The article below is reprinted with permission from The Capital Issue, a quarterly newsletter published by Lancaster Pollard.
Capital spending by hospitals will likely remain flat through 2014-2015 amid a still weak economy, tight credit markets, the uncertain impact of the new federal healthcare law, low patient volumes and the increasing number of uninsured/underinsured patients along with decreased reimbursement rates, according to the recent hospital median reports from the Big Three credit rating agencies. Serious external threats continue to apply pressure on a healthcare provider's bottom line while patients increasingly expect state-of-the-art facilities and services that provide quality and value.
In light of the current environment, hospital leaders need to be aware of the available refinancing options in order to choose the structure that best suits their respective needs, offers the lowest cost of capital and provides the best terms. For example, some refinancing options not only reduce interest payments, but also have the ability to fund renovations and improvements that will help hospitals adapt to new technologies and care-delivery methods. Refinancing lowers a hospital's monthly debt-service costs, thereby helping it improve liquidity and strengthen its credit profile.
Specifically, HUD/FHA programs, such as sections 242, 242/223(f), 242/223(a)(7) and note/loan modifications provide stand-alone hospitals, including community and critical-access hospitals, the ability to refinance existing debt. These programs are often overlooked as refinancing mechanisms despite the significant savings they offer.
This is especially attractive to borrowers since the current interest rates for this financing option are below 3.75 percent, including the annual mortgage insurance premium of 0.7 percent on the outstanding principal balance. Just as important, Sec. 242 eliminates interest-rate and renewal risk and has minimal financial covenants. If the borrower is using the 242 program to refinance debt that has associated trustee-held funds, such as a debt-service-reserve fund, the trustee-held funds will be released to pay down the existing debt, thereby reducing the amount of the newly issued debt.
To qualify for the 242 program, a hospital or health system must meet the following requirements:
Hospitals can use the 242/223(a)(7) to pay off their existing HUD-insured mortgage along with any refinancing costs (less than 1.5 percent of the mortgage amount). The loan can include the cost of repairs and renovations up to 20 percent of the mortgage amount. Furthermore, additional costs for equipment, inspections, title/recording expenses and fees for architectural, design and legal firms also can be included. The term of the new loan is typically not extended beyond the maturity date of the existing HUD-insured mortgage, but HUD will consider term/maturity extension requests, especially if the refinance transaction includes renovations or improvements to the property that would support a longer useful life. Similar to the original HUD-insured mortgage, the new HUD-insured mortgage is fully amortizing and nonrecourse. An environmental review and feasibility study are not required if the refinance transaction does not include construction/expansion projects.
Also applicable to existing 242-insured projects, a note modification is viewed as a refinancing/refunding transaction in which loan documents are amended and a new GNMA security is issued at current market interest rates. The main benefit compared to a 242/223(a)(7) is that a note modification is quicker (3-4 months) because HUD’s involvement is minimal. A potential downside is that repairs are not allowed and closing costs must be funded out-of-pocket or from proceeds generated from the sale of the new GNMA security.
In 2009, HUD approved Sec. 242/223(f), a pilot program that waived the 20 percent new money requirement of the 242 program. However, because of the vague and restrictive eligibility requirements, many hospitals' applications were rejected. Only one hospital out of dozens that applied was able to refinance its indebtedness before the program ended.
Meanwhile, hospital advocates pushed for changes. In response, HUD announced that a revised 242/223(f) program would be considered. The new guidelines are currently awaiting Office of Management and Budget approval. The hope is the program will be approved in early 2013.
To stay competitive during the current economic uncertainty of the healthcare market, hospital leadership should review the terms and covenants of their existing debt to determine whether a refunding/refinancing transaction could generate meaningful debt service savings. A good understanding of private and government-agency options, including HUD/FHA programs, is the first step hospital leadership should take to achieve the lowest cost of capital for their hospital's current and future financing needs.
Scott Blount is a vice president with Lancaster Pollard in Austin. He may be reached at sblount@lancasterpollard.com.
Capital spending by hospitals will likely remain flat through 2014-2015 amid a still weak economy, tight credit markets, the uncertain impact of the new federal healthcare law, low patient volumes and the increasing number of uninsured/underinsured patients along with decreased reimbursement rates, according to the recent hospital median reports from the Big Three credit rating agencies. Serious external threats continue to apply pressure on a healthcare provider's bottom line while patients increasingly expect state-of-the-art facilities and services that provide quality and value.
In light of the current environment, hospital leaders need to be aware of the available refinancing options in order to choose the structure that best suits their respective needs, offers the lowest cost of capital and provides the best terms. For example, some refinancing options not only reduce interest payments, but also have the ability to fund renovations and improvements that will help hospitals adapt to new technologies and care-delivery methods. Refinancing lowers a hospital's monthly debt-service costs, thereby helping it improve liquidity and strengthen its credit profile.
242 programs in action
FHA mortgage insurance is one option that can be used by hospitals to obtain some of the lowest interest rates and best terms available. According to the Committee on Healthcare Finance, since the enactment of the Section 242 program in 1968, the Federal Housing Administration, under the Office of Housing and Urban Development, has enabled about 380 hospitals to secure financing at lower fixed rates than could have been achieved without HUD/FHA insurance.Specifically, HUD/FHA programs, such as sections 242, 242/223(f), 242/223(a)(7) and note/loan modifications provide stand-alone hospitals, including community and critical-access hospitals, the ability to refinance existing debt. These programs are often overlooked as refinancing mechanisms despite the significant savings they offer.
