Chapter 2: Hospitals, corporate real estate management and alternative real estate financing structures

Healthcare systems across the globe are under continuous reform. Thus, it is important to note that healthcare systems are still evolving. Moreover, in Europe a distinction is made between so-called Bismarck "mixed" and Beveridge healthcare models. Bismarck systems are based on social insurance, and characterized by a multitude of insurance organizations, who are organizationally independent of public and private healthcare providers. Examples are such as in France, the Netherlands and Germany ("Krankenkassen").

In Beveridge systems, however, financing and provision are handled within one organizational system and based on taxation. This implies healthcare financing bodies and providers are completely or partially within one organization, such as the National Health Service (NHS) in the UK and Spain (Lameire, et al. 1999; Finfacts, 2007). Throughout history, healthcare systems across the world have evolved from Bismarck into Beveridge systems and vice versa. Usually, such reforms are a bone of contention.

A recent example is the highly controversial debate in US politics on reform of the American healthcare system, which is unique in its application of the Private Insurance model (Lameire, et al. 1999). Democrats have long called for a universal health insurance program, which involves the expansion of coverage and restricting the power of insurance companies. Proponents argue that health insurance should be affordable and accessible to all, while opponents (mainly Republicans) fear too large a role of the government and the use of tax money to finance the - arguably - enormous costs involved. Both parties seem to agree that the power of insurance companies should be restricted by banning underwriting practices that prevent many Americans from obtaining affordable health insurance.

However, though U.S. president Obama has praised various aspects of the Dutch social security-based (Bismarck) healthcare system, a similar evolution of the American healthcare system yet has to commence (NY Times, 2009).

This section begins with a brief historic overview of the Dutch hospital (or cure) sector, with a focus on its evolution. Second, the interdependencies between healthcare real estate, (strategic) corporate real estate management, and alternative real estate financing structures will be elaborated upon by using corporate real estate management (CREM) theory and comparing various sources from academic literature.

These are intertwined since healthcare heavily depends on real estate as a resource in fulfilling its core business activity. By opting for alternative ways to finance real estate, hospitals are able to free up additional capital to support their clinical activities. As the Dutch healthcare system currently is under reform and hospitals become responsible for real estate investments themselves, they are under increasing pressure to consider more cost-efficient options and enhance their competitive position. Alternative real estate financing structures such as public-private partnerships, where hospitals profit from the knowledge and experience of private sector parties through various partnership agreements, could provide a alternative feasible alternative here to more traditional real estate financing structures. For example, hospitals could opt for a sale-lease-back agreement, where hospital real estate is sold to a private party and leased-back to the hospital for an annual fee.

By analyzing the above, this theory and literature review will provide the reader with an answer to the following sub-questions:

  1. How are Dutch hospitals regulated and financed?
  2. How can corporate real estate management add value to hospital real estate?
  3. How do alternative real estate financing structures relate to hospital real estate?
The Dutch hospital sector

The origins of healthcare in the Netherlands can be traced mainly to the activities of voluntary organizations, which often provided healthcare on a charitable base.

These organizations used to be run mainly on religious or ideological foundations, resulting in the creation of healthcare facilities with a Protestant, Roman Catholic, Jewish or humanistic foundation (Folter, 2002).

The Dutch healthcare tradition reflects the changing relationship between the government and voluntary organizations. Dutch hospitals largely originated from private and often charitable initiatives; virtually all are non-profit and most are still private organizations. However, today they are no longer organized along denominational lines.

Though private ownership predominates, the Dutch government heavily regulates the healthcare system. In the postwar era of the 1950s, there was a focus on hospital construction, part of the broader effort to rebuild the country. In 1971, an extensive planning system was undertaken under the Hospital Provision Act (WZV) to regulate hospital capacity, the main motive being that many people felt hospitals were too concentrated in the urban areas and too few were located in other parts of the country (Den Exter, et al. 2004).

Planning, regulation and management

In the 1960s and 1970s, the expansion of health technology and healthcare resulted

in a steep increase in health care costs. The main cause of the cost increase was attributed to the building of new hospitals and healthcare institutions.

The Hospital Provision Act (WZV) of 1971 became the Dutch government's most important hospital planning tool, enabling the government to regulate construction of all healthcare institutions. The responsibility for its implementation was allocated to the provincial health authorities.

The overarching goal of the WZV was to regulate the supply and promote the efficiency of hospital care. Hospitals were not to be constructed or renovated without successfully passing a declaration and licensing process. Approval of the building project rested on a detailed plan for each hospital service affected in a specific geographic region, which included a description of the existing service capacity, the suggested change of capacity, and a schedule to complete the project.

The planning process began with the issuance of an "instruction" from the Minister of Health, Welfare and Sport to the provincial government. The instruction described the categories of hospital facilities for which plans were to be developed, the geographical region covered, and the deadline to complete this. Provincial governments considered a number of regulations and guidelines in the process. Regulations related to the planning process and guidelines to the content of the plan.

Many stakeholders were involved in the formation of regulations, including hospitals, patients and consumer organizations, local authorities, and insurance companies.

In the initial stage, the provincial government prepared a draft plan. This plan included: an inventory of existing capacities; an evaluation of the existing situation in terms of shortages and weaknesses; a description of construction, renovation and expansion proposals; and an implementation plan and time schedule.

Subsequently, the draft was forwarded to the health minister for approval. The health minister, after counseling the Hospital Provision Board (CBZ), determined whether or not the draft was acceptable. The draft plan formed the foundation for the issuance of so-called acknowledgements, which allowed hospitals to receive reimbursement for services from health insurers.

The drawbacks of the initial hospital planning process under the Hospital Provision Act (WZV) were its complexity and lack of flexibility. Therefore, in January 2000, in order to improve the planning process, a new Act, the Special Medical Procedures Act (WBMV), came into existence. The focus of this Act was on quality of care rather than cost containment and aimed at promoting healthcare with maximum quality and minimum risk to patients at affordable cost (Den Exter et al., 2004).

Decentralization

According to Den Exter et al., in the Netherlands policy traditionally has been prepared and implemented by a massive "neocorporate bureaucracy", uniting government agencies, quasi-governmental organizations (the advisory and executive bodies), suppliers and providers in the private sector, and insurance companies. This national body has a significant degree of control over decisions regarding the number and distribution of hospital beds and specialist places, and on investment decisions and management costs in health care.

