Healthcare providers are sitting on billions of dollars in assets.
Real estate holdings constitute 35% to 50% of a typical healthcare system's balance sheet, but few chief financial officers are actively managing those assets.
The average not-for-profit hospital had total assets of $90.1 million in 1995, including $39.9 million in net fixed assets, according to the Center for Healthcare Industry Performance Studies, Columbus, Ohio. CHIPS' industry composite is culled from a sample of 1,800 voluntary, not-for-profit hospitals.
Multiply net fixed assets by some 5,000 hospitals and that's roughly $200 billion-mostly land and buildings-under CFOs' command.
Yet, a new survey by Price Waterhouse finds that only 44% of healthcare executives, mostly CFOs, see an opportunity to enhance their competitive advantage through effective management of their real estate assets.
In these turbulent times, how can CFOs neglect such a large chunk of their holdings?
Healthcare executives have not focused on real estate management as an integral part of the entire organization's service strategy, operations and financial management, said Deborah Kops, Price Waterhouse's national managing director of corporate real estate consulting.
Price Waterhouse surveyed 156 healthcare executives-66% of them CFOs-representing a broad spectrum of providers, from hospital systems and home health providers to skilled-nursing facilities and managed-care providers. About three-quarters of respondents represented governmental, religious or community not-for-profits; the remainder were investor-owned.
In a report issued this spring, Kops said many healthcare organizations "may be missing important opportunities to enhance their financial picture and solidify their competitive position."
William O. Cleverley, president and co-founder of CHIPS, said there's a very good explanation for CFOs' inattention to real estate assets. "I think it's been a historic lack of interest in the balance sheet," he said.
Under traditional cost-based reimbursement and accounting, healthcare organizations didn't need to aggressively manage capital investments in property and plant. Such investments were considered a cost of doing business. Hospitals generated more revenues by boosting admissions and adding services. And tax-exempt capital was cheap. Medicare, in fact, still reimburses a portion of hospitals' capital costs.
But the move to capitation is reversing old incentives. Healthcare organizations are scrambling to shorten hospital stays and cut costs. And they're seeking new sources of capital to deploy their managed-care strategies. Under capitation, it pays to minimize overhead costs, such as property and plant.
Over the past five years, other industries have begun to focus on corporate real estate management, but healthcare still lags behind, Kops said. CFOs aren't paying close attention to real estate management issues because they've been distracted by competing issues such as cost containment, she said.
The healthcare industry also lags behind because of its structure, Kops said. "So much facility management is still done on a site-by-site basis," and facility costs are managed the same way. CFOs should be asking, "How can we bundle costs and manage them across the board?" she said.
In many cases, real estate represents an underutilized source of capital to be reinvested in operations or converted into a cushion of cash, some finance experts said. Property and plant also can serve as valuable bargaining chips in network development negotiations. And effective management of real estate assets can help cut costs, build returns and achieve a competitive advantage in the marketplace.
For-profit healthcare operators, because they must answer to their investors, often are more aggressive in managing real estate assets, CFOs said.
For example, Genesis Health Ventures, a Kennett Square, Pa.-based geriatric healthcare company, in March sold a 51% stake in an eldercare center to not-for-profit Doctors Community Hospital, a 250-bed hospital in Lanham, Md., for $2.8 million. It also entered a long-term agreement to manage the center.
Genesis and Doctors Community jointly financed the acquisition of the eldercare center through cash contributions and bank debt. In addition, Genesis entered a five-year management agreement to operate a 17-bed subacute unit at Doctors Community.
Genesis is negotiating similar deals with providers in New Hampshire, southern New Jersey and Philadelphia to tie its system to a source of referrals and attract managed-care contracts.
"We look at leveraging our real estate more from a network expansion (perspective)," said George Hager Jr., Genesis' senior vice president and CFO. The Doctors Community deal aligns clinical and financial incentives, he noted.
But managing real estate assets is a fairly new concept for not-for-profits, said Keith Harville, a senior director with VHA, an Irving, Texas-based not-for-profit healthcare alliance. "I think as they look at ways to access capital, more and more they're going to realize that they're sitting on a lot of capital."
VHA already recognizes the hidden potential of real estate. Last November, it announced an agreement aimed at helping its 1,330 members, including 1,100 hospitals, gain access to real estate capital and improve healthcare operations and property development. Under the five-year deal, Nashville, Tenn.-based Healthcare Realty Trust, through its Healthcare Realty Management subsidiary, will market its development and property management services to VHA members. So far, two members have used the real estate investment trust's services, and a number of other deals are in the works.
The alliance has a separate agreement with Dallas-based Staubach Co. to assist VHA members in evaluating their real estate needs and determining how to finance them.
In today's environment, hospitals are seeking more and more liquidity to buy physician practices and add ambulatory-care facilities, said Brant Bryan, president of Staubach Financial Services, a division of Staubach. But most are not thinking about asset financing as effectively as they could, he said.
In merger situations, hospital executives may be looking at what to do with physical assets from an operational point of view, but few are asking the question, "What can we financially do?" Bryan said. "Most CFOs have very strong accounting and control backgrounds but limited corporate finance backgrounds."
In many cases, medical office buildings, clinics and other outpatient facilities serve as "dumping grounds" for hospitals' allocated costs, such as housekeeping services, said Todd Lillibridge, chairman and chief executive officer of Chicago-based Lillibridge & Co., a healthcare real estate consulting, development and management firm. "Hospitals heretofore have not focused on these assets as contributors to the bottom line," he said.
