Health care systems on both sides of the Atlantic are converging. While the Obama administration appears to look at European public health fund models when contemplating general public health insurance systems, European policymakers have looked increasingly at the Unitied States when revising European health care systems. Related examples in Germany are the introduction of Diagnosis Related Groups (DRGs), i.e., the payment for hospital services on the basis of a case rather than on the number of days spent in a hospital; disease management programmes; and, in particular, the opening of the health care service market to private investors.
The market share of private for-profit investors in the hospital market in Germany, for instance, has become larger than in the United States. Rehab facilities and nursing homes are predominantly owned privately in Germany. Ambulatory medical services (i.e., physicians’ offices) are owned predominantly by the physicians themselves, but the market share of private non-physician investors is increasing.
In Germany, operation of a business and ownership of its real estate is often separate with regard to rehab facilities and nursing homes, and physicians occasional ly run their practice in offices owned by hospitals rather than by themselves. Real estate sale and leasebacks in the inpatient and outpatient medical service market in Germany have been few and far between, but this may change. Physicians and owners of ambulatory services strive increasingly to lease real estate in order to lower their financing needs. For real estate investors, properties used for ambulatory services seem appealing. Outpatient medical services bring stable revenues, and the importance of outpatient as opposed to inpatient services is expected to grow as a result of changes in the remuneration system and following a similar shift to outpatient services in the United States.
Sale and leasebacks in the hospital market are also, at the moment, uncommon in Germany. This is partly due to an outdated system of government financing of hospitals, as regulated by the laws of the individual federal states. But that system is fading, and it is likely that both private and public owners of hospitals in Germany will look increasingly at sale and leaseback models. What can be learned from the U.S. experience?
Health Care REITS: The U.S. Experience
In contrast to many European countries, in the United States the market for separation of the operation and ownership of assets in the health care sector has a long history. This separation was in part influenced by the passage of Real Estate Investment Trust (REIT) legislation in the United States in the 1980s. As far back as 1986, REITs have existed as publicly traded entities that generally own real estate and lease the operations to third parties in a tax efficient fashion. There are more than six major publicly traded REITs on the New York Stock Exchange that invest solely in health care related real estate assets.
REITs are a favoured investment of U.S. shareholders, as a REIT can distribute 90 per cent of its taxable income to shareholders as a dividend, to avoid taxation at the REIT entity level. REIT stocks are also a favourite with yield investors looking for stable returns. In the health care sector, the returns tend generally to be higher, reflecting regulatory, reimbursement and the single-use profile risks associated with these properties.
In addition to REITs traded publicly, there are several private REITs composed of U.S. and offshore shareholders investing in U.S. health care real estate assets. Cross-border REITs should pay significant attention to U.S. tax withholding rules, tax treaties and a myriad of regulatory issues prior to expatriating any gains.
U.S. REITs generally invest in four categories of assets: hospitals, senior and assisted living facilities, medical office buildings with physician offices, and ambulatory clinics (some physician and some hospital owned). REIT investments in hospital and medical office use/clinics tend to create potentially higher levels of legal complexity because of the health care regulatory environment in the United States prohibiting physician self referral, requirements for fair market value relationships with non-profits, and federal and state anti-kickback laws. Nevertheless, many hospital systems are now seeking to “monetise” real estate via REIT fianancing to divert proceeds to their core operations and pay down or restructure soon to be maturing debt. In addition, phys icians, investing in expensive diagnostic and imaging equipment, are seeking to minimise their real estate expense and focus on their core operations.
Leases in the United States by REITs to third-party health care operators are generally structured as “triple net leases”, requiring the tenant to pay rent net of all operating costs, including utilities, taxes and operating expenses. Some leases permit the tenant to have an option to purchase or renew at the end of the lease. Others permit the tenant to participate in the “upside” or increases in fair market value of the asset. All such arrangements must be structured carefully around appropriate regulatory requirements for fair market valuation.
Generally, REIT financing is attractive to health care operators as it provides 100 per cent financing at fair market value (compared to bank debt at 75 per cent or lower), permits operators to focus on their core business and allows operators to budget into the future fairly accurately their real estate expenses in the form of rent payments. On the down side, REIT financing deprives operators of control of the asset in the event of mortgage rates dipping or a company being sold. In some cases, it can deprive an operator of enhancement in the asset value and the “upside” in the real estate, and, depending on negotiations, can make the operator remain liable for cap X improvements during the lease term.
The viability of REITs depends heavily upon the condition of the capital markets. This is due to the requirement that 90 per cent of REIT taxable income must be distributed to shareholders in the form of dividends. Therefore, REITs must rely upon the equity markets, public debt markets and bank debt as well as asset sales to raise funds to leverage their balance sheet. Consequently, at the moment, most REITs are shoring up their balance sheet by raising equity, selling assets, buying back bonds at a discount, reducing their dividend and applying the proceed of the above to maturing bank debt.
The Future for Health Care Real Estate in Germany
The financial squeeze on German hospitals has led to more acute hospitals being taken over by private operators; hospitals are not in a position to simply increase their debts. It is not immediately clear whether sale and leaseback and health care REITs in Germany would help to encourage privatisation.
At first glance, there is no sign in Germany that sale and leaseback will be adopted nationwide any time soon. There are at least three obstacles. First, many political groups are afraid to “sell” health care to private investors—there are increasing numbers of supporters of a regulated industry, particularly in local government. Second, despite the financial squeeze felt by many hospitals, there is no sign of a health care “property crash” in Germany. Third, the history of sale and leaseback in other German industries is not successful. Many examples from the manufacturing and retail industry have proven to be financial disasters in the long run.
The situation for REITs also remains challenging. Only two REITs have been launched successfully, neither of them in the health care industry. Given the conservative approach of the German real estate market, governed by the renaissance of Pfandbrief financing, etc., it is unlikely that the increasing separation of business operations and real estate ownership in the health care sector will lead to a flourishing market for health care REITs in Germany in the near future.
These obstacles, however, can be overcome. In the United States, REITs are a product of tax laws, and the funds come from yield investors. Germany has promulgated comparable laws and the fundamental premise of a separation of the business operation from the ownership of assets is not without its success stories. A successful example is the hotel industry. Therefore, despite differences in market size and laws, the drive to privatisation for German health care operators should evolve along a path similar to the U.S. experience, albeit with its own unique investor style.