In the 1970s, centralized government coordination and planning became the leading principle in the Dutch healthcare system. However, the 1974 policy paper Structuring health care (Structuurnota Gezondheidszorg), contained proposals for decentralized administration by regional and local authorities (Second Chamber of Parliament, 1974). In 1986, the coalition government departed from the centralized model by undertaking major reforms, especially in the field of social health insurance.

The integration of different insurance schemes into one social insurance for all Dutch citizens (with largely income-related contributions) was a bone of contention.

The aim was to increase solidarity in healthcare financing.

Under these reforms, all insurance companies would function as independent and risk-bearing insurers and compete for insured patients under the same regulations.

A central fund ("centrale kas") was to provide budgets for all the insurers. A key issue in the reforms was the shift of the insurance risk from the public funding system to the individual insurance plan, justified by the "less government, more market" trend.

The shift of insurance risk involved a policy of transferring regulating competencies from the collective to the private sector, such as providers and insurance companies.

In the Netherlands, this policy is called "functional decentralization". This has mainly occurred in the cure-sector, which entails acute care and both specialist and general medicine. By means of negotiations and contracts, an increasing number of health insurers and providers have become important determinants in shaping and interpreting healthcare today, while the government and administrative agencies used to assume these roles in the past. This is emphasized by the new role assumed by medical specialists in hospital care. For example, they have acquired an independent coordinating position versus both hospital management and sickness funds (Scholten and van der Grinten, 1998).

Hospital budget reforms

In the Netherlands, today all hospitals and other healthcare institutions are required to have an overall annual budget. This is in line with the government's cost-containment policy. If the hospital exceeds its budget, there is no possibility of recalculation or compensation. Specialist fees are an exception to this overall hospital budget. Below follows an overview of the budget reforms that have taken place up until 2009.

Function-directed budgeting (1988 - 2000)

The old budget system, which was in use since 1988, was a function-directed budget system. The budget was divided in four cost components: location costs, fixed costs, semi-fixed costs, and variable costs.

Location costs concern infrastructure, for example buildings and equipment including depreciation and interest. In the old budget system, these investments required approval by the health minister under the Hospital Provision Act (WZV). Second, fixed costs are costs that do not generally vary with the activity volume. For example, the number of people served by a hospital in the region. Thirdly, semi-fixed costs are not affected by the scale of production of a hospital in the short run. These are capacity-based costs, and include the number of beds and specialist units. Finally, variable costs are directly related to the activity volume or the production ("production units") of the hospital.

Parameters for variable costs include admissions, outpatient visits, nursing days, day care and day treatments (Den Exter et al., 2004).

In the old system, the hospital budget was determined as follows:

  • Number of persons in service area (x tariff)
  • + number of licensed hospital beds (x tariff)
  • + number of licensed specialist units (x tariff)
  • + negotiated volumes of production units, for example hospital admissions (x tariff), inpatient days (x tariff), first outpatient contacts (x tariff), day surgery (x tariff) and special treatments (x tariff)

Tariffs varied with hospital size, implying larger hospitals were allocated higher tariffs than smaller hospitals.

In addition, hospitals were allocated capital expense budgets. For example, rebuilding projects and new hospital construction projects were covered by a 100% mark-up applied for 50 years. This implies payment was guaranteed for 50 years through a mark-up in the day rate. As a result, hospitals were not exposed to financial risk regarding major capital expenses. Further, hospitals received a standardized budget for small investments, such as maintenance. These investments did not require the approval of the health minister.

Performance-driven budgeting (2000 - 2005)

Until 2000, hospitals still received the full budget when it produced less inpatient days than estimated under the principle budget=budget. However, this was changed into a performance-driven payment system implying hospitals would get paid less if they would produce less inpatient days than agreed upon with health insurers. The underlying notion of this change was to increase hospital production, in order to put a halt to waiting lists.

However, this transition brought a number of new problems along:

  • Hospital budgets were unable to keep up with the increase in demand for hospital care. While patients paid insurance, they were unable to benefit from hospital service directly because of waiting lists.
  • The admissions, inpatient days and day surgery tariffs used to set the budget proved completely artificial, not reflecting true costs.
  • Incentives for efficiency were weak.
  • The budgeting system did not stimulate hospitals to inform insurers and patients about their performance. This is a politically sensitive issue, as hospitals received extra money to combat waiting lists but were reluctant to explain for what goals they used this money.
DBC-budgeting and dot (2005 - present)

Therefore, a new gradual transition is currently taking place to a Diagnosebehandelings-combinatie (Diagnosis Treatment Combination, DBC) financing system. The DBC system has the following implications: a transition to output pricing with defined and priced patient-treatment categories; location costs remain fixed and all other maintenance costs will be integrated into the location cost center of hospital budgets (set by the College Tarieven Gezondheidszorg, CTG, Healthcare Tariffs Council); and hospitals are contracted by sickness funds based on patient-treatment categories. The main notion is that hospitals are reimbursed for the costs they incur resulting from medical treatments. The DBC-A segment tariffs (acute care) remains government regulated (through the NZa, Dutch Healthcare Authority) and concerns acute care, whereas hospitals are largely free to negotiate tariffs with healthcare insurers in the DBC-B-segment (non-acute care) in an effort to promote market forces. Currently, about 34% of the DBCs is allocated to the B-segment; the Dutch Health Ministry aims to increase this proportion to 50-60% by 2011 (Van Poucke, 2009).

The DBC system is comparable to the DRG (Diagnosis Related Group) system used abroad. However, there are a number of differences:

  • DRGs are coded at the beginning of the treatment, while DBCs are coded afterwards.
  • A patient can be coded in more than one DBC.
  • In the DBC system the coding is not done by special personnel but by a medical specialist.
  • The physician salary is included in the DBC, giving physicians an incentive for "upcoding".

In the DBC system, more flexibility is granted to parties that negotiate at the local level on production, number of treatments, and number of specialists. Furthermore, efforts are being made to integrate the fee-for-service system for specialists and the hospital budget system into a single integrated budget (Den Exter 2004).

