REQUIRED READING: The development of healthcare real estate, such as medical office buildings (MOBs), has been a rare bright spot during the present economic downturn. In many development transactions, healthcare providers partner with third-party developers to put MOBs on hospital campuses, mostly with third-party financing.
This article offers a look at MOB development and financing from the perspective of the hospitals and other healthcare providers that are navigating the new realities of the economy.Â
Most of the past decade was a busy time for MOB developers. Hospitals were competing fiercely with one another to attract physicians and patients to their facilities. Impressive new MOBs were often seen as a way to modernize and improve hospital campuses and recruit the most skilled physicians.
Growing hospitals often looked to house departments in the new buildings. Often, it made sense for these hospitals to partner with third-party real estate developers to construct the buildings in a way that would allow the hospitals to use their own funds for healthcare services rather than real estate.
Another important factor in a hospital's decision to use a third-party developer has been (and continues to be) that the healthcare laws intended to regulate the business relationships between hospital companies and physicians who might refer patients to the hospital do not apply to professional institutional developers that do not have physician ownership.
For example, under most circumstances, a hospital owner of an MOB may not legally lease space to a physician tenant at a rate lower than fair market value, even if there are otherwise sound reasons to reduce the rent to attract the tenant (e.g., a physician with a certain medical specialty that is needed in the area).
For these reasons, hospital companies often preferred to go to institutional professional real estate developers for their MOBs, and the developers were usually eager for the opportunity. Hospitals and physicians were viewed as very desirable tenants and MOBs as great opportunities for profit.
In fact, healthcare real estate development became a primary focus for a number of development companies. Successful developers and the lenders providing project financing inspected and researched hospitals and sites before committing time, effort and money to develop a new MOB.
It was very rare – at least in my practice – to see large pre-leasing contingencies or to see requirements that the hospitals themselves lease space in the new MOB in order to enhance the creditworthiness of a development.
Lenders' financing requirements varied according to the healthcare provider and the developer, of course, but an experienced developer with a good track record and an established hospital with healthy operations could expect to get a new MOB up and running in fairly short order, usually without pre-leasing contingencies, large hospital leases or vacancy agreements, large up-front equity requirements or personal guaranties.
Hospitals were also usually able to retain a large measure of control over MOBs' medical uses by using restrictive covenants, ground leases and prohibitions on later transfers of MOB ownership interests to hospital competitors.
Sector resilience
Healthcare is generally known to endure economic hard times better than other industries because of the simple fact that people do not cease to become sick or injured during recessions. As a result, healthcare real estate usually has better access to credit for development than other forms of commercial real estate during downturns.
Although this turn of events has also proved to be true to a certain extent in the current recession, I believe it is far more accurate to say that healthcare real estate is resilient during a recession rather than immune to economic downtowns.Â
MOB development has not shut down, but it has certainly slowed down. The crisis in the financing markets have resulted in more rigorous lender requirements, more cautious investors and fewer and more modest MOB projects.
Compounding the frustration for a hospital is the fact that when an MOB must be built in order for a hospital to meet its community's healthcare needs that continue – and even increase – during difficult economic times, some projects cannot get off the ground, even when the hospital turns to an experienced development partner.
The hospital may consider building the MOB on its own dime, but the need to conserve cash in the face of unknown healthcare reform is particularly great.
The fact that there has been any activity at all in the healthcare real estate market over the past year or so, however, puts MOBs and other healthcare facilities in much better condition than most other forms of commercial real estate. It appears that developers that had not previously been interested in healthcare real estate are looking to break into the market.
Developers new to the sector must educate themselves about healthcare laws and regulations. Although third-party developers that are not also physicians are not themselves considered referral sources to hospitals under healthcare law, it is very common for developers to form a special-purpose entity to own and operate the MOB.
Often, those developers wish to bring MOB tenants (i.e., physicians) into the entity as members or partners. This partnership is a perfectly legitimate business goal that can enhance the MOB's operations and profitability. Once the physician-tenants become owners by buying into the special-purpose entity, however, then the developer is considered a referral source under federal healthcare law.
That does not mean that the MOB development cannot be structured to include physician investors, but it does mean that the project and related business agreements with the hospital are subject to healthcare regulations.
