Eager to trim some fat from their organization's far-flung operations, administrators at Orlando Regional Medical Center last year identified some big-ticket assets ripe for the chopping block: seven medical office buildings on four sites scattered over a 20-mile radius of the hospital's main downtown campus in the central Florida tourist mecca.
Jumping headlong into a booming trend in healthcare--real estate divestiture--the 1,331-bed hospital sold all seven buildings in one major deal. By shedding those assets in a $20 million sale, the medical center eliminated all the aggravations of managing widespread real estate holdings, wiped away considerable debt from its balance sheet and refocused dwindling resources to serve the system's primary purpose: treating patients.
The transaction made complete sense to Karl Hodges, Orlando Regional's vice president of business development, who had helped oversee the earlier divestiture of ancillary, noncore businesses including an HMO, a physician practice and a nursing home. Once the medical center got out of those businesses, Hodges thought, pulling away from property management was the logical next step.
"We think it's the best of both worlds," Hodges says of the midsummer deal with Dasco Cos., a medical real estate company based in West Palm Beach, Fla. "We think we get the benefit of having these buildings on or near our campus without having to deal with all the hassles of managing them. We know how to run hospitals, but not HMOs, nursing homes or office buildings. We converted assets to cash, and converted that cash to our core business."
These days, more and more hospital administrators are following Hodges' lead, unloading tens of millions of dollars of real estate once viewed by hospital owners as vital appendages. Indeed, two of the biggest faith-based systems in the U.S.--Ascension Health and Catholic Healthcare West--are considering plans to unload hundreds of millions of dollars in medical office buildings over the next few years.
The pace of these divestitures, known as "monetizing," is accelerating across the country as hospitals begin to view their once-cherished office buildings and other noncore assets in an entirely different light. Intent on shifting the focus to their central business in a sour economy, executives are now looking at these buildings as a quick, dependable source of cash.
"For a lot of hospitals, the biggest issue they have is all the cash they've got tied up in these buildings," says Richard Galling, senior healthcare partner at Hammes Co., Brookfield, Wis., one of the biggest healthcare real estate developers in the nation with nearly $300 million in properties "They don't necessarily manage these assets the way that the owner of investment-grade real estate would. So as they look at their situation, they have to ask themselves, `Exactly what business are we in?' "
As they exit the real estate market, leaving behind the hassles of managing these facilities--everything from arranging garbage collection to long-term improvements--hospitals also eliminate concerns about government crackdowns on fraud-and-abuse laws involving their relationships with physician-tenants. Because most hospitals don't make a lot of investment income from their medical office buildings, it makes good economic sense to steer clear of these potential legal problems, some say.
"Usually, these (medical office buildings) aren't great investments for the hospitals," says Garth Hogan, president and chief executive officer of Medical Realty Advisors, Newport Beach, Calif., which provides leasing services for about 1.5 million square feet of office space in Southern California. "But with compliance issues and fraud and abuse, they become a lose-lose proposition."
A change in ownership
Specific figures are not available, but many experts believe there is about $100 billion worth of medical office buildings in the U.S. A sizable portion of that pie is expected to be divided over the next several years by third-party developers, real estate investment trusts and other institutional investors that view these properties as rock-solid investments.
For their part, hospitals typically have spent more to construct medical office buildings than private developers, adding some of the features that might be found in a hospital as a way to attract and please their physician-tenants. Professional building managers usually will raise the rent and operate the properties far more efficiently than hospitals. The managers also are attracted by stable, long-term professional clients and the opportunity to pour money into property as Wall Street continues to struggle.
"Everything goes in cycles in this industry," Hodges says. "But integrated delivery systems, like ours, are beginning to peel off and sell HMOs, nursing homes and doctors' practices. I think medical office buildings will be the next great wave of transactions."
Though the active market in available medical office buildings is now relatively small, the divestiture of these assets is expected to turn into a torrent, according to some experts.
"A small fraction of these buildings are up for sale now," says P.J. Camp, a director at Shattuck Hammond Partners, a New York-based investment banking firm that helps arrange these multimillion-dollar deals. "But this market is going to grow by leaps and bounds."
In fact, St. Louis-based Ascension is expected to help fuel a good part of that widely anticipated growth. As the largest not-for-profit healthcare system in the U.S. with 55 hospitals, Ascension plans to sell a portfolio of medical office buildings worth somewhere in the "hundreds of millions of dollars range," says Tony Speranzo, the system's senior vice president and chief financial officer.
