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Senior and Post-Acute Healthcare News and Topics

Financial Tests Before Additions, Renovations or New Construction

A frequent, recurring question that I field, especially for CCRCs and seniors housing providers is “what” financial feasibility tests are most important before a project is started or for that matter, financed.  Given that capital is still relatively tight, project feasibility and key financial tests are today, critically important to assure the best financing terms available plus, project viability.  Below, I’ve broken out the initial “best” feasibility tools/tests to work through once a scope and general cost is known.

  • Revenue Efficiency: This is very simple: How much of the proposed project square footage produces revenue?  The more square feet tied to revenue generating functions, the more revenue efficient the project is.  For seniors housing, the factor or test is very important.  Too often, I see proposed projects that allocate way too much space to commons and other areas that aren’t related to revenue production.  While groups will argue that these spaces are necessary to attract prospective renters/residents, the reality is that smaller, more efficient is better from an operating standpoint and frankly, even from a marketing standpoint.  Too much space can give the project a “vacant” feel while driving up costs related to heating/air conditioning, maintenance, furnishings, etc.  Ratios of revenue producing square feet to  common or non-revenue producing square feet of 70/30 or less, tend to work best from a feasibility standpoint.  I’ll tie this point tighter in subsequent segments.
  • Prospective Rate Test by Square Foot: While rate charged is a function for many providers of market or other perceived and financially tied projections, a first basic test should involve a simple equalization model based on project square feet.  In fact, this test is an easily built model that can be used for many rate setting exercises and revenue pro formas.  First, total the revenue producing square feet in the project.  Next, determine the project’s projected or known, fixed costs, variable costs and desired margin.  Finally, decide at what level, stabilized occupancy will occur (e.g, 85%, 90%, etc.).  Hint: Amounts or levels greater than 95% are not realistic.  Once the aforementioned data is determined, divide the total of fixed, variable and margin (annualized) by the total revenue producing square feet, divided by 12 for a monthly factor or 365 for a daily factor.  Finally, multiply this result by the stabilized occupancy percentage.  The result is the gross revenue per square foot required by the project to cover the fixed and variable costs plus generate the desired margin.  To equate this number to prospective rates, multiply it by the unit square footage for each unit type in the project.  Next, analyze the results compared to market.  Are the rates calculated attainable?  If the rates are ultimately not, can the revenue be picked-up elsewhere via a shift among unit types?  Are the costs too high?  Back to the first point, is too much of the project square footage not tied to revenue production?
  • Occupancy Tests: Knowing what the projected gross revenue is on a square foot basis provides a basis for conducting some simple occupancy tests via adjusting fill-rates, overall occupancy rates, payer mix, etc.  Using the same formula above but varying the occupancy, it become easy to see the relationships between square foot expenses, particularly those that are fixed and the revenue levels required to cover these expenses.  I like to analyze the ratios between each or, how much occupancy do I need to cover fixed expenses (percentage) and where can I massage variable expenses based on occupancy levels or payer mix.  Typically, once a simple spreadsheet with square foot costs and revenues is built, it is fairly easy to do assumptive modeling and analyses.
  • Payback Testing: An important analysis or test too often ignored or, assumed to be tied to a debt service amortization schedule, is payback testing.  Payback should be factored to occur on or before the point in the project’s useful life, when major improvements need to occur.  The point here is that the project ideally is paid-for before major improvements occur, commonly known as the period of re-building.  At this point, one shouldn’t look at a scenario of re-building when the original debt or expenditure (if equity is the source) isn’t already recovered or substantially defeased.  If this doesn’t occur, the capital improvement process is akin to building the project twice (or major portions thereof).  In simple theory, new buildings or new construction provides a window of time where capital infusion for improvements is minimal if almost non-existent.  This period is where incremental cash (assuming proper pricing at sustainable occupancy levels) can accumulate, allocated for payback (either via faster current debt repayment or investment for future repayment when the arbitrage is positive).  My preferred methodology for this analysis is to develop a cash flow analysis where revenue is netted against cash expenses, including debt service.  I set my targeted payoff period as that time in the future where projected improvements via major system, structural, etc. upgrades will occur – typically by years 12 to 14.  I also will net my annual cash flow by anticipated or projected capital improvement expenditures that use “cash”.  For inflation assumptions, or investment assumptions, I try to use actual or historic data and I err on the side of conservatism.  Two methods can be used in this approach.  One that negates principal repayment in “real-time” and one that incorporates incremental principal repayment.  If debt is involved and on an amortization schedule with principal repayment incorporated, its easiest to assume a declining balance for the payback analysis.  If the source of funds is equity or a combination of  debt and equity, I assume equity repayment at a current cost of capital rate and while I may not create an amortization schedule with imputed principal payments (equity repayment), I will assume a “balloon” effect by imputing a cost of capital return assumption on the equity.

