Some Dirt Can be Good for Hospitals:

1. Some Dirt Can be Good for Hospitals: Getting the Most out of Hospital-Controlled Real Estate Assets Presented by: Matt Cunningham and David York Smith Moore Leatherwood LLP 434 Fayetteville Street, Suite 2800, Raleigh, North Carolina 27601 T: 919.755.8700 F: 919.755-8800 To ask a question during the presentation, click the Q&A menu at the top of this window, type your question in the Q&A text box, and then click “Ask.” After you click Ask, the button name will change to “Edit.” Questions will be queued and most will be answered at the end of the meeting as time allows.

2. Brief Overview A.  Finding Money: Financing Options for Core and Non-Core Hospital Real Estate Assets. B.  Breaking Ground: Zoning, Entitlements and Development Issues Affecting Hospital-Owned and -Controlled Projects. C. Maximizing Long-Term Asset Value of Real Estate: Restrictive Covenants, Exclusivity and Use Provisions for Hospitals as Landlords, Tenants and Sellers of Real Property.

3. Finding Money for Building Projects • Traditional Bond Financing. • Traditional Construction/Permanent Lending/Syndicated Loans. • Sale/Leaseback and Synthetic Lease Options. • Joint Ventures with Developers and/or Physicians.

4. Finding Money for Building Projects • Financing Vehicle Decision Drivers for Many Hospitals: • Cost of Capital (Expected Interest Rate) • Cost of Capital (Fees & Costs) • Availability and Timing of Funding (Certainty of Funding; Time Required to Close) • Interest Rate Risk (Variable Rates; Derivative Costs) • Regulatory requirements: Anti-kickback; Stark; mini-Stark; CON • Effects on Future Development and/or Non-Real Estate Project Finance • Core or Non-Core Service Line • Nonprofit/mission objectives for facility

5. Finding Money for Building Projects • Tax-Exempt Bond Financing • Traditional Benefits: • Lower interest rates and flexibility to structure variable rate and fixed rate obligations. • Rule of thumb is that “all-in” comparison between tax-exempt and taxable financing yields a spread of 2%. • Typically longer amortization schedules. • Result: Greater liquidity and ability to finance a larger project amount than through traditional financing.

6. Finding Money for Building Projects • Tax-Exempt Bond Financing • Traditional Drawbacks: • “Five Percent Rule” limits use of any portion of the bond finance facilities by for-profit subsidiaries or third party for-profit lessees. • Costs of issuance apply against five percent amount (upfront costs of issuance are high). • Basically limits use to true core facilities. • Use restrictions limit participation of physician stakeholders. • Ongoing Reporting, Covenants, Negative Covenants and Debt Service Coverage Requirements.

7. Finding Money for Building Projects • Current Market Effects on Tax-Exempt Bond Financing Availability. • Variable Rate Debt Remarketing Failures • Downgrading of Bond Insurance Companies • Overall Market Volume Decrease • Increasing spread between investment grade and non-investment grade debt securities

8. Finding Money for Building Projects • Current Market Effects Directly on Hospitals • Decreased Days Cash on Hand • Investment Portfolio Losses • Thinning Debt Service Coverage Ratios • Increased Cost of Collection on Private Pay • Diminished “Credit Enhancer” Availability • Reluctance of Letter of Credit Issuer Banks to Amortize over Longer Terms • Bond Insurers Growing More Rigid in Enforcing Covenants

9. Finding Money for Building Projects • Sale/Leaseback Options • Used for non-core hospital system assets (traditionally medical office buildings) • Consider as an alternative to mortgage-based debt • Benefits: • Divest hospitals of ownership-oversight obligations (i.e., “gets hospitals out of the real estate business”) • “Monetizes illiquid assets” • Potential (reduced by Stark III) to avoid regulatory hassle • Drawbacks: • Control (or rather, lack thereof) • Scope of rights of first refusal and options to purchase important • Deed restrictions necessary • Hospital pays for the developer/investor’s cost of capital

10. Finding Money for Building Projects • Joint Ventures with Physicians and Developers. • Key Characteristics: • Can be structured with developers as a sale/leaseback with hospital as master lessee, or JV LLC as master lessee, subleasing to physician groups (in MOBs) • Permits developer and physician participation in risk and rewards of development; alternative capital raising • Permits equity participation by physicians and community stakeholders • “Under arrangements = Under scrutiny” - Until recently, operating joint ventures between hospitals and physician groups were an attractive way to outsource closer-to-core hospital DHS

11. Finding Money for Building Projects • Joint Ventures with Developers and Physicians. • Hospital Stakeholder Considerations: • Must support non-profit/mission purposes -- retain control to some extent • Delivery of care concerns should drive development • Allows hospital to rely more heavily on experienced developers in construction management and in some instances in ongoing facility management • Increased efficiency in construction process and ongoing facility administration • Enhance quality physician tenant mix in hospital-proximate facilities • Physicians (and community members) as investors and collaborators

