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Reconciling Growth with Capital: Taxable Debt for Nonprofit and Municipal Hospitals

Most nonprofit health systems rely on six sources of capital to fund and grow their businesses: operating margin, external debt, sale of assets, investment income, joint ventures and philanthropy. Over the past two years, however, every one of these sources has come under pressure from an unprecedented convergence of capital market, economic and regulatory forces.

Further, some ratings agencies, in evaluating a hospital’s financial strength and access to capital, have begun to differentiate between “wealth” and true balance sheet liquidity, driving many providers to re-double their efforts to improve days cash on hand and cash-to-debt ratios. Herein lies the challenge – executing a long-term growth strategy while maintaining liquidity and balance sheet strength.

One of the most efficient methods of accessing capital, tax-exempt bonds, can sometimes cause a dip in a hospital’s liquidity because of the up-front closing requirements associated with these issuances. Historically, though, issuing tax-exempt bonds provided municipal issuers such a considerable interest rate savings that any escrow funds and other closing requirements were nearly irrelevant compared to interest rates savings, and taxable bonds and other taxable debt options – which generally have fewer demands on liquidity at closing – received much less notice from nonprofit health care borrowers.

But taxable debt is currently much less expensive than it has been in years gone by when compared to tax-exempt financing. The narrowing of this gap, along with the availability of new taxable funding options, has contributed to a considerable increase in taxable municipal issuances and greater awareness among nonprofit hospitals of taxable financing options.

Taxable Debt Issuance: Build America Bonds and FHA

One of the most significant contributors to the increase in taxable municipal issuances has been the Build America Bond program, which reimburses public borrowers (e.g. city-owned hospitals) for 35 percent of the interest expense of “new money” debt. Borrowers have been enticed to issue Build America Bonds because of the structure’s relatively low cost of capital and often less-onerous funding reserve requirements. The Build America Bonds program accesses the large taxable investor market and is an attractive municipal issuance alternative for investors accustomed to purchasing taxable fixed-income securities of all types. This increase in investor awareness and demand has in turn helped to keep interest rates down for borrowers, even before the 35 percent subsidy. The ability to issue Build America Bonds expires at the current subsidy level after 2010, though it likely will be extended with a lower subsidy.

 

The Federal Housing Administration’s mortgage insurance program for hospitals, FHA Section 242, is another efficient way to issue taxable debt. With fixed rates, a term and amortization of up to 25 years, and a low, flat fee for FHA’s highly rated mortgage insurance, the program has been appealing both to stand-alone, lower-rated credits and to large hospital systems, which can employ the non-recourse debt to carve out from the system’s credit profile facilities that the markets may view as higher-risk.

Perhaps most compelling is the combination of Build America Bonds with FHA Section 242 mortgage insurance, which can reduce a hospital’s net fixed cost of capital to substantially below market rates (currently below 5 percent fixed for non-investment-grade hospitals).

Traditional debt, whether enhanced or unenhanced, can also be evaluated in terms of whether a taxable or tax-exempt issuance would be more cost-effective for the hospital – or whether issuing multiple bond or note series, some taxable and some tax-exempt, could provide additional flexibility and cost savings.

Taxable Credit Tenant Leases

Another taxable option to consider, particularly for hospitals that need to get a project up and running immediately without damaging their days cash on hand ratio, is a Credit Tenant Lease. A CTL is a form of developer-provided external debt. In this structure, a hospital with a construction project – a medical office building, acute care facility or clinic, for example – would seek a developer to finance and build the project. The hospital would then make regular payments to the landlord. As an absolute-net lease, the hospital is responsible for any operating expenses, taxes, maintenance costs and capital expenditures. If the CTL is carried to term, the hospital would own the facility at the end of the lease. CTLs are typically structured to fully amortize over the term of the lease.

CTLs are useful as a “speed to market” option, often requiring only 90 days to complete the transaction. The lease generally has a term of 15 to 25 years. The CTL can also be structured with prepayment options at hospital-chosen points in the future. For example, a CTL prepayment date could be timed to be coterminous with the completion of a tax-exempt bond issuance, the call date on the "retail" series of a recent public financing, closing of a philanthropic campaign, or a decision to reallocate cash from the balance sheet following the sale of non-core assets. The CTL can be tailored to the operating objectives for a health care provider's real estate assets, including acute care facilities, medical office buildings, and ambulatory clinics.

CTLs are almost always considered on-credit and generally on-balance-sheet by rating agencies and accounting firms. Qualifying health care providers must currently have an investment-grade credit rating of BBB+/Baa1 or higher for optimal execution. The opportunity cost of most delayed initiatives can be measured as foregone revenue and net income, lost investment income, project cost escalation, and preemptive competitive pressure. The intrinsic value of utilizing a CTL often results from a health care provider having the ability to execute on its strategic initiatives at the optimal moment. One potentially ideal use could be for a hospital or system that saw an opportunity to build a high-end clinic to capture market share, but was between bond issuances and did not want to spend cash and diminish its liquidity ratios because of debt covenants or planned future debt issuances.

Over the long term, CTLs will be more expensive than debt financing via bonds or notes or an insured mortgage: The all-in coupon rate for an A-rated hospital currently ranges from 6.25 percent to 6.5 percent (7.8 percent to 7.95 percent lease constant) utilizing a 20-year CTL, compared to 5.5 percent for a straight A-rated, unenhanced, taxable bond issuance (and considerably less for a Build America Bond transaction after the rate subsidy). Since upfront transaction costs are low, CTLs may be an ideal source of interim financing to get a project off the ground. And since they use a third party’s money to finance the building, the hospital can maintain its liquidity.

The intrinsic value of utilizing a CTL often results from a health care provider having the ability to execute on its strategic initiatives at the optimal moment.

These taxable debt options can play important roles in diversifying health care funding sources, enhancing financial flexibility, managing the timing of accessing capital markets, and/or eliminating the opportunity cost of deferring projects. With more financing structures available in 2010 via the American Recovery and Reinvestment Act, and with the spread between taxable and tax-exempt debt much narrower than in the past, hospitals that are revisiting deferred projects and moving forward on their plans will do well to ensure they are exploring every possible option.

Mike Lincoln is Executive Vice President of Lillibridge, a private health care real estate investment trust. He can be reached at (877) 545-5430 or Michael.Lincoln@lillibridge.com. Steven W. Kennedy is a Senior Vice President with Lancaster Pollard and can be reached at (614) 224-8800 or skennedy@lancasterpollard.com.

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