However, since the system is still in early development, the effects of DBC financing on hospitals are still ambiguous. As a result, improvements have been proposed which will be implemented as of January 1 2011 under the DOT (DBCs Op weg naar Transparantie, DBCs on the road to Transparency). This implies that the 100,000 DBC products will be sized down to only 3,000 in order to increase transparency for the patient, healthcare practitioners and healthcare insurers (DBC Onderhoud, 2009).

Real estate investment reforms

Until 2008, the Dutch healthcare system applied a publicly supported healthcare real estate budget system. However, since 2008, Dutch healthcare institutions have become financially responsible for the return and risks of their real estate investments (see Chapter 5: Real estate investments).

Moreover, the Dutch healthcare system is changing toward a regulated market system with increased competition between healthcare providers. According to Van der Zwart et al. (2009), these developments are likely to change the way healthcare institutions will manage and finance their real estate, the location choices they make and the building typology they choose. Furthermore, real estate is becoming an increasingly strategic "fifth" source of profitability and overall performance, similar to capital, human resources, information and technology (see figure 2.1). For hospitals, considering and using real estate as a strategic production asset can reap added value, as will be explained in section 2.2.2.

Financing hospital real estate: from supply-driven to regulated market forces

As health insurers now negotiate quality and quantity agreements with hospitals and patients are broadening their horizons, the importance of an integrated approach to the "product" hospital care. Hospitals should be able to use their real estate as a distinguishing element in attracting customers (the patient). As a result, real estate is being transformed into a strategic resource for hospitals as well and hospital executives are paying growing attention to real estate management, including location management (what to do where), business plans (do investments yield positive returns) and real estate asset valuation. Building plans are based on functional clustering: hospitals divide new buildings into "hotels" (patient rooms), "hot floors" (operating rooms), "offices" (simple treatments, patient consults), and "industrial plants" (medical support/facilitating functions). As hospitals are no longer required to own their real estate assets, some are seeking partners willing to take over some of their real estate management (Windhorst 2006).

The Dutch government used to be in charge of allocating the budget of healthcare real estate investment, but is moving toward a regulated market system to keep healthcare affordable in the future. This deregulation gives healthcare institutions the opportunity to make their own decisions, translating into more individual responsibility and a higher risk exposure of investments. The government no longer guarantees financial support for real estate investments, and thus real estate investments have to be financed by the production and delivery of healthcare services. As a result, the need for competitive advantage will also increase (Van der Zwart, et al., 2009).

The Dutch government used to apply a strict approval system in the former real estate budget system in order to regulate the capacity and costs of hospital health care. All initiatives to build, renovate or demolish a hospital building were evaluated "in terms of their fit with a regulated overall capacity per service area, square meter guidelines per hospital bed and per function, and a maximum standard of costs per square meter" (Van der Zwart, et al., 2009: 2). The initiatives were approved by the Minister of Health, Welfare and Sports, who was advised by the Netherlands Board for Healthcare Institutions. The real estate capital costs (depreciation, rent, maintenance costs and so on) were guaranteed by the government. The healthcare provider's real estate budget was independent of the production of healthcare services.

According to Van der Zwart et al., hospitals did not bear any responsibility for the risks of their real estate investments in the old system. Furthermore, they were not responsible for the running costs and a possible deficit if production decreased. As a result, hospitals attempted to obtain the maximum amount of square meters and were not encouraged to be either cost efficient or cost effective. In March 2005, the Dutch Minister of Health, Welfare and Sports announced the modification of this real estate budget system and the introduction of a healthcare system with regulated market forces (Hoogervorst, 2005). The main goal is to keep healthcare affordable by stimulating competition and, as a result, reduce healthcare costs.

This deregulation provides healthcare institutions with more flexibility in the briefing, design and management of hospital buildings and real estate investments. Similar to the old system, private not-for-profit initiatives are still the main force behind the capacity of hospitals, but in the new system hospitals are themselves responsible for the return on real estate investment and the effects of real estate decisions on utility value, investment costs and running costs. Since January 2008, hospitals have to finance real estate investments and capital costs from their product and service revenues. This implies a switch from a "centrally steered real estate budget system with governmental ex ante testing of building plans and investment proposals ... into a performance driven and regulated finance system on the output" (Van der Zwart, 2009: 3).

To ensure a smooth transition, there is a transition phase until 2012 with a standardized and maximized budget for capital costs per m².

This trend will have a strong effect on the briefing, design and management of hospital real estate (Van der Voordt, 2009). Hospitals will get new opportunities while experiencing higher risks at the same time and hospitals will have to aim more at competitive advantage. Furthermore, partnerships with private partners will be more common. According to Fritzsche et al. (2005) and van Hasselt (2005), this transition has a number of implications, as illustrated in table 2.1 and figure 2.1.

Moreover, "organizational changes (e.g. mergers and network organizations), demographic changes (ageing of the population, multicultural diversity), technological developments (e.g. new medical equipment, new installation techniques), fluctuations in the economy and changing views on healthcare and the responsibility of government, healthcare organizations, market players and healthcare consumers play their role, too" (Van der Voort, 2009: 2). As a result of mergers and the growth in hospital functions, hospitals are likely to grow even larger than before. Van der Voordt argues that all these changes affect the healthcare real estate stock and cause a need for new health care real estate management strategies.

Christensen et al. (2000) warn for the entrenched and change-averse nature of healthcare systems. They argue governments and institutions should be more open to business models that may seem to threaten the status quo at first, but will eventually enhance the quality of healthcare for the end-user: the patient. New institutions with "disruptive" business models adapted to new technologies and markets should replace entrenched and old-fashioned institutions. Thus, they conclude that government and healthcare sector leaders should help insurers, regulators, hospitals and health professionals to facilitate disruption instead of preventing it.

Current challenges

The practical implications for hospitals of the current transition to a new healthcare system in terms of capital financing and real estate investments will be further explained in chapter 4 and 5. First, the following section will elaborate on the theoretical foundations of corporate real estate management.

Corporate real estate management

In order to make well considered decisions with regard to new building projects, rebuilding projects and the sale of real estate property, a deep knowledge of the real estate property and the many related internal and external developments is required.

For example, what actions need to be taken in order to eliminate or reduce discrepancies between demand and supply? And how effectively does real estate support the main business processes?

