By Timothy H. Baker
Hospital and health system financial statements should accurately reflect the lives of their assets. Whether or not they actually do so is up for debate.
When Medicare was introduced in 1966, it reimbursed hospitals on a “cost-based” structure. Depreciation of assets such as buildings and equipment was one such cost. Therefore, it was beneficial for healthcare providers to maximize depreciation, as greater depreciation equaled greater reimbursement.
Computing the depreciation expense required hospitals to capture the cost or value of the assets, as well as determine the anticipated life of the assets. To calculate the anticipated life, hospitals used the American Hospital Association Chart of Accounts, which in 1966 showed the average useful life of a hospital at 40 years.
From 1966 to 1991, not surprisingly, hospitals did their utmost to maximize depreciation expense for Medicare cost reporting purposes. In 1991, that began to change for two reasons:
- One benefit of rapidly depreciating assets went away when Medicare phased out cost reimbursement from 1991 to 2001, subsequent to the introduction of diagnosis-related groups (DRGs).
- The IRS and others realized that the average useful life of a hospital was longer than 40 years. In many cases, much longer. The same is true with the lives of equipment.
The reality is well-constructed hospital buildings frequently last more than 40 years, often more than 100 years. They are remodeled and/or renovated, or they acquire adjacent land for new construction. So although interior building components may change over time and the functions within the building may change, the structural components remain the same.
So what is the accurate life? Principle Valuation has analyzed the useful lives of more than 400 hospitals and their associated buildings, building components and equipment, relying heavily on engineering analyses that include a wealth of data. That data includes:
- Dates of construction
- Maintenance history
- Effective age
- Estimated remaining life of the building and its components
Principle Valuation’s study provides support for 70-year to 100-year lives for the structural components of a hospital building. This can translate to 40, 45 and in some cases 50 years or more composite lives. In some instances, the actual lives of equipment doubled.
Still, many organizations continue to use an average structural life of 40 years, resulting in depreciation that is too rapid. This causes an ongoing inaccurate and understated reflection of assets’ value on financial statements, and understates their investment value. This can have a major impact on a hospital’s ability to finance, and the term at which it finances.
Of course, every situation is different. Correctly assigning useful lives involves conducting an engineering review of the structural components and physical observation and inspection of equipment. According to the American Institute of Certified Public Accountants, asset life estimates should be changed when new information becomes available through a review of the assets, how they have been used and maintained, and what history shows.
Check out our article in the June hfm Early Edition, “The Truth About Asset Relifing.”
In our last post we discussed the concept of establishing fair market value (FMV) for rent (http://principlevaluation.com/establishing-fair-market-value-for-rent/). The example below represents a real project we recently did that resulted in expert testimony (we changed the actual numbers, but the percentage differences are the actual percentage differences).
In this situation, we represented a hospital that had leased ground to a developer to construct a medical office building adjacent to the hospital. The original 25-year ground lease was expiring, and the hospital was looking to exercise the purchase option, which called for each side to obtain a FMV appraisal. Both the hospital (buyer) and developer (seller) had appraisals performed. Another key point was that the hospital master leased about 90% of the building. Here is what happened, demonstrating why correctly establishing fair market value is so important.
After doing our analysis, we determined a FMV of $25.5 million for the purchase. The developer’s appraisal came in with a value of $40.5 million. That’s almost a 60% premium to what we were proposing. That magnitude of difference is very uncommon and safe to say the two sides couldn’t come to an agreement.
The dispute was headed toward “baseball arbitration” where an independent arbiter would rule for one side or the other (in baseball salary arbitration, both sides submit proposals and the arbiter decides on one or the other). There were some indications that the arbiter would side with us, so both sides resumed negotiations and ended up with a price of about $27 million, or just 5% above what we had proposed.
