WE MAKE YOUR HEALTHCARE REAL ESTATE WORK FOR YOU COMMON TRANSACTIONAL COMPLIANCE PITFALLS INVOLVING HEALTHCARE REAL ESTATE

WE MAKE YOUR HEALTHCARE REAL ESTATE WORK FOR YOU COMMON TRANSACTIONAL COMPLIANCE PITFALLS INVOLVING HEALTHCARE REAL ESTATE

Common Transactional Compliance Pitfalls Involving Healthcare Real Estate Table of Contents 1. Introduction 2. Legal Background 3. Common Transactional Compliance Pitfalls 4. Conclusion About Realty Trust Group Since our inception in 1998, Realty Trust Group has become one of the most experienced and knowledgeable real estate advisory firms in the healthcare industry. With offices in Knoxville and Johnson City, Tennessee and Atlanta, Georgia, we have completed projects for clients in 30 states serving hospitals, health systems, physician groups and other owners, users and investors of healthcare real estate. Our philosophy is to provide innovative solutions to the complex and challenging issues found in today s healthcare real estate market. These solutions include strategic campus and facility planning, portfolio optimization, portfolio monetization, project development, site analysis and acquisition, asset management, fair market value opinions and many other ideas and services. Copyright Statement RTG RESOURCE 1017-A. Copyright 2017, Realty Trust Group. All rights reserved. No part of this document may be distributed, reproduced or posted without express written permission of Realty Trust Group, other than the following uses: You may copy this document and its contents for personal use only. You may distribute quotes or content from this document to third parties in news articles, blogs, forums or educational resources provided you acknowledge Realty Trust Group as the source of the material. If distributed online or electronically you must provide a working hyperlink to: http://www.realtytrustgroup.com. Writers and Contributors Goran Musinovic, J.D., Senior Associate gmusinovic@realtytrustgroup.com For More Information: Greg Gheen, President ggheen@realtytrustgroup.com Michael Honeycutt, Senior Vice President mhoneycutt@realtytrustgroup.com One Cherokee Mills 2220 Sutherland Avenue Knoxville, TN 37919 865.521.0630 www.realtytrustgroup.com

Common Transactional Compliance Pitfalls Involving Healthcare Real Estate by Goran Musinovic, J.D. Introduction Ask the chief compliance officer of any health system to identify the types of arrangements in his or her organization that may not be fully compliant with the applicable healthcare regulations, and he or she will likely point to real estate arrangements. Real estate arrangements face numerous compliance pitfalls, any one of which can trigger a violation under the Stark Law. The compliance pitfalls associated with real estate arrangements can be generally subdivided into two categories: (1) transactional and (2) operational. Transactional compliance pitfalls stem from the real estate arrangements themselves and the specific structure of the transaction, such as the rent rate under a lease arrangement between a health system and a referring physician not being consistent with fair market value (FMV), as that term is defined under the Stark Law. Operational compliance pitfalls stem from the subsequent administration, or lack thereof, of the real estate arrangements, such as a health system s failure to collect rent payments from referring physicians or not properly allocating operating expenses to the spaces leased by the referring physicians. As explained in more detail throughout this paper, some common transactional compliance pitfalls involve rent rates, classifications of leases, tenant improvement allowances, square footage measurements of leased premises, and offlease benefits. A follow-up paper will address some common operational compliance pitfalls. Legal Background Healthcare real estate arrangements between health systems and referring physicians can implicate the Stark Law because those arrangements have the potential to result in financial benefits to both physicians and health systems at the expense of federal healthcare funds. For example, a physician could receive a financial benefit from a hospital by paying less for medical office space than the market would otherwise dictate. The theory is that in exchange for providing a physician with medical office space at rates below fair market value, a hospital could potentially recoup the money it is losing on that lease arrangement by relying on subsequent revenue from that physician s downstream patient referrals for services that will ultimately be paid for by Medicare and Medicaid. Realty Trust Group COMMON TRANSACTIONAL COMPLIANCE PITFALLS INVOLVING HEALTHCARE REAL ESTATE 3

