Thomas A. Czerniak
Hospitals acquiring real estate associated with physician alignment should understand the implications on ambulatory network planning, service delivery and distribution, and real estate capital planning.
At a Glance
When addressing locations of facilities after acquiring physician practices, hospitals should:
- Acknowledge the hospital's ambulatory plan is the driver rather than real estate assumed with the physician practices
- Review the hospital ambulatory service plan for each submarket
- Review the location of facilities within the service area and their proximity to one another
- Sublease or sell existing facilities that are not appropriate
The reengineering of the healthcare industry includes physician alignment strategies to strengthen the hospital-physician bond and facilitate the development of accountable care organizations. Employing physicians or acquiring physician practices often is the alignment strategy of choice.
Results of a 2011 survey of 68 hospitals highlight the challenges hospitals face in planning ambulatory network plans as a result of this strong trend toward physician employment.
When a hospital acquires a physician practice, it will either assume the space lease obligations of the physician's practice (60 percent, according to the survey) or will purchase the building occupied by the practice (33 percent). In addition, as part of the physician practice acquisition, the hospital may agree to purchase medical equipment, assume equipment lease obligations, and enter into employment contracts with the physicians and staff. As a result, the hospital may become committed to a location that was not part of its ambulatory plan.
Typically, it falls to the hospital's senior finance executive to determine what to do with the additional real estate. In making such a determination, the finance leader will need to address two primary concerns: the appropriateness of the location and the question of whether to lease versus own.
Eliminating facilities that are undesirable, adding or expanding facilities in attractive locations, and reducing services that are redundant are all complicated considerations. However, the following process can help hospital finance executives work through the chief location issues.
Acknowledge the hospital's ambulatory plan is the driver rather than real estate assumed with the physician practices. The facilities and their location should fit the ambulatory plan rather than the ambulatory plan fit the real estate.
Review the hospital ambulatory service plan for each submarket. This step requires creating a service mix matrix that shows the services provided at each location within the primary and secondary service area, noting those facilities outside the organization's target markets. All existing and acquired practice locations should be included. Mapping these facilities will give the finance leader a good picture of the organization's network distribution before and after acquiring physician practices. Facilities outside the targeted service area should be closed as soon as feasible.
Review the location of facilities within the service area and their proximity to one another. Typically, combining facilities that provide similar services results in significant savings. Determine possible operating synergies from combining services into a single facility. Review existing contractual obligations and cultural issues and develop a plan to combine services. The ambulatory plan should be the driver rather than contractual obligations.
Decide how best to dispose of facilities that cannot be reconciled with the ambulatory plan. If an existing facility is not appropriate, it can be subleased or sold.
Ensure that each facility in the market is of an appropriate size and possesses characteristics that are consistent with the hospital's image. Such characteristics include ease of access and adequate parking. If existing facilities are not appropriate or if the hospital does not have a facility in a targeted market, the finance leader should call for a site search to be conducted to identify existing facilities to be acquired and land for development.
Following this analysis, the finance executive can begin assessing the financial implications of purchasing, developing, or leasing.
Lease Versus Own
The next key question that hospital executives need to answer is whether to lease or own the facilities deemed to fall within the organization's ambulatory service plan. For a time in the early 2000s, the healthcare industry witnessed a trend favoring third-party ownership. Today, however, hospitals are likely to find direct ownership to be the more attractive option. (See the sidebar below.)
In determining whether to lease or own a particular facility, finance leaders should consider the property characteristics from a strategic perspective-particularly location, percentage of hospital occupancy of the property, and timeframe for intended use of the property-and the potential financial benefits of ownership.
Locations. Strategic areas favoring ownership include locations on the hospital's campus, on the hospital's ambulatory campus, and in strategic submarkets where the possibilities of relocating the healthcare operation to other locations are limited.
