Download Why Should Health Care Providers Consider Creative Real Estate

December 16, 2011
Practice Group(s):
Health Care
Real Estate
Why Should Health Care Providers
Consider Creative Real Estate Strategies?
By Stephen A. Timoni, Daniel A. Suckerman and Dean H. Wang
The current global economy, characterized by market volatility, uncertainty and capital constraints, is
surprisingly creating new opportunities in niche real estate markets, particularly in the medical real
estate sector. These opportunities in the health care real estate market have been spurred by the aging
baby boomer generation and the passage of health care reform, which is predicted to result in an
additional 32 million people in the U.S. having health insurance coverage. As health care coverage
expands and baby boomers come of age, demand for new and redesigned health care facilities will
continue to grow.
The increased demand for medical facilities (which includes many types of structures, such as medical
office buildings, administrative centers and assisted living centers) may be dramatic. One estimate
puts the increased health care facility need at approximately 64 million square feet.1 Much of this new
medical space will be focused on community-based outpatient care, which is emphasized in the recent
health care reform legislation, as technology outpaces the need for traditional inpatient hospital
services and operational efficiency becomes critical. In fact, one consulting firm estimates that the use
of outpatient services will grow by over 21 percent from 2009 to 2019, while the use of inpatient
services will grow only by 1.7 percent during that timeframe.2
Increased patient demand and quality of care expectations, coupled with government efforts to control
spending, will require health care providers to determine how to best service a growing patient
population while simultaneously reducing costs. Notwithstanding the possible repeal of the health
care reform law, providers will still need to focus on managing costs and improving the quality of
patient care. As the health care landscape evolves, the development of new and more efficient
delivery models, such as Accountable Care Organizations (ACOs), are likely to require increased
capital expenditures for medical real estate and technology. The reduced access to the debt capital
markets is challenging health care providers in need of funds to maximize the contribution that their
medical real estate makes to achieve their business and financial goals. One option many health care
providers, therefore, have turned to is the monetization of their existing real estate through a saleleaseback arrangement or other joint venture type transaction with third party partners. The saleleaseback transaction is potentially an attractive source of capital for providers as health care real
estate, now more than ever, is trading at higher values than similarly sized non-medical commercial
real estate.3 Obviously, however, there are numerous considerations as to whether a particular
medical building will be suitable for sale, such as: the physical condition and age of the facility, taxexempt status of the provider, the quality of existing leases, types of tenants and the level of the
facility’s specialized build-out structure.4
1
National Real Estate Investor, Health Care Reform: Boon to Commercial Real Estate?, Mar. 24, 2010.
Healthcare, In Focus, Guest Column: Healthcare Reform and Real Estate, May 27, 2011.
3
Industry Insights, Cain Brothers Newsletter for the Health Care Industry, Nontraditional Capital Sources: A Primer on
Monetizing Medical Real Estate, October 10, 2011.
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Id.
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Why Should Health Care Providers Consider Creative Real
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The attractive nature of medical real estate has drawn numerous types of buyers and investors to the
market such as pension funds, private investment funds, and frequently, health care focused real estate
investment trusts (“REITs”). By engaging in a sale-leaseback transaction with a REIT, for example,
providers are able to potentially raise much-needed capital, retire debt, increase efficiency by
maximizing the benefits of existing space, realize potential tax benefits and, importantly, focus on the
core mission of delivering high quality health care. This sale-leaseback financing strategy has grown
in popularity over the past few years because of recent tax code changes which specifically benefit
health care REITs. Currently, approximately 10% of the $700 billion health care real estate market is
held by REITs.5
As noted above, a sale-leaseback transaction may provide significant benefits to the health care
provider/property owner. The transaction is structured so that the provider/property owner sells its
real property to an investor, e.g., a health care focused REIT, which then leases back the property on a
triple net basis to the provider for an extended term (typically twenty or more years). It allows the
provider’s non-liquid asset – real estate – to be converted to cash, something that is not as easily
completed through traditional mortgage financing in today’s lending environment, or in the least, can
be completed under more attractive terms. Yet, the provider, as tenant, remains in possession of the
facility and maintains control over the clinical operations, but has additional cash and an improved
capital structure.
