Revisit Healthcare Real Estate

II:5 June 12, 2023

Many who look closely at the economy believe a crash is likely shortly in commercial real estate. Hybrid offices and record-low occupancies make for a perfect storm. Old low-cost loans are coming to maturity and will have to be financed at rates that will be many times more expensive than the original financing. Add to that the observation that healthcare has generally not done real estate well and it becomes prudent to revisit this topic.

What Business Are We In?

As a strategist, I am always interested in how clients approach their business. In healthcare, the fundamental question of, “What business are you in?” has gotten more complicated over time. This is generally regarded as the first of four fundamental questions that drive a strategic planning process.[1]

Historically, most hospitals were started as a “charity” back in the day. This designation as charity started as a tax-related description but has since come to mean more. The connotations evoked reflect the requirement to receive donations. Services provided by these organizations had the requirement to raise funds. Without funds, many of these needed services would cease to exist. Many of the services labeled charity simply were unable to pay for themselves otherwise. This was certainly true of many healthcare services, given the quirky nature of hospital payment systems. Over time, hospital services have expanded considerably their scope and reach, much of which is dependent upon major donations that cover startup costs. Over time, there are fewer and fewer service offerings in a hospital that actually generate a profit. For many hospitals, the medical component is a financial loser in comparison to surgical and other procedural services (a topic for a future article).

The Catholic Church, in particular, and other denominations were often involved in founding early hospitals, some in locations that otherwise were inaccessible and not attractive from a business standpoint. But then, churches are in the charity business. In this way, healthcare was thrown in with Goodwill, Veteran’s groups, The Salvation Army, and many other worthwhile causes. Anyone who has spent time with a not-for-profit (NFP) organization knows that in addition to maintaining close relations with donors and foundations, NFPs are also required to operate as a business. Oversimplified, this means that the spending is limited by the funds that are generated, regardless of sources. Initially, many charities operated on a hand-to-mouth basis with no vision for reserves. Over time, things have become more sophisticated with endowments[2] and other instruments of charitable giving.

In healthcare, this adds up to a revenue stream that involves a confusing mix of activity-based payments, fundraising, value-based payments, and other related activities that provide the necessary funds to provide for the needs of a community served by the enterprise. What has also come to pass is a more complicated mix of assets that have been assembled[3] to better compete in a marketplace that requires broad distribution instead of the old model of making the patient come to the hospital campus. “Build it and they will come” has long been eliminated as a viable strategy in healthcare. Unfortunately, this menagerie of assets tends to have been cobbled together without much thought given to functionality or the impact on brand. Unnecessary duplication of services (overlap) and suboptimal mix of services tends to run rampant in most community health systems.

As distribution has become far more important (access), we have seen an imperative to support a brand that attempts to meet customers “where they are.” This can include at home (including virtual), work, and (increasingly) where they shop (retail). And the consumer has choices in this more complicated market. When you factor in all of this, it becomes undeniable that healthcare organizations are also in the real estate business.[4]

For some, this is nothing new, as Kaiser has long been the largest single owner of real estate in California[5]. “Kaiser keeps growing the value of its owned real estate, particularly by building new hospitals and medical office buildings,” says Revista Principal Mike Hargrave.[6] Given the challenging economic times, being in the real estate business today raises serious concerns. Healthcare has generally not done real estate well.

Asset Management

The provision of certain healthcare services requires expensive equipment and buildings. Real estate focuses on buildings, which make up a remarkable part of the balance sheet assets of most healthcare organizations. What follows in an attempt to simplify what can be a complicated discussion regarding the capital markets and the general strategy of lease versus buy when it comes to these assets. In this simplification, there are two general concerns about maintaining such assets: operational and financial.

???????????Operational Concerns

This relates to the functional capacities of the asset. On-campus versus off-campus continues to be an important issue, with off-campus locations becoming more and more important. I have spoken elsewhere of the tremendous variation in such assets devoted to healthcare. Such assets are undergoing a transition where they are increasingly being dedicated to healthcare only and located in retail zones. The days of multi-tenant buildings are disappearing, though multi-use is still in play.

