1. The Tax Cuts and Jobs Act
Since the election of Donald Trump as President, Republicans on Capitol Hill have made attempts to repeal the Affordable Care Act (“ACA”) throughout 2017. A comprehensive repeal was not achieved, but certain legislative changes in the last year have chipped away at the ACA. Those legislative changes will have an impact on hospitals and health systems. Most notably, the Tax Cuts and Jobs Act (“TCJA”), which was signed into law on December 22, 2017, will significantly affect the healthcare sector.
Beginning in 2019, the TCJA will effectively repeal the “individual mandate” set forth in the ACA by reducing the penalty tax to $0. Without the individual mandate, the Congressional Budget Office (“CBO”) and the Joint Committee on Taxation (“JCT”) expect premiums for policies purchased in the marketplace to rise, with fewer people obtaining health insurance. The CBO and JCT estimate that with the repeal of the individual mandate, approximately 43 million people under the age of 65 will be uninsured by 2026. That is a significant increase over its previous estimate of 28 million uninsured under the ACA prior to the passage of the TCJA. This larger uninsured population may result in an increase in the use of financial assistance programs and a rise in uncompensated care costs for many non-profit hospitals and health systems.
Additionally, the TCJA has changed certain aspects of tax-exempt financing. While the TCJA did not repeal tax-exempt financing for private activity bonds, it does prohibit new advance refunding bonds. This removal of advance refunding opportunities may affect certain non-profit healthcare organizations by removing the ability to save money for other cash flow needs. Further, Standard & Poor's Outlook for 2018 suggests that other provisions of the TCJA, such as the reduction of the corporate tax rate, may reduce demand for tax-exempt paper and could mean an increase in interest rates for tax-exempt healthcare bonds, thus reducing banks' interest in doing direct placement or direct purchase bonds. Moody’s 2018 Healthcare Outlook suggests that tax reform may increase the cost of capital for hospitals and healthcare providers, creating greater merger and acquisition activity, especially for smaller hospitals who cannot afford higher interest rate costs in the taxable market. More broadly, the TCJA is expected to have a significant effect across all real estate sectors, with changes to include new rules for pass-through income and asset depreciation.
Overall, the continued uncertainty surrounding the ACA will make planning and strategizing difficult for hospitals and health systems. This uncertainty is compounded by the effect that the TCJA will have on the healthcare market, especially in the non-profit sector, including an increase in the cost of tax-exempt financing and a rise in uninsured patients. These changes may result in more pressure on operating margins for non-profit systems, especially as healthcare policy continues to move towards value-based reimbursement and outpatient migration. Commercial real estate owners and investors will likely benefit from the tax savings generated by the TCJA, with the change in tax treatment of capital expenditures and new deductions for owners of pass-through entities, which may result in increased investment in real estate assets and development.
2. Outpatient migration and the hospital sector
Outpatient migration has been a multi-decade trend and is a topic covered in almost every healthcare real estate conference or industry whitepaper. Looking forward into 2018, the theme remains as relevant as ever, as the shift toward outpatient, off-campus settings continues unabated. In 2017, Anthem announced that, by March 2018, it would no longer pay for MRIs and CT scans performed on an outpatient basis in hospitals in 13 of the 14 states where it does business. In the last few years, more total joint and spine procedures have moved to outpatient settings, and ASC management companies saw significant transaction activity in 2017, illustrating the continued M&A activity within the outpatient surgery setting.
Both for-profit and non-profit health systems face newly formed, large competitive entities which will compete in the outpatient setting. A recent study projected that more hospital closures would result from potential changes to Medicaid, which will create ripple effects throughout local healthcare real estate markets. Meanwhile, several of the large for profits will be selling a significant number of hospitals in 2018 in an attempt to reduce their debt load: Tenet (NYSE: THC) has announced it will sell nine hospitals as part of its $1 billion divestiture plan, and Community Health Systems (NYSE: CYH) has informally announced they would sell another 20 to 30 hospitals. The non-profit sector faces significant challenges as well. Fitch issued a negative sector outlook for 2018, citing regulatory, political, and competitive uncertainty, along with weakening in payor mixes and limited rate increases among commercial payors. Moody's revised its 2018 outlook for the non-profit sector to negative due to reimbursement and expense pressures. However, in January 2018, Standard & Poor's revised its outlook for the U.S. non- profit healthcare sector to stable from negative, noting that "favorable investment markets in 2017 helped improve cash flow and balance sheet reserves even while operating margins and coverage ratios dropped, thus also helping to maintain debt service coverage and ratings."
