Troubles in the bond market conspired against hospital development at the end of last year, and industry experts predict 2009 may be more of the same – or worse.
Moody’s Investors Service reported in December an increase in bond rating downgrades for the nonprofit health care sector. Throughout October and November of last year, the credit rating agency downgraded 18 hospitals’ bond ratings.
Fitch Ratings released similar findings at a December teleconference when it announced that its 2009 outlook for the health care sector is negative.
“The health care sector will face a more difficult operating environment in 2009 resulting from weaker demand associated with the global economic recession and the U.S. government’s focus on reducing the consumer burden of health care spending,” said Mike Weaver, managing director at Fitch, during the teleconference.
Weaver also cited growing economic weakness causing some consumers to delay or forgo spending on prescriptions and procedures because of rising unemployment and declining wealth, which could mean an increase in the amount of uncompensated care.
“Merger and acquisition activity is expected to remain high and this, along with aggressive programs of returning capital to shareholders, could lead to higher leverage resulting from increased debt levels,” Weaver said.
In its November report on the economy and its impact on hospitals, the American Hospital Association found that 8 percent of hospitals are considering mergers as means of getting through economic hardships. Fifty-nine percent of those hospital executives surveyed for the report, however, said that cutting administrative costs would be their defense in addressing the deteriorating economy and its impact on hospitals’ financial situations.
On the for-profit side, Lauren Coste, a Fitch health care analyst, said the ratings company’s outlook is negative for 2009 based on conclusions drawn about bad debt expense and an expected decline in credit metrics across the entire health care sector.
“Numerous states, including the key states of California, Florida and Nevada, among others, are facing budget shortfalls which will pressure Medicaid reimbursement,” Coste said. “As a result, we expect bad debt expense and uncompensated care to rise in 2009.”
However, Coste said providers are doing a better job of mitigating exposure to bad debt expense.
“In addition, the political environment will be more favorable with Democrats likely to push for additional Medicaid funding as well as incremental health care coverage,” she said.
Although most providers are expected to have sufficient liquidity and manageable debt this year, Cross said that 2010 could be more challenging.
No Money = No Construction
A survey of chief financial officers at hospitals conducted in November and released in January found that the deterioration of investment holdings has impacted the financial health of 70 percent of hospitals. The report, put out by the California Hospital Association, also found 16 percent of respondents were having trouble leaving the auction rate securities market.
“For hospitals in the auction rate securities market, when the credit started to dry up it became more costly so this finance mechanism was repricing similar to adjustable-rate mortgages, so it’s complicated,” said Anne McLeod, CHA vice president of reimbursement and economic analysis.
The credit rating agencies ratings downgrades have not made the situation any better.
“Many hospitals are still trying to exit the auction-rate securities market and secure bridge financing until they get permanent financing, but the other problem is that credit ratings have deteriorated and made it difficult to exist either because they don’t qualify or they have too much debt,” McLeod said. “It’s a vicious cycle.”
As a result, hospital construction is slowing with many projects being halted. CHA reported that 41 percent of hospitals are delaying construction projects or equipment purchases.
Even with construction material prices falling substantially in October and November on a monthly basis, year-over-year, hospital construction in 25 cities increased in November an average of 4.9 percent for a two- to three-story hospital, according to Reed Construction Data.
San Francisco had the second-highest year-over-year cost increase and dollar-per-square-foot costs. Additionally, Los Angeles and San Diego also ranked relatively high when it came to per-square-foot construction costs.
According to Jim Haughey, chief economist at Reed Construction Data, cost increases are expected between now and next year when comparing year-over-year data. However, month-to-month declines in material prices were still being noted even in the beginning of January, Haughey said.
And despite the financing issues, Haughey said the one upside to the current situation for hospitals is the competition for work among contractors.
“Money’s tight right now, but we’re going to get the best bids looking back and looking ahead in the next six months,” Haughey said, “because prices will be down and contractors are scrambling for work.”
