MONETIZATION TRENDS IN HEALTH SYSTEM AND PHYSICIAN-OWNED REAL ESTATE. Helping Create Places for Healing

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1 MONETIZATION TRENDS IN HEALTH SYSTEM AND PHYSICIAN-OWNED REAL ESTATE Helping Create Places for Healing

2 Monetization Trends in Health System and Physician-Owned Real Estate As capital demand for information and medical technology, physician alignment and other initiatives becomes more persistent, health systems are once again pursuing strategies to unlock equity from existing non-core real estate assets, as well as utilizing new vehicles in the form of third-party capital partners for new facility development projects. In addition to health systems, many large physician groups which have elected to own their real estate for business reasons are frequently dealing with similar issues as they align with hospitals and health systems in record numbers. The physician groups may be required to relocate or sell their owned medical office space prior to the affiliation for either regulatory, business or strategic reasons. This Realty Trust Group white paper explores the history of these transactions, summarizes current activity and the benefits for the owner/ seller, and looks ahead at what the future may bring in this sector. Historical Trends The use of third-party capital for facility development and monetization has increased fairly dramatically over the past 20 years, exemplified by this chart (shown right) which tracks medical office transaction volume between 2001 and Billions $ Volume $7.0 $6.0 $5.0 $4.0 $3.0 $2.0 $1.0 $- '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 Source: Real Capital Analytics Prior to 1997, most hospitals and health systems owned their facilities and had relatively little incentive to monetize assets under Medicare s cost-based reimbursement program. With the introduction of the Prospective Payment System in the early 1980s and the eventual elimination of cost-based reimbursement in the late 1990s, the way in which health systems viewed their non-core properties fundamentally changed. Many progressive health systems, including some of the major Catholic systems (Catholic Health East, the former Catholic Healthcare West, Ascension, SSM) and other large, prominent systems (Baylor Health Care System, Swedish Healthcare, IU Health, Orlando Health and Carolinas HealthCare System), systematically monetized billions of dollars of MOBs between 1997 and These organizations realized that the capital returns associated with operating their real estate portfolios were often far lower than the hurdle rates required for investment elsewhere within their organization. The financial theory behind these transactions became one of redeploying low-yielding capital tied up in bricks and mortar for higher returning investments in equipment, new services and acquisitions. With respect to real estate linked with private physician practices, especially the concern about physician self-referral and potential penalties associated with the introduction of the Federal Anti-Kickback laws in 1972 and the Stark laws in 1992 and 1993, many health systems became increasingly uneasy in their role as landlord to their referring physicians. Errors of both omission and commission can trip these statutes and result in fines and penalties, as well as potentially losing future Medicare reimbursement eligibility. The threat of these penalties increased some providers desire to remove themselves from a landlord position with their physician tenants. 2

3 Historical Trends (continued) The emergence of an institutional investment market generally coincided with the regulatory changes occurring in the industry. Prior to the mid-1990s, there were very few pension funds, insurance companies, real estate investment trusts and other large, public or private investment vehicles that were interested in investing in medical real estate. However, institutional capital funds continued to grow at an increasing rate, and after a few of the early monetizations were completed in the late 1990s, institutional investors relatively quickly became enamored with the solid fundamentals that healthcare investments provided. As noted in the preceding chart, transaction volume generally rose every year since statistics have become available. The music stopped, though, with the financial implosion in late Carolinas HealthCare System closed their 15-building MOB portfolio with Healthcare Realty Trust in December that year, and then there was only one major hospital-sponsored portfolio transaction in 2009 and Health systems were faced with crashing investment portfolios, early-wave EHR implementation, large scale physician acquisitions and a myriad of other strategic and operational issues during this challenging period. Real estate plans for new development and monetization gathered dust. However, over the past 18 months or so, there have been multiple hospital and physician-sponsored MOB portfolios which have traded, and several others which are either under contract or currently being marketed, including: Denver-based Centura Health sold a 317,026-SF portfolio in late 2011 In early 2012, Bethesda Healthcare in Palm Beach, Florida sold a 133,473-SF medical mall Northside Hospital in Atlanta sold two MOBs on its Alpharetta campus, totaling 287,191-SF The Harbin Clinic, situated on the outskirts of metro Atlanta, recently sold a seven-building portfolio totaling 333,581-SF Changes in the Air Although there is clearly some uncertainty about the future operating rules under the Patient Protection and Affordable Care Act, there is also a desire for many health systems and physician groups to move forward with their strategic real estate plans. Patient populations continue to grow and require services, and demand for new facilities and programs is increasing in many markets. The management consulting firm FMI, in its Construction Outlook published in early 2012, projected that health care construction would grow at an average rate of 9.9% between 2013 and So, too, is the demand for capital to fulfill the organizational mission, and thus more use of third-party capital for real estate needs. Further, third-party capital is currently priced at relatively inexpensive levels, providing organizations with efficient alternatives to using internal capital or accessing the tax-exempt bond market (for non-profit health systems) or the equity market (for for-profit health systems). Even though strong NFP credits can currently borrow in the tax-exempt market at historically low rates, the enterprise still must apply some cost associated with the use of their equity capital even NFP health systems can t be funded 100% with debt. With the weighted average cost of capital for most large organizations lying somewhere in the 8 15% range, third-party real estate investors and developers that will provide capital in the 6-9% range can be attractive to hospitals and physician groups. As will be discussed later, there is one monetization vehicle that is relatively new to the health care industry which is potentially even more attractive than some of the conventional third-party capital models described above. This inexpensive debt capital is also having an impact on current pricing of properties. The high-water mark for pricing and valuations of medical real estate came between late 2007 and late 2008, before the market crash. 3

