Smart financial management of medical office space

Healthcare Financial Management, June, 1993 by David Shactman

FACILITIES MANAGEMENT

In a healthcare environment of strained resources and scarce profits, hospital administrators must seek revenue from all available sources. Some potential revenue sources are capital intensive, however, requiring large initial investments for new construction and modern equipment. Other potential revenue sources may require starting new programs and recruiting additional staff. Few potentially income-producing alternatives can be funded from existing assets, require little additional investment, and yield significant revenue. But hospitals that own and lease medical office buildings, will find that with proper management these existing assets can become sources of additional revenue.

Consider the case of an urban hospital of 300 to 400 beds that owns and manages 50,000 square feet of medical office space. Gross revenue from this property could total $750,000 to $1 million, about 1 percent of total operating revenue. Net income derived from the facilities could total as much as $400,000. In many instances, it is possible to increase the net return on such a facility by $2 to $3 per rentable foot through improved management practices. In situations where levels of rent are particularly low, an even more substantial increase is possible. This additional income may require little or no investment and can have a significant effect on a hospital's bottom line.

The profitability of managed space can be increased in four ways: 1) by developing an effective policy regarding rent levels, 2) designing the commercial lease for management control, 3) assigning one administrator the authority and responsibility for operating results, and 4) employing effective techniques of real estate management.

Effective rent levels

A controversial and politically sensitive issue is the amount of rent staff physicians should pay to a hospital for hospital-owned office space. Historically, many hospitals have become locked into a policy of setting low rents to serve as an incentive for the recruitment of staff physicians, to retain staff physicians and maintain admission levels during periods of financial instability, and to maintain occupancy levels in hospital-owned property. Low rents can also be attributed to the perception of a weak negotiating position with large physician groups, a lack of consistent policy regarding periodic rent increases, or the inappropriate belief that a hospital should not make a profit from physician rents. Once low-rent policies have been established, raising the rent is difficult and may be met with both resistance and resentment from physician tenants.

The rent charged for hospital-owned office space should always exceed the cost of owning and operating the property. The true cost of owning real estate includes an opportunity cost. In his book, "Economics," Paul Samuelson defines opportunity cost as the cost "of the foregone opportunities that have to be sacrificed to do one thing rather than another." He further states that "the long-run break-even level of costs includes, in addition to explicit cost outlays, those implicit costs which accrue to factors which might otherwise be used in alternative ways."(a)

Thus, if a hospital could sell its office building to a private investor and invest the proceeds in certificates of deposit, that total is the minimum return it should accept for its property. If total rents, less all operating expenses, yield a net profit that is less than this opportunity cost, it is costing a hospital money to own and operate its own medical office building. In such a situation, either the rent should be raised, the property should be sold, or an economically better use for the facility should be found.

The Medicare anti-kickback statute (42 U.S.C. 1320a-7b(b)) provides a legal basis for maintaining minimum rents within the range of fair market value. The statute proscribes criminal penalties to any person or entity that offers or receives remuneration in order to induce business that is reimbursed by Medicare. The Office of the Inspector General of the Department of Health and Human Services has indicated that below market rents may be considered a payment to induce Medicare referrals. Whereas a range of rental rates can be defended as representing fair market value, minimum rent should be set at a level high enough to avoid exposure to this legislation.

If the Medicare anti-kickback statute sets a minimum "floor" for low rents, what would constitute a reasonable ceiling? A hospital must take into account the special relationship that exists between itself and the medical staff. Except in extreme circumstances, where demand for services is such that unusually large profits are normal, maximum rents should be set below alternative market rents. A hospital should not use the economic monopoly created by scarce campus space to achieve higher-than-market rentals. A discounted rent level 10 percent below that charged for comparable professional medical space is a reasonable ceiling for most situations. In a stable economic environment, where rent levels are below these amounts, there is a clear opportunity to enhance profitability through a change of policy.