Real Estate Investments

Chapter 4: Real estate investments

Healthcare real estate in the Dutch cure sector can be subdivided into 3 segments:

• General hospitals (around 80; 40.000 beds)
• Academic hospitals (8; 8.000 beds)
• Various specialist facilities, including Independent Treatment Centers (Zelfstandige Behandelingscentra, ZBCs)

This chapter will discuss real estate investments of general and academic hospitals in the Netherlands and focus on the years up until the regime change (2008). In doing so, it will answer sub-question 5: What are the potential effects of the regime change on real estate investments of hospitals? Real estate on the balance sheet In 2004, the book value of hospital real estate (tangible fixed assets) was estimated at €7,3 bln (of which 30% is accounted for by academic hospitals), and intangible fixed assets were estimated at €1,8 bln (see table 4.1). This book value accounted for almost 60% of the turnover (€ 12,95 bln) in 2004. Land had a share of only 4% of the book value, however, as will be explained below, land is undervalued. In 2006, the ratio between turnover and real estate capital costs of academic hospitals was 2:1 (RVZ, 2006), and the share of interest payments and depreciation was estimated to be <5% of turnover. According to the RVZ (2006), the depreciation on real estate amounted to 4,5-5% of the book value in 2006. If the interest rate on real estate is assumed to be 5%, the real estate capital cost of hospitals amount to 9-11% of the book value, or € 0,65-0,75 bln. This amount constitutes 5-6% of turnover; however, this share is 0,5% lower for academic hospitals compared to general hospitals. Though the financial risk hospitals are exposed to does not solely depend on the amount of assets they hold, it does play a role in determination of the risk profile. Capital intensity Another factor that determines the risk profile of hospitals is capital intensity: if capital intensity increases and more capital is allocated to real estate, risk will increase as well. Compared to other healthcare sectors, such as nursing homes and residential care homes, a relatively small amount of capital is allocated to real estate (see table 4.2). Book value problems It is questionable to what extent the 2004 estimated tangible fixed asset book value of € 7,9 bln corresponds to the actual market value. Because many hospital buildings are of a considerable age, their book value is usually higher than their actual market value. Hospital real estate is highly asset specific and is sensitive to fast aging because of ongoing technological change. The hospital sector is confronted with book value problems because buildings were depreciated (over 50 years) based on straight line depreciation. However, hospitals also possess hidden reserves which increase the value of their real estate. This is because land is not estimated at market value on their balance sheet. Financial position According to WfZ data, in 2005 19 out of the 26 financially weak and high insolvency risk participants in the Waarborgfonds were hospitals. Additionally, hospitals were also overrepresented in the participant category "negative operating results" (WfZ, 2005). The changes in profitability, solvability, working capital and the variance in the period 2001-2004 are illustrated in table 4.3 below. Reflecting on the data in table 4.3, the profitability and solvability of hospitals are increasing, whereas working capital is steadily decreasing. The variance of changes in profitability and solvability is small; the variance of changes in working capital is larger and steadily increasing. Real estate investments in the old system In the old building construction regime, hospitals were required to get a license in case of building and renovation projects. Hospitals financed projects that were not included in the building construction regime by using their built up drawing rights for midlife renovation. Though the hospital was compensated for capital costs in its budget, these costs increased with the compensation for interest and depreciation payments after completion of a building project. The interest compensation in the budget would subsequently decrease because of debt repayment; the depreciation compensation would end when the final depreciation payment was paid. In the new system, hospitals have to bear the risks of real estate investments themselves. According to the government, this results in more customer focus, more effective management of the estimated 6 mln mA² of hospital floor space, and innovative real estate management. Regime change Table 4.4 below illustrates the (anticipated) effects of the transition from the old system to the new system on the amount of exploitation costs Dutch hospitals are/were compensated for in their budgets by the government. Clearly, there is an increasing trend visible in the 5 year government forecast for both new buildings and maintenance & renovation at the end of 2003 (table 4.4a); apparently the government expected hospitals to spend more on new building and maintenance & renovation up until 2009, possibly to benefit from the old system regulations prior to the upcoming regime change. However, the government has subsequently readjusted its forecast with actual numbers for 2004, 2005, and 2006, which appear much lower than the numbers forecasted initially, especially with regard to midlife renovation (see the %-change with respect to 2003). Next, table 4.4b shows the new forecast for the period 2007-2011. The effect of the regime change is clearly visible here: the exploitation costs hospitals were compensated for in the old system have virtually dissolved with regards to new buildings and appear quite low for midlife renovation (apart from a sudden surge in 2010 and 2011). Finally, table 4.4c shows the government expects the regime change to have taken full effect for midlife renovation in 2012, as exploitation cost compensation equals zero. Real estate investments in the new system In the new system, the construction budget is integrated into the hospital tariff. Assuming an average for the building's lifecycle costs, these costs are integrated into the government-regulated segment (DBC-A) of healthcare tariffs, the so-called normatieve huisvestingscomponent (standardized real estate component, nhc). A net present value based on 190 % of the replacement value is averaged out over a 40 year period (Windhorst, 2006). This corresponds to the average investment pattern of an average hospital. The hospital is free to negotiate the tariffs in the market segment (DBC-B) with health insurers, including real estate costs. Thus, the hospitals should ensure real estate costs are sufficiently compensated for in the tariff negotiation. However, the new real estate financing system is not feasible for all hospitals and could even drive them into financial difficulties. The possible negative side-effects are explained below.