Providers have struggled in finding payment reform models which will reward value, and many health systems face significant capital expenditures required to maintain aging hospital campuses. The emphasis on adapting to value-based payment was a point of emphasis at the recent J.P. Morgan Healthcare Conference, and health systems are increasingly discarding the concept of the discharged patient, which results in systems seeking to integrate a complicated care delivery strategy outside of hospital campuses. As care delivery has become more complex, consolidation has sped up, ranging from payer-provider convergence to large non-profits joining forces (such as the potential Ascension – Providence St. Joseph merger, which would create the nation's largest hospital chain). Acquisition of physician practices has also continued; according to a 2017 AMA study, 2016 marked the first point at which the majority of physicians are no longer practice owners.
As health systems have sought more efficient ways to expand their geographical footprint and better serve their patient populations, various alternatives to traditional hospital development have arisen, such as multi-purpose specialty outpatient facilities and micro-hospitals. For instance, in the past five years, Baylor, Scott & White Health has constructed nine micro-hospitals, with development costs generally ranging from $7 million and $30 million per facility. Micro-hospitals typically feature five to fifteen beds and encompass 15,000 to 50,000 square feet. In September 2017, CMS issued new guidance clarifying the definition of "hospital"; new applicants which fail to meet the new statutory definition can be denied CMS certification, while currently participating hospitals could see their Medicare provider agreements terminated. Health systems pursuing new micro-hospital strategies – or investors and lenders underwriting the real estate – should carefully consider this recent CMS guidance.
With healthcare delivery changing rapidly and downward pressure on margins, some systems have elected to monetize their real estate assets in an effort to unlock capital. Additionally, as more care has moved to outpatient settings, a greater percentage of real estate assets have become targets of investors, as outpatient buildings tend to attract a larger buyer pool. Foreign capital has also increasingly invested in U.S. healthcare real estate assets; JLL reported that $2.6 billion of Chinese capital was invested in North American healthcare real estate in 2016.
In 2018, health systems should evaluate how their real estate strategies fit in as they transition to value-based reimbursement. Real estate can offer opportunities for enhanced physician recruitment and alignment, though health systems should be aware of potential compliance concerns as they pursue new strategies within outpatient settings. Real estate investors need to understand the varying risks associated with rapidly evolving reimbursement models, as the specialty building requirements for new healthcare assets can create significant downside risk if operational projections fail to materialize.
3. Evolution of long-term healthcare and behavioral healthcare
Over the past few years, there have been significant industry changes in long-term care and behavioral healthcare. In the long-term care space, skilled nursing facilities (SNFs) have struggled to remain profitable with continued pressure on reimbursement rates, payment reform in general and rising costs. In January, several operators sued the Illinois Department of Healthcare and Family Services, claiming low reimbursement rates are affecting the quality of care. Other operators, like Kindred Healthcare, have decided to exit the SNF business. In 2017, Kindred entered into an agreement with a private equity firm to sell its 89 SNFs and several assisted living facilities in a transaction valued at $700 million dollars. With headwinds facing skilled nursing, a number of diversified healthcare real estate investment trusts (REITs) have decided to sell or spin-off their skilled nursing assets. Many SNFs will likely trade at a discount in 2018 due to challenges facing the industry and the diminished pool of buyers. Nevertheless, SNFs remain an essential part of the continuum of care. The industry's current challenges will likely continue to present buying opportunities for private equity firms and pure-play senior housing and long-term care REITs such as Omega Healthcare Investors and Sabra.
In addition to the challenges facing SNFs, CMS recently implemented site-neutral payments for long-term acute care hospitals (LTACHs). Under the new rule, LTACHs will receive a lower Medicare payment for patients that do not meet LTACH criteria. But the future of the long-term care industry isn't all doom and gloom. Some providers are finding ways to generate additional revenue by treating higher acuity patients in the skilled nursing setting. These facilities are often branded as subacute facilities. The trend seems to be catching on. Another growing segment within the industry is the free-standing inpatient rehabilitation hospital (IRF), which have demonstrated comparatively superior performance as a result of favorable Medicare reimbursement rates.
