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How Will America Replace Its Rural Hospitals?

Healthcare Financial Management

Most of the nation's 2,000-plus rural hospitals are aging, have put off repairs and now need substantial renovation or replacement. These are big projects that many of these small hospitals might not have been able to afford -- until recently. Hospitals now have a wide variety of choices to finance big construction projects. For example, the federal critical access hospital program can enhance revenue by providing cost-based reimbursement to qualifying hospitals. The HUD 242 program from t he Department of Housing and Urban Development and the USDA Community Facilities Program from the Department of Agriculture can provide mortgage insurance and win AA or AAA loan ratings. Presented here are the thoughts of four professionals who have successfully put together financing packages for construction projects -- a financial advisor and three executives from rural hospitals that are replacing aging facilities or undertook other construction projects.

About HFMA Roundtables

With this article, HFMA continues a series of “virtual” discussions to offer thought leadership and practical perspectives on healthcare financial issues by leading industry professionals. This roundtable offers viewpoints and advice about the challenges of revenue cycle leadership and the qualities desirable in a revenue cycle executive. This HFMA Roundtable is made possible through the support of InnoVative Capital LLC of Springfield, Penn.

Alan P. Richman

President and CEO InnoVative Capital LLC, is an FHA-licensed mortgage banking and financial advisory firm based in Springfield , Penn. The company specializes in non-rated critical access, community, and rural hospitals.

Gary Moore

CEO of Shoshone Medical Center, a 25-bed hospital in Kellogg , Ida .

Marilyn A. Hays

Chief financial officer of North Valley Hospital , a 25-bed hospital in Whitefish, Mont. , managed by Quorum Health Resources.

Larry A. Kidd

Chief financial officer and Chief operating officer of St Mary 's Hospital in Cottonwood , Idaho , with 18 acute care beds, and CFO of Clearwater Valley Hospital, Orofino , Idaho , with 23 acute care beds . Both hospitals are affiliated with Benedictine Health System in Duluth , Minn. , which operates 60 facilities, one-third of which are hospitals.

1. How critical is the need for America 's rural hospitals to be replaced? 

Alan Richman : Rural hospitals have gone through a steady decline in the past quarter century. They needed to repair their physical plants and buy rapidly changing medical equipment, but until recently, it's been hard to find the funds. Medicare reimbursement levels made it impossible to break even, cash balances were strained and patient volumes were falling. This obsolescence has prompted patients to switch to more technologically advanced hospitals. But rural hospitals can improve their financial viability by reducing overcapacity, focusing more on outpatient services and taking advantage of regulatory changes such as the federal critical access hospital program. The hospital industry and capital markets are starting to take notice of these changes.

Gary Moore : The physical state of our 25-bed hospital, built in the 1959, can shed some light on the problem. You cannot get a wheelchair into a patient's bathroom unless it is folded up. The boilers, elevator, plumbing and electrical infrastructures are antiquated and it is hard to find parts for them. The low ceilings in our facility wouldn't meet current air exchange ratios. All of these problems were only going to get worse with each year. So we have decided to replace the whole facility with a new one, which opens in January 2005.

Marilyn Hays: Our 25-bed hospital was also built in the 1950s, the mechanical systems are also old and inefficient, and we also decided to replace our facility. The layout was geared toward inpatient services because outpatient services were unknown back then. It would have been hard to expand outpatient services in the old facility because they are located in the core of the facility. If we had renovated it, we would have faced substantial code compliance issues. For example, we would have had to remove asbestos at an estimated cost of almost $1 million.

Lawrence Kidd : We haven't replaced either of our hospitals, but are thinking of doing so eventually. In the next 10 to 15 years, if not now, a lot of rural hospitals are going to need major renovation or replacement. The alternative is to close them, but it's critical that they stay open. People in other areas of the country would be amazed at how far apart hospitals are in Wyoming . To get from one of our facilities to the nearest regional medical center is a two-hour drive over a mountain pass. And that's in good weather.

2. What process would you undertake to calculate your borrowing capacity and an affordable project size?

Alan Richman : The process differs somewhat for each hospital, but it's safe to say that it should never start with an architect. Instead, it should start from the hospital and finance side to determine what is financially viable. At North Valley Hospital , we generated a maximum affordable loan amount without any demand growth. It was based on historical results, reimbursement step-ups, interest rate assumptions and a rudimentary project budget. Then we performed a market analysis to forecast demand growth by service line. A final debt capacity analysis incorporated demand and financial forecasts. Then we commissioned a facilities master plan to develop the project scope.

