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Ministry of Health Advisory Paper - Napier


Ministry of Health Advisory Paper Released By Minister Annette King


File ref: 11/1/6


28 February 2000


Minister of Health

cc: Associate Minister of Health (Hon Ruth Dyson)
Associate Minister of Health (Hon Tariana Turia)

Healthcare Hawkes Bay (HCHB) - Napier Health Centre

This briefing responds to your request for details of the leasing arrangement for the Napier Health Centre between Healthcare Hawkes Bay (HCHB) and Calan Healthcare Property Trust.


Executive Summary

HCHB has entered into a lease agreement with Calan Healthcare Properties Trust for the purpose-built Napier Health Centre constructed at a cost of $11.8 million and attracting an annual leasing cost of $1.2 million.

The need for the establishment of the Napier Health Centre was as a result of the centralisation of the Napier and Hastings hospitals in Hastings with the aim of establishing one regional hospital that would facilitate the generation of efficiencies as well as the elimination of certain of the medical risks associated with the running of two general hospitals in such close proximity.

CCMAU accepts that HCHB were under pressure at the time to complete the rationalisation of services, to effectively close the old Napier hospital site and consequently to provide for replacement appropriate ambulatory secondary care services in Napier itself.

HCHB has reiterated that there was clear consensus amongst most local political leaders at that time that the building of a new downtown facility in Napier would be the best solution to satisfy the requirements of the community and give certainty that health services would continue into the future. CCMAU concurs with that analysis. The HFA, in an agreement dated 31 July 1998 agreed to “ enter into a contract at a price that reflects the cost of efficient service provision” for agreed services to be provided in Napier.

Prior to approval of the downtown facility by the board of HCHB, two independent evaluations were conducted of the benefits of providing services out of the old Napier Hospital Tower Block as opposed to the downtown site. The board of HCHB, after considering various funding options, ultimately approved the build and leaseback as a result of:
 its view that there was a clear indication from shareholding Ministers that they would not be prepared to provide any additional equity support over and above that already given for the reconfiguration project; and

 its view that private sector funding under an HCHB ownership of the facility would not be available due to the financial position of the company, the fact that the business plan had limited support from shareholding Ministers, and the fluctuating interest of the private sector at that time in providing finance for the public health sector.

CCMAU’s view is that notwithstanding any difficulties the board may or may not have had obtaining either Crown equity or private sector loans, using part of the old Napier hospital would have effectively frustrated the closure of that facility.

We have reviewed the terms and conditions of the lease agreement and the associated capital construction cost of the facilities on which the annual leasing charge is based and conclude as follows:

 the option to tender for the construction and leaseback of the Napier facility was not inappropriate given the circumstances detailed in the body of the report;
 the tendering process adopted by HCHB appears to have been both complete and robust;
 the terms and conditions applicable to the lease are similar, and in certain instances better than, terms quoted on projects similar in nature for another HHS;
 we are, however, concerned at the apparent lack of financial analysis of alternative financing options and leasing structures that could have resulted in a lower ultimate cost to HCHB e.g. a mix of equity and private sector debt;
 we note that the extent of the escalation in the cost of construction from original estimates although we accept the underlying explanations advanced by HCHB, the main reason being the land cost;
 we note that the facility has been said to be over-capitalised, although HCHB has noted that the cost and size are consistent with agreed requirements. This is a sizeable facility, based on the “Superclinic” concept. The cost is, nonetheless, under investigation as part of the joint Performance Comparison Project between the HFA, HCHB and CCMAU. We will report on this separately as part of the feedback on the outcome of this project.

Overview

The new Napier city-based health centre has been purpose-built by Calan Healthcare Properties Trust in line with the requirements of HCHB and is leased by HCHB. Specific areas of the facility have been/will be sub-let to other healthcare providers.

Background

A working party was established in 1997 to review the options for the delivery of services in Napier as specified in the Central Regional Health Authority’s purchasing intentions, and to make recommendations to the executive management team of HCHB on a preferred option. The new-build option was recommended by the working party on the grounds of better access, functional design, energy efficiency and long term sustainability of services.

