The capital markets for hospitals and health systems have yet to recover from the financial crisis of 2008, the Great Recession of 2008-09 and the continued weak economic recovery. From a peak of about $61 billion in 2008, tax-exempt bond volume for healthcare projects has declined steadily. Bond issuance sank 62.3 percent during the past three years to approximately $23 billion in 20111. The decline was partially due to a reduction in the number of new capital improvement projects in light of uncertainty regarding the economy and the ultimate impact of healthcare reform. However, another major factor has been the unfavorable lending environment for hospitals and health systems with weaker credit ratings. Many of these weaker credits have been forced to merge with or be acquired by stronger systems during the past two years. The more creditworthy systems are finding it somewhat easier to access capital, yet they also face the prospect of reduced revenues, continued economic uncertainty and increased costs due to the mandates of healthcare reform.
As a result, most hospitals and health systems – both the “haves” and the “have-nots” – are being forced to take a far more circumspect view of capital projects and capital allocation decisions than they did during the easy credit era of the early 2000s.
Yet time does not stand still – and neither does the competition. A hesitancy to commit to capital projects that satisfy real estate, equipment and technology needs can open the door to more aggressive competitors. Indeed, despite continued uncertainty, healthcare development and construction edged upward in 2011. The value of construction starts for U.S. healthcare facilities during the first 11 months of last year rose 4 percent, compared with a 2 percent decline in total development and construction starts during the same period2. And even if systems didn’t face competitive pressures, many are finding that aging plants and deferred maintenance leave them with healthcare facilities that are antiquated and ill-equipped to support the kind of integrated and accountable care required by today’s healthcare environment.
How can providers remain competitive and continue to deliver quality healthcare when uncertainty abounds, revenues are threatened, and there are so many competing demands for capital? Many forward-thinking healthcare executives are taking a fresh look at third-party real estate developers.
Third-party development, financing and ownership of non-core healthcare real estate is a proven model that has been successfully implemented by hundreds of hospitals and health systems nationwide. Yet some providers have remained hesitant, perhaps because they felt they did not “need” outside capital, or they were concerned about “losing control” of their real estate healthcare facilities. Some hospital executives also believe that if the facility will be occupied more than 50 percent by hospital services or hospital-owned medical practices, the hospital should own the building because it will be paying rent to itself rather than an investor. There might be valid concerns, but the ongoing transformation of the industry compels pragmatic hospital and health system executives to consider the third-party developer alternative.
This realization appears to be driving more providers to partner with third-party real estate developers to develop, finance and own medical office buildings and other outpatient facilities. Aside from the ability to shift the financial and capital burden and risk to an outside entity, many of these decisions are driven by the recognition that real estate is neither a core business nor a source of acceptable return on investment relative to other alternatives.
Third-party developers bring real estate expertise that few providers possess in-house. They can provide an integrated suite of development, capital, entitlement, procurement, leasing, property management and equipment management services that allow providers to focus on their core mission of delivering quality healthcare. At the same time, by tapping third-party developers as alternative sources of capital, equity and debt, providers reduce risk and avoid making relatively low-yielding investments in outpatient real estate, potentially adversely affecting their credit profile. Additionally, the “control” issue can be addressed through the use of long-term unsubordinated ground leases, use restrictions and other agreements. These instruments allow the provider to control what happens within the building, without owning the bricks-and-mortar. Healthcare providers can also benefit from third-party developers’ extensive expertise in the areas of regulatory approvals, architecture and engineering, innovative space planning, benchmarking, best practices and construction management.
In the past, many hospitals and health systems turned to third-party development, financing and ownership as strictly a financial strategy that would enable them to achieve “off-balance sheet” financing for their outpatient healthcare facilities. Rather than owning the facilities directly, providers leased the facilities from third-party developers and owners to avoid having any related debt appear on their balance sheets. However, proposed changes in the treatment of capital leases will likely soon require providers to recognize operating leases on their balance sheets.
Yet, this accounting change should not necessarily affect the decision to own vs. lease space. Consider this:
• Many investment bankers, healthcare executives and rating agencies recommend that hospitals achieve an unleveraged return of at least 12 percent on their investments to avoid a negative impact to their credit ratings, yet nearly all real estate investments fail to reach that threshold.
• Pressure to preserve capital remains a critical need. “Days cash-on-hand” might be the most important credit metric for a hospital
• The ability to “walk away” from space after lease expiration is an important consideration
• There is an inherent conflict between hospital-landlord and physician-tenant to create operational value in a medical office project. Third-party landlords can insulate the hospital from potential conflicts with physicians over rental rates, property management and other issues – helping to protect the all-important hospital-physician relationship
• Options to purchase third-party healthcare facilities can be incorporated into the ground lease agreement between the hospital and developer, allowing the hospital to regain full control of the asset, if necessary
There has never been a better time for hospital and health system executives to leverage the benefits that can be derived from using a third-party real estate firm to develop, finance, own, lease and manage their medical office buildings and other outpatient healthcare facilities. By availing themselves of the expertise and resources provided by third-party developers, hospitals and health systems can reap exceptional value in the form of development expertise, execution capabilities and capital solutions. Today’s competitive pressures, growing capital needs, and uncertainty regarding the economy and the effects of healthcare reform make it imperative to seriously consider this proven real estate and capital strategy.
Through a nationwide strategic alliance, Jones Lang LaSalle and PMB offer providers the most complete, full-service, third-party real estate solutions available in the healthcare industry.
Jones Lang LaSalle (NYSE: JLL) is a financial and professional services firm specializing in real estate. The firm offers integrated services delivered by expert teams worldwide to clients seeking increased value by owning, occupying or investing in real estate. With 2010 global revenue of more than $2.9 billion, Jones Lang LaSalle serves clients in 60 countries from more than 1,000 locations worldwide, including 185 corporate offices. The firm is an industry leader in property and corporate facility management services, with a portfolio of approximately 1.8 billion square feet worldwide. For further information, please visit www.joneslanglasalle.com.
PMB specializes exclusively in the development and management of medical office buildings, outpatient facilities and parking structures for hospitals, medical groups and universities. For nearly 40 years, PMB’s executives have led the industry in the development and management of medical care buildings, with 77 healthcare facilities constructed to–date throughout the Western United States. The firm currently owns and manages 44 facilities totaling about 3 million square feet with more than 7,000 structured parking stalls, and has eight projects under development that will total 750,000 square feet. The San Diego-based firm also has offices in Honolulu, Los Angeles, Phoenix, Nashville, Portland, and Vancouver, WA.
1 Cain Brothers, “Industry Insights,” Jan. 9, 2012
2 McGraw-Hill Construction, “November Construction Slides 11%,” Dec. 21, 2011