Valuation Triage: Stark/Anti-Kickback Valuation Issues within the Healthcare Industry
Valuation Triage: Stark/Anti-Kickback Valuation Issues within the Healthcare Industry
Navigating the complexities of the Stark and Anti-Kickback statute can be challenging for even the most competent physicians and hospital administrators. Nevertheless, compliance with these statutes is critical for all parties, as violations can lead to costly penalties, sanctions, and even incarceration. The following article provides a brief overview and history of Stark and Anti-Kickback, followed by real estate valuation implications for healthcare businesses.
Stark & Anti-Kickback Overview
The Stark Law consists of three separate provisions and governs physician self-referral for Medicare and Medicaid patients. Physician self-referral is the practice of a physician referring a patient to a medical facility in which he has a financial interest, be it ownership investment or a structured compensation arrangement. Critics of physician self-referral contend that an inherent conflict of interest derives from such a practice, given the physician’s position to benefit directly from the referral. These critics allege that such practices encourage the over-utilization of services, which in turn can drive up healthcare costs. Stark I barred self-referrals for clinical laboratory services under the Medicare program (Omnibus Budget Reconciliation Act of 1989). Stark II legislation, which was included in the Omnibus Budget Reconciliation Act of 1993, expanded the restriction to a range of additional health services and applied it to Medicare and Medicaid. Passage of Stark II raised numerous concerns that the legislation represented an unwarranted intrusion into medicinal practice, and many provider groups contended that the legislation, particularly the provisions regarding compensation arrangements, would encumber a physician’s ability to participate in managed care networks. Stark III, the final provision of the Stark Law passed in 1995, reduced the list of services subject to the ban of Stark I and Stark II, while also repealing prohibitions based on compensation arrangements.
The Stark Law is related to, but not the same as, the Federal Anti-Kickback statute. The Anti-Kickback statute provides criminal penalties for certain acts that impact Medicare and Medicaid or any other Federal- or State-funded program. The main purpose of the Federal Anti-Kickback law is to protect patients and the federal healthcare programs from fraud and abuse by curtailing the influence of money on healthcare decisions. If one solicits or receives any remuneration in return for referring an individual to a doctor, hospital, or provider for a service for which payment may be made, it can be considered a potential kickback. Remuneration is defined as any payment, monies, or any goods or services from any healthcare facilities, programs, or providers. Violations of the law include incarceration, substantial fines, and exclusion from future participation in federal healthcare programs.
A significant part of compliance with Stark and Anti-Kickback is the concept of Fair Market Value. Whether it’s an outright acquisition or a lease or service agreement, and whether it is the business or the underlying tangible assets (real estate and equipment), the transaction must be consistent with Fair Market Value. Under the statute;
“Fair Market Value means the value in arm’s-length transactions, consistent with general market value. ‘General Market Value’ means the price that an asset would bring as the result of a bona fide bargaining between well-informed buyers and sellers who are not otherwise in a position to generate business for the other party, or the compensation that would be included in a service agreement as the result of a bona fide bargaining between well-informed parties to the agreement who are not otherwise in a position to generate business for the other party, on the date of acquisition of the asset or at the time of the service agreement.”
The opinion of Fair Market Value should always be obtained from an independent third-party valuation expert who understands the unique nature of the healthcare industry and the unique complexities associated with the conceptual framework of determining Fair Market Value. Having that opinion from a well-qualified professional ensures that your transactions are consistent with Fair Market Value, and you have a strong basis that will stand up to regulatory scrutiny.
Real Estate Transaction Implications
In real estate transactions between hospitals and physicians, the hospital must be careful to comply with Stark and Anti-kickback regulations. The two most common types of real estate transactions where these regulations apply are lease transactions and purchase transactions. In each of these transactions, the hospital must make sure the lease or the purchase is at Fair Market Value as defined by the statute. For healthcare properties, this concept has nuances and unique considerations that require the expertise of a qualified appraiser with experience in the healthcare industry.
