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Just when our clients were becoming comfortable with the general premise of healthcare reform and the likelihood of declining medical reimbursements for years to come, enter the August 2010 Financial Accounting Standards Board proposed accounting rules for real estate and equipment. These changes have the potential of tremendous impact on equipment and real estate via the composition, execution and implementation of leases. In its current form, and depending on the breadth of an organization’s lease commitments, this has the effect of throwing tens of thousands to millions of dollars of lease commitments onto each balance sheet.
Speaking specifically to the healthcare industry, real estate and equipment leasing has been utilized extensively to assist with several business pressures, whether it be administrative, technological, competitive or regarding growth plans. This has been the preferred method, and a substitute to purchasing which requires significant cash outlays, among other prohibitive items.
Lease Accounting Changes
To explain where we are potentially going, we should address where we are currently. The Generally Accepted Accounting Principles (GAAP), which is code for how CPAs and businesses prepare financial statements for income and expenses, assets and liabilities, draws a line between an operating lease and a capital lease. Under the new guidelines, the difference in classification will be deserted.
It might surprise you, but, according to several sources within the accounting industry, the distinction should be abandoned. This is because the current trend has been where businesses place lease commitments off of the balance sheet, whereby financing new transactions without recording existing lease commitments as liabilities.
It has been suggested that the effect of adoption will add an estimated $1.3 Trillion onto balance sheets of businesses, significantly impacting both assets and liabilities of companies, which is to include private and non-profit organizations. Under the proposed standards, long-term real estate and equipment leases will be required to be disclosed, similar to that of a purchase.
The greatest impact would be that of dumping your equipment and real estate onto the balance sheet, but, even more complicated is that it would be necessary for lessees to calculate what is known as an ‘expected outcome analysis’. This can be defined as the present value of future lease payments. As each lease seems to differ from one other, under the rules it will be required by the lessee to determine potential financial outcomes within leases, including extensions, CPI adjustments and expense reimbursement items such as improvement amortization.
The new measures would require revisions at each reporting period. For each period, the changes stipulate that the income statement be revised to reflect the interest expense component, as well as losses to the asset.
Concerns are certainly mounting. Many are not sure how dramatic of an impact the shift will be, as well as their difficulty in determination of long-term forecasting models for relatively unpredictable financial outcomes. This uncertainty would create a deterioration of the use of lease term variables, to be explained further. Other criticisms include that of the time and costs transferred to real estate owners and businesses to implement such change.
As for impacts of leasing changes with regards to the healthcare industry, there are several as well. As was evident by medical real estate development growth that has occurred on and off the hospital campus, leasing has been a very effective tool for hospitals, now referred to as medical centers. These systems developed facilities to provide for favorable referral situations with physician groups to provide for and offset the enormous costs associated with operating a hospital. As for equipment leasing, most of these institutions have levered improving medical and technological advances by leasing equipment, so as to not become tied to the purchase of vital items, essential in patient satisfaction, that may become extinct within a short period of time.
The potential effects on real estate could have significant impact for systems and physician practices that have used lease transactions to add assets or expand in geography, now essentially having to make room on the balance sheet for all of it. Quickly, some will find themselves flirting with the line of allowable leverage that demonstrates necessary stability for the purposes of future investment. Arrangements such as ground leases or subleases have the potential to become negative consequences, rather than the opposite. It is no doubt that many healthcare providers are in their respective war rooms developing strategies designed for lease administration changes. MREA is currently working with hospital systems, large and mid-size physician groups to educate about such changes.
As for modifications to these proposed, monumental changes to accounting principals, please contact our firm. A new exposure draft is to be made public in the second quarter of this year.
MREA – Medical Real Estate Advisors was strategically designed to assist healthcare providers via our ‘healthcare business meets real estate’ mission statement. The firm’s owners are actively licensed CPAs, principals and real estate practitioners that, when utilized properly, have the ability to provide streamlined solutions to complicated business and real estate items that otherwise would absorb valuable time, multiple contacts and resources to remedy. Contact your representative today or go to http://mreausa.com.
