Valuing a long-term care facility - business valuation industry

Healthcare Financial Management, Oct, 1992 by Chris Mellen

APPRAISAL

The business valuation industry generally uses at least one of three basic approaches to value a long-term care facility: the cost approach, sales comparison approach, or income approach. The approach that is chosen and the resulting weight that is applied to it depend largely on the circumstances involved. Because a long-term care facility is a business enterprise, more weight usually is given to the income approach which factors into the estimate of value both the tangible and intangible assets of the facility.

Knowledge of the valuation techniques used by appraisers to determine the present worth of future benefits is critical to financial managers in long-term care facilities. These appraisal techniques commonly are used in the purchase, sale, or financing of a long-term care facility.(a) An understanding of these techniques, therefore, will help financial managers identify the sources of value in their facilities; decide whether to recommend expansion, new construction, or the sale of their facilities; and establish a fair market price at which to buy, sell, or lease a facility.

Valuation techniques also are employed during litigation and dissolution proceedings, in divorce settlements and estate planning, in the substantiation of insurance claims for property damage, and in the transfer of interests among partners or to real estate investment trusts (REITs), employee stock ownership plans (ESOPs), or master limited partnerships. An understanding of the appraisal process, consequently, is useful for financial managers in determining the elements of a good appraisal, the type of appraisal that may be required for a particular purpose, and the information the appraiser will need to complete the valuation.

The two most important factors that influence the valuation of a long-term care facility are the market value of its assets and the present value of future earnings. The process of valuation, however, is not as simple as merely inserting numbers into a formula. Although appraisers rely on financial models to make their determinations of value, they also consider many subjective factors.

A long-term care facility is a business enterprise with tangible assets such as land, land improvements, buildings, and equipment. It also has many intangible assets. Two of the most important intangibles are its physician referral networks and its contracts with hospitals that channel patients to the long-term care facility and to certain specialty service units. Both of these intangibles have the potential to increase a long-term care facility's revenues, and thus increase the facility's value.

Another important asset is certificate of need (CON) licensing that limits the nursing home bed supply in a state, thereby restricting new construction, reducing competition, raising occupancy levels, and increasing the value of individual nursing homes.

Other, less obvious assets, such as systems and procedures, provide an indication of the efficiency with which a facility is operated, and its assembled work force reflects the expertise the facility employs to function in the highly regulated healthcare environment.

Several standards of value are employed for specific valuation purposes, such as fair value, investment value, intrinsic value, and liquidation value. This article focuses on fair market value because it is the most widely recognized standard of value and is used in most appraisals of long-term care facilities.(b) While there is no set type or number of approaches to the valuation of a long-term care facility, three approaches are used most commonly: the cost approach, the market or sales comparison approach, and the income approach.

Cost approach

Using the cost approach, appraisers derive an indication of the fair market value of a long-term care facility based on the facility's tangible assets. Value is determined by estimating the worth of land as if it were vacant, the depreciated replacement cost of all improvements, i.e., physical deterioration and functional and economic obsolescence, and the value of all equipment.

The cost approach concentrates on the fixed assets of the facility; in general, it does not consider intangible assets. As such, this approach is most useful in the appraisal of businesses that have many tangible assets and businesses that are contemplating liquidation.

Appraisers generally do not use the cost approach to determine the value of a long-term care facility unless the facility is newly constructed according to current state structural requirements and does not have an established business record. Because this approach does not consider the intangible assets that are integral to the value of a business enterprise such as a long-term care facility, it can yield lower estimates of value than other valuation approaches. A study by Roberts and Roberts found that, in more than 80 percent of a sample of appraised nursing homes, the value established by the cost approach was considerably lower than the value determined by the sales comparison (market) and income approaches.(c)