Key drivers of operations are adjacency and flow. Technologies are increasingly co-located such that “one-stop care” is possible; this has become the golden rule for operational healthcare delivery in the future. Many if not most existing hospital-related assets do not offer a one-stop care solution, especially off-campus assets. A key play today is a roll-up of smaller, less efficient spaces into more integrated and better-located buildings that meet the need to be user-friendly and inviting. It is remarkable how slow some hospitals have been in upgrading less attractive real estate that no longer meets current requirements. A critical mistake that I see made by many health systems is to retain underperforming real estate that has become a drag on the brand by being allowed to linger well past its useful life.

???????????Financial Concerns

The second important consideration is financial. Few organizations can afford to own all their required real estate. Leasing used to be the dominant form of securing such space. But long-anticipated changes to accounting rules that previously allowed some leases to remain off the balance sheet are now requiring all leases to be capitalized. As a result, it has become even more important to control the real estate used by healthcare organizations with a clear recognition that leasing and ownership are not that much different, at least from a balance sheet perspective. However, there is considerable variation in these approaches at this particular time when cash is paramount.

Transactions

Healthcare is complicated enough without being subjected to the whims of a volatile real estate market. “Make or buy” has long been part of the arsenal of a strategist. At the heart of such analyses is the ability to control the use of the asset. Not all assets are strategic. But those that are strategic require even more careful analyses, similar to what might be undertaken by a typical retail purveyor.

Healthcare is local is a favorite saying for many. I believe it is becoming more regional, however. Regardless, it has been hard to break old habits in healthcare. One of these old habits is how we approach real estate. Here is a partial listing of what is wrong with the traditional approach:

·??????Short-term orientation. Too much emphasis on expediency and pursuit of opportunistic transactions rather than planned transactions with longer-term considerations. The result is incurring unnecessary costs to “take advantage” of an opportunity. This is the classic developer-driven model that injects developer fees and higher developer-based interest rates into the mix (i.e., developer as landlord).

·??????No distinction for strategic potential. How does a particular developer-driven transaction compete with alternatives? Too often, the opportunity is allowed to take over and no other options are considered. The sales pitch of talented developers is often allowed to supersede more structured thinking. While I am not trying to throw developers under the bus, I have seen far too many deals that have involved higher rates of financing that are avoidable.

·??????Transactions treated as “one-offs.”?Too often I encounter clients that say that numerous transactions were considered one-time only or as one-offs. However, this characterization is inaccurate after it has been repeated numerous times. I often heard the statement, “We would never do this again.” Only to be followed by yet another similar transaction.

·??????The inheritance problem. In the zeal to compete for acquiring physician practices, such acquisitions often involved “baggage.” Key among this baggage is poorly designed and located medical office buildings. The old scale of solo and small practices were housed in these older buildings that are simply obsolete in today’s one-stop care market.

·??????Lack of innovation. Often the inherited inventory involved so much maintenance that there was a reluctance to add to the inventory and/or attempt any innovation. “Don’t buck the system.”

Key Drivers for Future Real Estate Transactions

I have long been suspicious when people who volunteer on boards of nonprofit organizations seem to do so as a means to grow their business.[7] While working to benefit the host NFP organization is certainly commendable, interfering with normal commercial practices can raise concerns. This has certainly been true of healthcare real estate in the past where developers have joined hospital boards only to secure a key transaction. Rest assured; this is not just a theoretical construct.

The key drivers for future real estate are rather straightforward:

·??????Location remains critical.?Location, location, location may well continue to be critical.[8] But, unlike in the past, healthcare must now become an integral component of retail zones. Visibility is critical. Mall space is more inviting than ever before.

·??????Multifunctional use. The single-use focus that dominated the past (e.g., imaging centers) has given way to one-stop care. Co-location of critical services now makes convenience a key driver in the selection process. ?