That kind of thinking is a change for a lot of not-for-profits, said Calvin R. MacKay, executive vice president of corporate finance at not-for-profit Baptist Hospital in Nashville. MacKay, who oversees $235 million in net fixed assets, including the hospital and its subsidiaries, is managing real estate to improve return on assets, cash flow and overall operations.
"I manage my balance sheet as much as I manage my income statement," MacKay said.
A couple of years ago, Baptist entered a $40 million "synthetic lease" agreement, which provided a pool of funds to acquire or construct medical office buildings. To date, Baptist has funded seven Nashville-area medical office buildings by placing them into the synthetic lease, an operating lease structure that provides off-balance-sheet financing.
The deal enabled Baptist to avoid adding more debt and finance the deal at a rate based on its investment-grade rating, "so I'm using somebody else's capital and my credit," he said. Leasing from a traditional commercial real estate developer would have cost 40% more, MacKay estimated.
Today, more than 900 physicians practice at the hospital. According to Moody's Investors Service, a New York-based credit rating agency, Baptist has had "great success" in attracting physicians to its campus.
Recently, Moody's confirmed Baptist's Aa rating, partly because of a sale-leaseback of two medical office buildings to Healthcare Realty Trust. The 22-year lease agreement, which contains four 10-year renewal options, generated
$32 million for Baptist, which Moody's said would boost the system's cash balance above 1992 levels.
The outlook for improved liquidity was one of several factors leading to the rating confirmation. Executives from Moody's and other rating agencies say they generally reward cash more than real estate in assigning a credit rating. That's because cash gives providers the flexibility to carry out their strategic plans, while real estate is difficult to value until those assets are converted to cash.
For the year ended June 30, 1995, Baptist and its affiliates had $54.2 million in unrestricted cash and investments, compared with $59.3 million in the year-ago period. Cash on hand dropped to 50 days last year from 66.9 in fiscal 1994. The system posted net income of $15.5 million on net patient revenues of $298.5 million in 1995.
MacKay's strategic management of the balance sheet also is aimed at increasing the system's return on assets, a key measure of profitability. His goal is 12% or higher, as measured by cash flow divided by assets. Currently, Baptist is at about 10%, he said.
Although Baptist must begin making lease payments on the two medical office buildings, MacKay said the resulting improvements to the system's income statement, cash flow and balance sheet are worth the cost. The lease payments, at less than $10 per square foot, are a bargain compared with the market rate of $16 to $18 per square foot that Baptist would have paid a commercial real estate developer, he said.
Leasing instead of owning makes sense as long as healthcare organizations are making "wise strategic decisions," said Maribess Miller, a partner in charge of Coopers & Lybrand's business assurance practice in Dallas and chairwoman of the Healthcare Financial Management Association's Principles and Practices Board.
Another risk is that the REIT won't be able to lease the space at a market rate that equals or exceeds the rate paid under the master lease agreement, said Michael D. Ayres, CFO of not-for-profit Candler Health Systems in Savannah, Ga.
Last September, the system opened a 70,000-square-foot regional heart-lung center next to a physician office building on campus. Healthcare Realty Trust built the heart center, and Candler is leasing it back.
Because some physicians relocated to the new center, the system now must release the vacated space in the professional office building. As a result, Ayres anticipated a shortfall in rental revenues. The system is responsible for any capital expenses exceeding income from leases with doctors minus operating expenses (such as tenant improvements) and payments under the master lease agreement. Ayres declined to disclose the specific amount the system is losing, saying it was "more or less" what was expected.
"I think it's a long-term strategy," he said. Otherwise, he said, the heart center wouldn't be adjacent to the medical office building.
Michael E. McGinnis, CFO of Community Hospitals of Central California, Fresno, also sees leasing as a means of deploying long-term strategies.
When Rancho Cordova, Calif.-based Foundation Health Corp. put a Fresno-based ambulatory-care center up for sale, McGinnis saw an opportunity to house a new group of primary-care physicians. The building, just a year old, was in a good location. Rather than buy it outright and tie up cash, Community Hospitals, a three-hospital not-for-profit system, agreed to finance it off balance sheet through a synthetic lease agreement structured by Staubach Financial Services.
"This is a physician office building. It's something we don't necessarily have to own to take advantage of," McGinnis explained.
The synthetic lease will enable Community Hospitals to add primary-care services without committing a lot of cash.
"We think our cash assets need to be devoted to more core business activities," McGinnis explained. "Cash is used for hospital-related activities as well as to make sure we have relatively healthy cash balances."
McGinnis is anticipating an interruption in cash flow caused by the system's pending contract with Fresno County to operate Valley Medical Center of Fresno. It will take time to change Medicare provider numbers and get a new Medicare participation agreement on line. Meanwhile, the system still needs to make payroll and pay vendors.
Because the financing was structured using Community Hospitals' corporate credit, the rate is based on the London Interbank Rate, a much more favorable rate than prime. Community Hospitals' rent is half to two-thirds what the system would have paid a traditional REIT or commercial real estate developer, Staubach's Bryan claimed.
"The downside is that this is an expensive transaction to do," McGinnis said. Because of legal and structuring fees, it doesn't pay to do this for less than $10 million, he said, although realistically, a system probably should finance no less than $15 million at a time.
In addition to the clinic in Fresno, Community Hospitals' synthetic lease agreement will finance the purchase and leaseback of a medical office building and the construction of a second primary-care center. All three buildings fit the system's strategic plan, McGinnis said.
Some institutions are forced into leasing because they need cash. Others have enough breathing room to think and plan strategically and use corporate finance techniques to carry out the strategy. "That's what we're trying to do," he said.
So what will it take to persuade more CFOs to manage real estate assets on the balance sheet? CHIPS' Cleverley thinks it will take "a dramatic increase in the cost of capital."