Bill Wilson

Obtaining financing for capital projects may seem daunting today if you are the financial leader of a small hospital, but standing still is no option. The encouraging word is, you don't have to.

At a Glance

  • To succeed in the current financial markets, small hospitals need flexible project and financing plans.
  • Many small local banks today can offer small hospitals financing solutions on par with what was previously offered only by the country's strongest investment-grade rated banks
  • Federal assistance through programs such as HUD's Section 242 mortgage insurance program is also a viable option for small hospitals.

Defunct Wall Street investment banks were not in the habit of financing, or even visiting, small hospitals in Sidney, Mont., or Fredonia, Kan. But the financial market implosion and the tumbling of several well-known firms continue to reverberate throughout the healthcare world, from the largest health systems to the smallest critical access hospitals (CAHs). Endowments have suffered nightmarish losses, borrowing interest rates have skyrocketed, and covenants have significantly tightened.

Standing still and delaying major projects can feel like a safe choice in such an erratic environment. But capital plans often have a long lead time and cannot be delayed indefinitely, especially since even a short period without capital improvement can drastically affect a hospital's technological capabilities and competitiveness. Smaller hospitals-for example, critical access hospitals (CAHs) or those with sole community-hospital status-continue to face many unmet community healthcare needs-just as they also face intensifying competition to recruit physicians.

In the current financial markets, and the foreseeable future, the successful smaller hospital will have to be proactive with its plans and relationships as it seeks to borrow for renovation, construction, or refinancing. As noted in the bond rating agency Moody's November 2008 not-for-profit healthcare outlook, when the markets do unfreeze, it will be to the immediate benefit of investment-grade hospitals, not smaller facilities, most of which are unrated. Small hospitals seeking to move forward should consider three key strategies:

  • Create flexibility
  • Leverage local resources
  • Pursue federal assistance, when necessary

Creating Flexibility

In 2006 and during much of 2007, all a hospital needed to complete a successful financing was a clean audit for the prior fiscal year, a guaranteed maximum price contract, and a financial compilation. In fact, many hospitals succeeded with only one or two of these key due diligence items. With the loss of trillions of dollars of wealth, far fewer investors are now chasing the same number of hospital projects, so financing terms and requirements have changed significantly. To succeed, small hospital management teams and boards must create flexibility in both their project and financing plans.

Project planning. The easiest way to reduce dependence on the financial markets is to reduce the scope of a project. Small hospitals should work earnestly with their architects to identify phasing opportunities that reduce the amount of capital funding initially required. Prioritizing projects is challenging, but with the condition of the current financial markets, more risky or purely aesthetic projects will likely need to be delayed.

A fundamental issue facing many small hospitals is whether to build a replacement facility or renovate and expand existing facilities. A small hospital should not allow the current markets to influence this key strategic decision. Rather, the hospital should continue to focus on the geographic issues involved with moving or staying put, and on the fundamental challenges and opportunities associated with its existing buildings

To the extent a board decides a replacement hospital is in the community's best interest, many opportunities still exist to phase a project and reduce initial capital needs. Examples include limiting the initial space for inpatient beds and physician offices and examining community alternatives for long-term care, skilled nursing, and clinic services. Many architecture firms around the country are developing "expandable" small hospital designs to meet these needs.  When considering any phased project, it is important to research potential certificate of need regulations and implications.

It is also important to note that phasing projects may result in additional costs in terms of financing fees. These may (or may not) be partially offset by lower interest rates for leveraging less in the immediate market, as well as the option to refinance or pay down the debt in conjunction with later phases financed in potentially improved markets.

Financing flexibility. When a small hospital makes the strategic decision to a phase in a project, it should remain limber in both choosing and refining its debt structure. Recognizing the competing interests of borrowers and investors, small hospitals should multitrack financing options, especially given that even successful projects can take many months, if not years, to complete.

In a multitracking strategy, the hospital proceeds with applications and due diligence to meet the requirements of more than one financing strategy. It may, for example, solicit bids for a letter of credit while simultaneously submitting a preliminary application for the Section 242 mortgage insurance program administered by the Department of Housing and Urban Development (HUD), described in the sidebar below . If the primary strategy derails, the hospital should be able to switch tracks without losing much momentum or pushing back construction and other time lines. Multitracking financing options enables a small hospital to ensure competitive terms, adjust to additional market challenges, and in some cases, seize opportunities, such as the current market's exceptionally low variable interest rates.

Commercial banks and the HUD 242 mortgage insurance program provide flexibility within their structures. Although a commercial bank may not offer a long-term fixed interest rate, most financings involving a commercial bank will not have prepayment penalties or restrictions. A hospital is free to refinance out of the structure if the project or market changes. The HUD 242 program offers flexibility by having an additional debt program, the 241 program, with the same low level of financial tests as the 242 program. Although the 241 program will generally have a 10-year prepayment lockout, similar to a fixed-rate issue, the 242 program's more lenient additional-debt tests may prove more advantageous for a small hospital.