4 Changes in the Air (continued) Although many of the other real estate sectors are still recovering (including the residential market), medical real estate pricing has now returned to the point where most properties and markets are emulating, or are near to emulating, the peak pricing experienced before the downturn. available properties in which to invest. Simple economics suggests that prices will remain high for some period, until this imbalance changes. Thus, more owners are taking advantage of the currently favorable market conditions, and monetizing portfolios of properties. Institutional investment capital has once again begun to flow strongly into the medical real estate sector, creating a shortterm supply / demand imbalance between the capital and Benefits & Challenges As noted earlier, there are two primary reasons why health systems and physician practices monetize real estate. First, the capital generated from the transaction can be re-deployed at a higher rate of return. Second, this type of transaction can result in significant balance sheet improvement. Additionally, for hospitals, a monetization transaction removes the burden of being a landlord to the tenant physicians, thereby neutralizing penalties which could be suffered as a result of running afoul of the Stark or Anti-Kickback rules. In addition to these drivers, there are a series of other benefits which can accrue to a health system or physician group in monetizing a real estate portfolio. These benefits can include: Transferring the burden of managing and accurately accounting for operating expenses of the real estate portfolio From a credit rating standpoint, the ratings agencies have generally been neutral to slightly positive about monetization transactions, often favorably citing the increased liquidity they provide to a system. There are multiple challenges as well, including the potential transitioning of the property management function. Health system executives worry about third-party owners potentially damaging their relationship with their physician tenants, but frequently third-party owners can provide an enhanced property management experience for tenants due to their expertise in medical real estate management. The flexibility of moving tenants within a building could be diminished with a third-party owner, but can often be addressed by proper covenants in a ground lease. Possible avoidance of certain capital expenditures associated with the portfolio Maintaining or improving system credit rating Reduction of management time on real estate issues When a true third party takes ownership of a portfolio, the expenses and capital expenditures required to maintain the buildings move along to the new owner as well. Certain lease structures may require tenants to continue to pay all or a portion of the operating expenses, but a new owner would likely bear some of the burden for operating expenses and capital expenditures, thus relieving the hospital or physician group from these costs. 4

5 Structures Utilized There are three primary structures that have been used in most of the portfolio monetizations: a sale to a third party, with the seller leasing back a portion of the space; a sale with the seller master leasing back all of the space; and a joint venture. Each of these structures provides unique benefits and burdens, as summarized below: SALE/LEASEBACK Benefits Provides 100% of the market value of the facilities New owner responsible for property management and capital expenses Burdens Introduces third party into hospital / physician relationship Complete control of space is reduced Removes hospital from landlord / tenant relationship Hospital shifts leasing risk for vacant space to new landlord Hospital may maintain certain controls through properly-executed ground lease or other restrictive covenants SALE/MASTER LEASEBACK Benefits Provides 100% of the market value of the facilities; proceeds may be higher than traditional SLB More control over leasing and property management than traditional SLB Burdens Does not remove hospital from landlord / tenant relationship due to sublease arrangements Hospital maintains leasing risk for vacant space Hospital may maintain certain controls through properly-executed ground lease or other restrictive covenants JOINT VENTURE Benefits Allows hospital / physicians to retain partial ownership of the assets Hospital may maintain certain controls through properly-executed ground lease or other restrictive covenants Burdens Provides less than 100% of the value of the assets More complex transaction than other two structures Interest in property is relatively illiquid 5