We are commonly asked questions that pertain to concerns which are healthcare industry-specific, yet we can always find a way these issues relate back to the contractual obligations of real estate commitments. As a courtesy to those that are seeking guidance explicitly for when the rubber meets the road (real estate meets healthcare), we have provided some fairly uncomplicated scenarios that will likely exist in a health facility lease transaction.
Landlord Vs. HIPAA
Commonly, a lease agreement will allow the landlord entry onto the premises for the purposes of inspections and repairs. HIPAA provides guidelines to protect medical records and personal health information. A lease within a medical facility will typically provide that the landlord may not enter an exam room with patients present. Further, most leases will indicate that any location within the spatial premises leased by the tenant, if entered, will have the potential to breach privacy or confidentiality of patients or medical records.
Tenant Vs. Medical Waste
A medical lease agreement will typically include a provision that prohibits a tenant from using or storing any hazardous materials on the property without the consent of the landlord. If the tenant will require the use of such materials, the lease will commonly indicate that the materials commonly used in concert with the permitted use of the leased premises will be allowed, as long as the materials are stored in compliance with strict regulatory commitments.
As for the disposal of hazardous waste, leases commonly provide that the landlord will be responsible for janitorial services, but will require the tenant to arrange for its own disposal of medical waste.
Stark Law Vs. Landlord/Tenant
It is important to consider if a relationship exists that has the ability to breach Stark laws, or potentially, Texas law. The Anti-Kickback Statute deems it a felony to offer, tender or receive fee, or compensation, if the payment is determined to influence referrals for patients. So, it is important for a lease to exist and to comply with the following:
Permitted Use Vs. Technology
A lease agreement will include a permitted use provision that restricts the use of the space to certain business operations. Yet, a tenant wants to maintain flexibility, especially with the newly minted technological changes that are required to adapt and compete within a specialty. So, a tenant wants the provision to be as broad as possible, while a landlord seeks to restrict the use to improve tenant mix and provide other tenants with exclusive rights. While a rare bone of contention today, technology will eventually force tenants to seek very general, or highly specific opportunities.
Building Vs. Equipment
The medical industry has some of the most cumbersome and demanding equipment. It requires specific attention when placing on the premises of a multi-story structure. Thus, some buildings have special provisions for weight distribution or electrical capacity. The location and installation of necessary landlord and tenant is commonly addressed in lease.
Improvements Vs Landlord/Tenant
The lease agreement will provide how each party will become responsible for design, materials and installation of the tenant’s improvements. While a highly negotiable item within the lease, it should determine the control of implementation and ownership of improvements.
Lease Vs. Physician Practice
A greater number of leases are requiring personal guaranties from key members within a physician group for the purposes of adherence to contractual obligations. With more physicians defecting to hospitals, merging practices, or even leaving certain jurisdictions, we are noticing considerations for physicians to be released from guaranty if the leave the practice, while including those that enter. Other limits include guaranty amounts proportionate to ownership share of practice.
These are abbreviated responses to a few common inquiries pertaining to medical real estate, none of which constitute legal advice. Please make sure to contact Robert S. “Bob” Lowery for guidance with your healthcare real estate decisions.
Several years ago, a partner and I undertook a major leap of faith to become exclusively intertwined with the medical industry. With over 40 years of combined commercial real estate experience, looking back, we took some bold steps to immerse ourselves into this growing healthcare provider network.
In the beginning, we were witnessing tremendous demand from every medical network to expand ancillary service types and locales, and imaginations were certainly running wild. We became instant beneficiaries of this growth spurt and soaked up transactional experience and a command of the tenant mix and business components that were successful for a given medical office building or hospital system.
In just a few years, with changes occurring so rapidly, so dramatically, it is now difficult to talk ‘expansion’ with using the term ‘consolidation’ in the same sentence. This is not to say that medical groups are not expanding, it continues. As to where, you would not be surprised.