The primary factor that led to this settlement had to do with the anticipated rents utilized in each appraiser’s projections. As mentioned, the hospital master leased 90% of the medical office building, and the lease was expiring within a month of both the appraisal dates. The developer’s appraisal value assumed that the hospital would renew the lease and did not factor in the risk with the potential turnover of the lease. In actuality that was not a given, and a fair market value determination needed to factor in the reasonable possibility that the hospital would not renew the lease. So our valuation appropriately took into account the risk with the hospital potentially not renewing the lease. Our appraisal accounted for this risk in the potential revenue lost due to the 90% turnover, the costs to potentially re-lease the space (marketing, commissions and tenant improvements) and in the capitalization rate.
We were able to successfully testify as an expert witness based on the strength of our appraisal and ultimately get a “win” for our client.
Recently, we discussed establishing fair market value for physician compensation. But physician compensation is not the only item requiring establishment of fair market value. Hospital-owned entities require any real estate lease to be at fair market value when it involves a referral source: in other words, rent that reflects fair market value.
The market value (synonymous with fair market value) is the most probable price which a property should bring in a competitive and open market. Fair market value assumes the following:
- The buyers and seller are typically motivated
- Both parties are well informed or well advised, and acting in what they consider their best interests
- A reasonable time is allowed for exposure in the open market
- Payment is made in terms of cash in United Stated dollars or in terms of financial arrangement comparable thereto
- The price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale
Fair market rent is the rent a typical market participant would pay based on market metrics. This can be calculated multiple ways:
- Cost approach, which estimates rent by determining the annual return to the land based on its fair market value plus the annual return on the depreciated replacement cost of the improvements (building and site) over the remaining life of those improvements. This can also include furniture, fixtures and equipment if included in the lease. Expense structure also needs to be considered.
- Market approach, which estimates rent based on what other comparable properties in the market have rented for.
- Income approach, which estimates the rent based on the income that can be produced by the space and what other similar tenants have paid in rent for similar space, typically based on a percentage of net operating income.
These three approaches (or less depending on relevance) would then be reconciled to determine the fair market rent for the leased space.
When having a fair market rent analysis performed for your entity, make sure the following steps are included:
- Discussions with senior management and advisors about the prospective business operation and markets served
- An analysis of local demographic trends
- A review of local and national healthcare trends and transactions
- Conversations with commercial real estate brokers to better understand the local market and confirm land sales
Thomas J (TJ) Griffith is Vice President and Seniors Housing Practice Director at Principle Valuation. Contact him at TGriffith@PrincipleValuation.com
With more and more hospitals buying physician practices, both the purchasing hospitals and the practices being acquired must make sure the compensation arrangements are compliant with Federal law. The Federal government is closely monitoring these arrangements, and settlements for violations can run into the many millions of dollars.
There are three main Federal laws related to these arrangements: the Stark law, the Federal Anti-Kickback Statute and Internal Revenue Service guidelines. Together, these laws cover all financial arrangements between hospitals and physicians, including compensation.
One key is the bona fide employment arrangements exception in the Stark law, which is more strict than the Anti-Kickback Statute. This law permits compensation to physicians as long as it is for identifiable services, is consistent with fair market value for those services, and is not based on volume or value of referrals to the hospital.
Scott Becker, an attorney with McGuireWoods (www.McGuireWoods.com) suggests the following for hospitals entering into compensation arrangements with owned physicians.
- Ensure all compensation contracts with physicians are in writing, signed by all parties, and do not take into consideration the volume or value of referrals. Additionally, documentation should be retained to support the fair market value nature of the compensation.
- Arrangements should include a clear job description outlining the specific duties and services to be performed, as well as an analysis and record of why a physician position is reasonably needed.
- Hospitals should strongly consider obtaining third-party support for physician compensation arrangements where the physician is unusually productive or the compensation structure is outside normal practice.
- The hospital and physician should ensure that all agreements meet a core exception under Stark and comply or substantially comply with a safe harbor to the Anti-Kickback statute.
- Compensation agreements should be periodically reviewed to ensure compensation remains consistent with fair market value.
- Hospitals should consider adopting a reasonable compensation cap, especially if the arrangement is pursuant to a productivity-driven compensation structure.