Off-Balance-Sheet Financing Can Generate Capital for Strategic Development

Healthcare Financial Management, June, 2000 by Fred D. Campobasso

To manage their real estate portfolios effectively and obtain funding for strategic development, IDSs should consider adopting off-balance-sheet financing strategies, such as sale-and-leaseback transactions, synthetic leases, and joint-venture arrangements. Under these approaches, real estate assets are moved off of the organization's balance sheet via a partial or complete transfer of ownership to a third-party entity. The organization typically retains a satisfactory degree of control over the assets as lessee in sale-and-leaseback and synthetic-lease arrangements, or limited or minority partner in a joint venture, while freeing up cash to use for other strategic purposes.

As top-performing IDSs expand their service areas and offerings, they require an effective strategy to manage increasingly diverse portfolios of real estate holdings ranging from acute care hospitals and ambulatory care centers to skilled nursing facilities, wellness centers, and medical office buildings. Two key elements of an IDS's real estate strategy should be to identify nonstrategic and underperforming real estate assets and locate market and service areas in which new, medically strategic real estate developments are desirable to reinforce the IDS's market position. [a]

Attractive financing options are available to finance these essential real estate development projects using off-balance-sheet approaches, whereby an organization transfers ownership of a real estate asset to a third party, while retaining sufficient control over use of the asset. Such approaches include sale-and-leaseback transactions, synthetic leases, and joint-venture or partnering structures.

These approaches offer the following advantages:

* One hundred percent financing, which frees up cash for alternative investments for core business operating and capital spending needs;

* Long-term control over the use and tenancy of the transferred facility;

* Improved accounting ratios (eg, return on assets, return-on-fund balance, debt-to-fund balance);

* Potential to be structured as an operating lease in accordance with generally accepted accounting principles (GAAP); and

* Potential to be structured to achieve off-credit treatment.

Sale and leaseback. In a sale-and-leaseback arrangement, a property is sold to a financial intermediary which, in turn, leases the property back to the seller under a 15- to 20-year operating lease, as opposed to a financing or capital lease. Leases typically represent less than 75 percent of the expected useful life of the asset and are noncancellable. No transfer of ownership of the property back to the seller is permitted over the course of the lease, nor may the lease contain a bargain purchase option in favor of the seller/lessee at lease end.

However, the seller/lessee typically retains the right of first refusal to repurchase the property Lease rental payments are "triple-net-lease"; that is, the seller/lessee remains responsible for paying all of the property's associated taxes, insurance, and routine and nonroutine capital expenditures in addition to rental payments made to the purchaser/lessor.

Sale-and-leaseback structures offer several unique advantages to IDSs:

* The property is sold at the current fair market price, which is enhanced based on the credit rating of the seller/lessee. When a seller/lessee has a high credit rating, the buyer's borrowing costs are lower, which allows the seller/lessee to negotiate attractive rental rates.

* The buyer pays cash, which the seller can use to pay down its own debt and enhance its debt-to-capitalization ratio.

* The seller/lessee maintains satisfactory control over how it operates the facility.

* The seller/lessee does not have the right to exercise a purchase option at lease end, but usually retains the option to sign a new lease with any new owner that might purchase the property.

Sale-and-leaseback arrangements also have drawbacks:

* Any repurchase by the seller/lessee at the end of the lease term must be at the then-current fair market value, which normally is at a higher price than the selling price obtained at the initiation of the sale-and-leaseback transaction.

* The interest factor embedded in the lease rate usually will be somewhat higher than the interest rate of the seller/lessee's debt burden on the property.

* The seller's borrowing capacity may not be enhanced if credit rating agencies impute a debt service coverage factor to the lease payments.

* Any significant subleasing to an independent third party would require the transaction to be treated as refinancing debt rather than as a sale, thereby hindering off-balance-sheet treatment of the transaction for the IDS.

* Vacancy and subleasing default risk is retained by the seller.

Disposing of nonstrategic real estate assets via a sale-and-leaseback transaction can strengthen an IDS's balance sheet. Even on a triple-net-lease basis, the positive benefits of eliminating depreciation and amortization of mortgage debt outweigh the impact of lease payments on operating income. Debt-service-coverage ratios and days-cash-on-hand increase while debt leverage ratios decline. In addition, many IDSs find sale-and-leaseback arrangements attractive because they offer a long-term opportunity to reinvest net sale proceeds.