The HCHB executive supported the findings of the working party and recommended a new-build option in the CBD of Napier. HCHB sought opinion from the Ministry of Health and the HFA on the recommendations. Agreement in principle to the building of a new facility in Napier and the services to be provided was reached between HCHB, CCMAU and the HFA during July 1998. The Minister of Health supported the development provided that the HFA should consider increasing its offer to cover the full costs of HCHB’s facilities.

An extensive consultative process was then undertaken with the public and interested agencies and the design of the facility was extended to include Community Health Services, which were currently provided from three other sites in Napier, with the proviso that this was achieved on a cost neutral basis.

HCHB has indicated that there was a clear consensus amongst most local political leaders, at the time, that the building of a new downtown facility incorporating the co-location of services required by the community would be the best solution for the people of Napier given the movement of the regional hospital to Hastings. The facility would satisfy the requirements of the community as determined during the consultations, while at the same time giving them certainty that health services would continue into the future.

HCHB indicates that the design contract was negotiated and the finance and construction process tendered on the open market in accordance with the State Services Commission’s 1995 “Good Practice Purchasing Standards” for government departments.


Details of the Lease Agreement between Healthcare Hawkes Bay and Calan Healthcare Property Trust

1) Lessor/Developer – Calan Healthcare Property Trust.

2) The contract is an operating lease but it contains a right of first refusal to purchase the premises at market value at any time during the duration or on termination of the lease should the landlord wish to sell the property.

3) Principal lessee – HCHB.

4) Sub leases –
 City Medical (the provision of urgent medical services. They hold a five-year contract – tied to the term of the current HFA contract).
 Café and Pharmacy (negotiations are currently under way for the leasing of these premises).

5) Leasing costs – c. $1.2 million to be offset by sub lease receipts. Absolute confirmation of the lease cost will only be available after the collation of final costs by Calan. The lease is based on a rate of 10.25% of the total cost anticipated to be ±$11.8 million. Current indications are that the final project costs will be slightly lower than budgeted, which would result in a proportionate reduction in lease payments.

6) Sub–lease recoupments $ [deleted under s9(2)(b)(ii) of the Official Information Act 1982] per annum:
 City Medical - $[deleted under s9(2)(b)(ii) of the Official Information Act 1982] per annum
 Café and Pharmacy – an expected market rental income of $[deleted under s9(2)(b)(ii) of the Official Information Act 1982] per annum.

7) Lease tenure – 12 years with a further right of renewal of 3 x 6 years.


HFA purchasing for Napier Health Centre

The HFA, on 31 July 1998, agreed to “enter into a contract at a price that reflects the cost of efficient service provision” for agreed services to be provided by HCHB in Napier. It also agreed that in assessing the cost of the facility it would incorporate “the cost of capital and leasing so as to cover the cost of the facility”.

It was acknowledged that long-term contracts would be necessary to support new investment in facilities and ensure efficient delivery of the range of services the HFA was to purchase.

During contract negotiations for the 1999/00 financial year, the HFA could only reach agreement for five-year contracts for Urgent Medical and Maternity Inpatient Services from the Napier facility. It could not agree on long-term contracts for other health centre services and qualified the 5-year arrangements by stating that there was no commitment to either volume, price, or total revenue. HCHB maintains that the implication of this arrangement is that HCHB is the preferred provider of services and that the HFA will meet “the cost of efficient service provision”.


Financing Options for the Napier Health Centre

HCHB considered the following finance options:

a) HCHB ownership through equity funding – this was excluded by HCHB because the shareholding Ministers’ letter of response to the 1998/99 business plan precluded the allocation of any further equity for the reconfiguration programme. HCHB was required to prioritise its capital requirements within the financing sources available.

Correspondence at the time indicated that additional equity over and above that already allocated for the enlarged HCHB Hastings Hospital reconfiguration programme would not be easily available to HCHB. They were encouraged to consider alternative forms of finance to fund the Napier Health Centre. No formal approach for the allocation of equity for this project was made to shareholding Ministers.