Legal Background (continued) Regulatory authorities understand, however, that health systems and physicians have to enter into real estate arrangements with each other and, as a result, have created the Rental of Office Space Exception under the Stark Law. To avoid potential liability under the Stark Law, all of the elements of the Rental of Office Space Exception must be met: Lease must be in writing, signed by all parties, and adequately describe the leased premises; Term of Lease must not be less than one year; Leased premises must be reasonable and necessary for a legitimate business purpose; Leased space must be used exclusively by the tenant; Rent must be set in advance and consistent with fair market value; Rent cannot be determined in a manner that takes into account the volume or value of any referrals or other business generated between the parties or using a formula based on the percentage of revenue earned in the office space or per-unit of service rental charges; and The lease arrangement must be commercially reasonable even if no referrals were made between the lessee and the lessor. See 42 C.F.R. 411.357(a). One of the key elements of the Rental of Office Space Exception is the requirement for the real estate arrangement to be consistent with FMV, which is defined under the Stark Law as follows: Fair market value means the value in arm s-length transactions, consistent with the general market value. General market value means the price that an asset would bring as the result of bona fide bargaining between well-informed buyers and sellers who are not otherwise in a position to generate business for the other party, or the compensation that would be included in a service agreement as the result of bona fide bargaining between well-informed parties to the agreement who are not otherwise in a position to generate business for the other party, on the date of acquisition of the asset or at the time of the service agreement. Usually, the fair market price is the price at which bona fide sales have been consummated for assets of like type, quality, and quantity in a particular market at the time of acquisition, or the compensation that has been included in bona fide service agreements with comparable terms at the time of the agreement, where the price or compensation has not been determined in any manner that takes into account the volume or value of anticipated or actual referrals. With respect to rentals and leases described in 411.357(a), (b), and (l) (as to equipment leases only), fair market value means the value of rental property for general commercial purposes (not taking into account its intended use). In the case of a lease of space, this value may not be adjusted to reflect the additional value the prospective lessee or lessor would attribute to the proximity or convenience to the lessor when the lessor is a potential source of patient referrals to the lessee. For purposes of this definition, a rental payment does not take into account intended use if it takes into account costs incurred by the lessor in developing or upgrading the property or maintaining the property or its improvements. 42 C.F.R. 411.351. Additionally, the arrangement has to be commercially reasonable, which has been defined as follows: Commercial reasonableness means, in addition to fair market value, terms and conditions that would make commercial sense if entered into by a reasonable entity of similar type and size and a reasonable physician (or family member or group practice) of similar scope and specialty, even if there were no potential designated health services (DHS) referrals. Realty Trust Group COMMON TRANSACTIONAL COMPLIANCE PITFALLS INVOLVING HEALTHCARE REAL ESTATE 4

