Valuation of Healthcare Facilities

Tony D. Kamath, MAI, MRICS International Valuation & Advisory LLC

www.InternationalValuation.com Tony.kamath@InternationalValuation.com

Summary ●  Presented to the New York Chapter of American Society

of Appraisers (ASA) on Nov. 17, 2015

●  First section is a bird’s eye-view of the commercial property valuation work done over a period of 18 months

●  Midsection (Part II) focuses on broad market context and issues; Highest & Best Use being the central one

●  Last section, with latest data on this unsettled sector, identifies some professional valuation opportunities

Outline of Presentation ●  An Overview of Healthcare Facilities Assignments

●  Firm & Market Context of Assignments

●  Issues & Challenges – A Recapitulation

●  Viewing the Assignments in a Broader Context

●  Highest & Best Use – Examples Closer Home (e.g., LIU)

●  Current Trends Shaping the Future of Healthcare Sector

●  Appraisal Prospects – Concluding Viewpoint

14 Facilities

and

70+ Properties

in Six States

Healthcare Facilities Locations

An Overview ●  Valuation Assignments – April 2013 thru September 2014*

!  Maine – One facility; total 28 properties

!  Pennsylvania – Thee facilities; ten properties

!  West Virginia – One facility; three properties

!  Kentucky – Five facilities; 15 properties

!  Alabama – Two facilities; seven properties

!  Florida – Two facilities; eight properties

* Does not include one-off medical property appraisals in NY and ME

Firm-Wide Context ●  Portfolios of Properties under Mergers & Acquisitions

●  Two Portfolios (Example: 72 & 35 facilities)

●  A Few One-off Facility Acquisitions with Asset Portfolio

●  Firm-wide Team of Appraisers Covered the Entire Portfolio

●  Valuation Disciplines: Business, Personal and Real Property

●  Senior Leaders - Oversight of Respective Appraisal Disciplines

Property Types (Sub-sector) ●  Main Hospital Facilities –Outpatient, ER & Post-Surgery Sections

●  Multi-story Medical Office Buildings (MoBs)

●  Stand-alone Satellite Offices with Outpatient & Emergency Rooms

●  Doctors’ Condo Offices in Commercial Condo Buildings

●  Leased Doctors Offices/Physical Therapy Centers in Retail Centers

●  Nurse / Student Quarters

●  Patient Family/Guest Houses

●  Free-standing Mechanical/Engineering Buildings & Parking Garages

●  Parking Lots

●  Vacant Land for Future Development

Property Rights Appraised ●  Fee Simple

!  Fully Owned Properties

●  Leasehold Interests

!  Leased Offices and Buildings (Satellite Facilities)

●  Leased Fee Interests

!  Leased Sites to REITS for MOB Development

!  Independent Offices Leased to Doctors

Purpose & Use of Valuation – Transactional Circumstances

●  Mergers & Acquisitions

●  Valuation for Purchase Price Allocation (PPA)

●  Cost Segregation

●  Accelerated Depreciation Charge Analysis

Valuation Yardsticks / Premise of Value

1. Value-in-(Continued) Use – Going Concern Value

!  Cash Flow Is Important; Could Be Challenging

2. Value-In-Exchange – Orderly Disposition / Forced Liquidation; Negative/No Cash Flow

!  Value of Intangibles

!  Standards Rule 9-3 of USPAP: “This Standards Rule requires the appraiser to recognize that the continued operation of a business is not always the best premise of value because liquidation of all or part of the enterprise may result in a higher value.”

Mergers & Acquisitions ●  Booking Fair Value of Real Estate Assets on Balance Sheet

!  Purchase Price Allocation (PPA) of Land and Buildings

!  Cost Segregation (= Tax Savings!) – Acc. to Fed. Tax Depreciation Life Categories Schedules (Personal Property Depreciation - in some cases, as much as 40% of property’s cost can be classified as personal property and depreciated in fewer years – an incentive to investors)

"  Accelerated Depreciation for Tax Benefits – Wiring; Cables; Gases; Lighting; ER Fittings; Commercial Kitchen; Drapes; Nurse Stations; Land Improvements; Landscaping; Asphalt Paving; Site Lighting, etc.

Valuation Approaches ●  Income Approach (Business Value Premise)

●  Sales Approach – Selective Use (- Not the Best!)

!  Private Equity and Mergers & Acquisitions Drive Value

●  Cost Approach *

!  Depreciated Asset – Physical Wear and Tear

!  Functional Obsolescence – Design and Technology

"  Cost to retrofit; change use/repurpose; demolish and redevelop

!  Economic Obsolescence – Changing Demographics; Regulations; Economic Model. (- Lots of moving parts in the healthcare industry)

* Marshall and Swift Valuation Manual; and other similar data sources

Valuation Issues & Challenges ●  Mission, Mandate & History; Record-keeping Practices and Costs

●  Due Diligence – “…individually identifiable tangible assets”

●  CFOs & Property Managers

●  Property Rights: Fee Simple; Leasehold; Leased Fee

●  Meeting Audit Requirements & Deal Closing Deadlines

●  Consideration of Market & Competition: Assignment Scope – Dictated by M&A Considerations; Timelines/Rush to Closure…!