Ideally, this type of analysis is done sufficiently ahead of project finalization.  If such is the case, the project can be adjusted to conform to a proper payback period, be optimally efficient, and have a rate/revenue structure that fits within the target market.

March 16, 2012 Posted by | Assisted Living, Senior Housing, Skilled Nursing | , , , , , , , , | Leave a comment

Strategies for Accomplishing New Development or Major Capital Projects

One of the focal areas of my consulting practice/work is assisting health care organizations in accessing sources of funding (securing financing basically) for major projects and/or new development.  Given the state of the economy, most specifically the capital markets over the past eighteen months, getting funding for capital projects and/or development has been challenging, though not impossible.  Terms are definitely not as good (rates, covenant restrictions, and length or term of the obligation) and lending sources are far more credit adverse than two years ago.  Health care, although the defaults have been low, is an eclectic industry for most traditional lenders and their lack of specialization or knowledge makes them deal “shy”.  Even lenders with health care technical experience are more cautious and requiring far more information and deal due-diligence than say, two years or so ago.

Approaching a major capital project (expansion, remodeling, equipment replacement, etc.) or a new development (addition or new facility) is a daunting task and if any of the cost involves securing financing, below are some strategies or tips for project analysis and due diligence that I have found are virtual necessities to secure financing.  Obviously, this information does not supplant the credit worthiness of the organization doing the borrowing or in other words, bad financial ratios equals bad terms or today, no credit.