Gary Moore : A hospital can spend a lot of money putting together big plans and then not be able to afford them. We had to go through a calculation process to see how much debt service we could cover -- a variety of “what if” scenarios, based on market and demographic studies and payer mix. That yielded a total replacement cost that fit our projections of debt service coverage. Then our management company developed a total project budget based on a prototype replacement that it had developed . We massaged the square-footage we needed for continuing to do business over the next 20 years, with some projected growth in a few areas.

Marilyn Hays: Initially, our management company performed a facility replacement market assessment, evaluating demographics, economic climate, competition, medical staff, services, operations and volume projections. We came up with some preliminary costs for a new facility, then we ran financial forecasts to see if the necessary financial ratios for our loan could be met. To improve the financial feasibility, we applied for critical access hospital status. Joining the CAH program increased our Medicare and Medicaid reimbursements, and that was key to making this project possible.

Larry Kidd : The first step is to develop a master facility plan, which quantifies where you need to be at certain points in the project. You have to calculate the borrowing capacity and an affordable project size. We rely heavily on our corporate office to create the master facility plan. They would either do it internally or out-source it. We would pretty much leave it to them to make the call on that and we would feed them information as needed.

3. How would you weigh the options of renovation and replacement?

Alan Richman : I believe the first preference should always be a replacement facility. Compared to renovation, off-site construction is less disruptive and avoids structural impediments that limit how much you can remodel. Also, it allows for a more desirable location and you can get prototype designs for new hospitals. For cash-constrained hospitals, however, renovation may be the only way to go.

Gary Moore : In many cases, including our own, it's more cost-effective to replace than to renovate. There was a lot of emotion in our local community about tearing down the old hospital. People donated money to it. Maybe they helped put in a bathroom or a handicapped facility, or they sold cakes and cookies for a community fundraiser. So you need to let the community know that this is a necessary business decision, based on what we can afford.

Marilyn Hays: Sometimes it makes more sense to spend a few million more and completely replace your facility with a new one that is well laid out, accommodates the kind of patient you see and lets you grow. Initial estimates put our replacement at $15 million, not much more than an estimated $12 million for renovation. We chose replacement at a new site, which turned out to be a hot issue in our community. Some people were concerned that the new site would attract commercial development away from other areas. A community-wide committee appointed by the board stepped in, studied the issue and went with the new site, but they asked for medical-use zoning restrictions.

Larry Kidd : Replacement is usually preferable to renovation. If you do a major renovation, you have to comply with basically the same building codes as new construction. That means big expenses such as removing asbestos and installing sprinklers.

4. How do you determine which medical services will be added or subtracted at your new facility?

Alan Richman : We help the hospital rank current and desired future services by profitability and essentiality to the community. Don't be confused by the term “nonprofit” hospital. It doesn't mean “no profit.” Due to small hospitals' limited financial resources, developing the proper service mix is essential. These hospitals cannot be all things to all people. They may want to build upon a core specialty focus and defer other services. Some services, even if they are money-losing, have to be kept, while others have to be judged from a loan underwriting perspective for immediate and future profitability.  Shoshone Medical Center eliminated an underutilized and unprofitable OB unit and brought in a much-needed permanent MRI, which substantially improved its financial projections.

Gary Moore : Although the new Shoshone Medical Center will not have OB , our architectural plans make room for it in the future. We have also expanded or added other services, keeping in mind that we need to have the specialty physicians to operate them. A portable MRI that is here one day a week is being replaced with an open MRI that we will have all the time. It is expected, according to conservative estimates, to bring a 15 percent increase in MRI use. We are also adding a pulmonary functions room, building on our existing respiratory therapy services.

Marilyn Hays: Our 56-bed nursing home was losing money and was ineligible for HUD 242 financing. So our board decided to close the nursing home, whether we built or remodeled. Then we studied why patients are going to other facilities to determine which new services we should offer and we are considering some new services that will be determined later.

Larry Kidd : Alluding to something Gary said, before you add new medical services you should look at the skill set of your current staff. Will you have to recruit new personnel? I also want to add to Alan 's point that the hospital needs make money on some services. In some cases, savings for the hospital also mean savings for the patient. When we acquired new CTs, we were able to reduce charges to the patient by about $250 per scan.

5. Which capital sources are especially appropriate for rural hospitals wishing to undertake a major capital project?

Alan Richman : Nothing impacts a financial forecast more than interest rates. The bigger the project, the more interest rates matter. As a HUD-licensed mortgage lender, we can procure government-guaranteed hospital funding at AAA-rates without issuing bonds. For North Valley Hospital , an FHA loan will represent millions of dollars of savings in immediate and long-term debt service. Other hospitals have more modest borrowing needs, pressing CON issues, local tax support or assistance from design-build companies. These hospitals can find financing through private placements, general obligation bonds, USDA guarantees and commercial loans.