No matter the chosen structure, it is critical that the hospital's investment bank and attorneys build flexibility into the financing documents. Prepayment penalties, covenants, and collateral pledges must all be reviewed carefully to limit restrictions on a hospital's ability to proceed with future project phases. Historical examples of working flexibility into documents include writing in the ability to switch resale modes on bonds and creating specific permissions to restructure swaps.

To take advantage of multitracking and to build optimum flexibility into debt documents, small hospitals should seek investment banks that specialize in health care and offer multiple options; a bank must be HUD- and USDA-approved to be able to offer these financing strategies. Moreover, to be able to articulate the hospital's credit strengths to potential investors and credit enhancement providers, the bank should understand the nuances of hospital reimbursement and of how characteristics such as being a sole community provider can affect a small hospital.

Leveraging Local Resources

Although the current market forces are causing small hospitals financing headaches, geographic location can offer many a powerful dose of pain relief. A large percentage of the banks that were hard hit by the subprime mortgage crisis are located in coastal areas. Yet among the nation's 1,300 CAHs, 82 percent are in the center of the country, away from the coasts, and the many small banks in the nation's heartland that avoided huge losses still have an interest in lending. Desire to purchase "bank-qualified" issues is still strong, and recent legislation regarding the Federal Home Loan Bank (FHLB) has improved the ability of local banks to compete in the tax-exempt bond market.

Understanding smaller banks' appetite for loans can improve hospitals' chances of getting financing and help them time strategic plan implementation. First, due to their size and regulations, many local banks have lending limits below $10 million. As a result, most significant projects will require participation from multiple banks.

Second, banks generally try to match the amount they lend to the amount they receive from deposits. Since most deposits are left with the bank for less than 10 years, banks will prefer issuing loans of less than 10 years. Longer amortizations are possible to reduce debt service, but long-term fixed interest rates are not.

Finally, bank loans are real estate-driven from a regulatory standpoint. A bank loan will likely require an appraisal. The good news is that banks typically have fewer debt covenants than other types of hospital investors. Debt service reserve funds are generally not required, liquidity requirements are minimal, and issuance costs are relatively limited.

Bank-qualified bonds.Small hospitals can increase local bank interest by designating their bonds as bank-qualified. To do so, the bond issuer (usually the local municipality) must issue no more than $10 million in bonds that year, and the bonds must be issued for qualified tax-exempt obligations. Medical office buildings leased to private practitioners would not qualify for either tax-exempt or bank-qualified bonds. If needs are greater than $10 million, it may be possible to fund a project over multiple years.

Banks will fund the purchase of these tax-exempt bonds through their depositors, to whom they pay interest. To the extent a bank buys bank-qualified bonds, it can deduct 80 percent of the interest expense paid to the depositors. Because bank-qualified bonds are more profitable than conventional tax-exempt bonds, banks should be willing to share some of the savings by way of a lower interest rate.

FHLB backing.With long-term interest rates increasing while short-term rates are falling, many small hospitals want to take advantage of a tax-exempt, variable-rate bond structure. The lower interest rate can increase debt capacity and provide additional financial cushion. Unfortunately, a variable rate bond structure requires an investment-grade letter of credit, which has been harder and harder to procure.

In July 2008, however, Congress passed legislation that allows the FHLB's AAA-rated letter of credit to be used in conjunction with local bank financing commitments for health care projects. As a result, local banks can now offer a financing solution on par with what was previously offered only by the country's strongest investment-grade rated banks. The first application of this financing strategy closed in November 2008, and local banks and FHLB offices nationwide have expressed a keen interest in replicating the deal with other healthcare providers.

Fund raising. When seeking donations from the community to assist with a capital project, a hospital should consider requesting unrestricted pledges. Pledges designated as restricted can be used only for hospital construction or renovation projects. Unrestricted pledges, however, can be put to work as investments and earn interest.

Pursuing Federal Assistance

If local bank financing is not a viable option, federal programs for hospital borrowing remain committed to providing capital and have actually increased staff to accommodate hospitals' need for affordable financing.

HUD mortgage insurance. HUD's Section 242 mortgage insurance program already has seen considerable increased interest in the last year: The program completed 30 preliminary reviews in FY08, more than in FY06 and FY07 combined. FHA-insured obligations are nonrecourse to the borrower, meaning the loans are backed solely by the borrower's real estate and other assets. For a hospital that is part of a system, this structure provides minimal risk because the parent organization is not liable for the debt of the individual facility being financed.

The cost of using the 242 program limits its appeal for projects below $10 million. On the plus side, there is no maximum borrowing amount.

The FHA also has recently begun to include former hospital CEOs and CFOs on its team-an approach that helps ensure that program staff better understand the needs and perspectives of their hospital partners. The approach also has begun to pay dividends. For example, in 2008, HUD, at its expense, sent an outside consultant to work with a 242 hospital client. The hospital's CEO had become gravely ill just when the hospital began experiencing financial challenges. With the HUD consultant's help, the hospital has established a long-term plan for achieving financial success.