Corporate Real Estate Management is one of the disciplines that addresses such questions. The key issue at stake here is to align the supply (e.g. locations, properties) with the requirements related to the primary process (demand) and the strategic goals of the organization. The overall aim is to create maximum added value for the organization while ensuring a maximum contribution to total organizational performance (Van der Voort, 2009).

Increasingly, (corporate) real estate is becoming a substantial resource for firms and other institutions. For example, firms are looking at real estate to provide both stability and capital growth to their portfolios.

It thus presents an attractive return compared to the volatility in equity prices (DTZ, 2006).

Already in the early 1990s, researchers began to call attention to the largely unrecognized importance of corporate real estate to many businesses. They pointed at the substantial balance sheet value of real estate and the large proportion of operating expenses resulting from real estate services (Roulac, 2001). For example, Veale (1989) concluded corporate space costs account for 10% to 20% of operating expenses or nearly 50% of net operating income.

In their paper, Rediscover your Company's Real Estate, Zeckhauser and Silverman (1983) estimate corporate real estate accounts for 25 to 40 % of the total assets of the average firm. Many firms underestimate the intrinsic value of their real estate portfolio, even though the magnitude of costs related to owning properties are second only to payroll costs (Veale, 1989). Zeckhauser and Silverman's survey results mention 7 important steps a firm can take to make more efficient use of its real estate assets. For example, firms should manage real estate responsibly and set achievable goals in order to generate profits from its real estate assets or limit costs. Furthermore, a firm's choice of real estate activities other than managing property depends on the nature of the business it operates in and the historical record of its real estate portfolio. This implies that firms that more heavily depend on real estate for their business activities might be more actively involved with their property management. Zeckhauser and Silverman conclude that every firm should review and adjust its real estate policies to reconcile operating objectives with real estate values and opportunities, and evaluate the intrinsic value of its property.

Though the return on real estate is generally lower than the return on the core business activity, real estate may provide other forms of added value, such as efficiency and effectiveness of the activities in the firm. Kaplan and Norton's (1992) balanced score card approach describes the performance of a corporation as being defined by a combination of financial, internal business, customer, and innovation and learning perspectives.

In addition to the financial value of real estate, unique characteristics such as the design of a building transform real estate into an asset that can be difficult to imitate, substitute, or trade. Furthermore, the physical image of a building may function as a marketing tool, attracting attention to a firm's services. Thus, when buildings reflect the business' purpose and promote important work relationships they can contribute significantly to corporate strategy and serve to distinguish a firm from its competitors (Krumm & de Vries, 2003).

Strategic corporate real estate management

Roulac (2001), with his Aligning corporation real property with corporate strategy-model, links real estate strategies with sources of competitive advantage.

A corporate business strategy addresses key elements such as customers, employees and processes.

A corporate property strategy affects employee satisfaction, production factor economics, (realized and foregone) business opportunities, risk management decisions and other effects on business value.

Thus, it is crucial in enhancing or inhibiting the company's expression of its core competency and the extent to which it can realize its core capabilities to their full potential (Roulac, 2001).

The existing scientific research in this field has resulted in the conclusion that it is generally more advantageous for firms to rent, rather than own the real estate they use, enabling them to free up capital to invest in the things they are good at (Brounen and Eichholtz, 2003). The shares of firms who sell their real estate typically outperform the average and firms with large corporate real estate holdings are typically associated with relatively low performance.

However, within the field of real estate finance, little research has been conducted on the effects of alternative real estate financing structures on the performance of non-profit organizations, such as hospitals. Though Eichholtz and Kok (2007) examined the performance effects of alternative real estate financing on the American senior healthcare sector, little is known about the performance of hospitals owned and/or operated through alternative real estate financing structures such as, for example, public private partnerships (PPPs).

In 1993, real estate expert Michael Joroff (1993) expressed the need for a move in real estate management from a purely operational approach to a more strategic one, including a strong emphasis on the role of real estate in achieving corporate goals. According to Joroff, this requires a switch from a day-to-day focus on building management ("manager") and controlling accommodation costs ("controller") towards standardized real estate utilization ("trader"), adapting real estate assets to the market ("entrepreneur"), and eventually ensuring strategic real estate decisions contribute to corporate goals ("strategist"). See figure 2.2 below.

An organization often finds itself in a combination of different stages. According to Fritzsche (2005) hospitals still need to make the move to the upper stages. Thus, when hospitals make a transformation to more business-like entities, they will find themselves in the entrepreneur or strategist stage. However, it is debatable whether hospitals should be located in the final stage, as hospitals in essence are non-profit foundations and do not have the same goals and core-business activities as business organizations. This is where the classical debate regarding public versus private provision of a public good (healthcare) enters the arena; this will be discussed further in section 2.3.

The added values of real estate

According to De Jonge (2002), several ways exist through which a well-designed building can result in significant added value to an organization (see table 2.2 below).

He describes seven value-adding elements through which real estate can be transformed from a "cost of doing business" to a true corporate production asset. These elements improve the competitiveness and performance of core business activities and comprise both "hard" (production, cost, risk and financial factors) and "soft" (flexibility, culture, image) factors that determine the value contribution of real estate as a production factor.

With - on average - 60% of total assets being represented by real estate on their balance sheet, hospitals depend on their real estate assets in providing their product healthcare. For example, a hospital cannot function without operating and patient rooms. The substantial value of real estate and its contribution to the hospital's core activity make it a significant production resource for hospitals, with which they can reap profits and competitive advantage if used optimally.

Ambrose (1990) examined the role of real estate in corporate takeovers. He argues corporate real estate assets increase the probability of firms becoming takeover candidates. Brounen and Eichholtz explain that corporate raiders apparently are aware of the added value acquired through restructuring of corporate real estate assets that are managed suboptimally. In the Dutch hospital sector, various (real estate) companies and consortia are making first steps to taking over hospitals. Examples are the Slotervaart Ziekenhuis, taken over by Meromi Holdings, and IJsselmeerziekenhuizen, acquired by the MC Groep of healthcare venture capitalist Loek Winter. The MC Groep is currently in the process of considering other hospitals for takeover. From 2012 on, hospitals will be allowed to pay dividends to shareholders, which allows corporate raiders to earn back their investment (Bruinsma, 2009).