·??????Branded. Whereas multitenant space was the rule in the past with no names on buildings, this has given way to the belated emphasis on branding in healthcare. The past excuse that many buildings that were maintained by healthcare organizations were not worthy of carrying their name must give way to visible real estate in prime locations if the organization is to grow. Unwanted real estate that detracts from the brand must be replaced with better-designed and located facilities.

·??????Minimize operating costs. While those selling or leasing real estate often espouse low operating costs, this seems to rarely be delivered. A key issue is compared to what? All too often, decisions are made based on politics or other irrelevant variables instead of going with a lower-cost option that, among other things, leverages the tax-exempt status of the lessee. Property taxes that can be eliminated in most states for such organizations are rarely dealt with in such transactions. This can amount to millions of dollars of unnecessary expenses over the term of a typical commercial lease (as you will see shortly).

·??????Distinction between temporary space and strategic space. Not all real estate is the same, nor should it be treated as such. Sometimes it is necessary to establish a position in a key location that, while not optimal, can lead to something better. Recognizing which space has long-term implications versus other space that does not is extremely important. I have seen far too many long-term leases signed for space that was never optimal for such occupancy.

·??????Control is the key. Americans tend to have a preference for ownership, even when it is contra-indicated. The key in most healthcare transactions is control, not ownership. Can you exercise some control over who else may occupy space in the same building? Can you have some control over future expansion? These are among the control items that matter.

·??????A path to ownership. Too often, money is left on the table in such transactions. Healthcare organizations often end up paying multiple times the value of a property through ill-conceived transactions. Any property that has strategic value should have an identifiable path to ownership, even though ownership may not be required initially. Some more recent innovations have made this more possible that ever before, as discussed shortly.

One other item is worth discussing. Real estate, similar to materials management, represents markets that are susceptible to corruption. Materials management has been improved through greater transparency and collaboration across divisions. Real estate in healthcare too often seems to operate in isolation (usually as part of finance) with some back-office attributes. This should change as bad deals are rampant. Real estate now represents too much of the balance sheet to be left on its own. A high-value real estate portfolio requires integration across divisions and aggressive oversight to be done right.

Innovation Is Required

As things have become more challenging in healthcare real estate, it has opened the door to new innovations, including hybrid office practices. At the same time, the rules have also changed to favor the consumer. The healthcare experience is being emphasized with a growing recognition that poor building design adversely affects the ability to offer a favorable experience. It has never been easy to convert commercial space to healthcare use. Important improvements have been made in the delivery of one-stop care. I am one of the original proponents of off campus ambulatory care (distributed) becoming the new core business of hospitals. Sometimes such improvements can be as simple as providing an overhang at the point of delivery at a building (for inclement weather). Or it can be a bit more complicated such as adjacency of certain complementary clinical services. There is no question but that retail rules have begun to permeate all aspects of healthcare real estate-- from location, to design, to asset management.

The Charitable Foundation Model (CF)

Over the years, I have taken pains to introduce particularly exciting innovations to my clients when I find them. One of the important new innovations in healthcare real estate involves differentiating landlords and related motivations. Most commercial real estate understandably is organized for the benefit of the landlord who is interested in maximizing their return on investment. Where the landlord is also the developer this can compound the payments above what other options might be available in the market. A particularly important new innovation worth noting is the charitable foundation model (CF). While this has been in use for some time in the not-for-profit educational space, it is relatively new in its application to healthcare.

As a rule, charitable foundations support other charitable organizations. They effectively have a “donative intent charter.” This means that their business model is designed to reduce the cost of either leasing and/or potential ownership for other charitable organizations. Return on investment for such organizations has a different look and feel from more traditional models. The lower cost of debt helps the non-profit organization (client) to lower its operating costs and achieve ownership at the end of a lease represents a tangible return for such foundations. In comparison to other traditional structures available in the market, the CF approach can involve a reduction in the cost of millions of dollars to the client.

