Real Estate Due Diligence Considerations for Health Care Mergers and Acquisitions
This Briefing is from AHLA’s Real Estate Affinity Group of the Hospitals and Health Systems Practice Group and Transactions Affinity Group of the Business Law and Governance Practice Group.
- March 27, 2020
- Goran Musinovic , Realty Trust Group LLC
- Grant T. Williamson , Realty Trust Group LLP
Since 2017, health care mergers and acquisitions have repeatedly hit record-breaking numbers. Mergers and acquisitions allow health care providers to, among other things, increase access to care, improve quality of care, enter new geographic markets, retain or even increase market share, and increase revenues thereby helping ensure long-term viability. Additionally, recent shifts to value-based reimbursements have increased the financial pressures on health care organizations, requiring them to decrease their costs and become more efficient, further incentivizing consolidation. No signs point to this trend slowing down. That is not to say, however, that mergers and acquisitions are without risks. Health care organizations understand this and regularly engage in comprehensive due diligence efforts to identify and assess the risks and benefits of transactions before they are consummated. Most mergers and acquisitions in the health care context, whether hospital-to-hospital transactions, hospital-physician practice acquisitions, or other similar types of transactions, involve the consolidation of real estate, not just in terms of the physical assets themselves, but also in terms of real estate strategies, real estate policies and procedures, real estate administration, and, perhaps most importantly, real estate compliance infractions. To that end, it is critically important for health care organizations’ due diligence efforts to include, in part, a real estate review, which, at a minimum, should focus on the following: (1) compliance considerations; (2) strategic considerations; and (3) physical considerations.
In fiscal year 2019, the Department of Justice (DOJ) obtained more than $3 billion in settlements and judgments from civil cases involving fraud and false claims against the government. Of the more than $3 billion, $2.6 billion involved the health care industry, including drug and medical device manufacturers, managed care providers, hospitals, pharmacies, hospice organizations, laboratories, and physicians, and $2.1 billion arose from whistleblower lawsuits, which are filed under the qui tam provisions of the False Claims Act. The recoveries in 2019 marked the tenth consecutive year in which civil health care fraud settlements and judgments involving the DOJ exceeded $2 billion.
Despite these astronomical numbers, many health systems, and especially those that are being acquired, do not allocate adequate resources to create, implement, and administer effective compliance programs. Viewed by many organizations as cost centers, many compliance departments are not adequately funded and staffed and are not given the necessary authority within the organization to enforce and maintain a culture of compliance. In addition, many organizations view compliance as the responsibility of only the compliance and the legal departments and not of the entire organization.
One area that is often overlooked and neglected by health systems’ compliance programs involves real estate lease arrangements between health systems and physicians. Although health care fraud lawsuits that stem from real estate lease arrangements with referral sources represent a relatively small percentage of the total annual recoveries referenced above, a recent study of Voluntary Self-Referral Disclosure Protocol settlement data that is published by the Centers for Medicare & Medicaid Services and Provider Self-Disclosure Protocol settlement data that is published by the Office of Inspector General revealed that, in the period between 2009 and 2016, the cost of settling a potential violation involving a real estate arrangement was 66% higher than the average settlement that did not involve a real estate arrangement. The study also found that, during that period, “the average settlement involving a real estate arrangement was $731,654.17 compared to the average settlement amount of $439,097.43 for matters not involving a real estate arrangement.”
Even though real estate lease arrangements with referral sources pose regulatory risks that have a tendency to increase the average settlement amount health systems have to pay, compliance considerations often have less time and resources devoted to them during the due diligence process than other business considerations. Many health systems view compliance considerations as something that can be handled down the road instead of as potential “deal killers” that can lead to large fines and even exclusion from federal health care programs. However, health systems that are in the process of acquiring other health systems should conduct real estate compliance risk assessments as part of their due diligence analysis to ensure that they will not be inheriting noncompliant real estate arrangements or, if they will be, to adjust the business terms of the transactions to address the compliance infractions or walk away from the deal altogether. The real estate compliance risk assessment should be split into three major focus areas: (a) real estate compliance program assessment, (b) real estate arrangement testing, and (c) post-closing operational compliance risk assessment.
