Healthcare Real Estate: Sale-Leaseback or Hold?

Posted on July 14, 2010


Earlier this year, I heard a healthcare conference speaker question why hospitals own their land and facilities since it is not their bailiwick or mission. I heard of sale-leasebacks in other industries, but healthcare? It seemed like a bad idea. Wasn’t owning always preferred to renting, even if property ownership is not a ‘core competency’? I decided to discuss it further with a friend of mine in commercial real estate.

The case study subject is Valley Regional, a fictional non-profit, community hospital with looming financial difficulties. Valley currently owns its building and land outright, valued at about $30 million, but is carrying $10 million in debt. It owns a couple MOBs and a clinic on property elsewhere, but is not part of a system per se. Alternative financing—grants, bonds, donors—is unavailable at this time.

My real estate consultant wanted to know:  why does the hospital need the money? We will address three potential answers, but first let me outline some real estate basics from the expert. A sale-leaseback is an arrangement designed to strengthen the balance sheet. A building and land owner sells to a buyer in exchange for a very attractive long-term lease, usually 20-30 years. The seller realizes a capital gain on the sale while freeing itself of some potential liabilities that come with property ownership. As it was explained to me, buildings are not really assets; they depreciate, require debt service if not owned free-and-clear, maintenance, insurance, and have tax liability. And for a lessor, an empty building is a sure liability.

Two types of lease arrangements are common with sale-leasebacks. A triple-net lease is a long-term lease for a lower-than-market cost-per-square-foot. In exchange, the new landlord does not meddle with the operations and the occupants act like they own it; the tenants keep current service contracts in order and there is an understanding to not nickel-and-dime the new owner over trivial expenses. Triple-net leases are more common in sale-leasebacks. The other option is a full-service lease, where a typical market rate rent is paid and the owner pays for everything with the freedom to institute his cleaning crews, his landscaper and use his light bulbs of choice.

Scenario 1:  Acquisition Target – Buy
Valley Regional has identified another facility it would like to purchase, but has no capital to do it. The goal for Valley is to find a buyer for its campus and secure a 20-30 year lease in the process. It was explained the value of Valley Regional’s sale and lease would be tied to its credit worthiness, like its tax exempt bond rating, and its cash flow. As we mentioned, the building is virtually valueless without a tenant, so the owner is focusing mainly on Valley’s operations as a business unit for the sale price. Risk would be factored into the lease rate, but the lease value would be directly proportional to hospital income.

Scenario 2:  Building Project – New Construction
In this situation, Valley is in dire need of a renovation and addition for its Emergency Department. The issues are very similar to Scenario One. Based on our case study assumptions, a sale-leaseback would retire the $10 million debt and provide a profit of $20 million—just enough for the construction project. If Valley can secure a long-term lease, it may positively affect the ED pro forma once the sale is complete. Likewise, adding income capacity might assist in the negotiation of the sale, or at least benefit Valley in its lease terms once the sale is complete.

Scenario 3:  Acquisition Target – Sell
Valley Regional Hospital has been testing the merger market informally for a couple years. In preliminary discussions with one particularly desirable suitor, the acquiring health system noted the sizable $10 million debt as the only likely deal breaker. Ideally, Valley would want to find other ways to make the debt disappear before resorting to a sale solely to look more attractive for sale. Maybe its mortgage could be restructured, or a venture capitalist / hedge fund / investment banker could be brought in as an acquisition partner. Everything is for sale at some price and maybe a price discount or other concession would appease the potential buyer. If no other option could be reached, a sale-leaseback could be executed as a contingency condition of the sale written into the contract. This would protect Valley Regional from the risk of selling without a committed buyer.

If the hospital owns a large campus with undeveloped land, an alternative would be to sell unused acreage or land not part of a long-term master plan. Outparcels near a hospital could have unrealized value, especially if rezoned, and development opportunities of those surroundings are attractive to many businesses.

When selling anything, never be desperate; selling out of need is a distress sale, and usually the buyer takes advantage of the seller. As my real estate friend emphasized, a sale-leaseback is a desperate move for a non-profit because in most cases, it is liquidating the only asset a hospital owns. In fact, the property may very well be a restricted asset by donor or law and therefore unavailable for sale. A sale-leaseback could also create uncertainty with future lease negotiations. Many businesses can easily relocate to more attractive tenant space if their lease cannot be renewed, but hospitals do not have equal flexibility; on the other hand, a land owner wants a long-term tenant and property with a hospital that cannot make its rent is unattractive.

The hospital CFO, legal, accounting, steering committee and formal governance entities, among others, would definitely need to research and investigate options. That said, a sale-leaseback offers the potential for a drastic financial turnaround in a short period of time.