Take advantage of the 80/20 formulation
Sec. 242 has been primarily used for replacement hospitals; however, the program can be used to refinance existing debt and complete renovations as long as 20 percent of the requested mortgage proceeds are spent on construction or renovation projects, including equipment purchases. That means up to 80% of the proceeds can be used to refinance existing debt with a nonrecourse, fixed-rate mortgage. The maximum term/amortization is 25 years, depending on the age/status of the physical plant.This is especially attractive to borrowers since the current interest rates for this financing option are below 3.75 percent, including the annual mortgage insurance premium of 0.7 percent on the outstanding principal balance. Just as important, Sec. 242 eliminates interest-rate and renewal risk and has minimal financial covenants. If the borrower is using the 242 program to refinance debt that has associated trustee-held funds, such as a debt-service-reserve fund, the trustee-held funds will be released to pay down the existing debt, thereby reducing the amount of the newly issued debt.
To qualify for the 242 program, a hospital or health system must meet the following requirements:
- Acute-care patient days are 50 percent or more of total patient days.
- Maximum HUD-insured mortgage is the lesser of either 100 percent of the development cost or 90 percent of loan-to-value ratio [LTV = (Total Mortgage Amount)/(Total Estimated Replacement Cost + Net PPE)].
- Aggregate operating margin (EBITDA margin) is greater than 0 percent for the three most recent audited financial statements. (HUD may make an exception for a hospital that has undergone a financial turnaround with a positive operating margin in the most recent year).
- Average debt-service-coverage ratio is greater than 1.25 for the three most recent audited financial statements. (HUD may make an exception for a hospital that has undergone a financial turnaround with a DSC ratio of 1.4 in the most recent year).
HUD/FHA-insured refinancing opportunities
Sec. 242/223(a)(7) applies only to existing 242-insured mortgages. This program has been used infrequently to refinance loans due to several factors, mainly loan-to-value shortfalls and prepayment restrictions. However, as a result of the low interest-rate environment, HUD recently released interim guidance intended to make this refinance option more predictable and efficient.Hospitals can use the 242/223(a)(7) to pay off their existing HUD-insured mortgage along with any refinancing costs (less than 1.5 percent of the mortgage amount). The loan can include the cost of repairs and renovations up to 20 percent of the mortgage amount. Furthermore, additional costs for equipment, inspections, title/recording expenses and fees for architectural, design and legal firms also can be included. The term of the new loan is typically not extended beyond the maturity date of the existing HUD-insured mortgage, but HUD will consider term/maturity extension requests, especially if the refinance transaction includes renovations or improvements to the property that would support a longer useful life. Similar to the original HUD-insured mortgage, the new HUD-insured mortgage is fully amortizing and nonrecourse. An environmental review and feasibility study are not required if the refinance transaction does not include construction/expansion projects.
Also applicable to existing 242-insured projects, a note modification is viewed as a refinancing/refunding transaction in which loan documents are amended and a new GNMA security is issued at current market interest rates. The main benefit compared to a 242/223(a)(7) is that a note modification is quicker (3-4 months) because HUD’s involvement is minimal. A potential downside is that repairs are not allowed and closing costs must be funded out-of-pocket or from proceeds generated from the sale of the new GNMA security.
242/223(f) back again…almost
Up until the downturn in the economy in 2008, HUD generally focused on the need for financing new construction, renovation, rehabilitation and equipment purchases. Then, the demand for healthcare services rose while a lack of access to capital made it difficult for hospitals to obtain financing for facility, equipment and technology needs as well as to meet obligations on existing debt.In 2009, HUD approved Sec. 242/223(f), a pilot program that waived the 20 percent new money requirement of the 242 program. However, because of the vague and restrictive eligibility requirements, many hospitals' applications were rejected. Only one hospital out of dozens that applied was able to refinance its indebtedness before the program ended.
Meanwhile, hospital advocates pushed for changes. In response, HUD announced that a revised 242/223(f) program would be considered. The new guidelines are currently awaiting Office of Management and Budget approval. The hope is the program will be approved in early 2013.
Know your options
HUD/FHA 242 programs offer a number of financing options for healthcare facilities ─ replacement, new construction, renovation/expansion projects, refinancing or a combination thereof. In order to evaluate your hospital's refinancing choices, review each program's characteristics and remember these key takeaways:- Hospitals with an existing HUD-insured mortgage have two options available to take advantage of the low interest-rate environment and improve operating cash flow─Sec. 242/223(a)(7) and note modifications. If the hospital wants to include repairs/improvements, then the 242/223(a)(7) is the appropriate refinancing mechanism. If speed to close and minimization of interest-rate exposure are the most important goals, then the note modification is the better option to pursue.
- Hospitals that want to refinance tax-exempt bonds or conventional loans can take advantage of the low interest-rate environment and favorable terms of the 242 program by allocating 20 percent or more of the requested mortgage amount to new construction, repairs, improvements and equipment. They don't need to wait for the Sec. 242/223(f) program to materialize if they have some minor construction projects or equipment purchases, which could generate additional debt-service savings by buying out equipment leases.
To stay competitive during the current economic uncertainty of the healthcare market, hospital leadership should review the terms and covenants of their existing debt to determine whether a refunding/refinancing transaction could generate meaningful debt service savings. A good understanding of private and government-agency options, including HUD/FHA programs, is the first step hospital leadership should take to achieve the lowest cost of capital for their hospital's current and future financing needs.
Scott Blount is a vice president with Lancaster Pollard in Austin. He may be reached at sblount@lancasterpollard.com.
More Articles on Hospital Financing:
5 Observations on the State of Hospital Credit Markets
Mission Possible: Finding Capital for Standalone Hospitals
Opportunity Knocking: Taking Advantage of Low Short-term Interest Rates