CCMAU would point out that equity being the most expensive source of capital would normally be the source of last resort after, for example, RHMU.

b) HCHB ownership through private sector finance – this was excluded as HCHB’s discussions at the time with bankers elicited little or no interest in providing finance as a consequence of the limited support for the business plan, the continued projection of operating losses and a relatively highly geared balance sheet. An alternative financing package was explored at the time by the board (details will be subsequently reported, for context).

CCMAU does not accept that HCHB would not have been able to obtain sufficient private sector funding given the financial position of HCHB, but does concede that 100% would have been difficult. The fact that the business plan was not fully supported would have been a problem.

We would accept that HCHB perceived that sufficient debt and equity capital may not be available, however, we would with hindsight have expected that HCHB would have more actively or aggressively explored the possibility of obtaining a mix of equity and private sector funding to finance the Napier facility. Such an option would have been a benchmark against with to judge the Calan deal.

c) Build and leaseback – With the apparent elimination of the finance and equity options by the HCHB board, it appears that in order to get the best value for money in the new facility, the project would be split into three parts. Expressions of interest were sought for each part, either as a package or for parts. Thirteen expressions of interest were received and evaluated. Four companies were shortlisted and HCHB then proceeded to a full tender process. The combination of Calan Healthcare Properties Trust as financiers, and Mainzeal as the construction company, provided the most favourable result leading to the lowest overall leasing cost. This combination was therefore recommended by management and approved by the board.

We have reviewed the terms and conditions of the lease agreement and comment as follows:

 The actual tendering process adopted by HCHB was project managed by Octa Consultants. Based upon information provided by HCHB, and a review of documentation provided, the process appears to have been complete and robust;

 The tenure, implicit interest rate, duration, right of renewal and other terms and conditions applicable to the lease agreement appear to be in line with, or slightly better than, terms quoted on projects similar in nature at that time;

 The gross additional external leasing cost of the facility can be calculated as follows:
$m
Napier health centre leasing costs 1.2
[deleted under s9(2)(b)(ii) of the Official Information Act 1982]
True external leasing cost 0.9

Offset against this would be the ongoing costs of depreciation and interest associated with continued use of the existing facility.

We are, however, with hindsight concerned at the apparent level of financial analysis of the alternative leasing structures that could have been applied to a lease of this nature. Examples include the possible inclusion of a residual value buy-back option or ownership reverting to HCHB on termination of the lease. HCHB has indicated that a residual buy-back arrangement was not perceived by management or the board as a viable option as this would have significantly increased the yield rate.

CCMAU agrees that any transfer of title to HCHB at any future time at less than market price would have been reflected in the rent. CCMAU understands that HCHB unsuccessfully attempted to negotiate a straight right to purchase at the end of the lease term.


Conclusion

We consider that, given the performance circumstances of HCHB, the reluctance of shareholding Ministers to continue to provide unbudgeted equity for increased capital expenditure, more importantly perhaps the cost of equity, and the perceived reluctance of the private sector to provide finance, the option to tender for the construction and leaseback of the Napier facility was not inappropriate. However, we suggest that if the board considered the financing costs and terms of a leaseback to be unfavourable compared to more conventional finance sources (e.g. equity and private debt) then the board could still have approached shareholding Ministers seeking equity. At the time there were discussions with officials and with the Minister of Health on the issue but the board does not appear to have formally written to shareholding Ministers. We have not evaluated the decision on whether to construct the new facility or to utilise the existing Napier Hospital tower block, although it appears to be quite appropriate. Importantly, HCHB commissioned two reviews, both of which concluded that the city site was preferable.

The tender process appeared to be well managed and, based upon the information provided, resulted in the acceptance of the most cost-effective lease option.

The implicit interest rate attached to the lease is not out of line with the rates quoted for a similar project at Taranaki Healthcare. The rate has, however, been slightly skewed by the inclusion of holding costs in the capital construction costs.

