August 25, 2005

Can't fund your building project? Try private capital

  • Investors are eager to fund new health care projects. So why are hospitals pleading poverty?
    Capstone Partners


    Many architects have been selected by a health care organization to assist in developing plans for a new health care building project, only to see the project get delayed or deferred indefinitely by the health care provider's internal decision-making process.

    The most common reason for delay is the inability of the internal project sponsor — often a key physician or department head — to secure capital funding for the project from the limited pool of capital periodically available within the organization. It is not uncommon to see very promising projects with good financial returns delayed in favor of higher-priority organizational capital needs, such as new imaging equipment or technology infrastructure.

    In fact, health care organizations are finding it increasingly harder to generate capital for building projects, as their revenues are being pinched by payors (typically insurance companies) and their core health care technologies are rapidly escalating in cost.

    External capital

    It is ironic that promising projects are going unfunded at a time when external capital is readily available in private capital markets.

    A variety of traditional real estate investors are discovering the relative stability of health care and are interested in finding investment opportunities in the field. These include insurance companies, pension funds, real estate investment trusts and even

    Architects, engineers and contractors — before investing in a new project — should make sure their clients are aware of the availability of alternative capital.

    So, why would a hospital fail to build a new project that might enhance profits and keep the organization competitive if this source of capital exists?

    The simple answer is that most health care executives do not know how to locate or access private capital markets, nor do they have the time to do so.

    Lack of experience

    The majority of senior health care executives entered careers in health care management directly from educations in institutions that specialized in public health care administration. Few have any experience in private or public corporate finance, let alone the more specialized field of real estate finance.

    Further, the intense demands of sustaining daily operations in a highly regulated and rapidly changing health care operating environment prevents the typical health care finance professionals from having the time to keep abreast of the evolving world of private real estate finance.

    Traditional financing

    Predictably, most health care CFOs stick to traditional sources of health care capital finance — internally generated working capital and debt financing using tax-exempt health care bonds

    Tax-exempt debt is typically available for projects that are "core" to the direct provision of acute patient care. These types of projects include inpatient bed towers, surgeries and various direct treatment facilities.

    Tax-exempt debt is usually not available for secondary facilities, such as medical office buildings, outpatient clinics or some diagnostic facilities. It's not that these facilities aren't important. They just aren't categorized as primary to providing direct patient care, and thus any debt used on them is taxable.

    Given the lower cost of tax-exempt debt, a common strategy of the health care financial executive is to fund large core projects with tax-exempt bond financing, then use working capital to finance secondary (non-acute) facilities.

    It is at this point that the organization confronts the reality that more internal demand exists for project capital than the available supply. Some of the secondary (taxable debt) projects are canceled or deferred for future funding cycles.

    Outpatient services growing

    This traditional financial strategy worked fairly well when main mission of most health care providers was the provision of direct inpatient services — and they accordingly focused most of their investment in acute care facilities.

    In recent years, however, we have experienced in the United States a major shift in the delivery of health care. Many services are moving from inpatient to outpatient settings. In the last five years, for example, outpatient services have grown at twice the rate of inpatient services. Investment in outpatient facilities has grown at almost three times the rate of investment in inpatient facilities.

    Understandably, it is becoming more difficult for the health care executive to defer outpatient projects because of limited internal capital.

    Early adapters

    A few enlightened health care financial executives have begun to learn that private capital is available to fund some of these projects.

    In fact, in today's low-interest rate environment, private capital is often available on terms that are highly competitive with the health care organization's internal cost of capital. As a result, we are beginning to see health care executives partnering with developers and capital sources to finance, build, and operate a variety of medical office buildings, ambulatory surgery centers, and outpatient facilities.

    Ensuring client awareness

    Given the shrinking availability of internally generated health care capital, forward-thinking architects, engineers and contractors would be smart to hedge their time investment in a new project by making sure their clients are aware of the availability of alternative capital for the projects they are planning.

    The most direct way to accomplish this would be to sponsor an early discussion between the client's finance executive and sources familiar with real estate financing tools. These might include pension fund advisors, bankers or real estate developers who have experience in health care capital markets and facilities development.

    Of course, the client may ultimately decide to use internal capital to finance the project under discussion. However, exposing the client to new financing options may accelerate the decision process or even break a logjam in additional projects.

    At the very least, the planning professional will have demonstrated an interest in helping their client make the best financial decisions.

    Don Audleman is a principal at Capstone Partners, a Northwest-based real estate development company with a large health care practice.

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