FHA section 242. The FHA program. Primary Drivers for FHA Section 242 Financing. Crunching the Numbers. What is FHA Hospital Mortgage Insurance?

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2 The FHA program FHA section 242 Found Money: How a 1968 FHA Program is Financing Today s Healthcare Facilities Stephen R. Pack, President Armadale Capital Inc. Rolf Haarstad, AIA, LEED AP, Principal Hord Coplan Macht, Inc. Today s credit crisis has put traditional financing out of reach for many businesses. For a healthcare facility looking to borrow tens or hundreds of millions of dollars, it can be virtually impossible to obtain a conventional bank loan or secure credit enhancement for a fixed-rate bond financing. And while there are other options including variable rate demand notes backed by bank letters of credit, these present additional risks including fluctuating interest rates, letter of credit renewal concerns and the possibility of a bank rating downgrade. Bond investors are also demanding a substantial yield premium for uninsured healthcare debt. Yet many aging hospitals cannot afford to wait for a better economic climate to make much needed renovations and upgrades. In many cases, hospitals need to replace their facilities to provide adequate care, which involves substantial new debt expenses but the same revenue base. In light of this, many healthcare facilities are turning to a previously littleknown, government-backed form of financing: FHA hospital mortgage insurance. What is FHA Hospital Mortgage Insurance? Known to lenders as the FHA Section 242 program after the section of the National Housing Act under which it was created, FHA has supported the development of hundreds of communities across America by insuring 358 hospital mortgages totaling $13.5 billion since its inception in Clients range from small rural facilities to some of the nation s top urban teaching hospitals. According to the FHA Web site, hospitals in all 50 states plus U.S. territories have benefited from loans ranging from $5 million up to nearly $800 million. Administered by the HUD Office of Insured Health Care Facilities (OIH- CF) in Washington, D.C., the program has supported a wide variety of healthcare facilities over the years including acute care hospitals; critical access hospitals; large urban teaching hospitals; hospitals in systems; for-profit, not-for-profit and publicly-owned hospitals. Healthcare facilities can tap FHA-insured loans for a variety of funding needs such as remodeling, expansion, modernization, equipment and even refinancing (up to 80% of the FHA loan can be used for refinancing). Once an FHA loan is executed, a hospital has numerous ways to secure additional FHA approvals for future capital projects and refinancing as market conditions change. Crunching the Numbers The Section 242 program offers attractive loan terms, including no maximum loan amount, a loan-to-value of up to 90% (the 10% equity can be satisfied with cash or real estate), and a loan term of 25 years post-construction. Upfront fees are.80% of loan amount while ongoing insurance premiums are.50% of the declining loan amount per annum. Funding comes from a variety of sources, most commonly from the proceeds of tax-exempt revenue bonds (FHA-insured mortgage bonds) collateralized by payments on and the FHA insurance of the 242 Loan. This collateral structure allows FHA Insured Mortgage Bonds to be rated on the basis of the FHA s creditworthiness rather than that of the hospital, typically resulting in an AA to AAA credit rating which can mean lower interest rates and more spending power for your healthcare facility. A Section 242 loan may also be funded taxably through the sale of federally guaranteed Ginnie Mae Mortgage-Backed Securities. In the event of a 242 Loan default and a resulting insurance claim, FHA will pay benefits equal to 99 percent of the outstanding principal balance of the mortgage loan, plus accrued interest from the date of default. Unlike traditional financing, FHA loans allow for Primary Drivers for FHA Section 242 Financing Most hospital executives that utilize the FHA hospital program cite one or more of the following reasons for pursuing this financing alternative: Δ Δ Maximum Debt Capacity. In one case, a BBBrated hospital had no additional debt capacity under the BBB scenario but, everything else being the same, had over $200 million in debt capacity under the FHA scenario. This is reflective of FHA s more lenient underwriting criteria. Δ Δ Cost-Effectiveness. Despite higher upfront fees, FHA financing can often produce the lowest overall cost of capital due to higher bond ratings. Δ Δ Debt Covenants. Historically, FHA debt covenants have been the most conservative but given what has happened in the healthcare capital markets since the 1990s, they are typically deemed acceptable by hospital management. Δ Δ Future Access to Capital. Because a hospital can borrow more under FHA than under other financing alternatives, hospital executives see the FHA underwriting criteria as maximizing their hospital s access to capital for future projects. If the hospital s credit profile improves in the future and market conditions allow, the hospital WHERE YOU CAN LEARN MORE ABOUT FHA SECTION 242 Additional information on the Section 242 program