A rapidly changing healthcare market is impacting how health systems deliver care to patient populations, as well as development strategies for new buildings and facilities.
The impact of long-term capital allocation for on- and off-campus facilities is prompting leadership of many health systems to carefully consider either owning real estate outright or leasing space from a third-party developer on a build-to-suit basis.
Each approach has advantages and disadvantages that will impact long-term strategies for efficient delivery of care and the growth of an organization. The following is an overview of some considerations to be aware of with each approach.
Build-To-Suit and Lease
When a health system is seeking to partner with a third-party developer through a partnership agreement, it needs to conduct due diligence on developers in the market and their expertise in developing healthcare properties. There must also be a competitive bidding process to get the best value under a fair compensation model for all work performed.
One of the keys to finding success with these agreements is working with an experienced healthcare developer that understands how to structure strategic control and use of the asset for the health system partner.
Additional advantages of partnering with a developer that has proven experience and success working on healthcare projects is that the team can provide market knowledge, access to industry resources, general knowledge and expertise. A quality developer also provides “project momentum” to achieve speed to market on behalf of the healthcare partner.
Under such partnership agreements, the developer serves as property “owner” and initiates a site search, places targeted property under legal contract, acquires the land and develops the building. This includes all due diligence, engineering, design, government entitlements and construction, as well as management of leasing the project back to the health system and its allied partners. This developer/owner/operator can also further support the health system goals through full-service management over the course of the lease term.
Additionally, developers take on risk as the property owner, making them financially motivated to complete the project within budget and on time. Once the building is operational, they can manage the property over the long term and focus on stabilizing the investment, adding measurable value to achieve market competitive returns.
Some may question why a health system may wish to use capital of a third-party in lieu of its own relatively low-cost capital. The answer is that most high-performing health systems are expanding and competing in their market, which makes third-party capital a legitimate option for assets that can be leased such as outpatient facilities. As a result, the health system can preserve capital for assets that cannot be leased such as recruiting/retaining physicians, maintaining a primary hospital campus in addition to purchasing and maintaining IT and other equipment and furnishings.
Most importantly, the developer must be committed to the health system’s goals for the project. A partnership approach such as this ensures a successful project outcome reflecting the health system’s interests.
Fee Development Approach
When a health system chooses to own the real estate it is developing, this approach calls for engaging a real estate developer or project manager that is responsible for all phases of development, including land acquisition, due diligence, engineering, design, government entitlements and construction.
The developer can also assist in drafting a lease between the health system and a subsidiary of the health system as well as its allied partners, and, when appropriate, solicit prospective purchasers of the development.
One advantage of this approach is that the health system can realize direct cost savings and a development fee during the development process. It can also result in the lowest rent possible through a competitive sale/leaseback transaction on the open market.
Another consideration is that a real estate developer is hired to serve as the project manager, which is tantamount to hiring a consultant that will provide industry expertise, but may be less likely to push the project schedule, completion date and cost savings because they are being compensated less than what they would be as a developer/owner/operator.
Additionally, some would argue there is a “value risk” under such an arrangement as the developer hired as project manager may not take into consideration all the variables that a developer/owner/operator would when analyzing the property purchase and related due diligence tasks.
Additional Risks To Consider
Major healthcare facility development carries several inherent risks that any system considering development should be aware of, including:
•Predevelopment costs: These are costs that include time spent pursuing development sites, drafting site plans, securing targeted property under a legal purchase contract, meeting with local municipalities for entitlement work, and preliminary due diligence. Additional costs would include securing individual vendors to complete legal, design, environmental, survey and engineering due diligence.
oIn a build-to-suit and lease arrangement, there is risk of such costs not being reimbursed to the developer should a project fail to proceed to implementation.
oIn a fee development approach, the health system is required to directly compensate the developer or project manager for such work.
•Construction cost over-runs incurred by unforeseen events: Every project runs the risk of there being unforeseen project costs that do not fall under the initial project scope and will impact the project’s bottom line. These could include unknown site conditions that may not be exposed until a project begins, poor soils, bedrock, and undetected environmental conditions such as underground storage tanks.
oIn a build-to-suit and lease arrangement, the developer bears the risk for these costs, and any cost over-run directly impacts the financial returns realized by the developer and its investors.
oIn a fee development approach, the health system bears the risk for such costs, which likely means having to increase the capital budget accordingly.
•Uncontrollable schedule delays: Delays during the due diligence and government entitlement process can result in additional costs with legal, design, and other consulting services.
oIn a build-to-suit and lease arrangement, the developer bears the risk for these costs. Such costs are not written into the agreed upon lease rate, and construction delays can result in holdover penalties and additional construction loan interest fees, all of which are the developer’s responsibility thereby sheltering the health system from such cost overrun risks.
oIn a fee development approach, such delays may force payment of additional options fees or a higher purchase price. Additionally, there will be an economic impact from the unrealized revenues because of the delayed project.
•Financing Risks: Changing credit markets inject a level of risk for a project’s financing.
oIn a build-to-suit and lease arrangement, the developer assumes 100 percent of all financing risks. Uncertain credit markets have tightened underwriting standards, removed the conduits as a lending source, and have curtailed the availability of longer-term debt financing. The developer will consider these factors in its pro forma as well as in the final lease terms.
Additionally, the developer assumes all risks associated with guaranteeing debt financing in the form of construction completion, lease-up, and occupancy guarantees. Permanent financing is now seeing less non-recourse debt, forcing the owner to take on additional guarantee risk.
oIn a fee development approach, the health system will retain 100 percent of financing risks, and the project will remain on the organization’s balance sheet until the time of sale.
All of these considerations should be assessed and evaluated closely in order to achieve the most strategic advantage for the health system while optimally allocating that system’s capital. The best-value projects that set the course for long-term market success are achieved when proven approaches are methodically implemented by a highly capable team.
Dave Arnold is executive vice president of Milwaukee-based Irgens Partners.