But if there’s no money to spend, falling materials prices will not mean anything, especially with the looming deadlines of Senate Bill 1953, the seismic retrofit mandate. And even with the passage of the 2020 seismic safety extension, Senate Bill 306, hospital construction is a lengthy process.
“The problem is that if you’ve got to have a seismic-compliant hospital in 2013, that means you have to be building right now,” McLeod said. “That means folks that were gearing up to be compliant in 2013, 2014 or 2015 need to be securing financing right now. If the tables have turned and [interest] rates have gone through the roof or credit has dried up, then they automatically can’t meet the deadline. That’s really the big issue; financing is the first hurdle.”
In 2007, the RAND Corp. released a study of the implications of SB1953 outlining the obstacles hospitals face in meeting seismic compliance. RAND estimated that for financing to meet the mandate would be as much as $110 billion – a cost completely unfunded by the state.
“The government doesn’t even make up for it by covering costs,” McLeod said. “It’s just exacerbated that way.”
Throughout the nation, hospitals’ non-operating revenues were down $831.5 million in third-quarter 2008, according to AHA.
Construction, Design Reactions
Against this backdrop of the seizing credit markets and higher construction costs, architects and construction companies have only so many approaches to absorbing cost increases or mitigating high costs during a project’s conception.
The steady decline in materials costs since October was initially good news for owners, but Bruce A. Nelson, vice president at McCarthy Building Cos. in Newport Beach, said owners should still be cautious toward this recent trend.
“The trend is interrelated to a few factors, the downturn in the commercial markets creating an influx of subcontractors moving toward the health care market, more aggressive bidding and risk taken by all subcontractors trying to create future work backlogs and material deescalation,” he said.
Declining material prices has meant fewer early purchases of steel, which is what had been occurring when prices began increasing.
“For the last two to three years, buying steel as early as possible was the norm in an effort to stave off the mounting escalation which was consuming project budgets,” Nelson said. “Today, we don’t see the need for accelerated early steel purchases in this economic environment.”
In December, McCarthy completed the Center for Cancer Prevention and Treatment at the St. Joseph Hospital campus in the city of Orange, which was designed by TAYLOR architects. An 87,000-square-foot cancer center, 131,000-square-foot medical office building and 1,083-car parking garage comprise the new facility.
The project, completed in 18 months, was delivered using a design-build approach and building information modeling, or BIM, software.
“In this approach, we were able to control and direct the design to maintain the overall project budget,” said Jim Mynott, director of design management at McCarthy, “and more importantly, provide a high level of assurance that additional costs, due to drawing discrepancies, were mitigated.”
The integration of a BIM program also allowed the design team to produce permit and construction documents early in the design process.
“We were able to document early bidding packages with a high level of coordination so that our approach for packaging and fast-track design, permitting and construction was seamless,” Mynott said.
But keeping costs down once construction already has begun is more difficult.
Robert Beach, principal in the Tucson, Az., office of KKE Architects, said that since 2004, the price of steel has gone up. He cited one hospital project his firm had worked on that saw a 40 percent increase in construction costs as a result.
“When you absorb that significant increase, you really are kind of limited to reducing the project scope or size or seeking additional financing,” Beach said.
As a result, he said, some programs had to be cut and the design team ended up reducing the quality of some of the finished materials.
“It was a short-term response to something that probably should have had a longer-term consideration,” Beach said.
With the financial market uncertainty, it is giving many hospitals in the state pause on their construction plans – at least for the short term. But California’s shortage of hospital beds and the seismic mandate are forcing the construction issue even with little money to make such plans a reality.
“A lot of projects have been put on hold because of financing,” Beach said. “It’s interesting when you talk about increase in costs. It’s across the board for all property types, but because of hospital construction’s complexity, it has increased to a point that, frankly, is a bit hard to fathom from the perspective of the 30 years I’ve been doing this.”
Article By: Kari Hamanaka, of WWW.CAREALESTATE.COM