Exploring Preferential Rights in Hospital Ground Leases

10.02.20

Introduction

This article examines the different types of preferential rights in ground leases for medical office buildings, and examines strategies in drafting preferential rights provisions to protect the interests of both ground lessors and ground lessees.  Ground leases are a popular way for hospitals and health systems (collectively, "Hospitals") to maintain ownership and control of their hospital campus, while also allowing them expand their campuses or monetize equity tied up in Hospital-owned buildings.  Typically, a ground lessee (or, the "MOB Owner") is either a developer of, or investor in, medical office buildings ("MOBs") who either develops the MOB or acquires an existing MOB from the Hospital and then subleases space within the MOB to physicians, physician groups or the Hospital itself.  Under a ground lease, typically the MOB Owner holds a leasehold interest in the real property and owns fee title to the building and other improvements located thereon for the term of the ground lease, and upon the expiration of the ground lease, title to the improvements reverts to the Hospital. 

What are Preferential Rights?

Generally, a preferential right is a contractual right that enables a party to acquire an interest in real property as a result of or in connection with the sale, lease, assignment or other transfer of such real property or at some defined period or interval of time.  There are three main types of preferential rights: (i) rights of first refusal, (ii) rights of first offer, and (iii) purchase options.  For purposes of this subsection, the term "obligated party" means the party subject to the preferential right, and the term "benefitted party" means the party that may exercise the preferential right.

A right of first refusal (a "ROFR") is a contractual agreement that grants the benefitted party the right to match another party's offer to acquire the specified property interest.  Generally, ROFRs are triggered when the obligated party receives an offer from a third party to acquire the property on terms the obligated party is willing to accept.  The benefitted party would then have the right to match the third party's offer, in which case the obligated party would be required to convey the property to the benefitted party on substantially the same terms and conditions as in the third party's offer, subject to any modifications that may have been agreed to in the underlying ROFR agreement (such as a shortened timeline for closing or limitations on due diligence, since in the case of a ground lease, the benefitted party is in possession of the MOB and has previously underwritten the asset).   

A right of first offer (a "ROFO") is a contractual agreement that grants the benefitted party the right to negotiate with the obligated party to acquire the specified property interest prior to the obligated party taking the property to market.  ROFOs are typically triggered when the obligated party elects to make the real property available for purchase or lease prior to soliciting offers from third parties.  Depending on the terms of the ROFO agreement, either the obligated party or the benefitted party will make the offer, and the other party will have the right to accept or reject the offer, then, if the parties have not reached agreement after a specified negotiation period, the obligated party may proceed to take the property to market.  In some cases, the benefitted party will have a "last look" or right to match if the obligated party is ultimately willing to convey the property to a third party for less than the amount that was last offered during the negotiation period between the obligated party and benefitted party.  A ROFO differs from a ROFR in that the ROFO is triggered by the obligated party desiring to convey the property, and the benefitted party holds the right to either make or receive the first offer to or from the obligated party, whereas the ROFR is triggered by the obligated party actually receiving an offer to acquire from a third party.

A purchase option (a "Purchase Option") is a contractual agreement which grants the benefitted party the right to acquire the property interest on certain terms and conditions described in such agreement.  Typically, a Purchase Option will include either a fixed purchase price or a methodology for calculating the purchase price.  A Purchase Option may also either be in effect throughout the duration of the ground lease, or only in effect during a fixed period during the ground lease term.  Purchase Options differ from ROFRs and ROFOs because they are not triggered by the actions of the obligated party; rather, the benefitted party may exercise a Purchase Option unilaterally.

History of Preferential Rights

If you have ever negotiated or reviewed a medical office building ground lease on a hospital campus, you have no doubt seen some combination of ROFRs, ROFOs and Purchase Options in favor of the Hospital to acquire the MOB.  Although present in most of these ground leases, historically, these preferential rights were rarely exercised, and when they were exercised, it was more reactionary on the part of the Hospital.  A big reason for this is that historically, strategic real estate decisions such as these were typically not at the top of Hospital executives' priority lists. The result is that while most Hospitals insisted on including some form of preferential rights provisions in their ground leases, such provisions were rarely used and therefore the actual language of these provisions was not heavily scrutinized.

Times are Changing

Over the past couple of decades, Hospitals have begun to understand the value and strategic importance of their real estate assets.  As a result, many Hospitals have hired seasoned real estate professionals to shape their real estate strategy.  As strategic real estate decisions have become more important than ever to Hospitals, there has been an increase in Hospitals proactively exercising preferential rights in their ground leases for one reason or other.  Some Hospitals simply want to retake control of their on campus real estate (sometimes called a reverse monetization), some want to use their preferential rights as a defensive mechanism to steer ownership of an MOB to a preferred real estate partner or at least away from a particular buyer, while others are seizing on arbitrage opportunities to buy at "fair market value" when the Hospital's master lease of the MOB is nearing the end of its term and the value of the asset is therefore artificially depressed. 