including a Pre-Application Guide, Applicant s Guide and Applications is available by visiting the FHA/HUD Web site at and clicking on Healthcare Facilities in the left-hand column. Additional information on the Western Maryland Health System project is available on the Hord Coplan Macht Web site at com. Also visit the Armadale Capital website at With appropriate financial, architectural and construction advice in hand, only your team can make the decision about whether FHA Section 242 mortgage insurance is right for your healthcare facility, but one thing is certain: in today s uncertain economy, it s worth exploring every option, even one that dates back 40 years. design-build contracting on projects less than can refinance into another financing vehicle at $30 million in value. the appropriate time. 2 3

3 FHA section 242 program FHA section 242 financing Navigating the System HOW TO GET STARTED Recently, the FHA has implemented improvements to its Section 242 program application process designed to make it more user-friendly. While the Source: FHA Program Web Site According to the FHA, the program process consists of the following steps: FHA Section 242 Program Criteria FHA Section and 242 Conditions Program Criteria and Conditions HUD s OIHCF evaluates applicants to the 242 program against a set of program criteria. Primary requirements include: FHA clearly outlines the process and even offers an Applicant s Guide to assist in filling out the program application, there are a number of additional key issues that should be addressed early on by a healthcare facility considering applying for Section 242 mortgage insurance. First and foremost, it is critical to assemble a team familiar with program requirements to A self-assessment to ensure that your facility and specific project are eligible for FHA-insured financing. Lender selection. The FHA also maintains a list of active healthcare industry lenders if you need assistance locating one. A preliminary review similar to the selfassessment but conducted for free by the FHA to ensure basic eligibility criteria are met. The project must demonstrate a clear community need and financial feasibility under conservative assumptions. The facility must be an acute care hospital with no more than 50% of patient days attributable to chronic convalescence and rest, drug and alcoholic, epileptic, nervous and mental, mental deficiency, and tuberculosis. (This restriction does not apply to Critical Access Hospitals.) A Certificate of Need must be issued or pending in states with a CON process. The FHA-insured lender must be granted a first mortgage on the entire hospital, including property, plant, equipment, and receivables. Once construction is completed, monthly payments must be made into a restricted Mortgage Reserve Fund that will build to a balance equal to two years of debt service after ten years. Over the past three full fiscal years, the hospital s average operating margin must have been equal to or greater than 0.00 and the average debt service coverage ratio equal to or greater than The project must not have environmental issues such as soil contamination, wetlands issues or endangered species. For start-up facilities, additional considerations apply and the project must: Have in place a management team experienced in starting new hospitals Develop a detailed plan for the absorption period; and Most importantly, have sufficient working capital at closing as determined by OIHCF until one to two years successfully navigate the intricacies of the 242 process in a timely manner. Having an experienced financing, architectural and construction team familiar with FHA hospital financings can save millions of dollars in project costs and management time. In addition to an FHA mortgage banker or consultant, it s important to identify and engage the services of an architect, project manager, construction manager and CON consultant (if applicable), ideally who are familiar with Section 242 requirements in addition to healthcare construction. FHA processing times have improved dramatically since the 1990 s and today FHA approvals typically are issued in under 120 days, and in some cases as quickly as 60 days. (FHA does allow, subject to its approval, hospitals to commence work ahead of the FHA financing with their own funds and at their own risk.) 4. A pre-application meeting with the lender and hospital representatives at FHA headquarters to identify and discuss eligibility or underwriting issues. 5. Preparation and submission of the actual application. 6. Once the application is complete, a client service team composed of FHA staff members conducts the underwriting process. 7. Assuming all FHA criteria are met and the application is approved, the FHA issues a commitment for mortgage insurance. 8. Following commitment, FHA counsel assists the mortgage lender, hospital and their legal representatives to close the loan. 9. During construction, HUD staff members monitor and approve loan draws and perform monthly site visits. 10. Once construction is completed and the final draw has been made, the final mortgage amount is established and amortization begins. 4 5