●  Is the “Sum of the Parts” Greater than the Value-in-Use?

Hospital - “Special-Use Property”*

●  “Special-use property is one that is designed, equipped, and used for a particular type of business or operation,”

●  “…[it] is not easily adaptable to some other use because of the peculiar nature of the improvements.”

●  “It includes so-called “special purpose,” “service” and “single purpose” property.”

●  “Conversion of such properties to some other use is costly, and the market for them is generally limited.”

*Encyclopedia of Real Estate Appraising, 3rd Edition, (Prentice Hall,1978), page 765.

PART II

Market Context

●  Valuation under Broader Market Forces

● Considering Current Trends

● Regulatory Compliance Requirements

Healthcare Facilities Market ●  Healthcare is $2.5 trillion plus economy

●  188 healthcare buyouts occurred in 2014, down 10 percent from 2013 (Bain & Co.'s 2015 Global Healthcare Private Equity Report)

●  Strategic M&A deal value in healthcare industry nearly doubled from 2013 to $406 billion

●  10 hospital bankruptcies (includes St. Michael’s Medical Center, Newark, N.J.) and 9 hospital closures so far in 2015 *

* Source: Becker’s Hospital CFO, Nov. 12, 2015

Hospital Closures* ●  57 rural hospitals have closed (2010 onwards)

●  Many more may be headed down the same path *

●  More than 1/3 of rural hospitals were operating at a deficit, (National Rural Health Association, 2013)

●  Non-expansion States - that have not expanded Medicaid are feeling the most financial pressure

●  Estimated 8.5% of rural hospitals are vulnerable to closure

●  16.5% of rural hospitals in non-expansion states are vulnerable to closure

*Report from iVantage Health Analytics

Active Players ●  Consolidation Continues at a Fairly Rapid Pace

●  Most Are Public Companies with Wall Street $$

●  Some Are Aspiring Public Companies Aiming at IPOs in the Near Future

●  Major National Players Include: HCA (Hospital Corporation of America); CHS (Community Health Systems); UHS (Universal Health Services); LifePoint; etc.

Healthcare Facility Challenges ●  Decreasing Inpatient Volume – Vision & Long-term Growth Plans

●  Patient Out-migration to Larger Population Centers

!  “Build them…and they will come” Attitude; Acute Treatment Needs

●  Significant Capital Expenditures

!  Compliance; Technology (HER); Sophistication; Doctors’ Salaries; Maintenance; High Clinical Investments

●  Understanding the Cost of Care – Revenue Enhancement Strategy

!  MIS: Tracking All Costs…; Cost Analysis; Efficiency = Reduced Cost; Economies of Scale

●  High Levels of Bad Debt – Collection; Shortage of Primary Care Physicians Causing Surge of ER Visits

Accountable Care Organizations (ACOs)

●  Four Pillars of Value *

!  Regulatory

!  Reimbursement

!  Competition

!  Technology

●  Goals of ACOs *

!  Capital Formation

!  Financial Feasibility

!  Economic Returns * “Healthcare Valuation”, Robert J. Cimasi, MHA, ASA, FRICS, MCBA, AVA, CM&AA

Large Health Systems"

Large Insurance Companies"• Anthem, Aetna, United,

Cigna and Humana becoming three. "

• Low Payouts – 9/23 Co-ops Closing"

Large Phama Companies"

Large Health IT Companies"

Investment Companies"

Winners of PPACA*

Losers of PPACA* ●  Losers of Patient Protection & Affordable Care Act (PPACA)

!  Smaller Community Hospitals

!  Rural hospitals are particularly vulnerable to closure due to financial challenges (June report from iVantage Health Analytics)

!  Smaller Practices

!  Smaller Companies that Sell into Health Systems

●  Neutral Sectors (Neither Winners or Losers) of PPACA

!  Safety-net Hospitals

!  Innovative New Companies

* Source: Becker’s Hospital CFO, Nov. 12, 2015

Highest & Best Use (HBU)! ●  Challenging to Determine Alternative Use (“Special-Use”)

●  HBU defined as: “…that use among possible alternatives which is legally permissible, socially acceptable, physically possible, and financially feasible, resulting in the highest economic return.” *

●  Is the subject business worth more to the buyer and the seller as a going concern that will continue to operate as such, or as a collection of individual assets to be put to separate uses?

●  HBU - Important When the Facility is in Red

●  Is the Business Worth More as “Dead” than Alive!

