Capital Finance

Jeffrey H. Cooper

If a business school student were to suggest that it would be appropriate for a company to hold as much as 50 percent of its balance sheet in non-mission-critical assets, that student would likely be sharply criticized by his or her professor and peers.

And if this student then noted that these same assets were illiquid―although the company's operating income was under extraordinary pressure from all its customers―and that a paradigm shift was taking place in its fundamental business that would require unknown amounts of capital, that student would be advised to perhaps not pursue a business career.


It's not obvious to many of those charged with overseeing the finances of America's hospitals. In the United States today, many hospitals have balance sheets overloaded with non-acute care real estate that requires substantial capital to build, maintain, and operate, while yielding little to no return in support of the hospitals' main business: the delivery of health care.

Hospitals have been reluctant to part with their real estate through a sale and leaseback of all or a portion of their non-acute care building inventory as a means of raising capital. Increased occupancy costs, loss of control over its buildings, the interposing of another party between the hospital and its physicians, and a somewhat irrational concern that the capital markets will penalize the hospital have all been cited as reasons why a hospital has not monetized some or all of its non-acute care real estate. In some cases, hospitals have been restricted by the liens of a bond issue that had been unduly spread to all of their real estate rather than to their acute care buildings.

Currently, strongly rated hospitals are able to borrow at a rate as much as 200 to 250 basis points below that of the capitalization rate at which third parties are buying non-acute care hospital real estate. If the hospital leases back a portion of the space in the buildings it sells, this translates to rents higher than the hospital's bond rate.

Implications for CFOs

Assuming the hospital has adequate bonding capacity, CFOs often see no reason why they should be paying more for their capital than their borrowing rate. They fail to adequately consider that the hospital is not using its substantial illiquid asset base to create liquidity and improve the asset side of its balance sheet. In addition, although a borrowing under a bond issue must be repaid upon maturity, there is no such obligation when a hospital leases back any real estate required for its operations.

Many CFOs fail to consider that a monetization not only creates additional liquidity for a hospital's balance sheet, but also converts an asset to market value. The asset has been carried on a balance sheet at substantially below today's market value for the property. Liquidity created by monetization can then be invested in those areas that will advance the hospital's mission-critical activities, such as acquisition of physician practices, purchase of new equipment, recruitment, expansion of the hospital's ambulatory strategy, creation of an effective accountable care organization, conversion to electronic health records, and other such programming.

Capital available for monetizations is ample at the moment, fueled in large part by the abundance of debt and equity capital provided to publicly traded healthcare real estate investment trusts (REITs) in the public markets. In addition, several public, nontraded REITs, with strong access to capital from individuals seeking yield, are aggressive buyers of medical real estate. Numerous other sources of capital―including private funds, offshore investors, pension funds, and family offices―are seeking the secure cash flow stream and high rates of tenant renewals offered by medical office buildings (MOBs). CFOs, with the assistance of knowledgeable advisers, are able to create a competitive environment to maximize prices from a monetization because of the shortage of attractive product.

In many cases, hospitals have managed their real estate unprofessionally, resulting in substantial deferred maintenance at the buildings and poor service to their physicians. A monetization can improve the physician-as-tenant experience by substituting professional management for that provided by the hospital. After a monetization, the new owner is motivated and able to make significant investments of capital in its buildings, thereby curing deferred maintenance problems and providing service enhancements that significantly improve operations and boost physician satisfaction. Well-run MOBs also facilitate recruitment of new physicians to the hospital. The hospital is no longer investing capital in non-mission-critical buildings; it is using its limited capital elsewhere.

What Hospitals Should Do

Hospitals should be able to maintain adequate ongoing controls in a monetization through the use of ground leases. Hospitals rarely sell the land underlying the improvements involved in on-campus monetizations. Instead, they lease the underlying ground and convey only the improvements to the third-party operator. The ground leases contain provisions that require the new owner of the facilities to limit occupancy of the buildings to physicians on the staff of the hospital and prohibit any practice that might compete with the hospital, such as radiology or oncology infusions. In many cases, faith-based hospitals limit practices that may be contrary to teachings of their faith, such as the performance of abortions. In addition, the provisions contain requirements relating to the ongoing condition of the assets and an obligation to operate them as Class A MOBs.

The elimination of certain regulatory constraints is another positive by-product of a monetization. Because the hospital is no longer dealing with third-party physicians in the leasing of office space, it has less opportunity to run afoul of Stark and antikickback regulations. Rental rates offered to physicians no longer run the risk of being scrutinized as below market to benefit the hospital or otherwise overly beneficial to physicians as a means of attracting or keeping them on staff.


There are certain pitfalls to be avoided. Some hospitals have entered into master leases for all the real estate being sold to maximize proceeds derived from the monetization. Such master leases often carry terms as long as 20 years. Under current rules, these leases risk being treated as capital leases or financings, which can create adverse balance sheet and debt ratio problems under bond covenants.

In the future, GAAP rules are set to treat all operating leases the same as capital leases and to require that they be reflected on the balance sheet. Because the amount to be carried on the balance sheet will be the discounted value of the rental stream, hospitals will be well advised to avoid long-term leases of any nature when they are acting as the lessee.

In summary, the CFOs should look beyond the issuance of tax-exempt bonds in their search for capital. The monetization of non-mission-critical real estate presents an attractive opportunity to write up the balance sheet and create significant liquidity for the hospital. It also helps ensure compliance with Stark and antikickback regulations while allowing a hospital to maintain a degree of control over the buildings on its campus that house its physicians' offices.

Jeffrey H. Cooper is executive managing director, Savills LLC, New York, where he heads the firm's U.S. healthcare practice (


Publication Date: Monday, July 02, 2012

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