Speranzo says several key factors led the system to begin planning about a year ago for the widespread "recapitalization," including a belief that proceeds from the sale will be better spent in areas that directly affect patient care. He says he also believes that investment returns on the redeployed assets will exceed those of medical office buildings, and that the influx of new reserves will immediately enhance the balance sheet. The deals also might enhance bond ratings by erasing debt.
"This is clearly a trend that is gaining momentum among not-for-profits," Speranzo says. "It's been very slow in catching on. I'm not sure why. It may be that it's not high on the list of priorities yet. But once (hospitals) start this, and get into it and see how it works, they'll be more comfortable."
Meantime, Catholic Healthcare West, a San Francisco-based system of 42 hospitals in Arizona, California and Nevada, is planning its own massive real estate deal. Michael Blaszyk, the system's executive vice president, says he expects about $100 million worth of CHW's office buildings to go on the market in January 2003. "We think it's a good opportunity to raise cash for more productive uses," he says.
For his part, Camp says he believes there is a potential for about $1 billion in outpatient real estate deals per year. Another industry observer, San Diego architect and real estate developer Robert Rosenthal, describes the sale of outpatient buildings as potentially "one of the greatest real estate transfers" in U.S. history. Rosenthal is president of Pacific Medical Systems, which owns or manages about 1 million square feet of medical office space in six Western states and has another 1.2 million square feet under development.
In the end, most hospitals either break even or earn a modest profit on the sale of these medical office buildings. In most instances, administrators are satisfied to just get out of the business without losing any money, observers note, eliminating a mortgaged building and using that money elsewhere.
"Most hospitals simply don't want to be in the real estate business anymore," says John Driscoll, president of the healthcare division of Skokie, Ill.-based Alter Group, a major real estate development firm. "They can't manage outpatient real estate as effectively as a third party. And it puts the hospital in a compromising position as a landlord to the doctors they want to keep happy. There are lots of good reasons to get out of this business."
A typical transaction, Driscoll says, might involve a hospital that built its own 40,000-square-foot medical office building a decade ago at $150 per square foot, for a total cost of $6 million. With depreciation, the remaining balance would be approximately $3 million and the market value somewhere around $7 million. Thus, the hospital stands to pocket $4 million.
When hospitals sell these buildings to a third party, they usually don't cede control of the facilities--or the choice of tenants. Because hospitals typically own the land, they can impose conditions through a ground lease on the way tenants are treated or the types of medical services they provide to their patients. "Hospitals can reduce costs and headaches and still maintain strategic control over the buildings," says Fred Campobasso, president of AMDC Corp., a national healthcare real estate consulting firm based in Chicago.
Typically, Campobasso says, the ground lease with a third-party management company will include a provision that only hospital-affiliated physicians can rent space in the building. In addition to limiting the kinds of services that might result in direct competition with the hospital, ground leases for Catholic hospitals limit or prohibit some reproductive services.
"From the standpoint of a Catholic organization, there's concern about ethical and religious directives," says CHW's Blaszyk. "But you can control that with an underlying ground lease."
In recent years, concerns have mounted about antikickback laws and the close financial ties between physicians and their hospital landlords. Federal laws prohibit hospitals from encouraging patient referrals by providing physicians with anything of value, including below-market rents. Reduced rent or other considerations for physician-tenants also may violate federal laws governing illegal patient referrals.
"The oversight of that (fraud-and-abuse) legislation is increasing," says Alter's Driscoll. "And hospitals are becoming increasingly concerned because the interpretation can be somewhat arbitrary or subjective. They don't want to be in a situation where it's even perceived, so it's best just to be cautious."
Indeed, consultants such as Campobasso and others say today's physicians recognize that hospitals are required to charge market-driven rental rates to remain in compliance with federal fraud-and-abuse laws. Most doctors no longer expect to receive bargain-basement rental rates from hospital landlords.
"If the hospitals are operating these buildings as they should be, then they are already functioning within the market-driven rates," Speranzo says.
Yet those market-driven rates charged by hospitals to physician-tenants are sometimes artificially low, some experts believe. If that's the case, a new, nonhospital owner is likely to boost those rates significantly, potentially angering many physicians whose wrath supposedly would be directed at their old landlord--the hospital. One source cites a building where doctors are charged $17.50 per rentable square foot of space. Though technically the "market rate," at least according to surveys charting such figures, the rent is still about $5 below what a nonphysician-tenant would be charged for space across the street in a building located off of the hospital campus.