When a hospital owns a medical office building and leases space to a physician (or group of physicians), the lease terms must be consistent with Fair Market Value. The primary method for estimating market rent is to research and analyze comparable lease transactions. Comparable transactions include actual leases of comparable space along with asking rents for space that is currently marketed for lease. This method is based on the principle of substitution, which effectively states that the market rent for a property or space can be measured by the cost to rent a comparable property or space. While the concept appears simple, application of this methodology can be fraught with errors without proper consideration of key factors, including the following:
- Expense Basis – Is the subject space to be leased on a Net, Gross, or Modified Gross basis? On a net basis, expenses are paid by the tenant. On a gross basis, expenses are paid by the landlord. Modified Gross can vary, but indicates some expenses are paid by the landlord while others are paid by the tenant. An “apples to apples” comparison of comparable lease transactions to the subject property requires that the expense basis is the same for each, or appropriate adjustments must be applied.
- Location – Location has always been a critical factor in real estate. For healthcare, a unique consideration is proximity to the hospital. In general, on-campus medical space commands a higher market rent than off-campus medical space—as both patients and physicians prefer to be closer to the services and amenities provided by the hospital.
- Age/Physical Condition – In general, newer facilities that are in superior physical condition will command higher rents. This is especially true for medical space, as changing technologies in healthcare have resulted in a continued evolution of space requirements for physicians. Space with the latest and greatest in tenant improvements generally costs more and commands higher rent compared to older second- and third-generation space.
- Size – Large spaces will typically rent for a lower value per square foot than smaller spaces. For example, a 1,000 square foot medical office space might lease for $15 per square foot on a net basis, while a 50,000 square foot space in the same building might lease for $13 per square foot. When comparing actual lease transactions to the subject space, adjustments must be applied to account for this size difference.
- Usable vs. Rentable – This is a key factor that is often misunderstood by both landlords and tenants. The Dictionary of Real Estate Appraisal, 5th Edition, defines the two measures as follows:
- Usable Area – “The actual occupiable area of a floor or an office space; computed by measuring from the finished surface of the office side of corridor and other permanent walls, to the center of partitions that separate the office from adjoining usable areas, and to the inside finished surface of the dominant portion of the permanent outer building walls.”
- Rentable Area – “The tenants pro rata portion of the entire office floor, excluding elements of the building that penetrate through the floor to the areas below. The rentable area of a floor is computed by measuring to the inside finished surface of the dominant portion of the permanent building walls, excluding any major vertical penetrations of the floor.”
- Common Area Factor (CAF) – The difference between Usable and Rentable space in a particular building is typically referred to as the “Common Area Factor” (CAF). For example, if the total usable space in a building is 100,000 square feet, and the rentable area is 110,000 square feet, the CAF would be 1.10. If the subject space is to be leased based on the usable area, and comparable rent transactions are based on rentable area, then a comparison of these transactions requires adjustment for the CAF.
- Tenant Improvement Allowance (TIs) – Depending on the particular market and terms of the lease agreement, landlords may include a certain dollar amount per square foot for TIs. For example: A 10-year lease of space in a particular building may have a base rent of $15 per square foot on a net basis, and include $25 per square foot for TIs. Another lease agreement may have a higher base rent of $20 per square foot, but includes a much higher TI allowance of $50 per square foot. A comparison of these lease transactions to a subject space requires adjustments to account for the difference in TI allowance provided. To the extent the actual TI allowance provided to the subject tenant is in excess of what is typical in the marketplace, the excess amount will typically be amortized over the term of the lease at a market rate of interest (the landlord is effectively financing the TIs over the lease term).
- Lease Term – It is not unusual for shorter term leases to result in a rent per square foot that is higher than long-term leases. For example: A one-year lease might have a base rent of $15 per square foot net, while a 10-year lease of similar space might rent for $13 per square foot net. This difference is driven in part by the higher cost associated with short-term leases due to higher/more frequent transaction costs (leasing commissions, legal fees, etc.), potential downtime between leases, and the general disruption of having tenants moving in and out. Based on this, a landlord is often willing to accept a slightly lower rent in exchange for a longer lease term.
- Rent Escalations – Leases typically have some type of escalation clause based on a specific dollar amount or percentage rate. A comparison of lease transactions will require adjustments for differences in rent escalations.
Unique Situations in Lease Transactions
While determining market rent for generic medical office space is relatively straight-forward, unique situations often arise that require a nuanced approach. These situations include leases of specialized space such as ambulatory surgery centers (ASCs), imaging centers, dialysis centers, etc., timeshares for medical space, and ground leases.