12. Finding Money for Building Projects • Joint Ventures with Developers and Physicians. • Developer Considerations: • Balance own interests with hospital/physician stakeholder interests – collaborative rather than adversarial process • Must understand regulatory effects on use and funding applicable to healthcare sector • Competing against continually developing financial products aimed at industry • Find ways to make money while improving efficiencies and lowering overhead for physicians and hospitals • Reputation-based development standards

13. Finding Money for Building Projects • Joint Ventures with Developers and Physicians. • Physician Considerations: • Real property ownership (direct or indirect) provides an alternate revenue stream and/or method for flowing compensation. • Permits ownership (of either membership interests or a condo unit) without bearing the full risk of development and capital-raising • Typically relieves physicians of individual guaranty obligations (in the MOB context) • Relief of overhead/administrative burden

14. Finding Money for Building Projects • Joint Ventures with Developers and Physicians. • Ownership Entity Governance (Assuming LLC Structure): • Management • Pre-approved items – Construction and Permanent financing • Construction Period versus Post-Construction Period • Board of Managers versus Individual Manager • Strong or Weak Management • Removal of Managers • Decisions Requiring Approval of Members • Approval of Management Services by Affiliated Entities • Managers’ Fiduciary Duty; Member Duty?

15. Finding Money for Building Projects • Joint Ventures with Developers and Physicians. • Ownership Entity Governance (Assuming LLC Structure): • Initial Equity Injection Requirements • Value of non-cash contributions • Ongoing Equity Requirements • Mandatory Capital Calls • Loans by Members; Loans by Third Parties • Elective Capital Calls

16. Finding Money for Building Projects • Joint Ventures with Developers and Physicians. • Ownership Entity Governance (Assuming LLC Structure): • Distributions • Preferred returns for investor members? • Clear methods of timing for payment of interim distributions (i.e., ongoing operations) • Event-based Entry/Exit Strategies • Rights of First Refusal • Default-based Options to Purchase • Determination of Membership Interest Purchase Price may be Event-Specific • Dissolution and Winding-Up • ALWAYS SUBJECT TO CHANGES IN LAW, BECAUSE . . .

17. Finding Money for Building Projects STARK HAPPENS

18. Finding Money for Building ProjectsIPPS - Services Provided “Under Arrangements” BACKGROUND Stark general rule: prohibits physicians from making referrals for DHS to an entity with which the physician (or immediate family member) has a financial relationship, and prohibits the entity from billing Medicare for the DHS unless an exception applies. • Starting October 1, 2009, CMS has revised the definition of “entity” to include both the person or entity the submits the claim, and the person or entity that performs the DHS. • This makes many previously-exempt “operating” JVs performing services billable by hospitals “under arrangements” subject to self-referral restrictions as DHS entities.

19. Finding Money for Building ProjectsIPPS - Services Provided “Under Arrangements” • Gives “DHS entity” status to any physician group practice or other organization that provides inpatient and/or outpatient services “under arrangement” with a hospital. • Applies even if the service would not be DHS if provided by the under arrangements entity. • E.g. Cardiac catheterization services are not DHS unless billed by a hospital as inpatient or outpatient hospital services, but under the new rule, a physician-owned entity providing cardiac catheterization services to a hospital “under arrangement” would be a DHS entity.

20. Finding Money for Building ProjectsIPPS - Services Provided “Under Arrangements” • What does it mean to “perform DHS?” • CMS did not further define, but stated the phrase has its “common meaning.” (My copy of Webster’s seems to lack an entry for this common term.)

21. Finding Money for Building ProjectsIPPS - Services Provided “Under Arrangements” • CMS stated that it does not consider the following as “performing” DHS: • An entity that leases or sells space or equipment used for the performance of the DHS; • An entity that furnishes supplies that are not separately billable but are used in the performance of DHS; or • An entity that provides management, billing services or personnel to an entity that is performing DHS.

22. Finding Money for Building ProjectsIPPS - Services Provided “Under Arrangements” New Issues with Operating Physician-Hospital Joint Ventures Example: Physician A has a 3% ownership interest in a joint venture with the hospital that owns and operates an imaging center. The joint venture has an “under arrangements” relationship with the hospital under which it performs imaging services that are billed by the hospital. Physician A refers a Medicare patient to the joint venture for an MRI exam and the hospital bills for this service.

23. Finding Money for Building ProjectsIPPS - Services Provided “Under Arrangements” Operating Physician-Hospital Joint Ventures • Under current regulations – Physician A is making one referral to the hospital “entity” since it is the only entity billing Medicare. • As of Oct. 1, 2009, under the final rule – Physician A is making two referrals. First referral is to the hospital for DHS, and the second referral is to the joint venture since the joint venture performed the DHS.