Reverse Monetization Trend

As noted above, some Hospitals want to retake control of their campus real estate.  This can be driven by a variety of reasons.  In some cases, the Hospital is such a large tenant in an MOB that it changes the equation in the rent vs. own analysis of the MOB such that it makes more financial sense for the Hospital to own the MOB again rather than lease all or a substantial portion of it. 

Another reason for a reverse monetization is simply the desire to have more control over the MOB and its campus as a whole, whether through moving various services to different buildings, reconfiguring space, or even razing buildings to build more modern facilities.  Although many ground leases for Hospitals contain provisions that allow the Hospital to impose certain restrictions in order to maintain continuity or control over the hospital campus from both a design, functionality and campus integration perspective as well as restricting the services provided within the MOB, oftentimes these controls do not allow the Hospital to compel the MOB Owner to affirmatively take action at the direction of the Hospital.  The Hospital exercising a preferential right under the ground lease allows it to regain full control of the MOB and avoid these issues. 

In many jurisdictions, if the Hospital is not-for-profit, Hospital ownership of an MOB is necessary to preserve the tax exempt status of the MOB.  If the MOB is occupied primarily by tenants that are not owned or controlled by the Hospital, the pass through of the ad valorem taxes to the tenants is less of a concern, but when the Hospital becomes a large enough tenant in the MOB, the pass through of the tax burden can be significant.

Another factor driving some of the reverse monetization trend is Hospitals becoming more interested in physician co-investment programs for the ownership of Hospital-controlled MOBs.  Many physicians and physician groups have been active in investing in ownership opportunities in MOBs as a means to supplement their practice incomes, and Hospitals are able to provide more and more of these opportunities to their affiliated physicians by reacquiring ownership of previously monetized MOBs.

Preferential Rights as a Defense Mechanism

In some instances, the Hospital may not want to own an MOB itself, but may have a preferred real estate partner that it would like to own the MOB.  Perhaps the preferred partner already has an existing relationship with the Hospital or perhaps the Hospital is trying to steer the MOB away from another buyer with whom the Hospital does not want to do business.  In any event, in such an instance, the Hospital may exercise its preferential right with the intent of immediately flipping the MOB to its preferred partner.  This way, the Hospital can accomplish its goal of steering the MOB to a friendly owner (or away from an undesirable one) without having to expend the capital necessary to own the MOB itself.    If the MOB Owner wishes to protect against the Hospital utilizing this tactic, then attaching a hold period requirement on the Hospital upon exercising the preferential right would effectively achieve this result.

Revisiting the Types of Preferential Rights Provisions in the Context of Ground Leases with Hospitals

With the new strategies being utilized by Hospitals related to preferential rights, now is a good time to review the key elements of each of these rights and ensure that your ground lease provisions adequately protect you, whether you are the Hospital or the MOB Owner.  

A.  Purchase Option – A typical Purchase Option provision in a Hospital ground lease gives the Hospital the right to purchase the MOB at some point in the future for a defined purchase price.  Poorly drafted Purchase Options can be fraught with peril for MOB Owners, so attention to all of the nuances of these provisions is critical. This section examines the most common issues – timing and price.

  1. When can a Purchase Option be exercised?

An MOB Owner will want to limit when a Purchase Option can be exercised as much as possible because the Purchase Option affects the MOB Owner's ability to market and sell the MOB.  Generally, all preferential rights have an adverse effect on an MOB Owner's ability to market and sell an MOB, whether it's a question of a buyer risking losing due diligence costs because a Hospital exercised such right after a contract was signed, or whether the buyer simply refuses to consider the transaction because of the preferential right.  The timing of the exercise of a Purchase Option can either be a one-time right or a continuing right.  If the Purchase Option is a one-time right, it may burn off after a number of years, or after the first sale of the MOB if the Hospital does not exercise its Purchase Option (or other preferential right).  If the Purchase Option is a continuing right, it may continue for specific intervals throughout the term of the ground lease (e.g., on every fifth anniversary of the commencement date), or, less commonly, it may be exercisable at any time during the term of the ground lease without limitation. 

