By Ken Gould

The first public option to refinance hospital debt will be made viable for more hospitals if proposed changes are codified later this spring. The new eligibility standards for HUD mortgage insurance, announced in late January, would enable more hospitals, including those below investment grade, to reduce interest rates, exit troubled banking relationships, extend debt amortizations or otherwise alter existing hospital debt structures.

In the Proposed Rule currently published in the Federal Register, HUD emphasizes that its financing is designed for necessary community hospitals that are strong enough to qualify under its relatively conservative underwriting guidelines, but that do not have access to other funding sources. Comments on HUD’s revised threshold requirements are being accepted through March 30, and advocates already are developing responses to further refine the criteria.

The Evolution of Refinancing Through HUD
Mortgage insurance can be used by hospitals of all sizes to finance construction and renovation at some of the lowest rates and best terms available. Before July 1, 2009, a hospital could refinance debt with HUD mortgage insurance, known as the FHA/HUD Section 242 program, only if 20% of its transaction consisted of money for new projects. The 20% new money requirement was not viable for most hospitals, as taking on additional leverage or the burden of a project was not tenable.

The new-money requirement was eliminated with the Federal Housing Administration’s announcement of the FHA Section 242/223(f) refinancing program last July. But vague and restrictive eligibility requirements thwarted hospitals that sought to use the eagerly-awaited option: The required debt service coverage and operating margin ratios for refinancing, for example, were 1.8x and 0.33, contrasted with 1.25x and 0.0 for new construction. An additional requirement that the hospital either have experienced a 1% interest rate increase or be facing an “imminent” increase in its interest rate left doubt as to whether fixed-rate debt could be refinanced at all.

Hospital advocates nationwide pushed for eligibility revisions. The changes were announced Jan. 29 in a Proposed Rule published in the Federal Register for public comment.

How Has Eligibility Changed?
Changes to the refinancing criteria include:

• Reducing the required three-year average Operating Margin ratio to 0.0% from 0.33%.
• Reducing the required three-year average Debt Service Coverage ratio to 1.4x from 1.8x.
• The requirement that a hospital have experienced an interest rate increase of at least 1% or face an “imminent” interest rate hike has been replaced with a more flexible and defined standard. Hospitals must now meet three of the following seven criteria to be eligible to refinance:
  • Refinancing would reduce total operating expenses by at least 0.25%.
  • The new interest rate would be at least 0.50% lower than the current rate.
  • The current interest rate has increased at least 1 percentage point since Jan. 1, 2008, or likely will increase that much within one year.
  • Annual total debt service is over 3.4% of total operating revenues.
  • Credit enhancement on current financing has been or will be withdrawn or expired, or the enhancement provider has been or will be downgraded.
  • The current financing has overly restrictive bond covenants.
  • Other circumstances demonstrate that the hospital’s financial health depends on refinancing.

The hospital must also demonstrate that it provides an essential service to its community and that there are few affordable refinancing options. HUD is also focusing on market need, although this determination can vary in different scenarios. For example, a state-designated Critical Access Hospital will most assuredly receive more scrutiny than a federally-designated Critical Access Hospital, as will a hospital seeking to use a high percentage of its loan for expansion in a competitive market area. A market need study will usually be required, but can be waived at HUD’s discretion.

Hospitals that meet the above criteria would do well to include FHA in their refinancing considerations because interest rates are lower via HUD financing than via unrated, unenhanced fixed-rate bonds, and HUD’s cash collateral requirements are lower than those of many banks.

The traditional 242 program for new construction continues to be an option for independent hospitals, as well as for hospital systems that seek to isolate the credit risk of a single asset (perhaps a smaller hospital in a multi-hospital system). For public-owned hospitals, the 242 program can be utilized in conjunction with Build America Bonds, resulting in a significantly reduced cost of capital.

HUD estimates that it could complete about 40 hospital refinances in calendar year 2010, assuming processing of 60 days for each application. While this timing estimate appears reasonable given the assumed workload, as of early February no hospital refinance has yet been completed to provide an actual comparison. HUD’s timing also assumes an even distribution of applications during a calendar year, an assumption that in future years will likely be reasonable.

With the revisions to its FHA Section 242/223(f) mortgage insurance program, HUD has introduced a viable public sector refinance option where none existed before. While certainly not a panacea, the addition of a non-private-sector refinancing choice provides relief to mid-level community hospitals at a time when they need it, and will continue to be worth including in any comparisons of refinancing options even when the market stabilizes.
 

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