Keys to Capital Project Financing: Planning and a Variety of Funding

The shift to value-based care adds new investments, including outpatient facilities.

This article first appeared in the November 2016 issue of HealthLeaders magazine.

The shift to value-based delivery of medical services has boosted investment in outpatient capabilities, which has added a new element to the capital-project mix at health systems and hospitals.

"The ways of paying for capital projects are not changing all that much, but what we are buying is changing. There's a movement toward a different model, so we are investing in new capabilities, like patient-centered medical homes," says David Smith, senior vice president and CFO at Hollywood, Florida–based Memorial Healthcare System.

Two of the biggest capital projects underway at MHS are construction of outpatient facilities, Smith says. "We are expanding our geographic footprint. Our board has approved the building of two urgent care centers, on the east side and the west side of our district."

Operating in a state-chartered district, MHS features six acute-care safety-net hospitals. The health system posted patient service revenue at $1.8 billion for the fiscal year ending April 30, 2016.

MHS will wholly own the new urgent care centers, which will both be located in new buildings. However, the health system is only constructing one of the new structures. "The one we're building from the ground up is about 5,000 square feet, and the cost is $2.5 million, which includes equipping it," Smith says. "What drives up costs a lot in South Florida is we are in Hurricane Alley, and we have different codes here. You have to construct the buildings to be hurricane-resistant, which makes them a much more expensive proposition."

In addition to growing its market footprint, MHS recognizes the need to invest in outpatient facilities, he says. "There's already retail clinics. Urgent care centers are popping up all over the place in this market, and there are ambulatory care facilities, so the future of healthcare will include these shorter-stay patients who are no longer going to be in the hospital. That means hospitals will become at least somewhat more capital-intensive because they will be the place where the high-tech care is rendered. What we're seeing is not necessarily a lessening of the hospital side of capital projects, but more of an overall growth in capital investment because we need to account for the outpatient world as well."

Consumerism in value-based healthcare puts a premium on convenience, Smith says. "The whole idea is to make it easier on the patient. One of our affiliates has a partial ownership in a couple of ambulatory surgical facilities, and we see in the future where those will also become recovery care centers, where patients we need to have stay one night or even two nights can come in and not have to receive care in a hospital."

Local market conditions can dictate that a health system embrace a more traditional approach to capital projects, says Ben Spence, CFO of Lee Health, based in Fort Myers, Florida.

"Our investment in acute care is heavily weighted on the age of one of our facilities and the growth in our population. Lee Health serves Lee County, Florida, an area of rapid growth that also is twice the national average for population over age 65. Seniors have higher use rates for inpatient care and often have multiple chronic conditions. We also have an aging 400-plus-bed facility that was built in the 1960s and 1970s that needs to be replaced. We do feel that our efforts to improve health in our population will reduce inpatient use rates that will result in less demand for new beds, but we will still require hospital-bed expansion to replace and allow for modest inpatient growth," Spence says. "Other areas with slower growth, newer facilities, and younger populations are better situated to avoid future bed expansion."

Lee Health has a total of 1,426 licensed beds distributed across four acute-care hospitals, a rehabilitation hospital, and a children's hospital. In 2015, the health system posted patient service revenue of $1.4 billion.

While Lee Health is forecasting an ongoing need for capital projects on its hospital campuses, the health system has been increasing investment in outpatient facilities, Spence says. "During the past 10 years, we have allocated a growing share of our capital spending to outpatient services and will continue to do so going forward. We believe that expanding outpatient services will help keep patients out of the hospital and reduce our future capital needs for new bed towers."

For capital projects, planning is paramount
Growth in capital projects at health systems and hospitals makes planning for capital investments as important as ever, says R. Edward Howell, professor of public health sciences at the University of Virginia School of Medicine and former CEO of University of Virginia Medical Center in Charlottesville.