6 A New Structure A relatively new structure for real estate transactions in the health care industry is the use of Credit Tenant Lease (CTL) financing, which is currently available for A and AA -rated credits. This structure has been utilized in other industries for years, but has only recently found its way into the health care industry. Essentially, CTL financing is an alternative to the tax-exempt bond market, or the other structures described earlier. It provides up to 100% financing for existing and to-be-developed projects at extremely attractive, long-term fixed rates at or near what could be achieved in the tax-exempt market. This structure works best for single tenant, core facilities which the health system expects to occupy for an extended period. As noted above, it can be used to monetize existing facilities or for new development projects. The financing rates associated with these transactions are currently far lower than a comparable sale-leaseback. The typical structure involves the hospital setting up a single purpose entity which would maintain control of the property throughout the 20+ year lease term. A CTL lender / investor would fund the transaction, which would be paid back subject to a lease, which effectively serves as a self-amortizing loan. The lease payment would be based on a Treasury benchmark plus a spread, with no annual escalations. The final terms would be subject to the hospital s credit, the size of the transaction, the type of facility involved and the current market conditions. The term of the financing would be coterminous with the lease. This structure is rapidly gaining favor with strong credits as a way to leverage their financial strength and utilize alternative, more cost-effective capital sources for specific real estate assets. Physician Transactions While the majority of the real estate monetization activity that has occurred has been between health systems and investors, there are many factors influencing larger physician practices to consider monetization alternatives as well. Several of those factors are consistent with trends driving the monetization activity for health systems, such as the current pricing levels influenced by the imbalance between supply and demand and the opportunity for affordable third party capital. Similar to health systems, large physician groups are feeling the pressure of increased capital constraints, in addition to decreasing reimbursement trends. Now more than ever, it is critical for physician practices to invest their capital in areas of their business that provide the highest return (e.g., physician recruitment, medical equipment, etc.). In addition to the issues discussed above, there are other factors unique to physician groups which should be considered by physician owners in their monetization decisions. First, the wave of physician employment and/or alignment with health systems continues at a rapid pace, and this trend is not expected to end anytime in the near future. More physician practices with large real estate portfolios are seeing their real estate either significantly complicate a potential acquisition / alignment or, in some cases, completely prevent the transaction from occurring. By divesting their real estate portfolio, physician practices can potentially become more attractive from an employment perspective, since a divestiture would eliminate potential Stark / Anti-Kickback real estate-related issues. Additionally, it is very common for physician-owned real estate to be held outside of the actual operating entity and, as a result, the physician owners are typically required to carry recourse debt on the properties. Given the uncertainty within the traditional financing markets and the inevitable increase in interest rates, many physicians are not willing to be exposed to such severe potential refinancing risks, both from interest rate fluctuation as well as potential debt-to-equity requirement changes. As mentioned earlier, the Harbin Clinic, which is the largest multi-specialty physician practice in Georgia, recently decided to take advantage of the market conditions and monetized the majority of its real estate portfolio, including seven buildings consisting of 333,581 square feet. The Clinic s main reasons for monetizing were to free up capital for its physicians, mitigate substantial future refinancing risks, remove itself from the real 6

7 Physician Transactions (continued) estate property management business, and become a leaner, more flexible organization from a balance sheet perspective. All of these objectives were accomplished by entering into a sale / leaseback with a large health care real estate investment trust. Similar to sale / leaseback transactions between institutional investors and health systems, physician practices can often accomplish similar objectives from a control standpoint through certain covenants in the lease or ground lease agreements. Conclusion With demand for capital to grow and implement the changes required of the Affordable Care Act continuing to stress providers abilities to fund new initiatives, along with a market which is currently very attractive for sellers, several recent medical real estate portfolios have been monetized. Health systems and physician groups considering a monetization effort need to be aware of the issues which can impact them post-transaction, and fully understand the strategic and financial benefits which can occur as a result of a successful transaction. 7

8 ABOUT US Since our inception in 1998 Realty Trust Group has focused on healthcare real estate becoming one of the most respected and recognized firms in our industry. Through this specialization we ve gained a unique perspective and understanding of the healthcare industry s complexities and their impact on strategic real estate decisions. We believe that bigger is not always better and more people for the sake of numbers is not the answer. Our goal has never been to be the biggest in the industry, however being the best is what drives every member of our team. When you work with us you ll appreciate our people: their knowledge, experience and integrity. We provide valuable solutions for our clients because we ask the questions that others may be unwilling or incapable of asking. To us, your real estate is a precious asset that should contribute to your organization s strategic goals and serve as a catalyst for business growth and increased market share. Whether your organization is considering expansion, acquisition, disposition, or cost reduction we can help. Q U E S T I O N S? Greg Gheen, President ggheen@realtytrustgroup.com Scott Evans, Executive Vice President sevans@realtytrustgroup.com KNOXVILLE One Cherokee Mills 2220 Sutherland Avenue Knoxville, TN ATL ANTA 1100 Johnson Ferry Road Building 1, Suite 400 Atlanta, GA RealtyTrustGroup.com RTG RESOURCES 0113-A. Copyright 2013 Realty Trust Group. All rights reserved. No part of this document may be distributed, reproduced or posted without express written permission of Realty Trust Group, other than the following uses: You may copy this document and its contents for personal use only. You may distribute quotes or content from this document to third parties in news articles, blogs, forums or educational resources provided you acknowledge Realty Trust Group as the source of the material. If distributed online or electronically you must provide a working hyperlink to: 8