Healthcare providers are showing renewed enthusiasm for planning facility projects, having set aside anxiety about the future of healthcare reform or a negative impact from the Tax Act on tax-exempt borrowing. Yet recently rekindled facility plans are facing a new obstacle: The rising cost of capital.
Although there is a will to move ahead, the way could be difficult. For several years, there have been cautionary statements about expected increases in cost of capital. We now are in an environment of both rising interest rates relative to historic lows and rising construction costs.
Interest rates today are up significantly. Assume they will continue to increase. Total interest costs are determined by a combination of factors, but they generally are determined by market conditions and the credit strength of the borrower. Market conditions are constantly changing, but some general trends have emerged.
The indexes have increased
The basis of interest rate cost is an index, which provides a floor or the very least amount that an entity would be charged. For healthcare borrowers, common indexes are U.S. treasury rates and the Municipal Market Data (MMD) index for tax-exempt bonds. Both have increased significantly in the past year and are at their highest levels since 2011. These indexes don’t exactly track the Federal Funds Rate, but they do follow it. That rate was increased four times in 2018, although no more increases are expected in 2019.
The yield curve has flattened
The yield curve is investor shorthand referencing the shape of a graph on interest rates by term of the debt. The traditional yield curve shape is a diagonal line indicating that interest rates for a one-year bond are less expensive than for a 30-year bond because of the latter’s longer risk period (i.e., something unexpected and potentially bad could happen to prevent repayment of the debt). From a year ago, the rate for 1-year MMD increased about 1%, whereas the 30-year MMD increased about 0.5%, which means, in yield-curve lingo, the angle has decreased.
Credit spreads are unchanged
Credit spreads, or the additional charge for the risk associated with a specific borrower, are determined by both the financial strength/qualitative assessment of the healthcare borrower and investor demand. Credit spreads have remained relatively “flat” based on the belief that strong demand, which keeps them lower, will outweigh any requirement for an additional interest charged because of credit risk. Building a facility is much more costly today than even in 2018, and those costs will continue to increase.
Construction costs are way up and rising
The construction market has its own indexes, including the Turner Building Cost Index, which measures costs in the non-residential building construction market in the United States. That index increased 5.63% from the second quarter of 2017 to the second quarter of 2018. There have been not only fluctuations in pricing on 71% of the line items in a construction budget, but also price increases for items like concrete, steel and lumber (31%, 29% and 26%, respectively).a Although there are always geographic differences, planning firms have been using project cost escalation assumptions of 4% to 6%. Notably, these indexes have not yet incorporated the effects on demand from recent natural disasters and the full impact of tariffs.
A labor shortage is reducing bids and raising contingencies
In some areas of the country, contractors are not submitting bids for projects. In rural areas, which may be difficult to access or lack housing and other amenities, there has been a move toward negotiated prices with select contractors. Even in these situations, contingencies to provide cushions for unknown developments tend to be larger than one would expect.
Communication is key
Often, healthcare entities’ organizational structures split the facility planning team that communicates with architects and medical planning consultants between the design and construction team and the finance team, led by the CFO. Both large and small organizations can have a disconnect between the pent up needs for facilities and capital investment and the reality of what is affordable, especially for large-scale projects such as replacement hospitals. Just as finance people are not always attuned to the cost of construction, design and construction teams do not always know the cost of capital and whether the organization can afford an additional $10 million in construction costs. Even less commonly understood in the budgeting process are the financing costs and capitalized interest (i.e., the interest borrowed up front that accrues during construction). These costs add significantly to the overall project costs but often are not estimated or included in the construction budget.
Implications for projects
Consider cost differences for a $100 million project, as shown in the exhibit below. For simplicity, let’s assume that $100 million includes all costs, with financing fees, and that the project is planned for a year ahead, with a 6% increase in construction costs and 0.5% increase in 30-year debt from 4.25% to 4.75%. Then, let’s consider what happens if the project lasts two years, adding another 6% for construction and another 0.5% to increase the interest rate to 5.5%. These higher cost construction and capital costs make the estimated overall cost of completing the project about 14% greater than the cost of completing the project today. Meanwhile, the annual debt payment also would increase by $1.4 million, or 22%, per year.
From this scenario, we can glean the following takeaways:
- When planning, use generous projections of the costs of borrowing and the costs of construction. Don’t plan a project that can succeed only if there is no change in key assumptions, especially if it’s more than one year in the future.
- Think twice about borrowing short term or using interest rates that reset, because the future interest rate, even if it is another short-term rate, may be higher than the current long-term rate.
- Ensure that your facility planning staff and consultants are very aware of the organization’s financial limitations. Consider developing a high-level maximum spending level for planning which does not incorporate financing fees.
a. Gordian, Building Construction Costs, RSMeans data, 2018.