CREJ - Healthcare Properties - September 2016
After nearly a decade of efforts to put lease obligations on the balance sheet, the new standard for lease accounting was released by the U.S. Financial Accounting Standards Board earlier this year. While the goal is to put all leases on the balance sheet, health systems are significantly – and uniquely – impacted because of the substantial amount of real estate deployed in the delivery of health care services. And to ensure readiness for this change, planning needs to start now. Beginning in fiscal years starting after Dec. 15, 2018, the new standard will create new financial obligations, substantially increase balance sheets and apparent leverage, while increasing reported lease-related expenses at a time when operating margins of hospitals are under pressure. The scope of contracts considered leases will increase dramatically. Typical real estate and equipment leases are included, along with certain service contracts, previously overlooked, that will be considered to contain “embedded” leases. Hospitals will need to evaluate arrangements involving vendor-owned clinical or diagnostic equipment paid for based on usage or consumable supplies. Short-term leases (with a term of 12 months or less) will be excluded from capitalization under the new standard. Unique impact on health care. Hospital systems will be uniquely affected by the proposed standard due to their business. Leases of equipment and physician office space are standard operating procedure for today’s modern health care system and have grown considerably in number and volume with the proliferation of ambulatory care. Leasing has become an important vehicle for capital formation for fixed assets as systems preserve capital for physician alignment strategies and electronic health records. Hospitals have distinctive arrangements, which under FASB’s new lease accounting standard can shift the perception of financial strength as well as compound the administrative burden and complexity of financial reporting. Illustrations of this impact include: • Higher reported lease obligation due to the greater likelihood of inclusion of renewal periods as certain facilities are viewed as core, long-term locations for operations. The hurdle to overcome the certainty of renewal with auditors will be high for health care providers. • Common role as a landlord in owned facilities or sublandlord in master-leased facilities to physicians and clinicians. Hospitals will need to deal with both lessee and lessor accounting with potential gross-up of the balance sheet and pro forma occupancy expense and income, which are not symmetrical. • Use of ground leases and air rights to third parties on hospital campuses will need to be reported under the new standard. • Sale-leasebacks and monetization of real estate will be easier to achieve than under current restrictive standards and offer immediate gain recognition. The standard does away with restrictions on the amount of subleasing to third parties and other forms of continuing involvement. Purchase options or the right to re-control the asset will still be problematic and will greatly affect equipment sale-leasebacks. • Build-to-suit arrangements will be easier to achieve operating lease classification than under current standards, meaning that more commercial arrangements will comply. • Equipment leasing and financing has become commonplace with health care providers. Virtually all of these arrangements will be finance leases and accounted for as acquisitions of property with an accelerated expense profile. As such, features like residual guarantees or purchase options will not alter classification. How should health care systems prepare? Now that the new lease accounting is a reality, evaluation of health care real estate portfolios will come into critical focus. For organizations with established real estate departments, these professionals and their counterparts will need to be proactive in alerting finance executives about the upcoming changes and their likely impact. For organizations with small real estate groups, the proposed changes may point to the need to upgrade the professional focus on real estate. The requirements for administration and reporting of leases will become daunting for health care systems, which have grown through acquisition of hospitals and physician practice groups, each with their own real estate portfolios and unique operations. Organizations will face the formidable challenge of preparing their existing lease portfolios and reassessing the process for structuring effective leases going forward. This reassessment has four essential components: • Understand and quantify the impact – test how negotiated lease terms drive the balance sheet and operating expense. • Communicate with corporate treasury and accounting about the changes, decisions and reporting needs for the future. • Anticipate and plan for new financial reporting – identify additional data acquisition and make changes to lease administration systems. • Re-assess decisions about ownership versus leasing of real estate, much of which has been prompted by access to capital and liquidity. Sweeping changes in lease accounting will give health care organizations a valuable opportunity to articulate the fundamental business reasons for leasing. The value of access to real estate capital to support the growth of health care systems will be an important factor as organizations navigate through the challenging time ahead with FASB’s new lease accounting standard.