Analysis of nursing home capital reimbursement systems

Health Care Financing Review, Spring, 1991 by Heidi Boerstler, Tom Carlough, Robert E. Schlenker

The annual increase in cash flow generaged by the fair-rental systems is due primarily to the appraisal (asset revaluation) process. By systematically recognizing facility appreciation, which was estimated in the simulations by a modest 3 percent per year, the fair-rental systems provide an increasing cash flow to facility owners that parallels the increased value of their nursing home investment.

For all systems, cash flow was greater with greater equity financing. Again, this is similar to findings from other studies (Bartlett, 1984). The financial leverage produced by debt financing results in higher rates of return on invested equity, but the accompanying debt service requirements result in substantially smaller after-tax cash flows.

Cost to State

The cost to the State of reimbursement payments, being essentially the complement to cash flow, followed a similar pattern. In the early years, total cost to the State was higher in the traditional system than in the fair-rental systems. By year 30, however, it was lower under all financing assumptions tested.

As was the case for the cash flow results, cost to the State varied directly and significantly with changes in interest rate. Of the three systems, FRG (fixed debt-to-equity assumption) was most cost sensitive to interest rate changes. On the other hand, changes in debt-to-equity ratios resulted in little changes in cost to the State. Notably, it requires several years before the costs of the fair-rental systems exceed those of the traditional system.

Rate of return to investors

Rates of return were generally higher in the traditional system compared with the fair-rental systems, particularly in the early years. Again, this is similar to findings from Baldwin (1984), Cohen and Holahan (1986) and Bartlett (1984). Although rates of return increased with increased debt financing in all three systems, the traditional system appeared most prone to promote highly leveraged investment. At 95 percent debt, returns on investment for the traditional system were substantially higher throughout the 30-year simulation; at 50 percent debt, those for the fair-rental systems surpassed returns for the traditional system after about 15 years.

Between the two fair-rental systems, the most notable difference was the sensitivity of FRG (fixed debt-to-equity assumption) to changes in the interest rate. At a lower rate of interest on mortgage debt (5 percent), FRG had lower cash flows over 30 years, lower cost to the State, and lower rates of return over time than did FRN. At a higher rate of interest (15 percent), however, the opposite results occurred. Changes in debt-to-equity ratio impacted the systems fairly equally. At both a 50:50 and 95:5 debt-to-equity ratio, FRG had slightly lower cash flows, total cost to the State, and rate of return than did FRN.

Policy implications

Although the simulations conducted for this study revealed some differences between the two fair-rental approaches, both fair-rental systems appear superior to the traditional cost-based system in generating a positive and reasonably stable cash flow over time for nursing home owners and also in providing reasonable rates of return to investors. Such a reimbursement environment can encourage investment in nursing homes (depending, of course, on the structure and level of the total reimbursement methodology). This, in turn, can contribute to the objective of providing adequate access to care for Medicaid recipients.