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Hospital-Physician Leasing Arrangements: If You’ve Seen One, You’ve Seen One

May 24, 2017

Structuring legally compliant hospital-physician leases and establishing fair market value (FMV) rental rates can be challenging. This is especially true given that scrutiny has increased greatly over the past decade, with the government taking aim at fraud and questionable arrangements and more fervently enforcing the Stark Law and Anti-Kickback Statute (AKS). When regulatory and reimbursement pressures are combined with the wide variety of leasing arrangements, it’s easy to see why obtaining an independent valuation can be a prudent move.

Leasing arrangements can include many different variables (space, common area expenses, equipment, staff, etc.) and can have very different utilization (time-share, part-time, shared space, etc.).

Given all of the many variables, a professional valuation can further provide parties with an opinion of FMV value based on current rules and alternatives while also taking into consideration the many differences that require consistent and reliable adjustments and understanding of the financial and market conditions affecting FMV lease rates. The result is defensible peace of mind, particularly in light of the wide variety of leasing arrangements.

Leasing Arrangements Come in All Shapes and Sizes

No two leasing arrangements are the same, but all fall suspect to scrutiny because they provide an opportunity for violations of Stark or AKS. By understanding some of the intricacies and red flags therein, organizations can avoid unintended regulatory violations. Let’s examine some of the most typical arrangements.

Time-share arrangements are common in rural and other less populated areas, where patient volume doesn’t warrant full-time specialty coverage. In these cases, physicians don’t want to enter into a full-time lease arrangement if they are using space on a part-time basis. By entering into a time-share arrangement with a physician or physician group, a hospital can offer specialty coverage to its patients, and the cost of the lease is reasonable for the physician based on the physician’s utilization needs. If structured appropriately, a time-share arrangement can provide a higher standard of care for the hospital’s local patient population and address the requirement for the arrangement to be “commercially reasonable” under the Stark Law.

Full-time arrangements occur when a physician/physician group desires office space on site at the hospital, with the hospital acting as the landlord.

Whether full-time or time-share, the leasing arrangements can be structured to include a payment for the provision of a variety of resources such as space, staff, and equipment. In addition, the payment may include supplies, support staff, or other operating expenses. 

At inception of the arrangement, a one-time payment for leasehold improvements is sometimes included, as well, if the hospital intends to have the physicians share in the costs to remodel the space. As the resources included in the lease change, the FMV of the arrangement changes. Therefore, it is important to understand the specific parameters of every lease to provide an opinion on the FMV and commercial reasonableness of a particular arrangement.  

Time-share lease arrangements can be hourly, daily, monthly, or annually, depending on the terms of the lease and the frequency of use. However, the premium that would be warranted under FMV parameters is larger when the relative utilization is lower. For example, an hourly lease rate would warrant a higher premium than a daily lease rate.  In addition, the overall utilization and ability of a health care system to “fill” the time slots available will also affect the relative rate that would be charged to the various users of the space being leased. 

Some health care attorneys have been uncomfortable with hourly rates for time shares, since the argument could be made that hourly rates too closely resemble payment for volume (and ultimately referrals). Therefore, many legacy time shares are set up for a minimum of a half day (four-hour block).

Historically, there had been an exception under the Stark Law for leasing arrangements. It generally required that the agreement had a fixed schedule, that it was for more than one year, and that it provided for exclusive use of the resources.

In late 2015, a new Stark exception[1] was created, allowing more flexibility for hospitals and health systems to share space, staff, equipment, and other resources without violating Stark.

However, compensation for time shares must still be:

  1. Set in advance.
  2. Consistent with FMV.
  3. Determined in a manner that excludes volume/value of referrals.

Key Valuation Insights

As mentioned, lease arrangements can be challenging because of the differences in space and amenities included in the lease rate. Following is a list of information that is normally considered when assessing FMV of a lease arrangement:

  • Appraisal of the underlying assets (real estate, equipment, etc.)
  • Cost basis of the underlying asset, including the date purchased
  • Market rates for similar space per square feet
  • Square feet of the exam space utilized
  • Square feet of the common areas such as waiting rooms, hallways, etc. and number of parties sharing the common areas
  • Expenses relating to the space utilized that are included in the lease, such as utilities, maintenance, cleaning, property taxes, etc.
  • Comparison of rental income charged to the expenses associated with the space
  • Occupancy percentage of the space and the ability of the lessor to lease the space to other parties when not leased by the lessee
  • Services or supplies included in the lease rate, such as receptionist, computer utilization, copiers, medical supplies, etc.

Such lease arrangements require more than an understanding of traditional lease arrangements. The valuation of lease arrangements also requires an understanding of the fixed assets valuations, real estate appraisals, and health care business valuation/compensation valuation.

A combination of the cost and market approaches is often used to value leasing arrangements. An appraiser will want to review cost information for the building, equipment, and staff. In addition, market information for the lease of similar space, real estate and fixed assets appraisals, and market staff compensation should be reviewed and considered in the analysis. The appraiser should ensure that the square footage for the space includes the exam rooms and physician offices as well as an allocation of the common area.

The appraiser should also verify that the lease payment is covering the cost of the various expenses relating to the lease; otherwise, this could raise a red flag with regulators because it would not be reasonable for lessors to lease space if they lost money on the lease arrangements. An understanding of the related expenses is necessary to ensure support for the FMV of the lease. 

Once the costs and market values for the various resources are reviewed and correlated to a value, the appraiser should consider a premium to be charged for the related vacancy or the reasonable profit that would be expected under FMV parameters. Since the hospital is acting as a leasing company, the hospital should be expected to receive a profit from the provision of the services. 

Different premiums or markups are often applied for full-time arrangements versus time shares, with full-time arrangements generally having lower markups. This is intended to account for the full-time occupancy of the space, which prevents the hospital (the landlord, in this case) from experiencing vacancy risk. An appropriate analogy would be rental car rates, where daily rates to rent greatly exceed the implied daily cost of owning a car. In addition, discounts may be taken for full-day versus hourly arrangements.

From Complicated to Compliant

Lease arrangements between hospitals and physicians can be a simple concept but can quickly become complicated as a result of the various nuances of each lease. It is important that hospital decision makers and health care attorneys work with appraisers who understand the differences in lease arrangements to ensure the lease arrangements are consistent with FMV as required under the Stark exception for hospital-physician arrangements. Engaging an experienced valuator can help organizations spot issues, manage expectations, and provide support for the lease rates if regulators come calling. Just like normal lease arrangements between lessors and lessees, lease arrangements with physicians should be reviewed on a regular basis to ensure they are based on current market conditions and that they factor in any changes in utilization. 

If your organization is due for a review, Wipfli has appraisers who understand the nuances of lease arrangements and can help ensure the arrangements can be supported from fair market value and commercial reasonableness perspectives. 

[1] See 42 CFR 411.357(y)


Francis P. Egan, CFA, ASA
Senior Manager, Valuation Litigation and Transaction Services
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