Behavioral health is another segment of the industry that presents opportunities for healthcare real estate professionals. New behavioral healthcare facilities are being constructed all over the country. In states like Massachusetts, several new facilities have been completed over the past few years and more are under development. Mental healthcare professionals attribute the demand to an awareness of mental health issues and more patients with insurance under the Affordable Care Act. Additionally, the Affordable Care Act now requires individual health plans to offer mental health and substance abuse coverage. Compared to the acute care hospital industry, the behavioral healthcare industry is more fragmented. Services are often provided by state or local community healthcare centers. New facilities are also being constructed by a number of other players, including entrepreneurial mental healthcare providers, such as psychiatrists, along with large for-profit organizations like Acadia Healthcare. Private equity investment within the sector has also increased. However, new behavioral health facilities do face challenges in certain states. For example, in Wisconsin, providers are struggling to find qualified mental healthcare professionals to staff the facilities.
4. Alternative deal structures
In years past, it was common for health systems considering a new outpatient facility to engage a real estate developer. The developer would create a turn-key facility that would be leased in whole or in part to the health system. The developer would benefit by getting a return on its investment and the health system would utilize the developer's expertise and capital to complete the project. With health systems facing a myriad of issues from payment reform, a reduction in the number of insureds and changes in how leases will be treated for accounting purposes, more time is being spent analyzing whether to own or lease outpatient facilities. The analysis often involves a number of factors, including the location of the facility, the health system's cost of capital and the impact of the project on the health system's balance sheet, among other considerations.
In many cases, health systems are exploring creative ways to finance and own outpatient facilities. The scope of creative financing arrangements is broad, although there are a couple of trends that have recently emerged. A common approach involves health systems accessing the capital markets in order to fund strategically important projects on their own. This approach could involve the hospital issuing bonds or sourcing capital through a credit tenant lease (CTL). In 2017, we saw several significant debt placements by health systems, including a 4.4 Billion Dollar issue by Kaiser Permanente. Even with interest rates rising over the past few years, health systems recognize that interest rates remain at historically low levels. Non-profit health systems are especially interested in creative financing arrangements that result in the health system maintaining ownership of the facility. This is often driven by the desire to pursue a property tax exemption for the facility. For example, in states like Illinois, where hospital-based exemptions have been litigated in recent years, ownership is a requirement for property tax exemption. The value of a property tax exemption for the facility can be significant, especially in municipalities with high property taxes.
This is not to say that the need for healthcare real estate developers has significantly diminished. Despite the changing development landscape, 2017 was a banner year for development firms, according to a survey by Health Care Real Estate Insights and Revista. That trend is expected to continue in 2018. However, there appears to be a shift in how developers are being engaged, with an increased number of health systems pursuing alternative development strategies, such as fee-for-service arrangements or CTL structures, where the health system maintains ownership of the facility upon completion.
5. Capital Markets and Investor Sentiment
Within the healthcare real estate sector, the rise of interest rates in 2017 did not result in the increase in cap rates that many projected early in 2017. Some investor surveys illustrated an overall decrease of five to ten basis points within the medical office sector during 2017, with the market for core assets being particularly competitive. Looking forward, significant M&A activity within the healthcare sector is forecasted for 2018. Transaction activity between providers and payers, along with an increased investor pool targeting healthcare real estate, should create continued pricing pressure on prime medical assets through 2018. Across the general commercial real estate markets, investors are increasingly emphasizing return of capital with lower expectations on speculative return on capital.
Real estate investors continue to search for yield, and overall demographic trends which should drive continued increases in healthcare consumption remain unchanged. The Pew Research Center projected that approximately 10,000 baby boomers would turn 65 every day between 2011 and 2030.