The lesson learned is that HCHB should have undertaken a more in-depth financial analysis of alternative financing and lease structures as part of its internal business case process. HCHB has indicated that the some of the alternate lease options were effectively discounted during the initial stages of negotiations due to resistance from Calan.

Capital Cost of Facilities

Original estimates during September 1997 placed the construction costs of the Napier Health Centre at $5.9 million against the actual $11.8 million cost. HCHB has provided the following reconciliation:
$
Original estimates of construction costs 5.9
Inclusion of Community Health and other facilities 3.8
[Information deleted/amended to protect interest under s9(2)(b)(ii) of the Official Information Act 1982]
Holding Costs 0.7
Increased cost of the land 0.9
Unexplained increase 0.5
Total cost of the facility 11.8

1. Community Health – HCHB undertook an extensive consultative process with the community and the HFA. The clear expectation of the community, and to an extent the HFA, was that the services would be co-located with the other services to be provided from the Napier Health Centre. The added leasing costs associated with the change to include additional space for Community health was funded through the termination of their present leases in downtown facilities, along with efficiencies through co-location on a single site.

2. Pharmacy – HCHB included this on the assumption of cost recovery through sub-lease arrangements. This sub-lease has not yet been concluded, we understand, as a result of recent HFA decisions.

3. Holding Costs – HCHB indicates that in the original costings it was assumed that holding costs would be recovered through the yield. The developers, however, added the holding costs, to the capital construction costs charging a lower yield of 10.25% against the 13% included in the business plan.

4. Increased land costs - The initial tract of land identified by HCHB and included in the conceptual costings was not acquired as it would have needed to go through the Treaty protection mechanism and could have been landbanked. It could not then have been on-sold to a developer. Given that HCHB was not in a position to fund the building project, alternative options were considered by HCHB for the actual building on the basis of the land being owned by HCHB. These options failed to attract investors. Alternative sites were explored and the Wellesley Road property was selected on the basis of location, suitability of site and cost. This change resulted in increases in the cost of land from the original estimates and HCHB contracted Dow Group Ltd to conduct an independent option appraisal to quantify the cost differential between providing services from the Tower Block at the old Napier Hospital and the chosen site. This confirmed that the cost of operating the downtown site, including leasing costs, would be between $160k and $180k lower than the refurbished tower block.


Overall Conclusions:

 CCMAU notes that there was, at the time, pressure on HCHB to:-
 complete the closure of the old Napier hospital site, as part of the final stages of the rationalisation of secondary services on the Hastings site; and
 provide appropriate replacement ambulatory primary and secondary services within Napier.

 CCMAU believes that, with the benefit of hindsight, the options of a mix of Crown equity and private borrowings should not have been discounted by HCHB and that the costs of such financing options should have been compared to the Calan and potential other lease arrangements, as part of their internal Business Case process. We believe that HCHB responded to its perceptions at the time and would now accept this lesson.

 We understand that you plan to visit the Napier Health Centre for its official opening and will be able to view the extent of the facility and its services.

 We accept the explanations behind the escalation in the cost of developing the Napier Health Centre from $5.9 million to the eventual cost of $11.8 million but remain concerned at the extent of the escalation.

 CCMAU and HCHB are currently undertaking, as part of the performance comparison project, (see below) an evaluation of the possible of surplus capacity that may exist in the Napier Health Centre, specifically with the birthing unit.

 The facility cost of $3.5 million associated with the co-location of Community Health, resulting in a per annum leasing cost of c. $360k, is justified by HCHB, in part by a $140k per annum saving in prior lease costs and the remainder by additional efficiency savings to be achieved through the co-location.

 HCHB, CCMAU and the HFA are currently undertaking a performance comparison analysis in an effort to identify whether HCHB is being underfunded for the new facilities, i.e. whether the prices currently paid to HCHB include an adequate element for depreciation and interest that is attributable to the new facilities at HCHB.


Recommendation

I recommend that you

a note the contents of this report.

b note that the lessons learned are being clearly communicated to and understood by HCHB.

c discuss with us any further action you wish to be taken.


Steve Anderson
Principal Advisor – Health

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