But this time, several hospital systems have been kind enough to request our perspective on the physician marketplace and their specific growth opportunities. Ultimately, these calls begin, and circle back to, our long standing commitment to physician groups, whereby equipping them with best potential business and real estate options in the marketplace.
But, recent dialogue suggests that hospitals are having a difficult time inducing established physician groups to become part of their system. There are several reasons, most of which revolve around healthcare reform as a general theme, but others tend to be more specific to the physicians’ professional future and their general discontent of employment.
Thus, we want to highlight the reasons some physician groups are saying “no” to hospital employment.
1. Some hospitals are at significant risk of hiring too many doctors. With too many doctors come too many competitive pressures for doctors to perform comfortably.
a. Doctors will need to prove their worth during the contract, especially if new groups are absorbed. The thought alone may jeopardize physician commitment.
b. Hospitals may struggle with financial issues relative to their business plans in the mid-2000’s, or with future obligations of regulatory nature.
c. Contracts may include, sometimes discreetly, clauses that pertain to early termination.
d. Sometimes Hospitals go through mergers or acquisitions of another that has the ability to affect physician relations with one or all.
2. The intricacies of how employees should be compensated by hospital systems creates an unfair advantage from one to another.
a. Hospitals have the advantage when implementing metrics to determine the highest profitability within practice endeavors.
b. RVU methods can be abruptly changed when given the uncertainty of less or greater government support.
c. Patient increases have the ability to overwhelm certain pratice areas, such as family practice, without compensation measures that adequately provide for such increases.
3. Seniority is perceived not to be an attribute within the hospital system.
a. Hospitalists have assisted in call duty challenges, but more often than not, the younger physician population is not enthusiastic about taking a tremendous call load and are voicing their concerns.
b. Hospital systems may not provide adequate measures to control call duty and patient volume, where private practices may employ these actions.
4. Physicians are accustomed to being in control of outcomes under their supervision.
a. Physician groups are quickly implemented into system and can become disenchanted in how their doctors, or staff, are being utilized.
b. Ancillary services may be a large component of a practice’s income, in which most are absorbed or non-negotiable when entering into a hospital contract.
c. With the advent of electronic health records, comes the hospital systems consumption of physician data into the coffers of a strategic, web-based marketing and patient assimilation network.
5. Non-compete clauses could take the most highly informed physician groups by surprise, especially if contracts are for a limited period of time.
a. A Hospital system made have affiliates, or may merge or acquire another hospital or network of physicians which effectively places additional limits on where a physician, or practice, may perform.
b. Upon the conclusion of a contract or severe downturn in economy, non-compete clauses can interfere with a physician, or practice group, whereas services are no longer needed and physicians may not partner or practice where they choose.
These are just a few of basic issues that come to our attention regularly within physician discussions of Hospital employment. Hospital systems have been fairly reactive and are tailoring their contracts to remedy such objections, but a certain stigma permeates throughout the physician public which has kept most conversations mute or placed to sidelines…for now.
…could get worse (or better). This truly depends on which camp you associate with regarding the economic divide that is now a larger topic of debate in our country. As for policy that is directed towards a remedy, both political parties could not be wider opposed to proposed solutions from the other, which is certainly indicative of our political and economic divorce.
The dichotomy is evident throughout the consumer world. For an example, high end retailers such as Nordstrom are recording excellent profit, and the low end, Dollar Stores, is doing great volume. As for the middle, JCPenney is laying off.
Apple has the highest market capitalization for a technology company (or any company for that matter) with continued pricing power, yet products and inexpensive technological innovations from Google continue to see enormous, reliable volume. Yahoo and Blackberry are getting slaughtered.
From a real estate perspective, multi-family is witnessing increasing occupancy levels from above normal rental activity and, on the opposite end, high end homes are picking back up once again as salaries, stock market and stable investments are paying greater tangible and mental dividends.
