Hospital systems and healthcare providers develop ambulatory buildings for a number of reasons: to expand market share, attract new care partners, or realize an opportunity to address an unmet community need. Historically, hospital systems tend to develop and own their own buildings or hire a third-party developer to own the building in a lease-back arrangement. Many systems undervalue the power that they bring to these deals, not just with a long-term lease commitment but with reputational capital as well.
We work with clients to help them optimize everything about these deals, including program and scope clarity, delivery efficiency, and opportunities for joint ventures that can lock in strategic goals. One key element of this success is an efficient lease rate and attractive terms for everyone involved in the deal. Credit tenant leases (CTLs) are one way to achieve these goals.
Exploring the Credit Tenant Lease Advantage
Traditional funding avenues like real estate investment trusts (REITs) are often the default route for financing healthcare capital projects. However, in fewer urban areas, these REITs can drive up development costs, pushing health systems to seek alternatives. Enter the CTL model — a strategic financial tool that prioritizes the health system's A+ investment grade credit over real estate value, paving the way for more cost-effective project funding.
The CTL mechanism involves issuing taxable bonds covering 100% of project costs, with an orphan trust structured as a limited liability company (LLC) to act as a conduit borrower. This intermediary setup, facilitated by a bank, allows the LLC to assume the role of landlord, entering into a 25-year master lease with the hospital system. Notably, the associated bank fees remain minimal, making this a financially savvy move.
Case Study: Midwestern Healthcare System Success
A real-world example of the CTL model's impact can be seen in a Midwestern healthcare system's development of a new ambulatory surgery center (ASC). Here is how the CTL approach provided significant advantages:
Competitive Rent Rates: In a market with modest rent expectations — illustrated by a $20 triple net rent rate for existing medical office buildings — the CTL model enabled the health system to secure a rent yield over 75 basis points lower than the most competitive third-party developer proposal, which positions the hospital to offer the most competitive rents in the area.
Balance Sheet Benefits: When comparing net present values (NPVs), the CTL approach outperforms typical developer models.
A typical developer approach:
- A 15-year lease that is renewable for an additional 10 years
- Rent yield over 6.5% with 3% annual bumps
A CTL approach:
- A 25-year lease with a balloon payment built into the CTL structure
- Rent yield under 6% with 2% annual bumps
The rent yield differential generated about $5 per square foot spread in the rent. Escalated, it compounds the difference in the two rents such that you get to the end of 25 years and end up with over a 30% differential in the rent. This approach yielded an NPV difference of around $6.5 million.
Flexible Tenant Improvements: The CTL structure offers flexibility in how much of the tenant improvements to finance. The typical developer will only give +/- $75 for general office space, and $150 on specialty space like imaging and ASC.
Dynamic Exit Strategy: The CTL model grants health systems the liberty to own the building outright at any point by settling the bond's principal balance, a freedom not afforded in developer-led projects.
Strategic Relationships: Additionally, the health system leveraged the CTL model to forge a joint venture with a surgical partner, co-guaranteeing a 15-year lease. This setup allows stakeholders to co-invest in the ASC operating company. In addition, leasing the building to partners who will generate patient volume through referrals creates sticky growth for the health system.
Conclusion
The CTL model combines financial efficiency, strategic flexibility, and long-term economic benefits, making it a compelling choice for health systems looking to grow in today's competitive landscape.
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