By reallocating investment dollars from real estate to facility development and upgrades, health providers can build value while also reducing financial and administrative burdens.
Financing Facility Upgrades Through Real Estate Monetization
Selling and leasing back facilities can be a highly effective strategy for health systems seeking to fund facility improvements and upgrades.
Amid the healthcare industry’s ongoing changes in recent years, hospital and health system leaders have been compelled to reevaluate their business strategies to determine the extent that they might need to be reshaped to help their organizations gain or maintain a competitive advantage. The shift from volume- to value-based care and a new emphasis on consumer experience, for example, have altered hospitals’ and health systems’ perspective on real estate strategies, with the result that they are giving increasing priority to investments in facility changes and upgrades that provide enhanced comfort, enable state-of-the-art care, and expand outpatient capacity.
When hospital leaders want to make significant facility upgrades, however, they can find it challenging to come up with the capital necessary to complete all the items on their wish lists. Declining payments and rising operating expenses are constraining hospitals’ operating margins and ability to invest in capital projects. According to a 2017 report from Moody’s Investors Service, hospitals’ median operating margin fell from 3.4 percent in fiscal year 2015 to 2.7 percent in fiscal year 2016. In the same period, median operating cash flow declined from $76.4 million to $75.9 million.
These circumstances may require hospital leaders to think creatively about financing facility upgrades. RWJBarnabas Health, a large not-for-profit health system headquartered in West Orange, N.J., faced such a situation a few years ago as it was looking for ways to make facility improvements to its Clara Maass Medical Center campus.
Clara Maass Medical Center is a 472-bed hospital located in Belleville, N.J. Hospital leadership had been contemplating an overhaul of the facility’s intensive care unit (ICU) for some time. Built in 1956, the ICU was outdated—the space was too small, it lacked all-private rooms, and needed a comprehensive renovation and new equipment.
The hospital wanted to add a modernized, spacious front lobby, more medical office space, and renovate its existing group of three medical office buildings (MOBs) on campus. Although one building was relatively new, the other two were quite dated. And because MOB management was not a core part of the hospital’s business, leaders contemplated outsourcing this function to real estate professionals. Over time, that lack of investment in the MOBs threatened to become problematic for attracting new physician tenants and keeping existing physician groups satisfied.
Evaluating the Challenges
Recognizing the need to update the Clara Maass facilities to maintain its status as a destination for patients and top physicians, RWJBarnabas explored its options for a new lobby, ICU, and medical office space.
The solution was not readily apparent. Any newly constructed space for the ICU would need to be attached to the hospital, but its location on a tight urban campus with no obvious location for expansion made that problematic. RWJBarnabas considered 10 options, from adding new parking decks that would enable building on existing surface parking lots to demolishing existing campus buildings. It was decided that the best option was to build a four-story, 87,000-square-foot addition directly in front of the hospital’s main entrance.
In essence, the plan required demolishing the front of the hospital, replacing it with a new main entrance and reception area on the ground floor, adding two floors of medical office space, and topping it off on the fourth floor with a 27,000-square-foot, 32-bed ICU. Completing this project required rerouting the road leading to the main entrance and navigating a sharp change in grade on the site. Determining how best to connect the new building to the existing hospital posed another challenge, given that floor-height regulations had changed dramatically since the 1950s and each story of the new structure would be taller than those of the original hospital.
All told, the project was projected to cost about $60 million, without addressing renovation of the three existing MOBs.
To realize all its goals, RWJBarnabas employed a real estate strategy to “unlock” capital for funding the project by monetizing some of its real estate assets. Historically, hospitals and health systems like RWJBarnabas have owned all their real estate assets, including the hospital and outpatient delivery sites like surgery centers or medical office buildings. This approach not only involves a significant investment in bricks and mortar, but also ties up dollars in ongoing debt service, maintenance, and operations while diverting executive leaders’ time and attention toward noncore activities associated with property management.
Today the health system’s leaders are realizing there is an advantage to monetizing some of these real estate assets by selling noncore real estate to a third-party partner and then leasing back the office or facility space required for operations.
This strategy provides the following benefits, among others:
- It provides immediate capital for investments in mission-critical items, such as construction and renovation of core real estate assets (e.g., hospital inpatient/ambulatory spaces), IT and medical equipment, and mergers and acquisitions.
- It increases liquidity, which can enhance a hospital’s balance sheet and support an improved credit rating.
- It creates additional funds for strategic initiatives, such as physician recruitment and retention.
- It frees health system leaders from the burdens associated with real estate management and landlord/tenant relationships.
Designing the Solution
On the Clara Maass campus, RWJBarnabas decided to sell all three aging MOBs to its real estate partner. This strategy would enable the health system to get the new ICU and additional medical office space it desired without a significant capital outlay. In short, it could upgrade its MOB space, exit the property management business, and secure capital that could be deployed elsewhere.
Ultimately, RWJBarnabas secured $14.75 million from the sale of the three buildings and invested in the new 87,000-square-foot addition. The real estate developer assumed the risk for development of the construction project, which ultimately cost $24.6 million. It owns and is responsible for financing, leasing, and maintaining the new medical office space.
The issue of varying floor heights between the new and old structures was solved with a design that employed a split floor plan on the first and second floors. The design allowed the developer to connect the ground level and top-floor ICU to the existing hospital at grade with the two floors of medical space offset.
Further, to help attract physician tenants, equity ownership was offered to tenants interested in the new medical office space offered, and tenant improvement dollars were provided to build out the suites.
The real estate developer also invested nearly $3.6 million in renovations and upgrades to the three existing MOBs, including a major facelift on the exteriors and interiors, new HVAC, and modernization of elevators and other infrastructure.
Evaluating the Results
By monetizing its real estate assets and partnering with a real estate company on a creative design solution, RWJBarnabas was able to achieve all the items on its wish list without unnecessary expenditures. It opened a new ICU, gained a resource for recruiting more physicians to the campus through Class A medical office space, and was able to offer a modernized and more pleasing experience for patients and visitors entering the facility. Building the new hospital façade and entryway was a powerful way for Clara Maass to communicate to the community that it is thriving and it has been a morale booster for employees and physicians.
The health system’s leaders also were pleased to be relieved of the significant administrative and financial burdens of having to deal with construction, invest in infrastructure and the grounds, and maintain the MOBs.
Further, RWJBarnabas had capital left over from the sale of its MOBs and was able to reinvest it in Clara Maass. It purchased all-new equipment for the ICU and initiated a separate project to add four new operating rooms to accommodate increasing surgical patient volumes. In effect, its real estate solution to the ICU/MOB challenge enabled it to invest in revenue-producing services that deliver a return, rather than tying up capital in building construction and maintenance.
Today the new medical office space is 100 percent leased, and three existing MOBs have experienced rising occupancy and lease durations, with the average lease term increasing by about 1.5 years. The result has been a thriving community of physician practices that continues to bring added value to the hospital.
Altogether, RWJBarnabas considers its Clara Maass real estate strategy a resounding success for the hospital and the health system. The project has opened the door for further evaluation and discussion about other innovative real estate and development projects that can help the health system best serve its patients across the state of New Jersey.
Thomas Biga is president of RWJBarnabas Health’s Hospital Division, West Orange, N.J.