The present transition towards open market competition with growing autonomy of healthcare organizations offers hospitals - and private sector parties alike - an opportunity to put a stronger focus on the added values of real estate. This extends beyond focusing on real estate as simple "building bricks" to offering integrated solutions in maintenance, facility management and operations.

The practical implications of these developments will be further discussed in section 3.6 of Chapter 3: Capital financing.

Financial performance effects

As real estate represents a substantial proportion of corporate assets, it can impact the financial performance of a corporation in many ways. These include cost reduction, risk and shareholder value creation.

Cost reduction

According to Lindholm and Levainen (2006), the primary parameters used to determine the contribution of real estate are focused on cost reduction and capital minimalization. Cost minimalization and the facilitation of service improvement increase revenues and contribute to corporate profitability and value.

In order to control hospital real estate costs, the Dutch government has always applied strict criteria regarding the maximum floor area (m²) available per hospital bed and the maximum allowed construction costs per m².

On the condition that plans remained within these limits, little attention was paid to possible cost savings. As a result, hospitals were often stimulated to opt for the maximum possible amount of square meters.

After all, there was little incentive to spend less than the maximum permitted budget.

However, cost savings directly benefit hospitals and this presents interesting opportunities for market forces. Gradually, a transition from cost motivation to profit motivation and from cost control to performance facilitation and added value, seems to be taking place in the Netherlands and abroad. Though input parameters such as cost per m², cost per full-time equivalent, and m² per FTE or per workplace may indicate the degree of efficiency with which resources are used, they indicate little about effectiveness. Therefore, Van der Voordt (2009) argues, it is wise to not only look at square meter use but to consider potential benefits and the organization's goals and ambitions as well, when evaluating costs.

Risk & return

Real estate literature has offered a number of reasons to explain why firms that commit large amounts of capital to real estate could underperform because of their real estate exposure. First, non-real estate companies possibly use their real estate suboptimally.

When they use their real estate holdings inefficiently, these firms may not be earning a sufficient risk-adjusted return on their real estate assets. If this is the case, one would expect all firms with comparatively large real estate holdings to yield lower returns.

Secondly, it is possible that investors do not want the risk profile of a non-real estate firm to be changed by an investment in real estate assets and prefer to diversify risk more cheaply on their own accounts.

Since the beta of commercial real estate is estimated to be around 0.8-0.9 (Gyourko and Keim, 1992), relatively risky and high cost of capital firms would be impacted most intensely, whereas firms in industries with systematic risk equal to that of commercial real estate should not be affected at all under this scenario.

Thirdly, investor ignorance could be a reason for underperformance of firms that invest large amounts of capital in real estate ownership. Deng and Gyourko (1999) state that in this case, only firms in industries with costs of capital higher than that for commercial real estate would be negatively affected. As a result, if investors in these firms are not fully aware of the lower risk associated with real estate ownership, they discount the real estate investment at too high a rate.

Conversely, firms in industries with less risk than that of real estate would yield increased returns.

Thus, how would these findings relate to firms or investment trusts that invest all or part of their capital in real estate assets of hospitals?

Deng and Gyourko argue that risky, high cost of capital firms could suffer lower returns since the allocation of scarce corporate capital to real estate ownership may constitute a poor duration match with the firm's product cycle. Since these firms tend to be subject to more volatility over their production cycle, their real estate needs are likely to vary a lot over the cycle as well. They argue that real estate ownership implies a long-term commitment of scarce corporate capital that may provide an inappropriate match with the firm's capital requirements over the cycle. For example, it could result in the firm missing out on profitable projects, leading to lower returns in the long run.

Deng and Gyourko find a statistically negative relation between the idiosyncratic component of firm return and the amount of real estate owned for high cost of capital firms.

According to Markowitz's (1952) portfolio theory, due to real estate's low systematic risk (beta) including real estate assets in corporate portfolios should result in reductions in systematic risk. Therefore, real estate ownership is likely to affect the risk and return profile of firms investing in hospital real estate assets by decreasing its beta. As such, its cost of capital should decrease as well (see for example the case of the Australian Mildura hospital in section 2.3).

Table 2.3 below illustrates the (stock) performance of some major American and German hospital companies, including their market capitalization, return on average equity and assets (ROAE and ROAA), debt/equity ratio, beta and credit ratings, and net profit margin. Compared to the American hospital companies, Rhön Klinikum and Fresenius reap a relatively high ROAA, and, with the exception of LifePoint, a low D/E ratio. The overall high D/E ratio probably is a result of the consolidation in hospital sectors, with hospital companies issuing large amounts of debt to take over potential new candidates and reinforce their competitive position. Yet, apart from HMA, all credit ratings are investment grade, implying the default risk is low. Finally, the stocks of the American hospital companies in this example are more volatile, possibly because the US stocks market is characterized by more systematic risk. Apart from HMA, this does not result in a higher ROAE compared to the German hospital companies. The low betas of the German hospital companies potentially indicate these have less trouble in financing their real estate holdings with cheap debt or, vice versa, the real estate holdings of these companies cause a decrease of their beta through higher leverage.

On a macro level, Brounen and Eichholtz (2003) examined relationships between corporate real estate ratios, return and risk for a wide array of industries based in nine countries, including the healthcare industry. Their sample included 75 healthcare companies ranging from Australia to Germany and the United States, yielding an average return of 17.5% and a beta of 0.62. They show that the corporate real estate ratio of healthcare companies is negatively correlated with average total return and asset beta, but positively related to debt ratio. Further, their results indicate a negative relation between leverage and firm risk.

The United States and German hospital sectors know a more longstanding tradition regarding publicly-listed hospital companies and private hospital ownership and, in that sense, are difficult to compare to the Dutch situation. As of now, there is no evidence from the Dutch hospital sector as no single hospital is owned or operated by publicly-listed hospital companies. However, both the German and Dutch healthcare systems are based on the Bismarck financing model and have similar foundations. As such, evidence from the performance of German hospital companies could be an interesting benchmark when a similar trend occurs in the Dutch hospital sector.