The hospital's percentage occupancy of the property. If the property has a high percentage of occupancy, it is a candidate for ownership. The potential conflicts of interest in the relationship between the hospital as landlord and the physicians as tenants decline as hospital occupancy increases. Moreover, for a not-for-profit hospital, the potential for real estate tax exemptions increases as the percentage of the property occupied by the hospital increases.
Timeframe for use of the property. Ownership is typically favorable if the property will be needed for at least 10 years. Leasing is favorable for short periods or when the hospital may wish to relocate its operations to a different location. Typically, many of the smaller primary care physician offices are leased.
Financial benefits of ownership. Financial advisers use various methods to determine whether ownership is warranted. One simple method is to determine if the benefits (return) derived from ownership surpass the hospital hurdle rate for investments.
Ownership brings three major financial benefits:
- Reduced lease expenses-Rent is equal to the payments anticipated to be made to the landlord over the lease term. (Leases typically include escalation clauses that can cause rent payments to increase annually over the lease term.)
- Reduced or eliminated real estate taxes (for not-for-profits only)-As noted previously, an exemption for real estate taxes may be available if the hospital is a not-for-profit and owns the property.
- Capital appreciation-The hospital would benefit from the residual value of the property at the end of its hold period.
The net present value of the benefits should be divided by the acquisition cost (or development cost) to determine whether the return on the "ownership investment" exceeds the hurdle rate. Other factors that should be considered include the availability of funds and leverage.
Creating Operating Efficiencies
Many major U.S. health systems have become industry leaders in assuming greater ownership of facilities occupied by acquired physician practices. Banner Health, headquartered in Phoenix with 23 hospitals serving seven states, is one example. The health system has recently modified its lease-versus-own policy and now builds and owns medical office facilities.
Kip C. Edwards, vice president, development and construction for Banner Health, offers several reasons for his organization's approach:
"First, with the increase in employed physicians, we found that we were often leasing entire buildings. Second, changed accounting rules require us to capitalize leases so there is no balance sheet advantage to leasing. Finally, the life cycle cost of ownership is less than leasing, and we preserve the flexibility to change uses in the building easily as our needs change. Ownership is not an absolute, since we evaluate each situation, but it will remain a strong tendency as long as we can afford the capital expenditure."
In short, as hospitals acquire more physician practices and employ more physicians, their medical office buildings will be occupied by fewer independent physicians and a greater percentage of hospital-related programs. Ownership of such facilities can create an opportunity for a hospital that approaches this strategy in the context of its ambulatory service plan to create operating efficiencies by combining similar or complementary practices operating in the same market.
The hospital also can benefit from the synergy created by grouping practices and generating referrals across specialties. Hospitals continue to see the benefit of using third-party capital to finance the restructuring of their delivery networks, particularly off-campus facilities. Although change is always challenging, physician alignment strategies that maximize efficient and convenient access for patients with the right mix of services in the right locations may be one step in reengineering the delivery system.
Thomas A. Czerniak, CPA, is CEO, Healthcare Advisory Group, Chicago (firstname.lastname@example.org).
Recent Trends in Hospitals' Disposition of Acquired Real Estate
Before 1999, most hospitals owned their ambulatory and medical office buildings. At that time, there were two concerns in selling buildings: First, hospitals were concerned about relinquishing control to third parties over ownership, occupancy, use of the facilities by the third parties, and management and operation of the properties; and second, not-for-profit hospitals were concerned about the loss of the real estate tax exemption on hospital space occupied within the property.
Nonetheless, there were also advantages to selling properties:
- Hospitals could invest funds in additional hospital programs.
- Potential conflicts between the hospital/owner and the physician/tenant were eliminated.
- The balance sheet was enhanced. Until sale proceeds were needed for hospital programs, the funds could either be invested in securities or be used to reduce debt. Days cash on hand increased, property plant and equipment declined, and equity increased by the gain on the sale.
- Real estate was not the core business of the hospital, and the properties could benefit from professional management.