Gary Moore : Our local bank gave us a line of credit for initial expenses but it wasn't enough to finance the whole project, which is worth $18.5 million. We used the HUD 242 program for the full project. HUD can give you an AA or AAA bond rating, which makes for a pretty doable deal in getting your loans approved. HUD officials look around and follow up on your financials each month, but your board maintains control. I would caution against using municipal bonds for capital funding because it can tie up the community's ability to provide infrastructure improvements such as sewers and parks.

Marilyn Hays: Our $31 million project will be funded with bonds or Ginnie Mae loans backed by HUD 242 mortgage insurance. The HUD program targets rural facilities in the critical access hospital program and usually has lower financial requirements than other options. Because of the complexity of the HUD application process, it helped us to hire consultants with previous HUD experience.

Larry Kidd : We might have used the HUD 242 if we ever decide to replace a hospital, but for our smaller projects, we were able to come up with some creative solutions. For example, we financed a new ER at Clearwater Valley Hospital mainly with a $500,000 appropriation from Congress. That amount is the limit for one congressional appropriation and we have had a total of three. They are not easy to get, but we had a wonderful grant-writer and our congressman believed in our plan. The second appropriation funded the purchase of a CT scanner at Clearwater Valley . St. Mary 's scanner was purchased with two private bequests. We used tax-exempt bond financing from the Idaho Health Facilities Authority to build a clinic near St. Mary 's.

6. What advice would you offer financial executives at rural hospitals contemplating major capital construction projects?

Alan Richman : My advice is: D o not try to go it alone and do not go with amateurs. Hire experts, but only after you check references and review their accomplishments. And even though you have qualified experts , you will need to have a thorough understanding of the project to be able to align the expectations of your board, doctors and community with reality. Also, hold off major announcements until their outcome is certain. This preserves credibility and goodwill and makes for a robust celebration at loan closing.

Gary Moore : You will have a lot of money at your disposal, amounts that you have probably never seen before. Do not waste it. Before you spend anything on an architect, you need to know how much you can borrow. I would highly recommend considering the HUD 242 loan. That was our savior. Critical access status brought us back up to our needs financially. Even if you're new to cost-based reimbursement, as we were, HUD allows you to assume you had it two or three years back, which brought us to a positive margin. The HUD application process is not difficult but it can be frustrating. If there's no major problem, it should take eight or nine months for approval. You duplicate a lot of information sometimes because you're working with two entities, HUD and the Department of Health and Human Services.

Marilyn Hays: It's a long process, so be patient. Develop a strategic plan up-front, perform due diligence and educate your board. You should be able to continually incorporate plan changes and updated financial information to make sure the project is still feasible. Also, our financial advisor holds regular conference calls with all members of the project team. That keeps everyone updated on changing project costs and financial limitations. Another piece of advice: Involve your community, staff and physicians in the decision-making process. Seek their input and support. Community members can help you identify potential donors for a capital campaign.

Larry Kidd : My advice is leave no stone unturned. That's how we came up with the congressional appropriation. One other thing: public hospitals that rely on tax levies are going to have to take a real hard look at selling off their facilities to private health systems. The public is not enthusiastic about funding projects with tax dollars. Clearwater Valley Hospital , which our system operates, is still county-owned, but the county is considering selling it to us.

7. Before you received your loan, how did you balance your liquidity position with project-related capital outlays, and did it require the deferral of plant maintenance?

Alan Richman : As the hospital's financial advisor or banker, we begin all engagements by requesting financial statements and two-year forecasts.  We run sensitivity tests of profitability and cash reserves incorporating the project. Overlaying the timing of planned project development outlays with forecasted financials generates a cash flow budget. A liquidity-challenged hospital may seek the support of an interim credit facility, as well as a financial partner, or defer non-essential capital expenditures. Community fundraising can also help. North Valley Hospital used a fundraising campaign in its early project planning stages. I must emphasize that capital budgeting is a dynamic process that should be regularly updated by the hospital and its project team.

Gary Moore : Before the new facility could open, we desperately needed some portable radiology equipment and monitors, which we will later move over to the new facility. We acquired this equipment after the loan closing. Our local banker helped with credit lines and the timing was good, with some cost-report receivables coming back to the hospital.

Marilyn Hays: Local banks gave us a line of credit to assist with our upfront project, planning, design and financing costs. This meant that we could pretty much maintain our cash levels for required operations, current capital and plant. Those loans will be paid back with the first draw from our HUD loan. Also, you have to make sure you have money for future needs. After the building project is completed, your debt leverage for future purchases will be severely limited. If you know that you are going to need to replace your CT scanner within a year or two of completing construction, you should build that cost into the current project.

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