●  Complicated When County/Govt. Steps in Reluctantly (to Subsidize)!

* “Valuing a Business: The Analysis and Appraisal of Closely Held Companies” By Shannon Pratt, Fifth Edition, New York, NY: McGraw-Hill, 2008, p. 48.

Highest & Best Use - Case Studies

●  Mercy Hospital – Portland, ME

●  LIUH – Brooklyn, NY

●  St. Vincent’s – New York, NY

Value-in-Use, Interim Use, or HBU?

Mercy, Me! ●  127,895 SF, 1941 building, on 2.29 acre site

●  Value: Assessed $23.0 million; Cost App.:$8.65 million; Sales Comp. App.: $4.5 million

●  “As Is”, the highest and best use of the property was to continue operating as a hospital…!

●  “As if vacant” and available, and as improved, the highest and best use was concluded to be a senior housing or a residential multi-family

Long Island University Hospital (1858-2013)

●  Protracted disposal process due to multiple law suits

●  Once the dust settled, the potential developers bids were reviewed

●  Fortis Property Group emerged as a winner

LIUH Residential Conversion

●  Fortis Property Group revealed two plans for the site after a series of community meetings:

1. An "as-of-right" plan – 820,000 SF space; would not require community approval moving forward, and

2.  An ULURP plan – 1,000,000 SF space; calls for rezoning of neighborhood; would require a community approval

It wouldn't have affordable housing and might have a dorm

LIUH – Post ULURP Rendering

●  The 2nd plan involves a development that includes 30-story and 40-story towers

●  Fortis wants to proceed with their "preferred" plan; and a ULURP review of the site might play out

●  The second plan would have affordable housing, a school, and a tall tower closer to the Brooklyn-Queens Expressway

LIUH ●  The initial Fortis proposal offered SUNY about half of the

estimated $500 million value—for the 200,000-square-foot complex, of which 15,000-square-feet would be made into a facility with an urgent care center, physical therapy center, dental and other surgery space, but no emergency room and no full-use hospital

●  The internal decision process involved a third party valuation of fair market value, based on a Highest and Best Use analysis, for the benefit of the Board and the NY State Attorney General

St. Vincent’s Hospital (1849-2010)

●  In April 2010 (at time of closure), St. Vincent's occupied a large real-estate footprint in Greenwich Village

●  Consisted of several hospital buildings and number of outpatient facilities

●  Had more than 1,000 affiliated physicians, including 70 full-time and 300 voluntary attending physicians

●  Trained more than 300 residents and fellows annually

●  Building was completely demolished by early 2013

Part III

Prospects for Valuation

Healthcare Sector - Current Trends

A Mixed Bag…as the ACA Is still Being Challenged! ! Decentralize Model –People-centered; Not

Facility-centered ! Shifting Responsibilities to Patients and

Consumers from Doctors and Employers ! Fee for Value, Not Service ! Provider & Payer Convergence

! Novel Consolidation – Rehab Acquiring Home Health Agencies

Healthcare Sector - Current Trends

A Mixed Bag….! ! Emergency Care to Urgent Care " A resurgence of interest in urgent care

" New and interesting models: freestanding ERs, surgical care and joint-ventured urgent care

! Changing Business Model – Doctors as Employees (Is this a Win-Win for Both Parties?)

! Increasing Role of Distance Medicine/Telemedicine ! PE Capital Play Seeking Exit Strategy

! For Profits Growing; Not-for-Profits Declining!

Current Trends – Asset Market ●  Healthcare Is the Most Active Sector in Real Estate

Transaction Market

!  Record-breaking Consolidation: Cost Reduction; Efficiency; Cost of Compliance; Push for Market Share to Negotiate with Payers; Larger M&As; Acquisition of Physicians’ Practice by Large Facilities

!  Cheaper to Buy than Build!

!  CON (Certificate of Need) State Opportunities!

!  MOBs Attractive to PE’s (Cash Flow from Doctors)

Current Trends - Operational ●  Hospital Surgical Procedures Taken Care by Ambulatory

Surgery Centers (ASC) ●  Locations: Malls or Day Surgery Centers

●  No 1-/ 2-day Recovery Period or Need for Hospital Beds ●  Hospitals with Excess Beds Leasing to Others Skilled

Nursing Homes and Rehab Operations ●  Urgent Care Facilities – Stand-alone Places for Retail

Locations Cost Lower by 72-83% ●  OIG Recovery of $3.3 Billions in 2014 from Healthcare

Fraud and Abuse

Accountability Goals ●  Regulatory Edicts Contained Within:

●  Internal Revenue Code (IRC)

●  Stark Law

●  Anti-Kickback Statute

●  False Claims Act

●  Most Types of Healthcare Transactions Required to Adhere to Standard of Fair Market Value.