In structuring a sale-leaseback transaction, the parties must take great precautions to ensure
compliance with health care specific fraud and abuse laws, including the Federal Stark and
Antikickback statutes, if applicable to the specific transaction. The Stark law prohibits a physician
who has a financial relationship with a health care entity from making patient referrals to that entity
for the provision of designated health services for which reimbursement is sought from Medicare,
unless the financial relationship fits within a specified exception. The Antikickback law prohibits the
payment or receipt (or the offer or solicitation) of any remuneration for patient referrals or ordering
services for which payment may be made under a federal health care program. Since the penalties for
contravention of these fraud and abuse laws are severe, it is critical for the parties to structure any
transaction that implicates either law in such a way as to avoid any violations. For example, if either
law is applicable, the initial sale of the real estate should be at fair market value. Generally, a price
will be considered fair market value if it is a price that would have been reached between an
unaffiliated buyer and seller acting at arm’s length, when neither has an interest to generate business
for the other party and when both have reasonable knowledge of the relevant and material facts. It is a
prudent practice to verify fair market value through third party valuations. In addition, the lease-back
component of the transaction should be structured to meet the kickback safe harbor and/or Stark
exceptions, as necessary, applicable to real estate leases. Although the Stark and Antikickback laws
are codified in distinct statutes and the real estate kickback lease safe harbor and Stark lease
exceptions are not identical, the rules for both have the following general requirements: the leases
must (a) be in writing, (b) be signed by both parties, (c) include a description of all space to be leased,
(d) have a term of not less than one year, (e) be for space that is reasonable and necessary for the
legitimate business purpose (and, in the case of Stark, be used exclusively by the lessee when being
used by the lessee), (f) require rent that is set in advance and is consistent with fair market value, (g)
not include rent or other charges that are determined in a manner that takes into account the volume or
value of referrals, and (h) be for a commercially reasonable business purpose.
Furthermore, REITs are often a desired investment vehicle because they receive preferential tax
treatment because dividends distributed to their investors are tax-deductible by the REIT. Generally,
5
Modern Healthcare, Cashing in on Land, Mar. 7, 2011.
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Why Should Health Care Providers Consider Creative Real
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the REIT will be exempt from income tax at the corporate level if it passes through, in the form of
dividends, at least 90% of its income to its investors. Moreover, in 2008, the American Housing
Rescue and Foreclosure Prevention Act of 2008 (the “Act”) significantly changed rules relating to
REITs which focus on health care assets. To qualify as a REIT, at least 75% of the REIT’s annual
gross income must be derived from certain real estate items, such as rent, mortgage interest and shares
in other REITs. In addition, 95% of the REIT’s annual income must be derived from the 75%
aforementioned income categories plus certain categories of passive income, such as dividends,
interest, and gains from selling non-dealer stock or securities. The Act eased certain REIT rules
relating to taxable REIT subsidiaries (“TRSs”). Specifically, the Act expands the lease income
exception to include a TRS that rents the health care facility from its owner REIT. Under this
exception, the TRS will then typically hire an independent contractor to operate the health care
facility, sometimes known as an “Opco.” The REIT’s receipt of rental income from the health care
facility will qualify under the previously mentioned 75% and 95% income tests. Thus, health care
REITs are able to earn more non-qualifying income through TRSs without risking losing their REIT
status.
This change in tax policy came about in part because health care providers desired to focus on their
strength of providing health care services, rather than owning and managing medical office buildings
and facilities. Likewise, this tax change allowed the capital markets and institutional landlords, like
REITs, to invest funds in the considered stable and growing health care real estate market. This
treatment also allows for real estate management expertise and economies of scale.
In sum, as the demand for quality health care services increases, the need for new and more efficient
medical real estate continues to expand, and health care costs continue to rise, physician practice
groups, hospitals, skilled nursing and assisted living facilities, and other health care providers should
consider whether a monetization of their real estate assets, through a sale-leaseback arrangement or
other joint venture transaction, would be a viable strategy to keep pace with the rapid evolution of the
health care landscape.
For more detailed information regarding acquiring real estate for health care related uses, please also
see the K&L Gates LLP real estate alert entitled Critical Real Estate Considerations in Health Care
Transactions, authored by Stephanie C. Powell and Michael J. Ovsievsky.
Authors:
Stephen A. Timoni
[email protected]
+1.973.848.4020
Daniel A. Suckerman
[email protected]
+1.973.848.4057
Dean H. Wang
[email protected]
+1.973.848.4012
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Why Should Health Care Providers Consider Creative Real
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