Agency Options for Hospital Finance Better than Ever
Today is a good day to be an issuer in the bond market. With paltry returns available through government bonds and investment-grade paper, fixed income investors are reaching for yield and aggressively bidding for nearly all non-investment grade municipal bond credits, including hospitals. However, not all hospitals are a good fit for tax-exempt bonds. Restrictive covenants, transaction and borrower size, and cost of the issuance are a few factors that may make a public bond issue unfeasible.
Fortunately, there is a low-rate, long-term, covenant-light solution. The U.S. Department of Housing and Urban Development (HUD)/Federal Housing Administration’s (FHA) Section (Sec.) 242 program and the U.S. Department of Agriculture’s (USDA) Community Facilities (CF) program both made significant capital contributions to hospitals during 2015. Further, each program made strides toward becoming more user friendly, specifically with HUD’s new loan documents and USDA’s emphasis on processes and uniformity.
Until recently, the FHA Sec. 242 program used closing documents, covenant package and regulatory agreements that were created in 1973. This led to some of the terminology and legal concepts being outdated. The antiquated documents resulted in closing delays and additional costs, as a borrower and its lender counsel would have to negotiate changes to update and revise language. In 2016, HUD introduced a new set of documents that are expected to be finalized later this year. Although the documents do not introduce sweeping changes, much of the terminology and standard loan document provisions have been included. The changes should help alleviate the closing delays that occurred in recent years.
Similar to the FHA Sec. 232 program (used for skilled nursing and assisted living (AL) facilities), HUD has recognized that there are providers who use accounts receivable (AR) financing as a cost-effective means to manage cash flow. Unfortunately, the AR closing documents created for the 232 program were not easily transferrable to the 242 program because of the differing nature of reimbursement protocols. The new closing documents contain a form of intercreditor agreement and other necessary documents that meet the needs of AR lenders and HUD. Given the increased variability of reimbursement mechanisms and potential delays, the new AR lender provisions are a highly anticipated improvement to the program.
With regard to the 242 program volumes, a frequent criticism is that most of the loan volume is concentrated with existing HUD borrowers via second loan programs (the Sec. 241 program) and refinances of existing HUD loans (the Sec. 223(a)(7) program). In 2009, the release of the 242/223(f) refinance program was thought of by participants in the hospital finance industry as a compelling alternative to the traditional tax-exempt bond markets. For hospitals needing mostly refinance capital, HUD financing offered a highly-rated, inexpensive capital alternative that could fill a void left in the wake of the dysfunctional bond and credit enhancement market.1 Unfortunately, things did not go as planned as only one 242/223(f) commitment was issued from 2009 to 2012. Recently, however, the program has picked up steam. HUD issued one 242/223(f) commitment each during 2013 and 2014. Additionally, HUD issued three commitments during 2015.
Hospitals Improve Fiscal Outlook
Valley Presbyterian Hospital (VPH) was one of the new borrowers that successfully completed a refinance using the 242/223(f) program. VPH is an urban hospital that experienced difficult times in the early to mid-2000s, but an excellent management team had turned around the financial profile in recent years. VPH was interested in options to refinance its existing debt, which dated back to a time when interest rates were higher. The hospital carried relatively little debt and did not have any large immediate capital needs. Further, VPH serves a large amount of low-income patients and subsequently receives a large amount of its revenue from the California provider fee program, which led to a limited appetite in the bond market. Consequently, tax-exempt bonds would have been an expensive solution. Fortunately, the FHA program proved to be an effective low-cost option.
The Office of Hospital Facilities (OHF) identified VPH as a candidate for a relatively new accelerated processing initiative, which included a more streamlined application process. The project received a commitment for mortgage insurance within five weeks of submitting a complete firm application. VPH was also able to keep its revolving line-of-credit in place, using the first version of the AR documents described in the program changes above.
On the USDA side, the CF program provides financial assistance through direct and guaranteed loans for certain types of facilities or organizations in communities with less than 20,000 residents. Direct loan rates are reset quarterly (although fixed for the life of the loan), and the current rate is a historically low 2.875%. The maximum length of term is 40 years. A USDA guarantee is an agreement to guarantee 90% of a commercial loan, typically issued by a traditional bank. Guaranteed loan rates are determined by the lending bank. In recent years, the vast majority of funds allocated to the program have gone to direct loans. In many cases, USDA direct and guarantee loans are used for permanent financing in conjunction with lower-cost private sector solutions like bond anticipation notes or bank private placements for interim construction financing.
In fiscal year 2015, the USDA CF direct and guaranteed program obligated over $1 billion to 234 health care projects which includes hospitals, nursing homes and AL facilities. During the previous three governmental fiscal years, USDA CF obligated over $2.2 billion to 557 health care projects. The total USDA CF health care portfolio includes 448 hospitals with $1.6 billion of total principal. Loan sizes range from less than $1 million to $165 million.2
The USDA CF program guidelines generally require that projects include at least 50% of new money uses (i.e., less than 50% for refinance of existing debt). However, the guidelines do allow funds to be allocated for the “purchase of existing facilities when it is necessary either to improve or to prevent a loss of service.” Prospective applicants are encouraged to contact a financial advisor with USDA experience if they have a project that meets the above criteria.
In one example, Story County Medical Center (SCMC) is a county-owned critical access hospital in rural Iowa. SCMC built a replacement hospital in 2009 but wanted to build a medical office building on-site in order to consolidate operations. SCMC applied for and was obligated $14 million in direct loan proceeds towards its $15.4 million project at a rate of 3.5%. SCMC then secured private sector financing below 2% (fixed) to fund construction of the project. Upon construction completion, the USDA direct loan will be used to refinance the interim loan.
Because hundreds of local field offices serve as the initial point-of-contact for applicants, the national USDA CF program is administered in many different ways. As the program grows in popularity, market participants continue to encourage USDA to refine its processes in order to yield more predictable outcomes. Fortunately, the national office recognized these challenges and has started providing more training for local and state USDA staff in combination with the various market participants such as investment banks, feasibility consultants, architects and contractors. In addition, during the past year, USDA conducted four regional training seminars. These steps are helpful and encouraging for the trajectory of the program.
Clearly, both HUD and the USDA are being proactive in their efforts to make agency financing more efficient and effective. Recent results indicate that both are on the right path
1. FHA Sec. 242/223(f) limits the amount of loan proceeds to be used for capital improvements to 20% of the loan amount.
2. USDA Rural Development Office.