"Taking the longer-term approach creates the opportunity to make sure you are giving enough attention to infrastructure—electrical, plumbing, and HVAC—because healthcare institutions put a lot of drain on infrastructure," Howell says. "It's all too easy to say that we will spend on initiatives that make our physicians and board happy, or that add a lot of glitz to our patients, and forget the infrastructure. But the infrastructure is important. It doesn't take too many days of having your operating rooms closed because your HVAC crashed, or your imaging center closed because your electrical system failed, to realize just how important your infrastructure is to your organization."

For the fiscal year ending June 30, 2015, University of Virginia Medical Center posted patient services revenue of $1.4 billion. The teaching hospital has 584 licensed beds.

Howell says he prefers planning for capital projects over a span of 10–15 years, with a three-pronged approach. "First is taking an inventory of your physical plant; you should do it all the time. You get some sense of the age of your facilities. Second is the demand on your facilities—the percentage of utilization of your operating rooms. For example, if you have 80% utilization, you have operating capacity; if you have 95%, you don't have capacity.

"Third, look at capital from a financial perspective over the long term. You need to make some determinations on how much you are going to be spending on equipment and spend that amount consistently. For 12 years here, we spent between 8% and 9% of our operating budget on capital equipment and related renovations for capital equipment every year, just like clockwork. That gives you a nice steady stream of funded depreciation," Howell says.

Smith says MHS plans on a shorter time horizon for most capital projects, but the health system's five-year plan is updated on an annual basis. "We look out at a five-year horizon that includes what projects we feel we're going to need to do, either expansion of services, product lines that need to be enhanced, or major equipment purchases."

Financing recipes for capital projects
When health systems and hospitals are determining the form of financing for a capital project, size definitely matters.

MHS is financing the health system's two new urgent care centers with internal sources of funding, including operating revenue, Smith says, noting larger projects require at least some external financing. "We financed the urgent care centers through internal funds. We are very lucky that we are financially able to do that. For projects that are $3 million to $5 million, we would typically just finance those through operations. If we have a very large capital purchase, like when we built our children's hospital in 2011, we float a bond issue," he says. "There was also fundraising for the children's hospital—we had a huge capital campaign." The children's hospital cost more than $100 million to build, says Smith.

Howell says a wide range of options should be considered when selecting the optimal mix of financing for capital projects.

"You need to fund capital with all of the options available. First is operating margin. Most people believe that you need a minimum of 3% just to maintain your capital position. You should have as much as 5% operating margin in order to have adequate capital capacity," he says. "Combine that with funded depreciation: Make sure you fully fund your capital items—each and every one of them that qualifies for funded depreciation—and make sure you don't confiscate your funded depreciation for operating needs. You adequately invest both your reserves from operations and your funded depreciation, then maximize your interest revenue stream. You combine all of that with debt."

Nonprofit health systems and hospitals have multiple financing options for capital projects, according to Spence. "New hospitals or large-scale projects are often funded with bond issues that provide low-cost financing to health systems with good credit ratings and can spread the debt payments over 30 to 40 years at a variable or fixed rate. Smaller-scale projects can be funded through direct bank loans that also offer very attractive interest rates and terms for providers that are viewed as low-risk due to their long-term financial results and stability. Cash flow from operations is also a great source of funding for providers that have a strong balance sheet and cash position," he says.

For-profit healthcare providers have a keen sense of the financing market, Howell says. "The for-profits are acutely aware of capital markets, especially rates, and tend to go to the bond market when the rates are the best."

Nonprofit and for-profit organizations each have strengths and weaknesses in securing financing for capital projects, Smith says. "From a financing perspective, the for-profits have somewhat similar vehicles. They can't do tax-exempt debt like we can, but they have the opportunity to do equity financing that we do not have the ability to do. They can just sell common stock and raise funds that way to finance their capital needs."

It may be tempting for some healthcare executives to allow a large capital project to develop into a crisis that can serve as a rallying point for fundraising, but preparedness is a far safer strategy, Howell says. "The quick and easy is facing a capital crisis and turning to debt financing. But I have seen numerous hospitals that over-borrow. They are the ones that become the 'mergees' in a lot of mergers because they find they had little or very limited debt capacity."