24. Finding Money for Building ProjectsIPPS - Services Provided “Under Arrangements” Physician-Hospital Joint Ventures: Example Analysis • Both referrals must meet some other Stark Law exception. • In-office ancillary services exception no longer applies because the joint venture is not Dr. A’s group practice. • Joint venture must be restructured or dissolved.

25. Finding Money for Building ProjectsServices Provided “Under Arrangements” Physician-Hospital Joint Ventures – Moving Forward • Operating joint ventures still effective in non-DHS circumstances or where an exception exists • Radiologists, radiation oncologists, pathologists • Rural provider, indirect compensation exceptions • Property and equipment-leasing joint ventures are still possible

26. Entitlements & Land Use Issues • Expansion at Existing Site • New Construction at New Site • Avoiding Entitlements Pitfalls

27. Existing Facility/Site

28. Existing Facility/Site

29. Existing Facility/Site • Changes in Zoning Regulations Since Previous Development. • Non-conformities may complicate the plan approval process. • New construction and development standards may conflict with existing conditions. • Obligations to bring existing facilities up to current zoning code standards.

30. Existing Facility/Site • Changes in Zoning Regulations Since Previous Development. • Non-conformities may trigger more public scrutiny. • Requirements to obtain Board of Adjustment approval for • variances and/or • special use permits to address non-conformities

31. Boards of Adjustment • To be granted a variance or special use permit, the BOA must make specific Findings of Facts. • The BOA conducts evidentiary hearings that are quasi-judicial proceedings. • No ex parte communications (i.e. no lobbying BOA members). • Non-individual applicants must be represented by an attorney. • Decisions are appealable to Superior Court.

32. Existing Facility/Site • Changes in development patterns in the surrounding area. • Often low intensity uses develop around existing hospital facilities including residential uses.

33. Existing Facility/Site • Often these residential communities that have developed around existing hospital facilities • Do not share the Hospital’s vision of growth. • Become obstacles to plan approval. • Are organized and politically active.

34. New Site • Due Diligence to determine Feasibility of Land Use. • Comprehensive Plan land use designation. • Zoning. • Site Plan. • Special Use Permit.

35. Re-Zonings • General Use (all jurisdictions that have zoning) • Usually, cannot talk about your specific intended use, but only discuss appropriateness of all permitted uses of the subject property. • Conditional Use (Many but not all jurisdictions…). • Applicant agrees to additional restrictions (conditions) that limit development in a given district (signed by the owner). • Vehicle for addressing concerns raised by neighbors, community, government officials.

36. Avoiding Pitfalls • Perform your Due Diligence. • Meet with available government officials early. • Build community support early. • Be flexible in your planning. • Allow adequate time for the entitlements process.

37. Leasing and Disposition of Real Property • Maintaining Control: “Real Property is a Bundle of Sticks” • Leases give rise to Contractual and Real Property Rights • Landlord entry rights • Use restrictions • Negotiating tenant exclusives • Condemnation and casualty • Operating expense measures • Termination and holdover • Issues Regarding Sales of Real Property Proximate to HospitalCampus • Use restrictions • Rights of reversion, first refusal and first offer

38. Leasing and Disposition of Real Property • Focus on Leases: Antikickback and Stark Requirements Regarding Physician Leases • As discussed, Stark III imposes new focus on joint ventures with physician ownership participation • CMS also narrows the scope of office and equipment rental exception with respect to “per-click” and “percentage-based compensation” leases • Antikickback safe harbor and Stark exceptions now align closely • Leasing must be approached from a market-based perspective

39. Leasing and Disposition of Real Property • Focus on Leases: Antikickback and Stark Requirements Regarding Physician Leases • As a general rule, medical office leases will more closely resemble “typical” office leases in other industries • Written lease, of at least one year • Fair market value rent -- cannot include referral-based element • Determining FMV for existing and new ventures • Importance of land/improvement valuation, class of space and limitations on use • Tracking, estimating and billing operating expenses • Size of leasehold premises is not excessive, considering purpose

40. Matt Cunningham and David York Smith Moore Leatherwood LLP 434 Fayetteville Street, Suite 2800 Raleigh, NC 27601 T: (919) 755-8700 F:(919) 755-8800 matt.cunningham@smithmoorelaw.com david.york@smithmoorelaw.com

41. Some Dirt Can be Good for Hospitals Getting the Most out of Hospital-Controlled Real Estate Assets Presented by: Matt Cunningham and David York Smith Moore Leatherwood LLP 434 Fayetteville Street Suite 2800 Raleigh, North Carolina 27601 T: 919.755.8700 F: 919.755-8800