- Specialized Medical Space – Determining market rent for ASCs and similar high-cost medical space can present unique challenges. Often times, truly comparable lease transactions in the local market area are scarce to non-existent. Expanding the geographic area from which to draw comparable data may yield some useful information—but significant differences in location can make this approach less reliable. For this type of space, a “Return on Cost” analysis can be a useful tool in determining market rent. This method considers the actual cost of the building improvements (adjusted for depreciation) and underlying land value. A market-oriented rate of return (capitalization rate) can then be applied to arrive at a net rent for the space. For example: If the total cost of an ASC (land and building) is $350 per square foot, and an appropriate capitalization rate is 8.5%, the estimated net rent for the ASC equals $29.75 per square foot ($350 per square foot X 8.5% = $29.75). In the absence of local lease comparables, a “Return on Cost” estimate can be a reliable method of estimating market rent. This is particularly true for newer construction.
- Timeshares for Medical Space – In some markets, physicians may have a need for space on a part-time basis. In addition, they may require administrative support and/or furnishings and equipment. In timeshare situations, a premium is often applied to a “pro rata” share of the market rent—with adjustments for the cost of administrative support and/or furnishings. Research into standard custom and practice in the particular market will drive the adjustments and conclusions here.
- Ground Leases – Hospitals often lease a site to a group of physicians who then construct a medical building on the site, and these are typically for an extended period of time (25 years or more). While comparable ground lease transactions would be the most ideal basis of estimating market rent, the quantity of comparable transactions is often limited. Ultimately, market rent for a ground lease is typically driven by the underlying land value. If the site is worth $1,000,000, and a typical land capitalization rate is 7%, the annual net rent for the ground lease is $70,000. This figure may require adjustments for things like easements for access and/or parking, restrictions on use of the site, etc.
When a hospital buys a physician practice, oftentimes a medical office building owned by the physicians is part of the deal. In these transactions, the hospital must make sure the price paid for the real property is consistent with Fair Market Value. Fair Market Value in a purchase transaction is typically estimated by applying the three traditional approaches to value (Cost, Income Capitalization, and Sales Comparison).
- Cost Approach – This approach starts with an estimate of the Replacement or Reproduction Cost new of the building improvements. Deductions are applied for depreciation to arrive at the depreciated cost of the improvements. The land value is then added to arrive
at a final estimate of value.
- Income Capitalization Approach – This approach is based on the premise that the value of a property is driven by anticipated cash flows. Depending on the situation, contractual rent or market rent is utilized to estimate gross income. Deductions are applied for vacancy and collection loss and operating expenses to arrive at the net operating income for the property. An overall capitalization rate is then applied to the net operating income (reflecting the required return on and of the investment) to arrive at an estimate of value. Alternatively, a Discounted Cash Flow may be applied where income and expenses are projected over a holding period (typically 5 or 10 years) and discounted back to a present value indication.
- Sales Comparison Approach – This approach is based on the principle of substitution, which effectively says that the value of a property can be estimated by the cost to buy a comparable substitute. Comparable sale transactions are relied upon to estimate the market value for the subject property, with appropriate adjustments applied for factors including location, age/condition, size, building amenities, and economic characteristics.
The applicability of each of these approaches varies depending on the particular market and the characteristics of the subject property. In general, the Income Capitalization Approach will be most applicable for multi-tenant properties that are leased to third-party tenants. The Sales Comparison Approach will be most applicable for owner/user or single-tenant buildings where sufficient data is available to draw a reasonable conclusion. The Cost Approach is often the least reliable of the three approaches, but can be particularly applicable for new construction where minimal depreciation is present, and for high-cost special purpose properties like ASCs and imaging centers when market data is limited. In any appraisal, the three approaches are reconciled and most emphasis is given to the approach that is deemed most reliable for that particular situation.
Whether it is a lease or a purchase/sale agreement, real estate transactions in the healthcare industry have unique
complexities that make them different from “normal” real estate transactions. One of the biggest differences is regulatory compliance requirements. Obtaining a market value opinion from a well-qualified professional who understands the healthcare industry will ensure that your transactions are consistent with Fair Market Value, and you have the backup necessary to withstand regulatory scrutiny.