Real Estate Compliance Program Assessment
The real estate compliance risk assessment should begin with the assessment of the health system’s real estate compliance program, assuming one even exists. The due diligence review should focus on the following:
- General review of the target health system’s current approach to negotiating and maintaining real estate arrangements with potential referral sources;
- Obtaining an understanding of the individuals in key roles, the various departments, the responsibility of each department, their interdependence with other departments, and the role of external partners as it relates to real estate;
- Review and assessment of the health system’s real estate policies and procedures, including, but not limited to, policies for obtaining real estate FMV valuations in support of the health system’s real estate arrangements with referral sources;
- Obtaining an understanding of the real estate arrangement approval process for different types of real estate arrangements (e.g., new leases, lease renewals, leases with referral sources, leases with nonreferral sources, master leases, subleases, income leases, expense leases, ground leases, real estate purchase and sale agreements, etc.);
- Review and assessment of the health systems’ standard real estate contract templates;
- Review and assessment of current systems used to track real estate information and processes supporting those systems;
- Obtaining an understanding of key regulatory compliance risk areas including documentation for fair market value and commercial reasonableness opinions for real estate transactions;
- Becoming familiar with the health system’s compliance and audit functions and how they interact with real estate;
- Review and assessment of the health system’s real estate compliance training and education for its employees; and
- Becoming familiar with the health system’s compliance investigations and remedial measures processes.
The goal should be to determine whether the target health system has established a robust real estate compliance program that is designed to prevent real estate compliance violations. If no real estate compliance program exists, there is increased risk that at least some of the health system’s real estate arrangements are in violation of the applicable regulations, which will in turn have financial consequences for the acquiring entity if the transaction is consummated.
Real Estate Arrangement Testing
After determining whether the health system that is to be acquired has a real estate compliance program, and assessing its effectiveness, the next step should be to review the entire real estate portfolio, if it can be done in a cost-effective and timely manner. If it is not feasible to review the entire portfolio, the acquiring entity should select a sample of real estate arrangements to test. Sampling criteria should be established to ensure that a cross-section of the arrangements is chosen that is illustrative of the portfolio as a whole. A variety of lease types should be sampled—income leases, expense leases, full-time leases, timeshare leases, master leases, ground leases, subleases, etc. In addition to lease arrangements, the sample should include purchase and sale real estate arrangements between the health system and referral sources. As part of the real estate arrangement testing, the following questions should be asked to assess whether any compliance concerns exist or could arise in the future:
- Do the lease arrangements and other real estate arrangements have fair market value support? If not, are there other ways to show that the terms of the arrangements are consistent with fair market value?
- Do the lease arrangements and other real estate arrangements have business justification memoranda or other types of documents illustrating that the arrangements are consistent with industry practices and are commercially reasonable?
- Do the lease arrangements and other real estate arrangements have some method for determining and documenting whether the arrangements are with referral sources?
- Have searches of the Office of Inspector General Exclusion List of Excluded Individuals and Entities (OIG LEIE) and General Services Administration System for Award Management (SAM) been conducted?
- Do the lease arrangements and other real estate arrangements contain all documentation required under the target health system’s existing policies?
In addition, the reviewing entity should review and analyze payment information for the selected real estate arrangements by focusing on the following:
- Rent collection;
- Rent reconciliation;
- If appropriate, late fee charges;
- Operating expense reconciliations; and
- Enforcement actions taken, in the event of nonpayment under the selected real estate leases.
If the real estate arrangement testing reveals compliance violations, the reviewing entity should determine whether these concerns should be remediated as a condition of consummating the transaction, whether the reviewing entity is comfortable with remediating these concerns once the transaction is consummated, or whether another course of action is warranted. Detailed summaries of the observations, assessments, and findings at this stage will allow the reviewing entity to assess any existing compliance concerns and determine how they should be remedied if the transaction is consummated or if the concerns present too great a risk to allow the transaction to proceed.