  • Completion of an Internal Rate of Return analysis at “current” market cost’s of capital.  The analysis needs to include sensitivity adjustments/tests as well.  If the project is such that the expenditure will not add revenue (major equipment or even some remodeling projects), the Internal Rate of Return analysis uses assumptions of savings and depreciation expense as the source of “revenues”.  In other words, you begin the first phase by using a life-cycle cost analysis as the means to produce the “net inflow” assumptions (savings, etc.) for the IRR. 
    • Much of health care, especially the reimbursed and clinical segments is very much a fixed-revenue prospect.  I see providers get caught all the time trying to justify remodeling and even down-sizing projects as “revenue improvements” and it doesn’t fly.  It is possible to produce or to generate new or improved “cash inflows” from these types of projects but creating assumptions for this improvement and the resulting new inflows requires careful thought and impartial analysis.  Suffice to say that if the project involves remodeling or down-sizing, getting to the point of improved net inflows as a result of the project means something had to change on the expense side (especially again, if the bulk of the revenue related to the project is fixed reimbursement), efficiencies have to be clear and demonstrable, and/or the use of the remodeled or down-sized space is for a new product or service line that will generate incrementally higher revenues or reimbursements per patient day.
    • On new developments or expansion projects, the largest mistake I see made is around the assumptions of occupancy and revenue generation.  The assumptions used need careful analysis and should be weighed against comparable provider/market experiences whenever possible.  This is critical in the sensitivity testing portion of the IRR – stressing and testing the new revenue assumptions.  Some very important revenue assumptions cues are;
      • Reimbursement rates and the corresponding revenue assumptions need to fit the current legislative and policy trends.  For example, health care reform just passed and Medicare is looking at $500 plus billion in cuts.  Medicaid is another issue and state budgets and forecasts of rate cuts or rate stability are an issue.  Don’t use assumptions that don’t follow the present health policy issues.
      • Dramatic changes in payer mix and product line mix are unlikely to occur as rapidly as I see providers try to project.  If for example, your payer mix has been predominantly Medicare, some Medicaid and some private insurance (65/25/10),  it may change dramatically for a new development in a new market location but not for an addition to an existing location.  In reality, just by “building it”, they won’t “naturally come”.  Marketing strategy is the key to this change but in the analysis, the assumptions of any major revenue changes as a result of a project need to be smoothed.
  • Capital Budgeting techniques and analysis need to be performed for major equipment replacement or infrastructure improvements.  Alternatives to the project need to be reviewed and financial analysis of the costs and operating impacts of each alternative need to be completed.  Again, interest rate/cost of capital assumptions, even a cost of cash assumption (investments of internal cash v. cost of debt), need to be integrated into the analysis.  Lenders want to see that the provider has thoroughly evaluated analytically, the alternatives for each proposed capital project.
  • Benchmark your project against like projects and your numbers against industry ratios.  There are a number of sources for industry ratios by health care segment from Fitch, to trade associations, Ziegler, BB&T, etc.  I typically will add comments and a brief discussion of salient differences when the ratios and results are positive or negative to industry standards.  I also like to incorporate a pre and post project re-cap.
  • Discussion and information on Market and Industry Trends is important for lenders to understand how the project fits into the overall market, into your organization’s position within the market and where the organization views the project in light of current industry trends.  Remember, the policy landscape is quite volatile and lenders are aware of the volatility.  Explanations of a thorough understanding of this volatility and how the project and organization plan fits in light of this trend is imperative in order for lenders to have a grasp of  the organization’s project management and financial and strategic management capacity. 
    • Market discussions should focus on where the organization ranks competitively within a market area, where the organization’s target market is, how that market is changing, and how the project responds to the market needs, its market position, and to the changing demands within the market location.  I also like to incorporate sales advantages, competitive advantages, quality information (as pertinent), customer satisfaction information, and any commentary on competitors.
    • Industry trend discussions focus on what is happening in the industry and how the project relates to these trends and why.  If the project is for example, an infrastructure improvement (roofs, mechanical systems, etc.), it is entirely appropriate to discuss the average age of physical plants in the industry, deferred maintenance and or average capital spending trends, etc.  If the project is an addition, the discussion should focus around meeting customer needs, new products and services that will be delivered and how completing the project either keeps the organization up-to-date with industry advances or propels it ahead of the pack. Other industry information that is important to discuss is;
      • Major health policy trends such as reimbursement rates, new regulations or requirements (e.g., mandates for sprinkler systems in SNFs), and as applicable, changing patient/customer needs.  It is important to relate these trends to the project and as much as possible, across the anticipated horizon that covers the length of the credit.  For example, if reimbursement changes may positively or negatively impact the organization’s cash flow, a frank discussion of this impact is necessary along with how the organization is planning to address the impact.  The impact, of course, plus the organization’s assumptions of impact on the project and the organization should be incorporated in the financial analysis.
      • Industry information regarding payer mix trends, length of stay, service utilization, labor costs, etc. may or may not relate to the project but whenever it does, I like to point it out and moreover, discuss briefly the relevance and the distinctions.
  • For New Developments market and demand studies are critical.  I like to see demand studies that test demand at given prices, not just global demand.  Global demand assumes price doesn’t matter or location and service-depth is less relevant and in reality, it may be the difference between success or lack of success.  Although a bit esoteric, I am even in-favor of incorporating a bit of “central place” or “location” theory in my market and demand analyses.  This type of analysis looks at key project characteristics or specifications and analyzes how strongly they are met or reinforced by the development location.  For example, if proximity to a certain referral source is a key project specification, I’d analyze this in relationship to market size and perhaps, existing referral patterns. I’d then look at the cost of development and location (site) in relationship to the requirement that the location is proximal to a referral source.  In some cases, the cost of development may be to such a degree greater that an alternative location actually becomes preferrable from a financial feasibility stand-point.  Finally, market analysis needs to define the primary markets, the competitors within the markets, the socio-economic condition of the market location (population growth, income/wealth, age,education, etc.) and the market trend.  I will also address factors that may positively or negatively affect the project’s completion and revenue assumptions (occupancy/lease-up, etc.).

 As daunting as the above may sound, it is nearly a pre-requisite to access capital for large capital projects and/or new developments at acceptable terms (again, assuming the general financial profile of the organization is solid).  While each project is different necessitating more analysis in one area and less in another and each organization is different, I’ve found that lenders today prefer more on-point discussions, even if they seem trivial, than less.  Building a solid case, financially and strategically, for the project is critical in order to achieve success in the capital markets and frankly, in order for the project to achieve the organizational objectives.

March 24, 2010 Posted by | Assisted Living, Hospice, Senior Housing, Skilled Nursing, Uncategorized | , , , , , , , , , , | Leave a comment