Healthcare finance professionals are accustomed to constant uncertainty and a general lack of control over policies that affect our business model.
The volatility these professionals contend with today can be mitigated by a willingness to adjust to changing conditions coupled with a certain rigor around assessing the affordability of investment: The need to remain nimble, creative, and responsive to a changing industry remains as true as ever.
Such unpredictability also affects healthcare capital planning, which can face contrary conditions, such as the coexistence of favorable interest rates and unfavorable construction costs. Planning for and obtaining capital requires making informed decisions based on what we know at the time. Capital finance planners can mitigate today’s volatility by remaining both willing to adjust to changing conditions and committed to rigorously assessing the affordability of investments. The undisputable constant is the continued need for healthcare capital investment to provide cost-effective, high-quality care for an aging population.
After a significant post-credit-crisis slowdown in construction, the urgency in healthcare facility investments is resurging. Many hospitals have taken advantage of all-time-low interest rates, as evidenced the record issuance of $418.9 billion in municipal debt through November 2016 compared with $294.7 billion in all of 2012. a However, the low interest was partially offset by an increase in construction costs, as contractors and architects still needed to add labor after the earlier downsizing and increasing construction across many industries led to a backlog for steel, dry wall, and other essential building materials. The 2016 Turner Building Cost Index, which measures costs in the nonresidential building construction market in the United States, has increased to a value of 995 from a low of 799 in 2010, and costs are predicted to continue rising. b
The future of the healthcare business model is uncertain. Interest rates are rising, and so are construction costs. Yet we know the need for capital investment in healthcare facilities, equipment, or services for an aging demographic will increase. Putting off such needed investments will only exacerbate problems and increase costs.
So how can healthcare finance planners move ahead with confidence while remaining fiscally responsible? Dust off some familiar tools and remain nimble and bold.
It is best to begin the capital planning process with a maximum amount of borrowing based on a worst-case scenario to keep the project scope in check. This approach ensures that if unexpected spikes in interest rates or significant changes to Medicare payment occur, the project can still move forward. Such contingency planning is particularly important in the early stages for a project after the capital need is identified but before the details are determined.
Financial performance always should be projected over the subsequent five years, and a financial model should be used that allows for sensitivities on interest rate, revenues, construction costs, and the resulting impact on financial ratios used in underwriting. The five-year horizon provides a perspective on the speed with which the financial ratios change based on drivers of performance not under the organization’s control. The sensitivities help quantify the magnitude of change that must occur before the impact of such change becomes a concern. Financial modeling won’t change the circumstances but should help define the amount of risk associated with a particular capital investment.
It’s also best to pursue multiple financing options concurrently to increase flexibility as the capital project is refined. This approach can include considering variable rate debt instruments mixed with long-term fixed rate debt. Alternatively, it could include the use of different financing vehicles, such as the U.S. Department of Housing and Urban Development’s 242 mortgage insurance program for hospitals, the U.S. Department of Agriculture’s Community Facilities Loan Program, or a traditional tax-exempt bond issue. However, duplicate application and diligence requirements under this strategy can cost more time from the borrower, carry higher legal fees, and potentially require concurrent coordination with different underwriters or lenders. The benefit of this approach is that it keeps options open if market conditions change unexpectedly.
Attention should be paid to nuances in financial planning. Meaningful effort is required to evaluate options for minimizing capitalized interest, using cash or debt to fund a project, and investing bond proceeds. Planners should consider the proper amount of internal cash to use to fund construction—and what ROI they otherwise would gain from it—before issuing debt. If the difference between short- and long-term interest rates continues to widen, then options for minimizing capitalized interest can include construction loans, which allow for a drawdown of project funds as needed, or bond anticipation notes. When considering these options, the real and indirect (i.e., opportunity) costs associated with an additional financing also should be part of the evaluation.
Even if a capital project is not on the near-term horizon, planners should make sure they have an up-to-date debt map. Creating a simple spread sheet with all the organization’s debt, including annual amortization schedule, and flags for interest rate reset dates provides a visual for managing the organization’s debt portfolio. Given that bank placements dominated capital financing over the past five years and many such instrument are likely approaching an interest reset date, the debt map is an effective tool for early planning.
Capital planning for health care requires considerable effort and a resolve to change with market conditions. Good decisions are based on understanding risk and preparing for the shifts in the business model. That said, financial planning professionals should embrace the challenge of working in an industry that ultimately is essential to our society and our economy.
Kelly Arduino is a partner at Wipfli, LLP, and a member of the Great Lakes Chapter of HFMA.
a. Securities Industry and Financial Markets Association (SIFMA), US Bond Market Issuance Monthly, Dec. 22, 2016.
b. The Turner Building Cost Index is determined by several factors considered on a nationwide basis: labor rates and productivity, material prices, and the competitive condition of the marketplace.