"There are lots of different ways a hospital can jury-rig the figures to show that (physicians) are not being subsidized when they are," says Tim Oliver, senior vice president of healthcare development at Denver-based Neenan Co., which specializes in healthcare construction and architecture.
Under these circumstances, Oliver says, real estate investment trusts and other property managers focused on the bottom line "are going to raise rents aggressively, and doctors are not going to be happy."
For this reason, the short-term benefits of such a monetizing deal can sometimes provide long-term headaches that were not envisioned. Third-party developers who pay millions for real estate are looking for returns on their investment. Even modest rent increases are likely to trigger considerable discontent among the physicians who might grumble about even a modest increase in lease payments.
Because leases often run five or 10 years, many physicians haven't yet faced a rent increase in this wave of recent divestitures. But even big property managers, much more focused on these buildings' bottom line than hospitals, acknowledge that they bring an entirely new business model to bear on most physician-tenants.
"Our tenants are our customers, and we try very hard to be responsive," says Sydney Scarborough, executive vice president of the Lillibridge Health Trust, a Chicago-based real estate investment trust that owns about 1.2 million square feet of medical office space and manages another 6 million more. "But many of these buildings need renovations. When we buy them, we're responsible for all tenant improvements. So rents need to be adjusted."
"You have to be a special kind of a property manager to work with physicians," she adds.
Take, for instance, the case of Thomas Traylor, M.D., an obstetrician-gynecologist who enjoyed a close tenant-landlord relationship with 376-bed St. Mary's Health System in Knoxville, Tenn., for 14 years before Lillibridge acquired nine of the hospital's medical office buildings in 1999 for about $16 million. Though he praises Lillibridge for its professional management, he says he is unhappy with a lot of the changes, including an increase in his rent from about $12 per square foot to about $16 per square foot.
"I couldn't have had a better relationship with the hospital," Traylor says of those bygone days. "The hospital had a vested interest in working with us on any problems. When you bring in private business, it changes the environment. I think Lillibridge has done well as a landlord, but we don't have the same kind of association with them that we had with the hospital."
The increase in rent, along with new payments to maintain common areas and increased taxes, Traylor says, have added to problems that include low payments from insurance companies, regulatory concerns, increases in staff salaries and the mounting cost of malpractice insurance. "That rent increase comes right off the bottom line," he says.
A new portfolio
Despite concerns about unhappy doctors, the great land rush in healthcare real estate is likely to intensify as it slowly builds momentum, Oliver says.
"In all my years in this business, there's been a pent-up interest in medical office buildings," he says. "Now, with Wall Street looking for places to invest that are alternatives to the stock market, everybody's looking to real estate--medical real estate. Right now, money is chasing medical real estate like it's never done before."
The total value of healthcare real estate in the U.S. was placed at about $470 billion in 2000, according to estimates from Legg Mason Wood Walker, a Baltimore-based real estate research group.
Although the potential market seems staggering, the vast majority of hospitals and healthcare systems have moved slowly and deliberately toward divestiture. Until about a year ago, most hospitals were not even testing the market for medical office buildings, seemingly content to stick with the status quo.
Several factors, including tighter margins, have prompted renewed consideration, says Todd Lillibridge, chairman and CEO of the Lillibridge Health Trust, whose medical office empire stretches over a dozen states.
"In the last 12 months, we've seen a dramatic (shift toward) assessment (of the possibilities of divestiture)," Lillibridge says. "Hospitals are now hiring people who are analyzing both the financial and the nonfinancial implications of reinvesting this capital."
While he says he still hasn't seen the "huge onslaught" of expected divestitures, he believes it's only a matter of time.
"It's a significant trend," Lillibridge says. "We're betting our future on it."
Alter's Driscoll estimates that about three out of four hospitals in the nation are involved in a "phase one analysis" on the disposition of these assets.
At Orlando Regional, Hodges helped coordinate a complicated deal that included a total of about 270,000 square feet of space and netted the hospital system a small, undisclosed profit. "It wasn't huge," Hodges says, "but we're happy to be out of the real estate business." The cash from the real estate deal, Hodges says, will be used to help fund expansions at two campuses and the construction of a new, $100 million women's and children's hospital directly across from the Arnold Palmer Hospital for Children and Women in downtown Orlando.