Shareholder value creation

According to shareholder value theory, maximizing the wealth of the shareholders creates value to the firm. Therefore, a firm should aim at maximizing shareholder return, as measured by the sum of capital gains and dividends, for a given level of risk or reduce the risk with the same level of income (Jensen, 2001). However, value maximization as a corporate driver must be complemented with a corporate mission and strategy, and objectives that help a firm achieve dominance in the competitive arena. Lindholm and Levainen (2006) argue that a business strategy directs all functional areas of a firm, including real estate (see figure 2.3)

Real estate decisions are optimal when they reflect an appropriate balance between the shareholder's and the user's perspective of the firm's real estate portfolio (Pfnuer, Schaefer, and Armonat, 2004). A proper management of corporate real estate begins with an inventory and valuation of current facilities. Lease versus own decisions can have a direct impact on shareholder value (Allen, Rutherford, and Springer, 1993) and must be made while considering both real estate users and the main long run strategic and financial objectives.

Though hospitals in the Netherlands are not yet publicly-listed and shareholder value creation is not yet a key issue, this may change in the near future as a result of alternative capital financing structures, such as a commercial holding structure. This will be further explained in Chapter 4: Capital financing.

Alternative real estate financing structures

Currently, the increasing costs of Dutch healthcare coupled with the ageing of the population have resulted in a heated debate with regards to the future of the Dutch healthcare system. Some have called for the introduction of private sector parties to the Dutch hospital sector to improve cost-efficiency. However, others fear private parties will prioritize profit-motivated interests over quality of healthcare and argue a public service such as healthcare should remain in the hands of public parties.

There are various ways in which Dutch hospitals could profit from the knowledge and experience of the private sector. For example, the transformation of hospitals into profitable businesses, the partial privatization of hospitals, and the introduction of business techniques which the private sector can apply to the hospitals in order to increase efficiency. This will also affect the infrastructure and the real estate financing structure of hospitals (Bisschop, 2004).

Public-private partnerships

Across countries, there is increasing interest in a model in which a public institution contracts with a private firm to build and operate a hospital. Countries which have experimented with this model include Australia, Spain and the United Kingdom.

For example, private firms are made responsible for the hospital's infrastructure and for providing specific hospital services. This model is the so-called public private partnership (PPP).

In the UK, many hospitals are being built and/or operated through PPPs, since the government, which is responsible for healthcare provision via the NHS, lacks the financial means to do so.

If the Dutch government would opt for a PPP-based model, this does not, in fact, translate into a public-private partnership "pur sang", since Dutch hospitals already are private organizations (non-profit foundations or "stichtingen"). As such, this would imply a private-private partnership. In this case, there is no added advantage of savings on government expenses. However, it is interesting to examine whether a PPP could offer other advantages (Bisschop).

A PPP implies a private sector party is responsible for the exploitation of a hospital, however, this could be extended to other responsibilities, such as financing as well. The idea is that a hospital can free up additional capital, which it can invest in its core-activity, by having a private party exploit its real estate in more cost-efficient way. The main issue is whether a hospital PPP should solely focus on real estate exploitation (non-core activity), or should include healthcare provision (core-activity) as well.

A main feature of a PPP is the contract, which is essential to creating a tailor-made PPP model with measurable results. In general, the quality of the contract is determined by its completeness, i.e. the degree to which it covers for uncertain (risk) factors. For example, the British model aims at contracts that are as complete as possible. On aspects such as cost-efficiency and quality improvement, the incentives of the different parties to the contract determine the results. In reality, there are considerable incentives for cost-efficiency, which can be achieved by the private sector over time. However, the incentives for quality improvement, as desired by the public sector, are less concrete. Usually, a substantial part of ownership is allocated to the private party in the contract. In case of a PPP the different parties involved should cooperate as partners. As such, a contract should provide them with the incentive to prevent opportunistic behavior. Since the healthcare sector is dynamic and complicated, a PPP can create opportunities for flexibility. Flexibility is required in order to cope with complexities and to create synergies from the strengths of two (or more) partners.

A PPP is a positive NPV investment if it provides the public sector with a high price-quality ratio, i.e. value for money. This is mainly determined by the extent to which risks have been transferred. For example, in the past PPPs were mainly used for government services such as infrastructure. The most important transferable risks concerned construction, exploitation, maintenance, and demand. A hospital PPP transfers risks with regards to construction, availability/effectiveness, and the demand for healthcare.

The European Investment Bank examines to which extent the projects it finances contribute to the objectives of government policy. With regards to healthcare, this concerns the effectiveness of healthcare provision, the accessibility to the public and efficiency. These factors are important no matter the party that owns the hospital. According to the European Investment Bank, it is important to analyze the problems in Dutch healthcare first before a PPP is considered as a solution. For example, a lack of new capital, a lack of innovation, and ineffective exploitation of hospitals.

The Dutch government should be cautious when introducing the PPP model to the Dutch healthcare system, since Dutch hospitals already operate as a private legal person without the goal to make profit (EIB). The larger capital requirements of PPPs (shorter write-off terms, no financial government guarantees) have to be earned back through greater exploitation efficiencies. Thus, contracts should be designed as such as to stimulate the development of new healthcare models (Wright, 2004).

Another problem with hospital PPP constructions in the Netherlands is that hospitals are not required to pay 19 percent value added tax (VAT, BTW). Thus, when hospitals fully own their projects there is no problem since they do not have to pay VAT. However, when a private party (partially) owns the project they have to pay VAT but are unable to reimburse this. As a result, hospitals cannot profit from the 19 percent cost savings in PPP transactions. Therefore, when other costs are added up, a PPP should at least result in a 20 - 25 percent cost saving (compared to fully public project) in order to be profitable (Scheerder, 2005).

Recent experience in the netherlands

In the Netherlands, the Ministry of Health, Welfare and Sport and the Ministry of Finance have examined opportunities to use PPPs in the Dutch hospital sector in the form of DBFM(O)-contracts (Design-Build-Finance-Maintain-Operate).

The underlying notion is that the application of DBFM(O)-contracts in the development of healthcare real estate enables hospitals to focus on their core business activity - providing healthcare - and transfers building, maintenance and exploitation risks to specialized private parties. Though PPP-studies at the Groene Hart Ziekenhuis in Gouda (2005) and the Röpcke Zweers Ziekenhuis (2007; project value of € 40 mln), which is part of the Saxenburgh Groep, have indicated that the application of PPPs can have added value, DBFM(O)-contracts have yet to be applied in the Dutch hospital sector (Dutch Health Ministry, 2009).