There are three boxes that can be checked off under a CF model: ownership, occupancy, and use.?I have long advised ownership of core assets (strategic assets) or, at a minimum, control by the healthcare organization. Again, not all assets are strategic nor does ownership have to be accomplished at the present time if it can be more cheaply secured over time. At this time of financial stress, it is important to minimize the impact of ownership or a lease on the balance sheet. Healthcare organizations are reluctant to tie up their capital where they can secure an asset while minimizing the impact on their debt capacity. The CF can access taxable or tax-exempt debt under a variety of structures depending on the use of the asset. Where the majority use of the asset is operated by the healthcare organization (i.e., operates as the anchor tenant) for a charitable purpose (healthcare services), ownership can shift deed-free to the healthcare organization at the end of the term. [9]

The CF approach involves considerable flexibility. Occupancy relates to who is in the space. The tax-exempt entity must occupy most of the space (or sublease to another tax-exempt entity) in order to qualify for tax-exempt bonds (and potentially avoid unnecessary taxes). Not only is it possible to access tax-exempt bonds issued by the foundation or other entity (thus not impacting the health organization’s debt capacity), but amortization can be customized to address the specific interests of the lessee (e.g., lowest operating costs, shortest time to ownership, etc.). One particular benefit that is quite popular is delivering the asset over a shorter term (e.g., 20 years) versus a typical commercial lease (i.e., 30 years). Creative options can even include an “interest only” lease where the lessee has three options at the end: buy the asset for a predetermined price, renew the lease for another term, or terminate the lease and walk away (with a “walkaway clause”). Unlike most landlords, the foundation is not generally interested in owning the asset, but rather in delivering a service that supports the charitable mission of the lessee.

The final box is use. Not all activities of a healthcare organization constitute a charitable purpose. For example, use is not charitable if the space is leased to a taxable physician group, gym, pharmacy, or imaging center. Using the building to support the charitable mission of the NFP hospital is what allows the?potential elimination of taxes.

When transactions are structured under a CF model, there is the comfort that the landlord has aims similar to the healthcare organization that is leasing the space. Firms that offer this service can involve fee-only developers and deliver various models that are flexible. It can involve financing only and/or turnkey development of the project. Healthcare organizations range widely regarding specific in-house skills they may possess. Through flexibility offered by the charitable foundation model, a hospital can provide any and all services in the mix to the extent that they are comfortable and experienced with certain roles instead of outsourcing the entire process, at a higher cost.

This model not only applies to new buildings and space but can be applied to assets that are currently owned by a healthcare organization. Sale-leaseback has long been a recognized strategy in healthcare. ?It can also allow for a buyback of an asset from a developer/landlord (tends to be the most expensive because of the higher interest rate involved). Adding the CF model into the mix makes it possible to monetize an existing asset at a time when cash is at a premium while not giving up total control. The balance sheet implications, while important, are augmented by P&L operations improvement with lower operating costs (through lowest-cost debt financing) thus enabling the application of scarce resources into other activities more appropriate for future growth. Many healthcare organizations are struggling today to identify the aspirational capital that is required to implement future strategies. A traditional approach is to finance a building with a CTL (credit tenant lease). These devices are very profitable to the lenders and expensive for the tenant who is paying a high-interest rate (as the lessee) that adversely affects their credit rating. Using a charitable foundation model can yield significant benefits at this critical point in time when the commercial real estate market is likely to experience significant disruption. Timely evaluation of an existing real estate portfolio with this in mind can represent significant financial benefits.

Please feel free to contact me if you would like more information on this innovative approach to healthcare real estate. [email protected]

[1] The others are: Who are your customers? What do they want? How are you going to give it to them?

[2] Particularly important to educational institutions.

[3] Property, plant, and equipment to name a few.

[4] See an earlier newsletter Location, Location, Location | LinkedIn

[5] It is noted that Kaiser includes an insurance component.

[6] As reported by John B. Mumford Feature Story: Kaiser remains on a roll (for real estate ownership) (wolfmediausa.com) January 19, 2021

[7] Most organizations that I have worked with are rather lax about conflicts of interest among board members.

[8] See one of my original newsletters Location, Location, Location | LinkedIn

[9] Commonly referred to as reversion.