A real estate arrangement between a health system and a referring physician which is not consistent with FMV or which is not commercially reasonable can result in the violation of the Stark Law, which could expose health systems to potential liability to the government. It is worth noting that in some instances, a real estate arrangement can be consistent with FMV but still be commercially unreasonable, in which case the health system could still be in violation of the Stark Law. Common Transactional Compliance Pitfalls Health systems face a myriad of transactional compliance pitfalls when they enter into lease arrangements with referring physicians. Some, such as the term of the lease being less than one year or the lease not being signed by all the parties, are obvious. Others, particularly compliance pitfalls associated with FMV and commercial reasonableness requirements, can be more subtle. Health systems should be especially cognizant of the compliance pitfalls associated with rent rates, classification of leases, tenant improvement allowances, square footage measurements of leased premises, and offlease benefits. RENT RATES It is imperative for health systems to charge rent rates to referring physicians that are consistent with FMV, as that term is defined under the Stark Law. Although many health systems rely on third-party valuation experts to provide FMV rent ranges for particular buildings or markets, it is worth emphasizing that the health systems are ultimately responsible for Stark Law violations if the provided rent range is below FMV. Therefore, health systems should have internal protocols through which qualified personnel critically analyze the rent range that is provided in the FMV report. As part of this critical analysis, health systems should first ensure that the FMV opinion is based on the actual definition of FMV under the Stark Law and that it covers the actual terms of the arrangement between the parties. For example, and as discussed in more detail below, a FMV report may contain a defensible opinion on a rent range for a triple-net lease, but if that rent range is used for a full-service gross lease, the opinion will be inapplicable to that particular transaction. Similarly, if the lease arrangement contains tenant improvement allowances, rent escalators, and certain free benefits to referring physicians, such as free covered parking, the FMV report and the computed rent range should address and take into account all of these components of the transaction for the report to be applicable. Second, health systems should analyze the comparable buildings on which the rent range is based. Health systems should make sure that the comparable buildings are of the same type and quality as the subject building. For example, a rent range for a medical office building should be based as much as possible on comparable medical office buildings instead of general office buildings because medical office buildings typically demand a rent premium. Additionally, if the subject building is a Class A medical office space and the rent range in the FMV report is for Class B medical office space, an upward adjustment to the rent should be made to account for higher quality space. Further, geographic location of the comparable buildings is also important. If the FMV report relies on a medical office building that is five miles away from the subject building as opposed to a medical office building located across the street, that should raise a red flag especially if the comparable medical office building across the street charges higher rent rates than the comparable medical office building located five miles away. Third, rent rates should take into account the term of the lease, the size of the premises, and the location of the premises in the building. Leases with longer terms and larger spaces typically demand lower rent rates per square foot than leases with shorter terms and smaller premises. Ground floor spaces with good visibility from the street may command a slight rent premium in comparison to spaces on higher floors of medical office buildings. Fourth, the FMV report should address annual rent escalators. A long term lease with no annual rent escalators can automatically raise a red flag, especially if the inclusion of rent escalators is consistent with the local market. The absence of annual rent escalators can be especially troublesome for long-term ground lease arrangements because land typically appreciates in value over time, which would in turn be reflected in rent rates. Realty Trust Group COMMON TRANSACTIONAL COMPLIANCE PITFALLS INVOLVING HEALTHCARE REAL ESTATE 5

Finally, health systems should make sure that referring and non-referring physicians are not treated differently under the lease arrangements. Nothing casts a bigger suspicion on a lease arrangement between a health system and a referring physician than a situation in which a referring physician is paying a lower rent rate than a non-referring physician for similar medical office space. CLASSIFICATION OF LEASES As mentioned above, different types of leases command different rent rates. Health systems should make sure that the lease arrangements they are entering into with referring physicians are properly classified. Leases can be generally subdivided into net leases and gross leases. Under a net lease, the tenant pays base rent for the use of the premises and additional rent which may, depending on the type of a net lease (single, double, or triple), include common area maintenance fees (CAM), property taxes, and property insurance. Conversely, under a full-service gross lease, the tenant pays a single, all in rent, and the landlord is responsible for paying CAM, property taxes and property insurance. A modified gross lease is a hybrid between a net lease and the full service gross lease. Under this type of arrangement, the tenant pays base rent at the lease s inception but in subsequent years pays the base rent plus a proportional share of some of the other costs associated with the property, such as CAM, property taxes and property insurance. Regardless of which type of a lease is entered into, it is important for the health system to ensure that the classification that is given to the lease matches its substances, so that an appropriate rent rate can be assigned to it. As mentioned, charging referring physicians triple-net rent rates for full service gross leases can likely result in health systems charging below FMV, which can potentially subject health systems to liability. TENANT IMPROVEMENT ALLOWANCES Careful consideration should be given to the amount of the tenant improvement allowances that are granted to referring physicians. If provided under the lease, tenant improvement allowances should be addressed in the FMV report, and the recommended rent rate range should take into account the tenant improvement allowances that will be provided under the lease. Failing to account for tenant improvement allowances can result in what would otherwise be a rent range that is consistent with FMV drop below market value, which could in turn be perceived as remuneration for patient referrals. Additionally, providing overly generous and unnecessary tenant improvement allowances to referring physicians can also lead to transactions not being commercially reasonable. For example, providing a $100,000 tenant improvement allowance for a lease arrangement that will generate $125,000 in total rent revenue may not be commercially reasonable in many instances. Some health systems create internal benchmarks and caps for tenant improvement allowances, which can create additional compliance pitfalls. First, tenant improvement allowances that exceed health system s internal benchmarks and caps may be indicative of potential compliance risks. Health systems would need to be able to justify why a referring physician is receiving tenant improvement allowances in excess of internal benchmarks. Additionally, basing tenant improvement allowances on standard benchmarks as opposed to the actual tenant improvements that need to be made to a particular space could be problematic. For example, if the space is in a turn-key condition that requires little work to prepare for the incoming tenant, providing a standard tenant improvement allowance well in excess of actual work that needs to be performed can be interpreted as remuneration for inducing or rewarding patient referrals. SQUARE FOOTAGE MEASUREMENTS OF LEASED PREMISES While it is critically important for health systems to charge referring physicians rent rates per square foot that are consistent with FMV, ensuring that the size of the leased premises is accurately measured is as equally important. Remuneration to referring physicians can be accomplished by charging rent rates below FMV or by not charging the referring physician for all of the leased space. If a referring physician is leasing 10,000 square feet from a health system Realty Trust Group COMMON TRANSACTIONAL COMPLIANCE PITFALLS INVOLVING HEALTHCARE REAL ESTATE 6

