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Planning a Medical Real Estate Development

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Land development for the purposes of building a facility is a complicated process with several stages involving multiple parties and encompassing many financial risks. The process consists of a series of actions from that of land purchase to leasing, construction and sale, but most of the items that pertain to development occur prior to land acquisition.

While the process of healthcare real estate development planning will differ based on medical type, the preferred series of events is one which eliminates risk early through pre-construction commitments for leasing, permanent financing and potential final sale. Prior to initiating the development process, it is necessary to analyze how the development will assimilate into its market. Planning for a medical development requires the consideration of these general principles:

Land Analysis – A potential medical development site has physical characteristics that make it more or less adaptable for a specific use. These include the terrain, dirt composition for land, its shape and size, accessibility, neighboring residential areas and appearance of surrounding land uses.

Planning Commissions – Zoning and city planning will limit certain types of medical development that may be permitted or refer to the process for change to these requirements. An aspect for the approval of a project consists on how the community will accept the development and what will be received in terms of quality, appearance and use. In most cases, developers will be required to identify who the principals are and how approval and how the structure is arranged for project completion.

Market Analysis – Because the market ultimately determines the success or failure of the developed medical project, initial planning should assess demographics, patient or trade area, competitive projects and supply of demand.

Financing – Identifying the potential lenders, equity participants, terms and interest rates, along with the developers level of participation should be outlined early in the process. All too often the original plan is modified or entirely changed by lending requirements.

Uses – While specialized medical development is difficult to reconfigure for alternative uses, determining whether the facility may be re-adapted easily should be outlined early.

Site Selection – Consideration for the medical site’s capacity should includes tests of layouts and site coverage arrangements required by zoning and certain users. Analyzing parking areas, access roads, utilities, floor and common area ratios and building-to-site ratios are specific requirements that will alter the original development.

Highest and Best Use – A few tests may help to determine the feasibility of a medical development for a certain area. Whether the development is physically possible, legally and economically achievable and maximally productive should be applied to the site analysis. This examination should take into consideration development costs, assumptions for financing and potential revenues, and subject to multiple variables.

Development Plan – The healthcare real estate master plan embodies the assemblage of land, the layout of the development and its phases, parcel configuration(s), and ingress and egress from on and off-site components.

Visual Identification – Initial architectural drawings and graphic layouts of the medical project should be prepared to illustrate the results of each item within the master plan.

Financial Proforma – With the specific items and costs identified, the planning unit must ready a financial projection that chronicles such costs, the project’s funding sources, project revenues and investment returns for the entire project.

Marketing Strategy - The marketing procedure chosen for the project will help to identify the project’s place in the market. It will highlight the themes of the marketing plan and provide a strategy for marketing implementation to ensure the success of the project.

Implementation - Lastly, the itemized agenda includes all of the development steps, time management goals, the members to the development and responsibilities of each.

In January 2013, MREA will highlight the process of securing, permitting, construction and potential sale of a medical real estate development. If you have not already, please click the orange RSS icon at the top right of this web log to have our posts delivered to your inbox or preferred reader.

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3 Development Strategies for Healthcare Providers

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Hospitals and physician groups are embracing third party ownership, management and development of real estate because it has the ability to preserve capital resources for acute care needs, eliminate the conflicts that arise in the landlord/tenant relationship and minimize the potential legal and regulatory challenges associated with leasing space to referring physicians.

Many partnership synergies and dispositions have been publicized through our organization’s newsletter, but a new trend is occurring in which small providers up to large systems are utilizing third parties to develop and own new medical real estate projects. This trend has the potential to have a significant impact on capital structure decisions for going forward.

The use of outside capital to fund non-core real estate assets has been used with improved adoption in corporate America to facilitate growth and expansion. Retailers such as Wal-Mart, CVS and Walgreens, which are becoming stronger competitors in providing healthcare, have all increased liquidity and implemented cost efficiencies using third party capital and development expertise to fund billions of real estate expansion over the last few decades.

As for the development of medical facilities, healthcare providers may choose a few approaches that have been highly successful.

One. Providers may select to develop a project internally using an owner’s representative in place of the traditional developer. The owner’s rep determines the size and scope of the project and works with architects, engineers and the general contractor to build the facility. The provider is responsible for procuring entitlements and utility easements and covering the costs for the site preparation process. In this scenario, third party consultants may be employed to assist with these individual processes. The hospital is also responsible for the leasing and management of the building, although it may appoint a property management firm.

Two. Another approach is through the use of a third party to develop the medical facility for a fee. The third party will receive a fee for its services. In this case, the provider is contracting the developer’s expertise, which commonly includes feasibility analysis, project guidelines, pre-leasing, management of the entitlement process, value engineering for the project, negotiating the contract with the general contractor, as well as project management.

Three. A third party developer and owner both develops and owns the building through its completion. The developer/owner performs all the same functions as the fee-based developer. The main difference is that the developer assumes all of the risks and benefits of the development process and the ownership. A fee-based developer may have an incentive to reel the project in at a contracted cost and within a specified timeframe. The developer-owner has the same incentive, but is likely to strategize on ways that will lower costs of the long-term ownership, because this will ultimately determine the owner’s total cash flow and return on investment. Furthermore, a developer-owner has an incentive to minimize the size of the building to assure high occupancy rates, which has the ability to create conflict with the providers longing for vacant space to accommodate future needs.

If you should have any questions or require a proposal for a medical development under one of these three proven commercial real estate development strategies, please contact MREA at 713.701.7900.