Farm and shale land are all the buzz, with prices quadrupling during a recessionary period, yet large tracts of land unloaded by lenders are dirt cheap. Midsize land tract owners and developers have had no place to hide, with speculative plays now in another’s coffers.
This all said, there remains activity in the middle and it is improving, which is absolutely essential for commercial real estate to fully function as a healthy investment consideration. When the headlines such as ‘commercial real estate is gradually improving’ echo throughout, it is the middle where analysts tend to concentrate. As for the high end, which I consider to be strategically located, newly developed, and freshly tenanted, it is going up, while the low end is dissolving. The middle (aka. the fence) is falling on one side or the other.
As for our firm, we are well positioned to guide and administer needs of the small (combining forces), middle (established, seeking to compete in other markets or adopt new identity) and large (strengthening and capitalizing on current position); we have solutions for all.
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8 Brain Benders (from easy to more difficult):
Property sales prices may be $600 per square-foot tenanted and will likely continue higher. What could change this trend? Stronger Dollar.
Property sale prices may be $6 per square foot vacant and will continue lower. What could stop this trend? Lower Oil Prices.
Lease Rates will continue improving. What will change this trend? More Problem Banks.
Rental concessions will likely continue to increase. What will change this trend? Mortgage Rates Moving Higher.
Tenants will begin to purchase buildings. It is going to happen. As for cautions, several purchases on high end will eventually suffer due to current and future price speculation and a small percentage on the low end with sacrifice their business principles for a real estate play that will weaken their competitive position in the long run.
CPI will likely remain steady. What will change this outcome? Stock market decreases significantly.
Buildout costs will continue higher. What will change this trend? Fannie and Freddie are officially taken over.
Eyesore buildings will continue to worsen. What could change this trend? REIT prices continue higher.
Around 15 years ago, physician practices were purchased by hospitals at compellingly high prices. Unfortunately for these hospital systems, within a matter of just a few years, the physicians were re-injected back into the community, largely because the hospital systems had not realized a return on investment. Fast forward to 2012, we hear similar stories about physicians becoming incorporated into a hospital’s network.The most common way that a physician practice group is absorbed by a hospital is through a method where physician owners and practice administrators keep an ongoing operation in place, essentially subjecting to less guidelines and oversight, but to assume some naming rights, some jurisdiction, as well as partnership for likely for potential future transaction.
As for the outright sale of a practice to a hospital, it may be achieved in several different ways. A hospital may purchase a practice’s tangible assets with physicians and staff as employees of the practice, whereby the unit is obtained as a separate entity. In another instance, the hospital may acquire the assets, physicians and staff to become employees of the hospital, in which the practice discontinues. As for unique circumstances, the staff becomes employees of the hospital, but the physicians remain separate.
A certain consideration should be made by physician groups as to the value of their practice to the hospital system. Because anti-kickback laws exist, the hospital cannot pay a physician group more than ‘fair value’ for their practice. Any payment that is beyond a certain amount could be considered a ‘kickback’ for services provided to the hospital. Also, keep in mind, the revenue generated by physicians for referrals outside of the practice itself are not considered in the valuation.
Another issue that comes from a practice purchase is that physicians are not relieved of their responsibilities. This is because the acquisition is commonly considered a separate operating division or profit center of the hospital. Consequently, the physicians compensation is still tied to the profitability of their previous medical practice. This provides troublesome if physicians are nearing retirement.
One last reminder, and a stark reminder of how this time may be different, is how the practice’s patients now can easily become part of hospital’s affiliated practice, especially with the advent of electronic medical records. In essence, the hospital now owns and operates all patient lists and records that have been accumulated by the practice group.
While I will leave you with the determination of whether it is better to sell, partner or lease with a hospital, MREA has established healthcare real estate professionals, accountants and attorneys to whom you have access. Contact us for our wide range of client responsibilities that incorporate business strategies with extensive real estate capabilities.