4 Case Study Western Maryland Health System (WHMS) A NEW REPLACEMENT HOSPITAL Cumberland, MD Bond Financing: $348,650,000 tax-exempt / $2,180,000 taxable FHA Insured Mortgage Revenue Bonds Series 2006 Project Background WMHS was formed in 1996 with the affiliation of Memorial Hospital, Cumberland, circa 1888, and Sacred Heart Hospital (now Braddock Hospital), circa Both hospitals had a long, distinguished history of providing care to the community and agreed they could do more to enhance those services by working together cooperatively. WMHS developed Specialty Centers as part of the merger to centralize certain services on each campus. A master plan was developed to begin planning for the new specialty centers and the associated ancillary growth. Hord Coplan Macht, an architecture firm specializing in healthcare design, was hired by WMHS in 2000 to take over that project and complete the multi-campus master plan. During the course of that work, it became apparent that the initial assessments of existing infrastructure capacity were overly optimistic. It was determined that the amount of money needed to simply bring the systems up to date, much less support new additions and renovations, would be cost-prohibitive and not the best use of the system s resources. The WMHS Board of Directors halted all work in late 2002 and enlisted the new architectural team, led by Rolf Haarstad of Hord Coplan Macht, to help put them back on track. Financing Once it became clear the hospital would not achieve its desired bond rating for the proposed financing, WMHS engaged Stephen Pack (through his previous banking firm) to analyze the FHA insurance alternative against other alternatives. The FHA alternative proved to be the most cost-effective and also positioned WMHS optimally for future access to capital. Mr. Pack then led WMHS through the FHA application and bond financing process which involved: Assembling and filing all FHA applications Negotiating debt covenants with OIHCF Securing FHA and CON approvals and minimizing the cash equity contribution to the project by leveraging off of existing real estate Utilizing an appraisal of one of the WMHS facilities to help meet loan to value requirements Assisting WMHS with the divestiture of one of its member companies Minimizing the amount of debt issued on a taxable basis (due to tax law constraints relating to refinancing of existing debt) and minimizing its interest cost Leading the bond working group and securing all bond issuer approvals Proposing and securing additional equipment funding and a letter of credit to assist WMHS with its liquidity position Bond marketing to ensure maximum demand from retail and institutional investors Structuring all detailed mortgage and bond cash flows including yield calculations and 300 hypothetical default runs to satisfy rating agency requirements Outcome With one of the largest FHA hospital loans ever structured, Western Maryland Health System will consolidate two operating hospital campuses into one health care campus on the former site of the Allegany County Health Department Building to serve the City of Cumberland and the surrounding region. Slated to open in the winter of 2009, the new hospital will include 275 beds in a 589,000 square foot, seven-story structure. The first three levels will be devoted to diagnostics and treatment departments while the upper floors will function as an inpatient tower. Mechanical equipment will be located on the mid-level fourth floor, providing a central location for distribution of HVAC throughout the facility. The project also includes a four-level, 940-car parking garage and pedestrian bridge over MD Route 639. Once construction is complete, WMHS will move to final endorsement of the FHA loan. Depending on how quickly it draws the loan proceeds, WMHS expects to achieve a rate of 4.48% at the Final Endorsement for the 25 year loan amortization period. 6 7

5 About the Authors Stephen R. Pack, President Armadale Capital Inc. Since 1988, Stephen Pack has worked with more than 100 healthcare clients, securing more FHA Section 242 firm commitments and structuring more FHA insured bond financings for hospitals than any other healthcare finance professional. Steve has structured more than $7 billion in healthcare transactions and has worked on all types of tax-exempt and taxable healthcare financings ranging from non-rated private placements and limited public offerings to letter of credit variable rate financings and synthetic fixed rate transactions. Previously a leader at two Wall Street firms, he founded Armadale Capital Inc. in 2008 to specialize in FHA Section 242 financings for hospitals and is largely responsible for the proliferation of this type of financing across the country. Rolf Haarstad, AIA, LEED AP, Principal Hord Coplan Macht, Inc. An award-winning architect, Rolf s designs have been honored by AIA Minnesota, AIA Maryland and AIA s Baltimore Chapter. His work has been featured in numerous publications, including Architectural Record, HealthCare Facilities, Healthcare Design, Architecture Minnesota and Custom Home. Rolf has taught, critiqued and lectured at several universities including Arizona State University, Catholic University, the University of Maryland, Morgan State University and North Dakota State University. He is principal-in-charge of the new $268 million replacement hospital for Western Maryland Health System in Cumberland, Maryland.