Why a health system’s growth strategy should include a build-versus-buy analysis
In today’s U.S. healthcare environment, health systems are likely to find that purchasing assets for purposes of expansion is often the most cost-effective and affordable option.
September 19, 2024
3:24 pm
Recent market disruptions in the hospital industry make it imperative that health systems be precise in their capital planning for growth initiatives as part of an overall strategic vision. An essential goal for such planning is to find a balance between service line diversification and expansion, while maintaining sound financial results. Weighing the pros and cons of building new facilities versus acquiring existing ones is intrinsic to achieving that goal.
Moreover, the need for such a build-versus-buy analysis has grown as a result of the COVID-19 pandemic, which caused a wave of operational challenges for management teams, including degraded patient volume, escalated labor expense and a disrupted supply chain.
Some organizations have dealt with these issues better than others and have gradually recovered to pre-pandemic financial performance. However, amid the current environment focused on mergers and acquisitions (M&A), even large, well-capitalized hospital companies with strong credit ratings have sharpened their focus on making informed decisions around potential transactions while addressing operating pressures.
In this M&A environment, the economics for new construction may be less favorable than those for purchasing assets, making it all the more important to perform a thorough build-versus-buy analysis.
3 factors shaping the current environment
New construction’s reduced economic favorability is primarily due to the following three factors, which health system management teams and boards should consider as they assess potential acquisitions and whether new campuses or new partnerships might be a better path toward growth.
1 Construction risk. The pandemic proved that large shocks to the U.S. economy could occur unexpectedly and profoundly disrupt a health system’s operations and debt capacity for new construction. The most significant effects have been supply chain disruption and potential construction delays if the labor force’s ability to fulfill job responsibilities are limited by worker shortages or restrictions. Although building costs have come down from their March 2022 peak, they are still up roughly 37% compared with the pre-pandemic economy, putting a strain on day-to-day operations and the financial feasibility of new development projects.a
Furthermore, the high fixed costs associated with hospital organizations make them susceptible to large increases in supply expenses, which also impact the price tag for new construction. A recent study by Health Facilities Management indicated that the cost per square foot for hospital projects has risen by more than 6% between 2023 and 2024.b That same study also states those costs have escalated more than 20% in the past five years.
The lingering impacts of the pandemic are driving these increases. Supply chain disruption has shown signs of subsiding, but as of 2023, square-foot costs were still showing steady year-over-year increases nationally and in 10 urban markets.c
HVAC materials are the largest proportion of the cost per square foot for hospital buildings, which is not surprising given that there are significant energy needs for their operations. The financial risk associated with building new facilities therefore is pronounced given the uncertain risks of another macroeconomic event like the COVID-19 pandemic and the protracted operational issues facing management teams.
2 The state of the capital markets. Expensive capital structures have prompted organizations to revisit the prospect of acquiring existing assets as an alternative to building new ones. Higher borrowing costs could not only dilute operating income but also significantly undermine the ROI health systems would need to justify strategic and major capital projects.d
In other words, a strong financial return for building new facilities is less attainable in today’s capital markets.
Operators previously benefitted from over a decade of cheaply priced bond issues and commercial loans to finance new projects, making the payback period manageable for new facilities. Creditor appetite to fund new construction has also dwindled; lenders are tending to be skittish after recent banking crises and business challenges at hospitals, making them hesitant to invest in new construction projects.
To provide context, in January 2021, the five-year swap rate (a typical benchmark for new construction capital) was about 0.50%, but by April 2024, it increased to 4.37%. Keeping credit spreads the same at 2.50%, based on tracking of the five-year swap rate curve from Bloomberg’s daily postings, the all-in cost of borrowing in April 2024 was about 6.87%, which is more than seven times January 2021 levels. Borrowers would thus need to reduce the principal amount of their loan in today’s market by about 20% to have the same level of debt service as they would under 2021 market conditions, which by some estimates would cause a capital shortfall.e
This 20% gap is often filled with cash contributions (not-for-profit hospitals would most likely explore that option given their excess reserves and inability to issue stock) or with financing from an external equity source, which is costly and difficult to obtain for for-profit operators.
The combination of higher interest rates and costs of construction has therefore significantly changed capital stack compositions. Borrowers need more proceeds to complete projects due to elevated construction costs, but high interest rates and diminished creditor appetite reduce the availability of capital. In 2021, capital stacks constituted roughly a 90-10 debt-to-cash and/or investor-equity split, but today’s market conditions dictate 60-40 or 50-50 splits to finance a project.f
Another byproduct of the disruptions created by the pandemic is that capitalization (cap) rates for hospitals are more volatile than in previous years.
The risk profile of hospital investments is elevated due to the uncertainty of health systems’ ability to generate adequate operating cash flows to repay investors. Because of this increased risk, the “going-in” cap rate for investors might vary significantly from their exit cap rate, making it difficult to accurately assess the rate of return at the end of the investment period. To compensate for the higher credit risk, lender covenants are stricter and loan-to-value requirements are lower than in previous years.
3 Land scarcity and geographic premiums. Markets that have strong growth but require additional healthcare services tend to have scarce real estate for new buildings, which means construction involves significant cost premiums. As a result, operators might consider expanding into certain areas to ensure better access to care by acquiring existing assets and reinvesting in them instead of developing new ones.
