Back in 2021, my wife and I were searching for our next home. The market seemed insane. Home prices were seemingly increasing every day and every offer we made encountered double-digit competition. Our prospects seemed dim, and it felt like the risk of overpaying increased with every passing day.
Contrary to rising prices, interest rates were at an all-time low. To make myself feel better, I did what any good CPA would do … the math. I simply calculated what our monthly payment would be with the current terms and then calculated how much that payment could afford at historical rates. The results were shocking. With such favorable financing terms, we could overpay by up to $90,000 and still have a lower payment than purchasing a house at a lower price with an average mortgage rate.
Over the last two years, at least where we live, home prices have continued to rise. However, the favorable financing terms seemed to disappear overnight, and rates returned to figures we hadn’t seen in over a decade. In other words, the math has dramatically changed.
For simplicity, let’s say a home buyer is comfortable with a monthly payment of $2,650. At today’s rate of 7.0%, that monthly payment would buy a $400,000 house. [1] When interest rates were 5%, our shopper could have afforded a $495,000 house – or a $629,000 house back in the days of 3% interest rates. The same monthly payment buys dramatically different houses.
Many hospitals and health systems, like many home buyers, use financing for capital expenditures. There are two key differences, however. First, hospital loans are not for $400,000. They are 5x, 25x, or 100x+ these amounts. Second, hospitals and health systems typically utilize corporate or municipal bonds to fund capital expenditures instead of mortgages.
Like mortgage rates, the effective interest rates on bonds have increased since 2020 by roughly 2.5%. While seemingly inconsequential, this increase is massive considering municipal bonds have increased from 1% to 3.5%, AAA Corporate bonds have increased from 2.1% to 4.6%, and BAA Corporate bonds have increased from 3.3% to 5.7%. [2]
These rates make it more expensive to build or renovate healthcare facilities because the issuing hospital is forced to spend more on debt service, which leaves less money to invest in the capital project. In fact, based on today’s bond yields compared to 2020, a hospital will receive $14 to $20 million less when issuing a $40 million bond [3].
As if that isn’t bad enough, according to CBRE, construction costs increased by 11.5% in 2021, 14.5% in 2022, and are projected to increase by 5.4% in 2023. That means a facility costing $40 million to build in 2020 will cost roughly $53.8 million in 2023. These price increases will also be felt in facility remodels and updates. Even if a hospital funds its capital expenditures with cash, the impact of these price increases alone is significant.
If we combine these two elements, a facility funded in 2020 for $40 million would have an effective cost of $68 to $79 million today. [4] The cost has nearly doubled!
Hospitals and health systems are capital intensive businesses that typically carry large amounts of assets and debt on their balance sheets. Any hospitals that failed to refinance during the low interest rates of the past several years will face increasing capital costs as loans come due. In addition, as we’ve discussed in previous blog posts, we saw hospitals cut back on capital expenditures in the thralls of the COVID-19 pandemic. We predicted that these delays could require future expenditures as equipment or facilities age and break down.
Increased capital costs and financing expenses will impact the income statement, the balance sheet, and cash flows for years to come. The necessity of careful planning is even more important in a market where capital costs and interest rates continue to increase. There is less margin for error than ever before and the need to prioritize capital expenditures is critical. It’s paramount to consider every alternative as facility, equipment, service line, and other investments are made.
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[1] To keep the example simple, this assumes 100% financing with no PMI. [2] Based on AAA and BAA corporate bonds and municipal bonds. St. Louis Fed Link, Charles Schwab Link [3] Comparing the present value of bonds with a $40 million face value at a coupon rate of 5% with the 2020 and current effective yields. [4] Range based on utilizing the 2020 effective yield on a $53.8 million face value AAA or BAA corporate bond with a 5% coupon rate.
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