International evidence

Other evidence of hospital PPPs is found abroad. For example, the Australian government selected a publicly listed hospital company to build, own, and operate a new public hospital under a 15-year contract, the Mildura hospital contract.

According to the contract, the private operator (Ramsay Healthcare) must provide free, universal access to all patients who come to the hospital. The Australian government grants the operator annual payments based on the prospected mix of clinical patients plus a small grant to cover costs such as teaching, while the operator is required to maintain the hospital's accreditation and is penalized in case of non-compliance with the contract. Since the initiation of the contract, the performance of the Mildura hospital has been impressive. Mildura's capital costs were 20 percent below those of publicly operated hospitals and the hospital manages to provide clinical services at lower cost than government owned hospitals. Furthermore, Mildura met all its performance targets, the number of patients increased by 30 percent during the first year of operation, and the operator made a profit (Taylor and Blair, 2002).

According to the latest PPP-progress report of the Dutch government, the Dutch healthcare system can draw valuable lessons from the experience obtained with healthcare PPPs abroad. It is important, however, to consider the differences between the various foreign healthcare systems and the Dutch healthcare system. For example, differences in healthcare specific expenses and expenses related to real estate, and the difference between healthcare financing based on social security (Bismarck) and taxes (Beveridge). As a result, the lessons drawn cannot be translated into uniform solutions for the Dutch healthcare system. The current reforms of the capital expense financing system of Dutch hospitals offer new perspectives with regards to the use of DBFM(O) and other constructions and emphasize the relevance of translating international DBFM(O) experience to the Dutch healthcare system (PPS Voortgangsrapportage, 2007-2008).

Figure 2.4 provides an overview of current PPP models used in the hospital sector. However, it is important to note that these are not mutually-exclusive: various alternatives incorporating different elements of the mainstream models have been used.

An ongoing debate

The foundations of the controversies regarding (hospital) PPPs lie in the classic debate between private and public procurement of a public service. Privatization of public services became more widespread in the 1980s with the emergence of neoliberalism, which aims at reducing the role of the state (Savoie, 1994). However, in the health sector privatization was perceived as a threat because of the existence of market failure (Arrow, 1963). Thus, governments rather opted for the separation of purchasers and providers instead.

In line with Williamson and Ouchi's conceptual argument that the public sector is less efficient and responsive than the private sector (Williamson, 1975; Ouchi, 1980), Preker et al. applied this to healthcare. They propose that if there is a low degree of contestability in providing a public service (e.g. ease of market entry) and if it is relatively difficult to measure the outcomes, it should be provided by a public party. Conversely, it should be purchased from the private sector (Preker, et al. 2000). However, this proposition is not fully supported by the evidence. For example, Australian research indicated that public hospitals are more efficient than those that are privately operated, possibly because of the more intensive patient management in private hospitals (McKee, et al., 2006). Another reviewed 149 comparisons of for-profit and non-profit health facilities in the US healthcare sector: 88 studies concluded non-profit facilities performed better regarding cost, quality, and access; 43 studies found no difference, and 18 concluded for-profit facilities performed better (Vaillancourt Rosenau and Linder, 2003).

Supporters of private procurement of hospitals highlight the example of the German publicly-listed Rhön Klinikum hospital company. This company, which currently owns 46 hospitals, succeeds in making substantial profit without compromising quality and access of care. Their real estate strategy plays a vital role here: capacity planning around care pathways (instead of beds) and building design that facilitates work process systematization (Rechel, et al., 2009a). These developments will be further discussed in section 3.6 of Chapter 3: Capital financing.

Case study: the Spanish healthcare system and the Alzira model

This section provides a brief overview of the Spanish healthcare system, which is characterized by a relatively longstanding hospital PPP tradition in continental Europe and a unique administrative concession model known as the Alzira model.

Historical overview

After the Spanish civil war, the Spanish healthcare system was marked by public healthcare provision within a social security system. An extensive, modern public hospital network was developed during the 1960s and 1970s. The public sector owned 70% of the available hospital beds, and employed 70-80% of all hospital doctors.

In Spain, responsibility for public health services has historically been attributed to the central government and, in particular, to the Ministry of Gobernación (Ministry of the Interior), dating back to 1855. The role of the government was to respond to health problems that were likely to affect the whole population, leaving personal healthcare in the hands of several healthcare networks.

Public health infrastructure and facilities changed only slightly, with waves of decentralization followed by recentralization.

In 1977 all health-related programs, departments and centers were merged under the responsibility of the Ministry of Health and Social Security. The 1978 Spanish Constitution confirmed the right of all citizens to health protection and proposed a new regionally based organizational framework. The basic constitutional goals were outlined as follows: to recognize the right of all Spaniards to a healthy environment and adequate public health services; to define the territorial division of powers in the fields of public health and healthcare; and to achieve an equitable territorial distribution of healthcare resources as well as in access to health care.

In 1982, the social democratic party PSOE won the general elections. The General Health Care Act (1986) introduced by the first PSOE Government (1982-1986) implied the transition from a system of social security (Bismarck model) into a National Health Service (NHS; Beveridge) model. Exempt from this act are three publicly funded mutual funds, MUFACE, MUGEJU and ISFAS, which deliver exclusively to civil servants in government departments. These mutual funds constitute a unique quasi-public position: civil servants have the freedom to choose between public provision within the social security network and fully private provision (Duran, et al., 2006).

The General Health Care Act confirmed the recognition of the universal right to public health care established by the 1978 Spanish Constitution. According to Duran et al. (2006: 18), it "defined the regionally based organizational framework and established the necessary provisions for the future integration of all public health care networks under the authority of regional governments".

During the late 1980s and 1990s, most of the reforms proposed by the General Health Care Act were gradually implemented.

Planning and distribution of infrastructure

In Spain, the decentralization of the health care sector has transferred most managerial and policy-making powers to the regions. There is no agency in charge of the overall infrastructure and planning with the exception of the Interterritorial Council of the NHS.