Post-Closing Operational Compliance Risk Assessment
The final component of the compliance risk assessment should focus on gaining an understanding of the feasibility and ease of transitioning the target health system’s real estate practices to those of the acquiring entity. All due diligence conducted here is focused on the target health system’s ability to effectively and efficiently adapt to the acquiring entity’s real estate policies and procedures to ensure future consistency across the acquiring entity’s real estate portfolio.
Only after the acquiring entity determines that there are no compliance concerns that will derail the transaction, or if there are identified compliance concerns, after the acquiring entity determines how they will be addressed, should the acquiring entity proceed to performing real estate due diligence related to strategic and physical considerations.
Although it is easy get bogged down in the details while performing real estate due diligence activities, it is imperative for health systems to remember the strategic objectives of the transaction and real estate’s role in achieving those objectives. The first step is for the acquiring entity to create a summary of the real estate portfolio, both owned and leased, that is to be acquired, which should include the following property information:
- Property Name
- Tax Parcel
- Square Footage
- Year Built
- Owned vs. Leased Status
- Fee Owner
- Fee Owner Affiliations (if available)
- Lease Abstracts of Material Terms (if applicable)
- General Property Description/Class
- Current Vacancy Rates in Owned Buildings
- Rent Rolls for Owned or Master Leased Buildings
- Current Property Use(s)
- Aerials and Parcel Maps
- Photographs of Facilities
- Demographic and other Market Data Reports
For each property in the portfolio summary, the acquiring entity should also obtain a current title report (together with all underlying title documents referenced in the report) and a corresponding American Land Title Association survey for the applicable property.
Once the real estate portfolio summary has been developed, the acquiring entity should conduct a portfolio analysis to determine whether the real estate that will be acquired as part of the transaction will meet the strategic objectives of the transaction. Specifically, the analysis should be guided, in part, by the following questions:
- Will the real estate allow the entity to expand its service offerings?
- Will the additional real estate help satisfy the demand for increased space for a growing service offering?
- Will the real estate allow the acquiring entity to offer services in desired geographic areas?
- Will the real estate compliment other strategic objectives behind the transaction?
If these questions are answered in the affirmative, the acquiring entity can focus its portfolio analysis more specifically on the buildings that are to be acquired. A key part of the due diligence surrounding the strategic considerations phase should be title/survey review. The goal during title/survey review is to first determine whether there are any issues with title currently, and second whether there are any restrictions on title or other related issues that could impede the long-term strategic goals for the real estate to be acquired in the transaction. The reviewing entity should assess whether there are any restrictions on title or map characteristics (e.g., covenants, codes, and restrictions; easements; liens; rights of first offer or refusal; setbacks; etc.) that could cause an issue for future development and growth. For example, if there is an easement that runs across the northern side of a property that currently does not overlap with the building, it could become a problem if the reviewing entity hopes to eventually be able to expand the size of the building into the space where the easement is located. The easement on its own does not necessarily prevent this option, but it does force the reviewing entity to consider its future plans for the property to determine whether it supports the type of growth and future use that they have planned and what obstacles they will eventually face. Another example could involve setback issues where the overall property includes more than one legal parcel because the setback requirement would be violated if the acquiring entity desires to expand or construct a building over the existing property lines between the two subject parcels. In that case, subdivision map work, such as a lot line adjustment, may be necessary.
The analysis should also focus on how the acquired buildings will be utilized following the transaction and on their financial performance. If the acquiring entity determines that, following the transaction, certain buildings will serve duplicative functions to those that are already a part of its portfolio, it should determine whether those buildings can be repurposed, whether they can be sold, or whether they should be excluded from the transaction. This would include zoning and related land use analysis to, among other things, verify permitted uses and determine whether the property currently benefits from any grandfathered uses and/or legal non-conforming status that could be terminated if there is a change in use or significant alterations to the property. To aid in this zoning and land use analysis, many entities will obtain comprehensive zoning reports prepared by third-party consultants. The acquiring entity should also examine the vacancy rates and the rent rolls in the buildings to determine their profitability. Buildings with high vacancy rates, high outstanding receivables, or high operating costs could potentially be excluded from the deal, sold after the transaction is consummated, or improved in their operations following the transaction.
