You frequently hear the phrase “location, location, location” be used to describe the value of real estate. True, location matters tremendously, no matter the type of real estate. But, in hospital M&A transactions, the value of the real estate assets is often derived from “strategy, strategy, strategy”. Today, the real estate assets of hospitals are playing an increasingly important role in hospital M&A transactions. This trend is caused in part by the desire of purchasers to support purchase prices or other financial impact of the transaction with “hard” physical assets, given the current uncertainty about reimbursement rates and concerns of the ratings agencies about the hospital sector in general. We see hospital M&A parties using several strategies for using real estate assets.
Perhaps the most common strategy is for a purchaser to pledge the hospital’s real estate assets as collateral for a loan to finance the purchase. This approach frequently frees available capital for other purposes—such as performing needed repairs or investing in operational improvements. This strategy may also provide easier access to capital since many traditional lenders are more comfortable in determining the value of physical real estate assets rather than attempting to understand how to value the revenue, operations, and good will of a hospital. But, this strategy may not be useful if the purchaser is assuming existing debt and the assets are already heavily leveraged as is often the case with struggling systems. Although purchasers such as private equity and other investors may be familiar with and actually have employed this strategy in prior transactions, the terms and conditions for any such financing must be carefully considered and specifically planned for each transaction. When reviewing this strategy, purchaser may also want to consider whether tax-exempt financing may be available.
In instances where the real estate assets are not used to obtain financing for the acquisition, some purchasers use the real estate assets to obtain different financing. Because many healthcare-focused real estate investment trusts (REITs) and publicly traded companies may not need to obtain financing to fund the purchase, these purchasers often pledge post-closing the acquired real estate assets for the purpose of obtaining or increasing revolving lines of credit. The added capacity in the credit facility is then frequently used to fund additional acquisitions or to pay for improvements and upgrades for the hospital. We would expect to see this approach increase in frequency if current trends for-profit hospital acquisition of community hospitals and private equity investment continue.
A third strategy is to monetize certain non-core real estate assets by divestiture, which may be accomplished through outright sales, sale-leaseback transactions, or other means such as joint ventures. Medical office buildings, outpatient medical centers, and non-campus imaging centers are frequent candidates for monetization. Outright sales involve the total divestiture of the non-core asset so that the hospital no longer holds any interest in the property. Newer medical office buildings are sometimes sold by hospitals not only for the financial benefits but also because the hospital will be relieved of its responsibilities to oversee the management of the building and the leasing of space. Another benefit to hospitals is that an outright sale may avoid future regulatory complications that may occur when space in a hospital-owned building is leased to physicians or other potential referral sources. In sale-leaseback transactions, the non-core assets are typically sold to REITs, private equity companies, or other investors and then leased back to the hospital under a long-term lease. So, although the hospital may no longer own the real estate asset, it is still able to use the property through the lease. Proceeds from sale-leaseback transactions are often used to reduce debt or occasionally to pay for physical plant or operational improvements. For example, some hospitals use the sales proceeds to acquire state-of-the art medical equipment or to invest in electronic medical records systems. REITs continue to be active purchasers of non-core real estate assets as many REITs currently enjoy solid borrowing capacity at attractive interest rates in today’s market. Some hospitals, however, do not wish to sell their entire interest in non-core assets and instead seek joint venturers which frequently purchase a controlling interest in the non-core assets. This strategy is often best-suited for hospitals that desire to achieve some level of monetization without relinquishing its entire ownership of the real estate.
Parties to hospital M&A transactions should consider whether these strategies may be appropriate for their deal and, if so, how to tailor these strategies to best accomplish their goals. In future posts, we’ll explore some of these strategies in more detail and discuss ways to maximize their potential while also avoiding common pitfalls.