Community hospitals face many challenges given the dynamic nature of the health care sector today. Compressed margins, competition from acquisitive health systems, and physician recruitment and retention are just a few examples. However, community hospitals may be able to leverage some of their inherent strengths to mitigate some of these challenges through prudent investments in seniors housing within their market area.
An investment in seniors housing can provide additional cash flow to subsidize compressed hospital margins and diversify a community hospital’s revenue streams. Nonrecourse funding options are available through both the U.S. Department of Housing and Urban Development (HUD) and the United States Department of Agriculture (USDA) to finance the acquisition or construction of seniors housing projects, thereby keeping them separate from the hospital’s credit profile.
Hospital Sector Performance
The general consensus from the three major credit rating agencies, Moody’s Investor Service, Fitch Ratings and Standard & Poor’s (S&P), is that the overall sector outlook is poor, as rating downgrades exceeded upgrades across the board. The downgrades were a function of negative profitability trends, declining inpatient volumes, and reductions to rate increases compared to prior years. These negative trends were partially mitigated by effective cost cutting on the part of hospitals. However, these expense reductions are limited given the need to maintain quality patient care.
Conversely, many hospitals saw strengthening balance sheets over the same period with well-performing investments, astute capital expenditures and by limiting the amount of new debt undertaken. Hospitals that have seen increased cash balances, however, likely have limited and conservative investment options which would result in minimal returns.
Increased volatility in the sector is expected to continue in the near future. Operating margins are expected to continue to compress as expense reductions will likely fail to keep pace with reimbursement and volume declines. In addition, the transition to a value-based reimbursement system will be highly disruptive as volume and reimbursement will decline with no offsetting increase in admissions. Financial ratios are projected to gradually decline due to incremental pressures stemming from health care reform and difficulties controlling expenses.
Given the historical and projected financial pressures experienced by community hospitals, an investment in seniors housing in the hospital’s market area can provide additional cash flow to mitigate the recent negative trends. The excess cash flow generated from seniors housing projects can support operations at the hospital to further its mission to provide quality health care to the residents of the community.
Demand for seniors housing in secondary and tertiary markets is generally robust given two factors. First, there is typically a lack of modern facilities. Facilities in rural areas tend to exhibit functional obsolescence given the vintage of the buildings. Newly constructed facilities are generally more appealing to potential residents. Second, rural communities tend to have an aging demographic driving demand for seniors housing. Many communities have demand in excess of the supply, creating a shortage of units. A newly constructed facility can help meet excess demand.
Why Community Hospitals?
Community hospitals are well positioned to capitalize on this opportunity for a number of reasons. First, the hospital is already tied into the market’s health care sector which creates a potential source of referrals to the seniors housing project. Second, when compared with other local nonprofits and for-profit businesses, hospitals generally have strong balance sheets with adequate liquidity. This liquidity, which can be an equity source in a new development or acquisition, is a critical component of a successful seniors housing project. Third, conservative investment policies tend to limit the hospital’s options with respect to investment vehicles. Investing in seniors housing can be a logical vehicle to drive a hospital’s non-operating revenue and relieve the pressures of compressing net operating income (NOI) margins hospitals have experienced over the last few years.
The State of Seniors Housing report reflects NOI margins ranging from 31% to 38% depending on the acuity level of the seniors facility. These margins are far superior to even investment-grade hospital cash flow margins. In addition, a very active sales market has been established resulting in an average sale price totaling near $180,000 per unit for lower acuity seniors housing (assisted living and independent living) providing an additional outlet to generate cash flow in the event the hospital desires to exit the investment.1
Hospital leadership may also be compelled to invest in seniors housing due to the reimbursement tie between hospital and long-term care providers. A hospital has no direct control over senior facilities that are owned and operated by third parties. As such, the hospital cannot control the quality or processes and procedures of the unrelated seniors facility. A poorly managed facility can result in increased readmission rates to the hospital, negatively impacting the reimbursement received by the hospital from Medicare. If the hospital has an ownership interest in the project, whether through a joint venture or sole ownership, it can more directly influence the operations of the seniors facility. Providing quality care to the residents not only will drive profitable operations of the seniors facility but would have the added benefit of improving hospital performance through reduced hospital readmissions.
Keys to a Successful Project
There are three primary keys to a successful seniors housing project. First, an experienced operator must be in place to manage the operations of the facility. The hospital could elect to operate the facility if it already has experience in that sector or it could bring in a third party operator. Having a proficient operator is of paramount importance to the success of the project’s lease-up, stabilization, quality of care and profitability. Second, it must be determined if the local market can support additional seniors housing. This can be achieved through retention of a reputable third party firm to perform a market study. Lastly, equity must be available to fund the equity requirement, which includes working capital and initial operating deficit funds. The strength of a hospital’s balance sheet can be leveraged to fund these equity needs. In many cases, experienced operators would like to build new facilities but do not have the requisite equity to fund the construction of the project. A joint venture with a hospital can be mutually beneficial as the hospital would own the asset and collect a lease payment that is notably higher than the cost of capital on its debt. Additionally, the lease payment can provide superior returns when compared with the hospital’s traditional investment returns given a community hospital’s typically conservative investment policy.
Two primary funding options are available to facilitate the purchase or development of seniors housing assets in a nonrecourse fashion (no guarantee from the hospital). Financing through the FHA Sec. 232 program can be used for both new construction and acquisition financing. This can result in a fully amortizing loan over a 40-year term with all-in fixed rates currently below 4.75%. There were over 500 Sec. 232 financings completed in fiscal year 2014, exemplifying how active and popular this funding option is.
The second option is a USDA Community Facilities (CF) loan. This can also be used for refinancing and new construction (at least 50% new money is required), but can only be used for rural facilities (areas with less than 20,000 of population). There is an abundant supply of USDA CF funds at present, and current fixed rates are approximately 4% for up to a 40-year term and amortization. Both funding options provide permanent financing and are nonrecourse, thereby preserving the credit profile of the hospital. This is achieved through creation of a single asset entity to own the real estate. This entity would be owned by the hospital but is essentially independent, insulating the hospital in the event the project is unsuccessful.
Investment in seniors housing is a natural fit for community hospitals that are already an integral part of the health and welfare of the community’s residents. The investment can provide much needed incremental cash flow to allow the hospital to further the mission to serve its community, as well as provide modern seniors housing stock to the market the hospital serves.
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1. The State of Seniors Housing 2014, American Seniors Housing Association.