USDA Community Facilities Program. The USDA offers direct loans, guaranteed loans, and grants under its Community Facilities program. These loans are available only to not-for-profit rural organizations serving communities of fewer than 20,000. The pool of money for the direct loans and grants is limited, but the guaranteed loan program historically has not used its total obligation capacity.

A USDA loan can cover up to 100 percent of the cost of the project, and 90 percent of that loan is guaranteed by USDA. While the loan is designed for building new and improving existing facilities, it can be used toward refinances under certain conditions. Borrowers have up to 40 years to pay off the loans. The program's most significant drawback is that interest on these loans is taxable. However, discussions continue about a legislative fix to this obstacle.

Typical loan amounts under the USDA program have tended to be less than those made under the FHA 242 program because funding is limited to the amount appropriated by Congress. Like the 242 program, however, the USDA program has no maximum loan amount.

Maintaining Momentum

Amid the challenges of today's financial markets, as well as the negative impact of the recession on operating margins and balance sheet liquidity, small hospital senior management and boards must strive diligently to maintain project momentum. Shelving plans, or deferring decisions, would make it that much harder to revisit major capital projects. Furthermore, with tough operational decisions needed to meet the economic conditions, having ongoing replacement, renovation, and expansion goals can assist in sustaining employee morale. The financing landscape has changed, but proactive management of project development, as well as local and federal relationships, can help hospitals continue to meet the healthcare needs of their communities.

Bill Wilson is senior vice president and director, Central States office, Lancaster Pollard, Lawrence, Kan., and a member of HFMA's Oklahoma Chapter (

Spend Cash or Borrow?

In December, the international bond rating agency Fitch revised its not-for-profit hospital sector outlook to negative from stable, citing multiple falling credit profile factors. Drops of 20 percent to 30 percent in days cash on hand ratios were noted from 2007 to 2008, and during this period, utilization was down and investment portfolios were weaker. Fitch anticipates that hospital rating downgrades will outpace upgrades for the next three years, with smaller hospitals bearing the brunt. There is growing concern the gap between hospital "haves" and "have-nots" will continue to widen.

It can be tempting for a smaller hospital to pay for projects in cash as funds become available. Any discussion of this option should closely consider the impact on liquidity ratios. Cash will be king when the credit markets come back on line: Paying in cash may get an immediate need met, but it could damage long-term borrowing ability. The cash cushions many hospitals built up from 2004 to 2007 already have been eroded by investment losses. Building it back up again will be even more difficult if the money is spent down on capital projects rather than protected as a credit profile asset.

Renovate or Replace?

Recent studies of rural renovations and replacements indicate that both can result in significant improvement to physician recruitment and operations. Hospitals that cannot afford to make wholesale replacements may be able to phase projects that together can have a similar impact.

According to a 2007 study (Rural Hospital Replacement Facility Study, Stroudwater Associates), rural communities that built replacement critical access hospitals saw an average growth in outpatient visits of 13 percent and an average increase in overall staffing of 6 percent the year after the replacement.

A 2008 study (Rural Hospital Renovation & Expansion Study, sponsored and prepared in part by Lancaster Pollard) disclosed similar positive impacts after one year among rural hospitals that renovated their facilities rather than completely replacing them: The average growth in outpatient  visits was 8 percent, and the average increase in overall staffing was 4 percent.

These studies found that both renovations and replacements also eventually resulted in higher average operating margins: Replacement hospitals had an average operating margin of 1 percent in the year before the project and 21 percent in the first year after the project, which gradually increased to 3 percent in year four. Renovated hospitals saw a slightly quicker recovery, with an average operating margin of 1.7 percent in the year before the renovation and 2.8 percent in the year after.

Renovations can in some cases cost more than replacements, and the hospital's geographic location-for example, if it has changed in relation to the town center-and fundamental physical condition of facility, among other unique factors, also will impact the feasibility, decision, and results.

HUD's Section 242 Program

The 242 mortgage insurance program of the U.S. Department of Housing and Urban Development (HUD), which is administered by the Federal Housing Authority (FHA), offers mortgage insurance for hospitals of all sizes, and its key strength is its ability to provide fixed, tax-exempt interest rates. Because its pricing structure is not risk-based, smaller hospitals can better afford capital issued via this program than capital secured through some other vehicles. The 242 program offers borrowers the opportunity to issue bonds at an "AAA"-equivalent rating. Borrowers have 25 years to pay back FHA mortgage-insured loans, a relatively long amortization that gives hospitals better opportunities to service the debt. No financial guarantees are required by parent or affiliated entities, and a high loan-to-value ratio can minimize up-front cash requirements.  Should the borrower require additional capital, it can increase the amount of mortgage insurance and available funds through HUD's streamlined Section 241 program.

Publication Date: Sunday, March 01, 2009

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