These fundamentals, along with yield compression in other commercial real estate sectors, continue to attract institutional capital to the sector. After 2016 brought the industry's largest single sale/leaseback transaction (CHI's sale of 52 MOBs to Physicians Realty Trust for $724.9 million), 2017 saw Duke Realty (NYSE: DRE) sell its entire MOB portfolio and platform to Healthcare Trust of America, Inc. (NYSE: HTA) for up to $2.75 billion, which industry sources reported as representing a cap rate between 4.75% and 5.25%. Additionally, for the first time in a single year, two individual real estate assets sold at over $200 million in 2017: Physicians Realty Trust (NYSE: DOC) acquired the 458,396-square-foot Baylor Sammons Cancer Center for $290 million (with a year one unlevered cash yield of 4.7%) and Easterly Government Properties (NYSE: DEA) acquired the 327,614-square-foot VA Ambulatory Care Center in Loma Linda, CA (which is 100% leased to the VA through 2036) for $212.5 million. In October 2017, Bentall Kennedy announced that it would sell its 1.4-million-square-foot MOB portfolio, and some experts have projected the sale price at $600 million.
The market for healthcare real estate assets should remain highly competitive through 2018. Rapid changes in care delivery, however, can create shifts in underlying real estate values within particular healthcare verticals. While the spread between on- and off-campus assets has diminished, bifurcation between core and non-core assets has been a recent theme that is expected to continue. Going forward, real estate investors and analysts should be aware of shifts in reimbursement models, along with the ways hospital performance can affect the value of real estate, particularly buildings located on or near campuses.
6. Telemedicine and Disruptive Technology
Technology in healthcare continues to evolve, driven by the movement towards a value-based model and a need for more efficient delivery of healthcare. Tech companies have been ramping up their efforts to step into this market in recent years. The New York Times has reported that, in 2017, “10 of the largest tech companies in the United States were involved in healthcare equity deals worth $2.7 billion, up from $277 million for 2012.” Companies like Google and Apple continue to increase their presence in the healthcare arena with health tracking devices and increasingly integrated applications. Recently, Apple launched a pilot program to integrate patient medical records into its Health app, with the goal of providing consumers with greater accessibility to their medical data. Meanwhile, speculation as to Amazon’s entry into the prescription drug market becomes more of a reality, as it openly expands its team of pharmacy experts. The size and capital resources of these tech giants allow them to potentially act as disruptive forces across the healthcare industry; the most notable potential new competitive force in the industry may be the proposed company to be created by J.P. Morgan, Amazon, and Berkshire.
The threat of large tech companies entering the healthcare space may have contributed to the onslaught of recent mergers of healthcare insurers and providers. The recent consolidation of some large non-profit health systems could signal a proactive approach by hospital systems to “protect their turf” from mergers like CVS/Aetna, who plan to expand outpatient services by acquiring health centers and clinics.
Increased activity by tech companies in the healthcare market is not surprising. As described in Kaufman Hall’s Winter 2018 Report, “disruption is not the exception but the rule” in this new internet economy, as “high costs, often-inconvenient consumer interactions and $3 trillion size” of the healthcare market creates significant opportunity for innovators to disrupt the status quo. Similar disruption has occurred in other industries over the last fifteen years, with companies like Amazon taking a multifaceted and expensive service and offering the same to consumers at a lower price and with more convenient delivery models.
The short-term impact of technology on hospitals and health systems is difficult to determine. Use of technology in healthcare could mean positive impacts on efficiency and value of delivery of healthcare services in the long run. Only the sheer size and complexity of healthcare, with its regulatory and ethical issues related to reimbursement, liability and fraud and abuse compliance, has temporarily slowed the disruption of the healthcare. Standard and Poors’ 2018 Health Care Outlook suggests that over the long term, we may see a different type of competition from nontraditional companies to the healthcare market that is not inpatient oriented, with the success of these new business models being quite “disruptive to our traditionally rated healthcare providers.”
Traditional healthcare providers are attempting to respond to threats from nontraditional companies entering the healthcare market. Growing technologies, such as the continued spread of telemedicine, promise to revamp the healthcare delivery system – along with the industry's real estate needs. Hospitals and health systems must rapidly adapt in order to develop the most effective strategies for investment in innovation and technology.
For more information, contact:
Victor McConnell – victor.mcconnell@vmghealth.com
Kelly Bondy – KBondy@hallrender.com
Andrew Dick – adick@hallrender.com