1. 1. Real estate investments > normatieve huisvestingscomponent

The extent to which hospitals are able to cope with the new system strongly depends on the lifetime of its real estate. For example, hospitals with comparatively old buildings will be able to benefit from the new system as their fixed building costs are below the nhc. As a result, they can save up additional funds for some time. However, new hospitals that have recently completed or started real estate investments will experience financial difficulties, as their fixed building costs exceed the nhc. Theoretically, this implies new-built hospitals lose around 10% of their equity in the first 10 years of their lifecycle. This is a cause for concern as many hospitals already suffer from a low solvability.

1. 1. Reallocation-effect

In the old system, the determination of the capacity of the current hospital buildings was based on the capacity required at the time of building. Based on an estimate of the healthcare service area, hospitals were allocated floor space. Over time buildings appeared to be either too small or too large, and the estimates did not correspond to the real numbers. For example, hospitals in expanding urban areas such as Almere, Zoetermeer and Purmerend have too little capacity whereas hospitals in the large cities often have too much capacity. Furthermore, the average size of new hospitals is smaller, since the average amount of patient days has decreased. Today, real estate financing is based on the production profile of hospitals. The floor space areas calculated in the past are now unrelated to financing. This results in another problem for many hospitals, as their abundant real estate will be difficult to put to alternative use because of its high asset specificity. Furthermore, the abundant real estate is usually scattered over the building and most parties are not interested in locations in the vicinity of hospital functions.

Conclusion

The new system brings a number of real estate investment issues to the surface. These include book value problems and hidden reserves, a weak financial position, budget effects, real estate investments>normatieve huisvestingscomponent (nhc), and the reallocation effect.

1. 1. Book value problems and hidden reserves

Because many hospital buildings are of a considerable age, their book value is usually higher than their actual market value. Hospital real estate is highly asset specific and is sensitive to fast aging because of ongoing technological change. The hospital sector is confronted with book value problems because buildings are depreciated (over 50 years) based on historic cost. However, hospitals also possess hidden reserves which increase the value of their real estate. This is because land is not estimated at market value on their balance sheet.

1. 1. Weak financial positions

In 2005 19 out of the 26 financially weak and high insolvency risk participants in the Waarborgfonds were hospitals. Additionally, many hospitals experienced negative operating results. The higher risk exposure and increased investment responsibility in the new system can lead to an aggrevation of this situation.

1. 1. Real estate investments > normatieve huisvestiginscomponent

Hospitals with comparatively old buildings will be able to benefit from the new system as their building costs are below the normatieve huisvestingscomponent. However, new hospitals that have recently completed or started real estate investments will experience financial difficulties, as their fixed building costs exceed the normatieve huisvestingscomponent. This implies new-built hospitals lose around 10% of their equity in the first 10 years of their lifecycle and is a cause for concern as many hospitals already suffer from a low solvability.

1. 1. Reallocation effect

In the old system, the determination of the capacity of the current hospital buildings was based on the capacity required at the time of building. Today, real estate financing is based on the production profile of hospitals. This results in another problem for many hospitals, as their abundant real estate will be difficult to put to alternative use because of its high asset specificity.

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