As hospital and health system leaders address new levels of uncertainty in capital planning, the monetization of real estate assets can be a key strategy for hedging against interest rate risk.
“Medicine is a science of uncertainty and the art of probability,” cautioned the Canadian physician, Sir William Osler, sometimes known as the “Father of Modern Medicine.”
This sentiment is also true when it comes to predicting the future cost and availability of capital. When hospital CFOs and others prepare the organization’s budget, the attempted goal is to match the cost and availability of funds with anticipated needs. In a dynamic capital markets environment, great uncertainty surrounds the cost and availability of funds. If the hospital is already sitting with a large pool of capital earmarked for future obligations, such uncertainty isn’t too great a problem. However, if the hospital needs to raise funds to meet the requirements of its capital plan, then its leaders will need to take an artful approach and determine the probable impact of a variety of factors.
Two of these key factors are the direction and velocity in movement of interest rates. When borrowing funds, the CFO has to evaluate not only the current cost of funds, but also the probable future cost and availability as the current borrowings mature and have to be replaced. Accuracy of assumptions about interest rate movements is vital, because the rates not only directly impact borrowing, but also affect the organization’s buying potential through cost of goods, salaries, and many other areas.
One means of hedging interest rate uncertainty in an increasingly unpredictable capital market is to raise funds through a sale and leaseback of fixed assets. Many CFOs and their boards have been eyeing their real estate as a way to take advantage of the current attractive capital markets environment, where low capitalization rates have translated into high prices for medical real estate.
Monetizing Real Estate
As with many aspects of hospital decision making, the potential monetization of real estate is often a long and arduous process muddied by political considerations, issues of control, conflicts of interest and Stark compliance, power bases, and competition for funds derived from the monetization. Should the CFO wade into this area to hedge the future cost of funds? Is this the right time with so much uncertainty surrounding the decisions of the Federal Open Market Committee? Will the value of the hospital’s real estate be negatively impacted by rising interest rates that many predict will exceed another 100 basis points by 2015? Based on the current market conditions, it might be wise for hospital CFOs contemplating utilizing their real estate as a source of cost-effective capital to heed Mother Teresa’s advice: “Yesterday is gone. Tomorrow has not yet come. We have only today. Let us begin.”
The range of overall capitalization rates for medical real estate today is almost exactly where it was five years ago, before the recession started bearing down on the markets. The key questions are whether these rates are likely to change and how soon. The probability of interest rates going up further at some point is quite high. Since May 2013, the 10-year U.S. Treasury rate has already moved up by at least 100 basis points, although the movement has leveled off for the time being. To date, however, the capitalization rates for medical real estate have not followed suit. Pricing for this asset class remains strong. Prices have been propped up and capitalization rates have remained steady at current low levels due to the lack of first-class medical real estate available for acquisition. Matched with the large pools of uninvested equity raised for investment in this type of asset class, pricing for medical real estate has been unimpaired. The market continues to be characterized as a seller’s market.
Changes Afoot in REIT Acquisition
It is time to be cautious and not put off a decision on whether to utilize an institution’s real estate to raise capital. The largest buyers of medical real estate have been and are likely to continue to be real estate investment trusts (REITs). Although REIT stock prices are down from their highs earlier in the year, they are still viewed by investors as an attractive alternative to fixed-rate debt, considering their generous dividends. The movement in 10-year Treasury yields from 1.66 percent in early May to 2.9 percent in mid-September negatively impacted REIT pricing and caused most of them to withdraw from raising equity in the public markets to avoid stock price dilution. As a result, the REITs, although still flush with debt and equity capital, are becoming somewhat cautious in expending their capital. They want assurance that their acquisitions will remain accretive to their overall asset value.
Capitalization rates tend not to move exactly parallel with rising interest rates. Rising rates usually follow overall economic improvement, which in turn leads to increased rental rates and higher occupancies of real estate. Over time, however, the REITs will require higher rates of return on their acquisitions, but this goal may be achieved in part by increasing property cash flow. Historically, however, cash flow on medical real estate has not increased at the same rate as other real estate asset classes. One can reasonably assume that the ability to raise rental rates at medical office buildings will be limited by downward payment pressures on hospital and physician revenues. It will be difficult to raise rents at a rate in excess of the growth rate of the Consumer Price Index.
Shifting Interest Rate Outlook
Unexpected and rapid interest rate rises tend to slow transaction activity in real estate as pricing mechanisms become inefficient. The rules relating to educated planning are suspended as the markets overcome the “shock” effect. This scenario is unlikely to occur in the near term, as the Federal Reserve has communicated with various levels of clarity a plan to taper its bond-buying program, thereby allowing the market to slowly price the coming adjustment. Capitalization rate changes tend to lag interest rate changes. In addition, interest rate increases are not occurring in a straight line, particularly with the caution being shown by the Federal Reserve at its Open Market Committee meeting on Sept. 18, when it unexpectedly failed to reduce the level of its buying of U.S. Treasury and mortgage-backed securities.
Despite George Bernard Shaw’s admonition that “If all the economists were laid end to end, they’d never reach a conclusion,” we can reach one here: Although rising interest rates will eventually impact pricing on all real estate, including medical real estate, this occurrence will not dampen pricing or diminish interest in medical real estate in the near term. As noted, capitalization rate changes tend to lag interest rate changes, particularly where assets are in short supply and the availability of capital focused on the area remains ample. Most likely, hospitals will feel the impact of rising interest rates on their bonds before the value of their non-acute care real estate is adversely affected. Hospitals and health systems still have time to take advantage of monetizing their real estate before the Federal Reserve slowly tapers its bond-buying program and interest rates and capitalization rates return to their historic levels. To repeat Mother Teresa’s advice: “We have only today. Let us begin.”
Jeffrey H. Cooper is chairman and executive managing director, Savills LLC, New York.
Jeffrey D. Corkhill is vice president-Healthcare, Savills LLC,New York
Publication Date: Friday, November 01, 2013