The financial features of such a project, however, could warrant transaction multiples of revenue or earnings before interest, taxes, depreciation and amortization (EBITDA) above typical market medians.g
The balancing act is therefore not only to arrive at feasible financial terms that reflect the higher purchase price driven by land scarcity and market desirability, but also to ensure the financial benefits outweigh the cost and risk of new construction.
Precedent transactions
Recent transactions offer good examples of findings from build-versus-buy analyses in health systems have performed today’s environment.
On Dec. 11, 2023, University of California San Diego Health (UCSDH) completed the purchase of 302-bed Alvarado Hospital Medical Center (AHMC) from Prime Healthcare. UCSDH’s expanding market has robust, increasing healthcare needs, particularly for behavioral health. The bustling San Diego metro area is also short on bed capacity, which presents a challenge for providers and residents seeking high-quality and accessible care.
UCSDH needed to broaden its services with new facilities and add beds at its campuses to meet growing demand, but constructing new campuses would be costly and time intensive.
Patty Maysent, CEO of UCSDH, told The San Diego Union-Tribune that the $200 million purchase price for the facility is a “massive” cost difference from building a new one. In fact, according to a recent article written by Scripps in the News, the cost to build new beds in San Diego is roughly double the national average, thereby supporting Maysent’s thesis.h
Similar recent transactions include the acquisition by Novant Health, based in Winston-Salem, N.C., of three hospitals from Tenet Healthcare in South Carolina and the purchase by Adventist Health, based in Rosedale, Calif., of two Tenet hospitals in California.i
Like the UCSDH acquisition, Novant and Adventist recognized opportunities to expand in growing areas with strong demand for services, which ultimately drove above-market transaction multiples for each transaction. The exhibits below highlight key measures of the UCSDH and Adventist transactions compared with market medians. Novant is not included in the exhibits because of the exceptional nature of the acquirer’s purchase price (as discussed later in this article).
Multiples comparison: Adventist Health and UC San Diego Health (UCSDH) versus median price to revenue
Price-per-bed comparison: Adventist Health and UC San Diego Health (UCSDH) versus median price per bed ($ in millions)
The transaction multiples for Adventist and UCSDH were well above the median revenue multiple over the past five years of 0.48x.j
However, it typically costs roughly $2 million per bed to construct a new hospital in a desirable market, which means Adventist’s and UCSDH’s recent acquisition prices were considerably lower than the costs of new construction. Simultaneously, divesting companies obtained favorable transaction terms at very high multiples of revenue, indicating the economic terms of the transaction made good sense for all parties.
The Novant acquisition is a significant outlier. The price to revenue for this transaction was about 4.35x, and the cost per bed was approximately $8.5 million, which are well above thresholds shown in the previously cited exhibit.
Novant’s high purchase price was driven by similar market dynamics that existed for the UCSDH and Adventist acquisitions. Hilton Head Hospital, for example, has a unique, desirable location and has sparse real estate to build new facilities, prompting high transaction premiums. In addition, the three hospitals were profitable, further driving up the purchase price.
A new reality
The need to assess whether to build or buy is now more important than it was before the pandemic. At one time, hospital operators aimed for a 3% operating margin, but they now are more realistically targeting breakeven operation.
The 3% threshold was the former “golden rule,” allowing organizations to generate enough profit to cover debt service, pay vendors and have cash leftover for a rainy day or future capital needs.
Given the adverse factors resulting from the pandemic cited above, that 3% target is much harder to attain. The cost and lower availability of debt, coupled with operating expense escalation in recent years, hamper a health system’s ability to construct new facilities from their own balance sheets, particularly in dense, growing markets like Southern California and Coastal Carolina.
For the foreseeable future, hospitals will continue to grapple with increased rates as long as inflation remains elevated, and they continue to deal with many lingering operating disruptions from the pandemic. Until these challenges subside, new construction will be less attractive than it was previously, and the prospects of buying will be more attractive. Depending on market conditions, acquisitions paid at prices equivalent to very high multiples of revenue might be the more affordable option compared with the price tag for new construction. Management teams and boards will need to design capital plans with care and diligence to properly weigh the pros and cons in a build-versus-buy analysis.
Footnotes
a. St. Louis Fed, “Producer price index by industry: building material and supplies dealers,” U.S. Bureau of Labor Statistics, Aug. 13, 2024.
b. Griffin, S., “Hospital construction costs increase,” Health Facilities Management, Jan. 28, 2024.
c. See, for example, Gordian, “Healthcare construction costs for 2023,” Building Design + Construction, April 13, 2023.
d. Davis, A., McDonald, B., Walker, B., Marty, K.M., Is your health system team ready for what’s next? A recession or more malaise? Juniper Advisory, Aug. 8, 2023.
e. Based on Juniper Advisory and Blue Owl estimates.
f. Based on Juniper Advisory and Blue Owl estimates.
g. For a definition of transaction multiples,” see Corporate Finance Institute, “Transaction multiples, 2015 to 2024.
h. “The high cost of building California hospitals,” Scripps in the News, April 18, 2023.
i. PR Newswire, “Novant Health to acquire three hospitals from Tenet Healthcare,” News release, Nov. 17, 2023; and Ashley, M., “Adventist completes acquisition of 2 Tenet California hospitals,” Becker’s Hospital Review, March 29, 2024.
j. Data were drawn from a periodically updated roster of transactions provided by Scope Research (scoperesearch.co).