The final aspect of the real estate due diligence should focus on the physical considerations of the real property that is to be acquired, which could ultimately have a financial impact on the transaction. The acquiring entity should perform environmental and facility condition assessments for the properties to be acquired, which should generally consist of the following activities:
- Obtain and review target entity property reports, including environmental site assessments and other property condition reports.
- Conduct walk-throughs/site inspections of all hospital facilities, office buildings, residential buildings, and parking facilities.
- Photograph existing conditions.
- Meet with facility staff to discuss known building conditions.
- Conduct a limited review of maintenance records to determine type and scope of routine and unforeseen maintenance work.
- Review all mechanical, electrical, and plumbing (MEP) engineering systems and determine whether a more in-depth study of those systems is necessary.
- Review The Joint Commission Statement of Conditions (or equivalent for other applicable accreditation organizations) and determine status of outstanding issues, if any.
- For each building, review existing conditions of:
- MEP systems and mechanical rooms
- Parking lots / Structures
- Review state-specific laws such seismic requirements, and whether each applicable building complies.
- Review of budgeted capital repairs and improvements for next the fiscal year.
- Develop order of magnitude pricing for deferred maintenance items, if any.
- Develop order of magnitude pricing for significant capital improvement items, if any.
- Conduct environmental site assessments.
- If the building was constructed prior to the 1980’s, perform asbestos and lead-based paint testing.
- Prepare a final comprehensive report detailing findings and recommendations.
The facility site condition assessments should help the acquiring entity project future financial costs that will be incurred in connection with the acquired properties. The acquiring entity will then need to determine whether the need to acquire the properties is outweighed by the cost to improve the properties to a certain standard. If not, an adjustment may need to be made to the ultimate price of the transaction because of the investment that will still need to be devoted to improving the real estate being acquired. Rough plans should be created at this stage to address any of these necessary repairs and/or updates and factor their costs into the overall strategy for the transaction.
For those mergers and acquisitions that involve the acquisition of real estate (whether acquiring fee title or taking assignment of existing lease arrangements), it is critically important for health care organizations’ due diligence efforts to include, in part, a real estate review. Although an acquiring entity may not view compliance as a major component of a real estate due diligence analysis, it should be because compliance violations could have significant financial impacts on the acquiring organization—not just in terms of compliance infractions that may be inherited, but also in terms of future compliance infractions that could arise if the acquired entity has difficulties transitioning to the real estate policies and procedures of the acquiring organization. Similarly, strategic and physical considerations should also be carefully analyzed because even if they are not necessarily deal-breakers for the transaction, they can impact the ultimate purchase price for the transaction. As mergers and acquisitions continue to occur in the health care industry, prudent health care organizations would be wise to invest time, money, and energy into conducting comprehensive due diligence reviews, as failure to do so may very well lead to “penny wise and pound foolish” regret following the consummation of the transaction.
About the Authors
Goran Musinovic, JD
Goran Musinovic is a Vice President at RTG and serves as the leader of RTG’s Compliance Service Line, which provides a broad spectrum of real estate compliance advisory services, ranging from helping health systems create, improve, and implement effective real estate compliance programs to minimize their exposure under The Stark Law, The Anti-Kickback Statute, and The False Claims Act, assisting with real estate due diligence efforts in connection with various health care mergers and acquisition transactions, and providing fair market value and commercial reasonableness analyses in connection with various real estate arrangements and transactions.
Grant T. Williamson, JD
Grant Williamson serves as a Regulatory Compliance Analyst at RTG working primarily as a member of RTG’s Compliance Service Line, providing a broad spectrum of real estate compliance advisory services, including helping health systems create, improve, and implement effective real estate compliance programs to minimize their exposure under The Stark Law, The Anti-Kickback Statute, and The False Claims Act.