In 2003, there were 783 hospitals in Spain, of which 319 were owned by the NHS and employing around 336,000 people. Since less than half of all hospitals are publicly owned and public organizations own two out of every three beds, there are large differences in the sizes of public and private hospitals; usually, public hospitals are much larger than private ones. In 2002 the total number of hospital beds available was 158,500 (3.86 beds per 1000 inhabitants on average) (Duran, et al., 2006).

The Alzira model

The role of the private sector in capital investments in the NHS has been growing. This is, for example, manifested in the use of public-private partnerships. One of the first examples of public-private partnerships for capital investment facilities in Spain was the Alzira model in the autonomous community of Valencia, where an innovative hospital management mechanism was introduced.

The "administrative concession" model is the most radically innovative and controversial model developed by autonomous communities to provide health care services. This model was first introduced in Valencia to offer hospital care, but was later extended to include the management of both primary care and ambulatory specialized health care for the region's inhabitants (Duran, et al., 2006).

  1. Hospital care: 1999-2003
  2. On January 1 1999 the Spanish government granted a 10-year concession to a temporary consortium led by a private insurance and health services company, Adeslas, in exchange for the building and management of the Valencia-based Hospital de la Ribera hospital ($95 mln). This consortium - the Union Temporal de Empresas - was formed by Adeslas (51%), two banks (45%) and two construction companies (4%).

    Unique to the Alzira model is that it is publicly financed through capitation fees (see figure 2.5):

    • The company receives a yearly capitation fee from the Regional Health Department for each inhabitant in the healthcare area
    • The company is reimbursed 80% of the cost of treating patients from other healthcare areas
    • The company has to pay 100% of the cost of patients of the hospital's healthcare area being treated in other hospitals

    Up until 2003, the capitation fee estimated $300 plus an annual adjustment for inflation (Duran, et. al.; Rechel, et al., 2009a; Trescoli, 2008).

  3. Integrated care: 2003-2018
  4. The concession contract was changed in 2003, when it was renewed for another 15 years and now includes management of primary and specialist healthcare in the hospital's operating area as well. The investment amounts to $115 mln during the 15-year period and the capitation fee now constitutes $570 plus the % annual increase in the Regional Health Department's budget. Further, the internal profit rate is limited to 7.5% on investments annually (Rechel, et al., 2009a; Trescoli, 2008).

    With regards to risk transfer, the private company currently operating the Alzira hospital fully accepts the risk of negative financial outcomes. The operator states it was elected the best hospital of the year in its category 5 times. The evaluation criteria included quality measures and efficiency (Quiros, et al., 2009).

Conclusion

This chapter has provided answers to sub-questions 1, 2 and 3:

Hospital regulation and financing

In the old Dutch healthcare system, the Dutch government used to regulate hospital construction planning by means of the WZV (Hospital Provision Act), which was supply-driven. Over the past decades, a transition has taken place from centralization to decentralization, shifting power from the public sector, i.e. the government, to the private sector, i.e. healthcare providers and insurers.

Until 2000, hospitals received the full budget, implying payment was guaranteed and hospitals were not exposed to financial risk regarding major capital expenses.

In order to increase hospital production and combat waiting lists, this was changed into a performance-driven payment system, implying hospitals would get paid less if they would produce less inpatient days than agreed upon with health insurers.

However, the performance-directed budget system brought along new problems and proved to be inefficient and non-transparent. Therefore, a transition is currently taking place to a Diagnosebehandelings-combinatie (Diagnosis Treatment Combination, DBC) financing system. Implications include a transition to output pricing with defined and priced patient-treatment categories, and hospitals are contracted by sickness funds based on patient-treatment categories.

Until 2008, the Dutch government applied a publicly supported healthcare real estate budget system. Since 2008, Dutch hospitals have become financially responsible for the profits and risks of their real estate investments. This opens the door for open market competition and marks a transition from supply-driven real estate investments to regulated market forces.

Hospitals will get new opportunities while experience larger risk exposures at the same time and hospitals will have to aim more at competitive advantage. Partnerships with private partners will be more common. Other issues include demographic changes, technological developments, and changing views on healthcare and the responsibility of government, hospitals, market players and consumers. All these changes affect the healthcare real estate stock and cause a need for new health care real estate management strategies. Similar to business organizations, real estate has become a significant strategic "fifth resource" in determining profitability and operating performance.

The added values of corporate real estate management (CREM)

Through more market-oriented real-estate management, and the alignment of real estate strategy with business strategy, hospitals and other organizations can reap cost and efficiency advantages. It is essential to enhancing or inhibiting the organization's expression of its core competency and the extent to which it can realize its core capabilities to their full potential. For example, the real estate strategy determines to which extent a hospital is capable of using real estate as a strategic resource in providing its core "product" healthcare.

Corporate real estate management adds value to hospitals through increasing productivity, cost reduction, risk control, financing opportunities, increasing flexibility, changing the organizational culture, and PR and marketing. In the context of a more market driven hospital sector, it improves their competitiveness and the way they perform their core activity.

In addition, corporate real estate management can have a significant effect on the financial performance of an organization, especially through cost reduction, risk control and the creation of shareholder value. These parameters will become more important to manage now hospitals are experiencing increasing competition and some hospitals have made the move to a commercial business organization.

Alternative real estate financing structures and real estate investments

Healthcare systems abroad show evidence of alternative real estate financing structures. A well known example is the public-private partnership (PPP), where a private sector party is responsible for the building and/or exploitation of a hospital. The rationale is that hospitals can save up additional funds if its real estate is exploited by a private party.

The main issue is whether a hospital PPP should solely focus on real estate exploitation (non-core activity), or should include healthcare provision (core-activity) as well.

A PPP is a controversial but, at least according to some evidence, effective means to do so as it transfers risks from the public sector to the private sector, enhances flexibility, and enables a hospital to focus on its core-activity. Many variations of hospital PPPs exist, for example the administrative concession or Alzira model in Spain.

A PPP is a positive NPV investment if it provides the hospital with a high price-quality ratio, i.e. value for money. Important lessons can be drawn from international healthcare PPP experience, however, these have to be translated to the Dutch healthcare system as there are major differences in healthcare and real estate financing regulations across healthcare systems.