Leasing Vs. Owning a Medical Facility

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While opinions widely differ among the ranks of healthcare providers, most would agree that the financial ramifications of long term commitments for medical real estate space will continue to weigh heavily on growth in people or technology. Some see real estate as a cost of doing business, yet, we attempt to dispute this notion and advise that it can be a tremendous avenue for personal wealth if performed with diligence and comprehension. The leasing vs. ownership model for a medical building still significantly benefits the providers seeking to purchase or development. That said, is the advantage of real estate ownership appropriate for you and your organization?

Providers, especially small to mid-size physician practices, need to answer several questions in order to determine if ownership is the right strategy going forward.

  • Will the provider own the building alone or should a joint venture with other practices be considered?
  • Will partnering with a hospital be considered?
  • Will a third-party developer or investment partner be considered to help guide the practice through the development process?
  • What are the front-end cash requirements?
  • What is the tolerance for debt guarantees?
  • How does ownership align with long-term practice strategies or goals?
  • What is a viable exit strategy?

The answers to these questions will help guide the physician group (and broker/developer/investor) to the right decision regarding equity participation in a medical office project. In today’s tight lending environment, the more cash invested, the better the borrowing terms available. Although borrowing for commercial real estate today has become increasing more challenging, especially compared to residential, we routinely take calls from lenders who will fund medical single and multi-tenant buildings by qualified buyers that will use the space.

How will the provider’s occupancy help to determine the cost of the building? Follow me here, as this is difficult for medical tenants to grasp. Rents are based on the cost of the entire project and cost of borrowed funds along with the return on cash investment desired, rather than the availability of space. In today’s medical real estate investment climate, the typical cash on annual return ranges from 9% to 15% per year based on a fully occupied building. As time lapses and rents improve, two favorable investment events happen: The cash return increases on an annual basis, and the market value of the property increases. Both of these events create increased value and wealth for their owners.

The inherent risk is the inability to maintain building occupancy with a practice group or medical rent-paying tenants. Empty buildings are extremely volatile and difficult to price. Prices parallel the availability of space coupled with the absorption of space in the regional and local marketplace. Rarely do vacant buildings increase in value unless the land underneath appreciates in value.

If you have a question regarding leasing, ownership, or simple investment into a medical building, please contact MREA at 713.701.7900.

Joint Ventures for Outpatient Facilities

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Historically, hospitals have entertained reliable income streams from the their surgical and diagnostic imaging components. Now, because patients have greater access to physician-owned surgery centers, coupled with advancements in imaging technology, it is increasingly difficult for hospitals to have income certainty from these procedures within a hospital setting.

On the other hand, proposed and already implemented changes to the Medicare payment system suggest that physician providers face the threat of losing a greater percentage of revenue. Thus, many are seeking partners with hospital systems from a joint venture perspective.

1. The most common form of joint venture is the division of ownership between the hospital and physicians. In this agreement, the hospital and participating physicians form a new entity and each contribute funds or lender approved interest equal to their pro rata ownership in the new entity. The equity investment model has proved to be a “win-win” situation for both the hospital and the participating physicians. The hospital better secures a long-term relationship with referring physicians, builds loyalty and trust, and recaptures a lost revenue stream. The physicians are better positioned for a positive ROI and can focus on patient care rather than highly detail-oriented tasks and risks that exist in real estate ownership and management. A potential drawback under the surgery center setting is that the payment received under this form of joint venture can be significantly less than what the hospital would receive for the same procedures performed on a hospital inpatient basis.

2. The healthcare industry has seen more “under hospital arrangements” over the past decade, although many have been recently banished from hospital settings. While this model can take on many variations, several characteristics are in common. The participating physicians provide to the hospital a certain ancillary service (from the use of primary equipment to turn-key management).The hospital purchases that service on a “per-click” or “per-use” basis. The hospital is the billing entity and is paid under the hospital ambulatory payment classification codes. The primary advantage of an under arrangements model is the higher payment received by the hospital as a result of the hospital billing under the hospital payment system. Moreover, the hospital bills under its managed care contracts, which commonly provide for higher payment than what is received by freestanding outpatient facilities. A few potential drawbacks to the under arrangements model are the increasing regulatory scrutiny of hospital and physicians transactions. Also, because the hospital performs the billing of the surgical procedures, the Stark law is in effect.

3. A standard block lease is where the hospital leases ancillary equipment or management responsibilities to participating physicians in return for a fair market value lease. Each participating practice bills under its own group number. The primary advantage of a block lease arrangement is its ease to initiate and terminate. Since a participating practice does not have ownership of the equipment or facility, the hospital or physician practice can quickly terminate the relationship. One major disadvantage to block leasing arrangements is that the physicians do not feel like ownerHistorically, hospitals have entertained reliable income streams from the their surgical and diagnostic imaging components. Now, because patients have greater access to physician-owned surgery centers, coupled with advancements in imaging technology, it is increasingly difficult for hospitals to exercise income certainty from these procedures within a hospital setting.

4. The shared expense model is a variation of the block lease model, except that instead of each practice leasing blocks of time, it would assume a commercially reasonable proportion of the costs of the diagnostic business and utilize the imaging equipment on a first-scheduled, first-served basis. From a regulatory perspective, the shared expense arrangement may be considered more aggressive than a block lease arrangement because it will not qualify for safe harbor protection under the Anti-Kickback Statute. However, many physician practices may still prefer this type of an arrangement due to its added flexibility of being able to schedule patients on a first-scheduled/first served basis and paying expenses in a manner that more closely reflects the actual use of the imaging equipment.

MREA is a truly comprehensive medical real estate platform that plugs the gaps from that of traditional buy-sell-lease-manage commercial real estate companies. To receive a complete package of our healthcare services, real estate offerings, consulting assignments, or merger/acquisition successes, please contact Robert S. “Bob” Lowery at 713-701-7900.