For example, if the developer is purchasing the MOB site from the hospital, the purchase price must be no less than the property's fair market value as determined by an independent appraisal. As an another example, if the developer and/or its lender want the hospital to lease space in the new MOB to provide credit enhancement for the project, the hospital must have an independent operational need for any space that it leases.
Any burn-off lease or vacancy agreement made by the hospital is now extremely risky as a potential violation of healthcare law.
Project financing considerations
In the current economic environment, the credit enhancement that a hospital lease can provide in a new MOB is now critically important in obtaining MOB project financing that, more often than not, the developer and its lender are willing to forgo the physician-tenant investors.
In that case, the hospital will often ask the developer-landlord for representations and warranties that there are no and will be no patient referral sources with any ownership or beneficial interests in the MOB or in the entity that owns the MOB for as long as the hospital leases any extra space in the MOB.
Assuming that the hospital, developer and lender have navigated through the regulatory issues, the parties still have many other business issues to resolve. From the hospital's perspective, it views the MOB as an integral part of its campus and its hospital family.Â
This means that the hospital will often want terms that may seem to conflict with the idea of third-party ownership and may create tension with the lender's and developer's business goals.
The first concept has already been discussed in this article: the hospital's need to know whether any referral sources hold any ownership or beneficial interests in the developer. Normally, a developer would not expect its ownership structure to be of concern to its hospital partner. As mentioned earlier, however, this setup has a direct effect on what incentives and enhancements the hospital may be able to offer the developer and the lender.
Second, the hospital will not want an MOB on its campus to compete with it. This idea will not astound any experienced lender or developer; after all, who would plan to start another hospital within an MOB?
What can be a surprise, however, is the breadth and depth of the typical hospital's preferred-use restrictions. A particular source of tension is often a prohibition on any occupant of the MOB other than the hospital offering ‘ancillary medical services and facilities.’
These can be summed up as any medical or related service to or for any person that is in addition to the examination and diagnosis of patients performed directly by a physician or by other healthcare professionals under the direct supervision of a physician, or a facility operated for the provision of any such service. Such services include X-rays, MRIs, physical therapy and mammographies.
Any reasonable lender or developer will be concerned about limiting the profitable uses of any building, especially during economic difficulties.
Although a hospital is not likely to agree to forgo use restrictions on an on-campus MOB, there are some common compromises that continue to work in current MOB developments. First, the hospital is probably not concerned about physician-tenants providing ancillary medical services to their own patients as a merely ancillary part of the physician's practice.
Permitting the ancillary services under these circumstances allows the physicians to carry on their normal work in the MOB while preventing the establishment of a serious competitor, such as a commercial laboratory, in the MOB.
Points of contention
Another compromise seen frequently in the negotiation of MOB use restrictions is including a provision that all restrictions will terminate if the hospital permanently ceases operations. Of course, sometimes, there is negotiation over the definition of permanent cessation of operations. Hospitals have been known to ask for 24 months before restrictions can terminate, while developers and lenders usually believe that six months is ample time.
Probably the most contentious issue involves restrictions that a hospital wishes to impose on who can own or occupy an MOB already owned by a third party. Even with use restrictions in place, the hospital would be very concerned if a competitor were to establish a beachhead on its campus by acquiring an MOB from its original developer-owner.
If a hospital can, it will insist on an outright prohibition of sales to other hospitals or healthcare providers. This term was much easier for a hospital to get before the recession began. Then, most developers and lenders were comfortable that they could find a suitable buyer if necessary, even with the prohibition.
Now, developers and lenders are vigorously resisting any restraints on alienation based on an understandable desire to keep the universe of buyers as large as possible. Hospitals, however, are more concerned than ever in this economy about preserving the strength of their operations.Â
A right of first refusal for the hospital's benefit can ease this concern, although that may mean that the hospital might have to spend significant money to buy a building on short notice.
In an era where cash is king, hospitals are as reluctant as any other business to spend cash. Alternatively, the definition of ‘hospital competitor’ may be acceptably limited to a specific group of companies or a limited geographic area.
Carla F. Fenswick is a partner in the real estate group at Waller Lansden Dortch & Davis LLP. She can be contacted at (615) 850-8956 or carla.fenswick@wallerlaw.com. The author wishes to thank Charles A. Traughber, an associate in the real estate group at Waller Lansden Dortch & Davis, for his research assistance.