"We had a need for capital for these projects," Hodges says.
Several other large deals also have been completed over the past two years for many of the same reasons Hodges expressed.
Earlier this month, for instance, Advocate Health Care, based in Oak Brook, Ill., sold eight buildings totaling about 459,000 square feet of space to Great Lakes Real Estate Investment Trust for $59.6 million. The system sold two other buildings to individual physicians. Deborah Rhode, vice president of facilities and construction, said the total package represented about 65% to 70% of the total medical office building space at Advocate, which decided to continue ownership of several buildings that housed affiliated medical practices.
Meantime, Lillibridge spent about $56 million less than two years ago to purchase a single, 350,000-square-foot medical office building and a 1,160-space parking garage from Saint Joseph's Hospital of Atlanta. About a year earlier, Clarian Health Partners, a three-hospital system in Indianapolis, sold six of its medical office buildings as part of a package deal to Newport Beach, Calif.-based Health Care Property Investors, the largest real estate investment trust in healthcare. That package, which included five other buildings owned by a local developer, totaled $68 million.
The evolving trend in divestiture began in the mid-1990s, when real estate investment trusts and private developers began snatching up buildings from for-profit companies such as Nashville-based HCA, which recognized the economic benefits of shedding some of these properties and reinvesting the proceeds.
HCA, which owns or operates 181 hospitals, helped lead the way by selling off a big chunk of real estate without really relinquishing control. The for-profit giant unloaded 116 medical office buildings for about $250 million in late 2000 to MedCap Properties, which was formed by HCA in partnership with First Union Capital Partners and other investors. HCA's stake in the privately held company is 48%, though it is expected to decrease in the coming years, MedCap officials say.
"Like most Fortune 500 companies, (HCA) decided they didn't need to own everything," says Chuck Elcan, MedCap's CEO. "For a publicly traded company, this gets depreciation off the balance sheets, helps earnings per share and helps redeploy assets back to the hospitals."
MedCap, based in Nashville, also closed on a deal in late June for 19 medical office buildings owned by Sparks Health System, Fort Smith, Ark. Though neither Elcan nor Sparks officials would reveal the amount, industry sources say the price was $35.5 million for about 350,000 square feet of space.
In a transaction similar to HCA's, 24-hospital Bon Secours Health System, Marriottsville, Md., sold its nonstrategic medical office buildings to a new partnership in which it holds a 49% interest. The system sold nearly 20 buildings for a total of $38.2 million in two deals during the past two years, says Michael Cottrell, senior vice president of finance and CFO. The most recent deal closed at the end of September.
"We maintain a significant, vested interest through the partnership," Cottrell says. "For us, (the sale) wasn't a technique to get the properties off the balance sheet. We just didn't operate them very well. We weren't in the real estate business--it wasn't our bailiwick. In fact, we did a study and we learned that we're very inefficient at it, to the tune of about $1 million a year."
Other big investor-owned hospital companies--including Santa Barbara, Calif.-based Tenet Healthcare Corp., the second-largest for-profit hospital chain in the nation with 115 facilities--are holding tight to their real estate. "Others may be selling; we're not," says spokesman Greg Harrison.
Yet for many of the same reasons they are now selling medical office buildings, many hospitals are relying on third-party developers to finance, build and manage outpatient centers and medical office buildings. This market is also massive--construction of outpatient facilities for the U.S. healthcare industry is forecast to approach more than $6 billion over the next several years, including everything from traditional offices to high-tech surgery centers. About $3.2 billion of that figure is expected to go toward basic medical office buildings, as many as 425 a year, boasting a total of about 21 million square feet of space, says Shattuck Hammond's Camp.
"There's one big reason why hospitals are doing this--they can use other people's money," AMDC's Campobasso says of the increasing reliance on third-party involvement. "They can get all the benefits, and it doesn't cost them anything. It's a perfect scenario, if you get the right developer and the right relationship."
Hammes' Galling says hospitals that were once reluctant to consider deals with third-party developers are now eager to take advantage of the many perceived benefits.
"We tried to convince hospital chief financial officers in the mid-'90s about the benefits of selling real estate," he says. "It was slow going. After the Balanced Budget Act, which really hurt hospitals, they needed to find an alternative method of achieving their objectives without having to use cash on their balance sheet. Now we're getting an inquiry a week about our willingness to either develop a new building or acquire an existing one."