases, they generally are most interested in an asset after it has been developed and has stabilized cash flow. These larger REITs often enter into ventures with medical facility developers to optimize investment opportunities.
Other REITs seek development opportunities on behalf of a hospital through which they develop ambulatory facilities on or off campus, with significant preleasing from the hospital or its physicians.
In all cases, the REITs fund 100 percent of the development cost and own the asset upon completion, subject to a variety of controls implemented through a ground lease structure that protects the hospital from unacceptable uses of the property on the hospital campus. For example, ground leases almost always provide that only physicians with staff privileges are permissible tenants in the buildings or that the buildings cannot be sold to another hospital or healthcare system without consent of the hospital.
The Cost of Capital
Currently, REITs have ample access to attractive short-, medium-, and long-term capital from both bank consortiums and the public markets. The low cost of available funds enables REITs to pay a higher price for hospital assets and allows the REITs to receive a lower rental rate from the hospital than that required from another capital source to achieve an acceptable investment return. In addition, equity markets for REIT equity are particularly liquid.
A hospital’s cost for REIT capital today ranges from 6 percent to 7.25 percent, depending on the hospital’s rating, the age of the assets, the critical nature of the asset to the hospital’s operations, occupancy levels, and the hospital’s commitment to the asset through long-term leases.
Development transactions generally have a cost of capital that can be from 100 to 200 basis points higher than that sought on existing assets.
A hospital senior finance leader may consider these rates as a higher cost of capital than the coupon on the hospital’s bonds. But these leaders also need to remember that bonds need to be repaid or refinanced at some point. Real estate sold to a third party has no similar obligation.
In addition, real estate on a hospital’s books should have an equity cost attributed to it, even though the hospital does not raise equity or have stockholders. The equity cost—i.e., the cost of having assets on the hospital’s balance sheet not fully committed or available to expand and sustain its operations—can be high, although difficult to quantify.
Nonmonetary Benefits of REITS
Outsourcing a hospital’s ambulatory care real estate to a REIT offers some important nonmonetary benefits as well. By exiting from the business of entering into leases with its physicians, a hospital can avoid running afoul of federal conflict-of-interest prohibitions. In most cases, the hospital also relinquishes its responsibility to expend capital on its ambulatory physical plant and instead can more profitably use this capital to support its existing operations or to implement its overall strategic plan.
Hospitals are notorious for not having a realistic knowledge of the true expense of operating their real estate. Often, expenses allocated to a hospital’s owned ambulatory care facilities are arbitrary and do not reflect the true cost of operations. For example, utilities costs may not be separately metered for on-campus medical office buildings, or buildings sharing services with an acute care hospital may not be adequately charged for the amount they use. REIT owners provide professional management of these assets, which can reduce facility operating costs while creating a better occupancy experience for physician tenants.
By taking advantage of the generally low cost of capital available to REITs, a hospital CFO can attract cost-effective capital to meet expansion or renovation plans without committing scarce capital to a physical plant. The opportunity cost of a hospital’s strategic plan is significantly lessened when the hospital no longer has to allocate capital to a depreciating asset. At the same time, the hospital enters a partnership with a long-term owner of the real estate that has little motivation to churn the asset for short-term gain.
Jeffrey H. Cooper is executive managing director, Savills LLC, New York (firstname.lastname@example.org).
Publication Date: Friday, March 01, 2013