●  “Private inurement” -when a 501(c)(3) nonprofit's money is devoted to private uses instead of charitable purposes

Fair Market Value ●  Stark Law*

●  “Fair market value means the value in arm’s-length transactions, consistent with the general market value. ‘General market value’ means the price that an asset would bring as the result of bona fide bargaining between well-informed buyers and sellers who are not otherwise in a position to generate business for the other party, or the compensation that would be included in a service agreement as the result of bona fide bargaining between well-informed parties to the agreement who are not otherwise in a position to generate business for the other party, on the date of acquisition of the asset or at the time of the service agreement.” [emphasis added]

* Medicare and Medicaid Programs, Physicians’ Referrals to Health Care Entities with Which They Have Financial Relationships (Phase III), Final Rule, Fed. Reg. 72, 171 (September 5, 2007), 51081. The Stark Law (as stated in the U.S. code) also equates the terms fair market value and general market value, to wit: “The term ‘fair market value’ means the value in arm’s length transactions, consistent with the general market value.” From Limitation on Certain Physician Referrals, 42 U.S.C. § 1395nn (April 4, 2012).

Fair Market Rent

●  Anti-Kickback Statute*

●  “…fair market value in arms-length transactions…not determined in a manner that takes into account the volume or value of any referrals or business otherwise generated between the parties for which payment may be made in whole or in part under Medicare or a State health care program.”

*Program Integrity, Medicare and State Health Care Programs, Permissive Exclusions, 42 CFR 1001.952(b)(5), (2009), 735.

What’s Coming – More Change! ●  Financial Trouble Towards Closure – 13% (or

283/2,224) of Assessed Rural Hospitals Across 39 States (iVantage Health Analytics)

●  Retail Clinics - 47% Surge by 2017

●  Medical Retail to Be Faster Growing RE Sub-sector

●  More than 2,800 Nationwide Clinics - Retail Stores, Supermarkets and Pharmacies

●  Lower Costs; Shorter Wait Time * Becker’s CFO, Ayla Ellison, Sept. 15 2015 & Sept. 24, 2015; June 15, 2015

What’s Coming – The Budget Bill ●  Republican congressional leaders and the Obama

administration recently reached a tentative budget deal that would raise spending $80 billion over the next two years and includes cuts in spending on Medicare

●  The budget bill will "unquestionably" reduce the incentive for hospitals to buy more outpatient facilities

●  Under the tentative deal, off-campus outpatient facilities that are bought or set up by hospitals after the date of enactment of the bill will not be eligible for reimbursements under the outpatient prospective payment system

●  Instead, these departments would be eligible for reimbursements from either the physician payment or ambulatory surgical center payment systems

Conclusion – Greater Consolidation

We All Have a Stake in This!

●  Cost Reduction Is Good

●  We Can Help Bring Greater Efficiency to the System

●  Help Compliance – Fair Rental Value Appraisals

●  Sector Needs Appraisers and Could Use More of Us!

Potential Business for Appraisers!

What’s in It for Valuation Experts?

●  Business Valuation

●  Real Property Valuation

●  Intangible Asset Valuation

Broad Market Scenario

●  Patient Protection and Affordable Care Act (PPACA) – Expected to Add Coverage for 32 Million People

●  Already Added 10+ Million

●  It Will Need 64 Million SF of Additional Space (1.9 SF per Patient)

●  Technological Changes Driving Values

●  Digital Tsunami – Electronic Health Records (HER)

●  Accountability Awareness

Valuation Opportunities ●  Advisory - Property Value; Value of Air Rights

●  Mergers & Acquisition Transactions; PE’s Exit Plans

●  Sale & Lease-back Negotiations

●  Highest & Best Use Analysis / Property Repurpose Studies

●  Tax Assessment Challenges – Not-Profit to For-Profit Status

●  Market Rent Analysis – Increased Govt. Scrutiny of Hospital-Physician Relationships

●  Market Rent Analysis – Meeting Annual Updates

●  Cost Segregation – Accelerated Depreciation Studies

Thank You! ●  Thanks to Kathleen Ha, ASA, President of ASA, New York Chapter for the opportunity to speak at the ASA NY

Chapter meeting on November 17, 2016

●  Thanks also to my former colleagues at American Appraisal Associates for their cooperation and contribution of information and ideas:

•  Jeff Briggs, ASA, MAI, MRICS (Dallas)

•  Shelita Crompton, MAI, ASA (Atlanta)

•  Dan Platten, CPA, ABV (Chicago)

•  Dan Salcedo, CCIM, MAI, MRICS (Miami)

•  James Zwald, ASA (Atlanta)

Tony D. Kamath, MAI, MRICS

Phone: 917-558-1945

Tony.Kamath@InternationalValuation.com

International Valuation & Advisory LLC

www.InternationalValuation.com

Note: The opinions expressed in this presentation are solely of the author.

Note: The opinions expressed in this presentation are the author’s only.