but is only paying for 9,500 square feet, the physician is receiving remuneration from the health system by not having to pay for 500 square feet of space, regardless of the fact that the rent rate per square foot that is being charged to the physician may be consistent with FMV. Similarly, health systems should be consistent internally and with the local market in structuring leases based on usable or rentable square footage and charging appropriate rent rates based on the chosen structure of the lease. Usable square footage is the square footage of the actual space that is occupied by the tenant, and it does not take into account the common areas of the buildings, such as lobbies, common restrooms, and shared hallways. Conversely, rentable square footage takes into account the common areas of the building and allocates a portion of those areas to the leased premises. Rent rates per square foot for leases based on usable square footage should typically be higher than rent rates based on rentable square footage because the referring physician is being charged for less total square footage than he or she is ultimately using. Arrangements based on rentable square footage can have lower rent rates per square foot because the total square footage that is being charged to the referring physician will be higher. The market will ultimately dictate whether the lease arrangements should be based on usable or rentable square footage. Nevertheless, it is important for health systems to be consistent internally and with the local market in structuring all of their leases based on either usable or rentable square footage to avoid situations in which referring physicians may not be charged for the use of common areas of the building. OFF-LEASE BENEFITS Finally, health systems should be aware of providing free benefits to referring physicians that may not even be referenced in the lease arrangements. Examples could include complimentary hazardous and medical waste removal services, free parking in certain markets, complimentary meals, and free transportation services. All of these free benefits could be interpreted as remuneration to referring physicians for the purposes of inducing or rewarding patient referrals, which could subject health systems to significant penalties under the law. Conclusion As demonstrated above, real estate arrangements between health systems and referring physicians are fraught with regulatory compliance pitfalls. Prudent health systems may wish to consider retaining qualified and independent thirdparty advisors to review their existing lease arrangements with referring physicians to ensure that those arrangements are not in violation of the applicable healthcare regulations. Realty Trust Group provides a wide range of regulatory compliance consulting services to some of the largest health systems around the country. From conducting independent, third-party reviews of health systems lease arrangements with referring physicians, to working with health systems compliance and legal departments to establish and implement strong real estate compliance programs, Realty Trust Group has the experience and expertise to fully service all of its clients real estate compliance needs. For more information on Realty Trust Group s Regulatory Compliance services, contact us at 865.521.0630. About the Author: Goran Musinovic, JD Senior Associate Goran provides a broad range of real estate advisory services to clients, many of which focus on regulatory compliance issues involving healthcare real estate. Additionally, Goran is responsible for the risk management of the firm s services lines and the firm in general. Realty Trust Group COMMON TRANSACTIONAL COMPLIANCE PITFALLS INVOLVING HEALTHCARE REAL ESTATE 7