Starting in 1999, there was an increase in hospitals selling medical office buildings. Hospitals needed cash to fund hospital-related programs, and there were heightened concerns over potential Stark violations from hospital/landlord-physician/tenant transactions. By selling the buildings, retaining the land, and negotiating restrictive long-term ground leases, hospitals could restrict the ownership, use, and leasing of the properties and could influence the properties' operations. During the next 10 years, hospitals sold more than $5 billion in on-campus medical office buildings. In addition, scores of new on-campus medical office buildings were developed and owned by third-party developers on land retained by hospitals.
In recent years, however, the balance has again tipped toward ownership, with hospitals now likely to find direct ownership to be the more attractive option for a number of reasons:
- Most hospitals have access to capital at attractive interest rates.
- With employed physicians, the hospital-physician conflicts of interest do not exist.
- Credit rating agencies are capitalizing leases when analyzing credit risk.
- Because leasing to third parties is not necessary, maintenance and management of the medical office building may be more economically handled by hospital staff.
Practice Acquisitions Pose Real Estate Challenges for Hospitals
A recent Healthcare Advisory Group survey on physician alignment strategies and their impact on real estate found that 98 percent of hospitals have either employed physicians, acquired physician practices, or plan to in the future. Roughly 76 percent of the 68 respondents surveyed said they have already acquired primary care physician practices.
The acquisition of various specialist practices lagged behind at 22 percent. About 40 percent of respondents said they are more selective in the hiring of specialists, hiring only those specialists they believe are necessary for the hospital to remain competitive.
The majority of respondents indicate they plan to either relocate the acquired practices to hospital-owned space to reduce costs or combine acquired practices to obtain operating efficiencies. Hospitals are still cautious about making changes too quickly. Almost half the respondents plan to operate the property as is until they can determine what to do with the space. The survey also found that 63 percent of hospital executives now favor ownership of their on-campus ambulatory care facilities, but 23 percent opt for ownership of off-campus facilities.
Although third-party ownership of real estate acquired through a physician practice acquisition has declined for many hospitals, nearly half of the survey respondents reported that third-party ownership was still an important source for funding of hospital real estate needs, particularly for off-campus properties.
Among hospitals surveyed, credit rating was not associated with viewpoint on owning versus leasing. Direct lease costs range from 7.5 to 9.75 percent. And as the hospital and its owned physician practices occupy a higher percentage of the buildings, the potential for a real estate tax exemption becomes more significant. When considering that real estate tax exemptions are typically available only if the hospital both owns and occupies the space, the true lease cost may be from 9.5 percent to 11.75 percent for leases by not-for-profit hospitals. Irrespectively, the survey found that hospitals with strong credit ratings (and presumably, very low cost of capital) were still willing to consider third-party ownership for their off-campus medical properties.
Although only 40 percent of respondents indicated they believed leasing additional on-campus space was a viable option to meet their on-campus space needs, 72 percent said they would consider leasing to meet their off-campus space needs.
From a business perspective, there is little difference today between ownership of hospital facilities and ownership of on-campus ambulatory buildings. As the hospital acquires physician practices, it takes over control in operating medical office buildings. Operations of medical office buildings will continue as long as the hospital remains open. In addition to high leasing costs, third-party ownership of these buildings makes space renovation more difficult because the owner's approval is required. However, third-party ownership of off-campus buildings provides the hospital flexibility with its ambulatory network. If the property is no longer adequate, the hospital can move to a different facility at the end of the lease.
Hospitals still shy away from playing landlord to physicians. Because most hospitals are not employing all the physicians on their staff, the potential for conflicts of interest still exist. As such, 47 percent of the hospitals surveyed believe the relationship of hospital as landlord and physician as tenant remains as important a consideration favoring third-party ownership as it was in the past.
Finally, with the credit agencies including lease obligations as liabilities when underwriting hospital credit, balance sheet enhancement of leasing versus ownership is reduced. Nevertheless, 26 percent of hospitals indicated that their credit ratings still provide favorable treatment of leases.
Publication Date: Friday, June 01, 2012