If the Purchase Option is ongoing, a buyer's two primary concerns will be making sure it has a guaranteed minimum holding period before the Purchase Option may be exercised so that it can earn a sufficient return on its investment, and that if the Purchase Option is exercised, the purchase price will be an amount sufficient for such buyer to recoup its original investment.  One way MOB Owners have gotten comfortable with ongoing Purchase Options is to draft them so that the earliest date the Hospital may exercise the Purchase Option resets as of the date of each sale of the MOB so that the successor MOB Owner will have a guaranteed minimum holding period for the asset.  Typically, a Hospital will also have a ROFO or ROFR along with the Purchase Option, so it would have had an opportunity to acquire the MOB prior to the option exercising date resetting.  Another way to protect the MOB Owner's investment is to set a floor on the exercise price of the Purchase Option in order to guarantee a return on such MOB Owner's investment.

  1. What is the Purchase Option price?

There are a variety of methods for determining the Purchase Option price, ranging from simple formulas based on an agreed cap rate, to very complex formulas based on the original development costs plus all capital expenditures during the lease term and an assumed IRR for the MOB Owner based on its investment, to a pure appraisal process.  Typically, the Purchase Option price will be tied in some way to fair market value ("FMV"), in large part due to compliance concerns related to the Federal Stark and Anti-Kickback Statute.  When the Purchase Option price is based on FMV, there are some pitfalls the MOB Owner will want to be sure to avoid.  First, the assumptions (or lack thereof) used by the appraiser determine the FMV can have a dramatic effect on the outcome of the appraisal.  For example, if an entire MOB is leased to the Hospital and the lease term is nearing its end, without any required assumptions that must be considered by the appraiser, the value of that MOB will be significantly lower than it would be if the lease term had 7-10 years or more remaining.  Savvy Hospitals who have Purchase Options based on FMV with no required assumptions built in to the appraisal analysis have taken advantage of this arbitrage opportunity to force a sale of the MOB at an artificially low valuation, then either hold the MOB themselves, or flip it to another investor at a higher price in exchange for the Hospital agreeing to enter into a new long term lease at market rent rates with the new investor.  This arbitrage opportunity for the Hospital may also exist if the MOB is leased to third-party tenants and a large number of the space leases expire in close proximity to each other.  In that case, the Hospital may decide that it would prefer to own the MOB at a discount and then either renew or sign up new space leases with its physicians as the existing leases expire.

To protect against this, the MOB Owner will want to have either a set of assumptions the appraiser must consider when valuing the MOB, a floor purchase price, or both. Examples of assumptions the appraiser should be instructed to follow are an assumed minimum remaining lease term (10 years, for example), or an assumption that all available extension options will be exercised.   The parties should also take into account the diminishing value of the leasehold estate towards the end of the ground lease term (most sophisticated MOB investors will not purchase an MOB on a ground lease unless it has at least fifty years remaining on the term).  The challenge negotiating these appraisal assumptions is that Hospitals that take a more conservative approach to regulatory compliance will take the position that any parameters in the ground lease that alter the methodology or analysis by the appraiser will necessarily yield a result that is not truly FMV.

The other main protection for an MOB Owner here is a meaningful minimum Purchase Option price.  A common methodology for determining this minimum price is that it must at least be sufficient to pay off any leasehold mortgage on the MOB and to cover all closing costs.  This generally only works for an MOB Owner using a relatively high leverage loan on the MOB.  Even if the MOB owner has a relatively high leverage loan on the MOB, this minimum price could still potentially result in the MOB Owner losing all of its equity if the appraised FMV comes back low for whatever reason, such as the example noted above.  The result is potentially even more catastrophic for an MOB Owner that uses low leverage, or even no leverage.  A better floor price for the MOB Owner would be one that is based on the price at which the MOB last sold – either as an absolute dollar amount, or by using the cap rate from the last conveyance.  This should be something which can easily be established if the Hospital also has a ROFR on the MOB, because the Hospital will have been given notice of the terms of the most recent conveyance of the MOB.  Some MOB Owners have had some success also including an assumed minimum rate of appreciation over and above the price they paid for the MOB or, as mentioned above, a minimum rate of return to the MOB Owner on its investment in the MOB.

B.  Right of First Offer

Generally, ROFOs are the best option for the MOB Owner because ROFOs are the "softest" of the rights and only require the MOB Owner to offer the building to the Hospital before taking it to market in order to satisfy the ROFO requirements.  ROFOs can be set up so that either the MOB Owner or the Hospital proposes the purchase price.  When the Hospital receives the MOB Owner's offer the Hospital should, in theory, know whether they want the building or not, so the only real question should be the price.  If the Hospital and MOB Owner cannot agree on the price and other terms, then the MOB Owner can market the MOB for sale.  One way that the Hospital can protect itself is to ensure that the ROFO contains language allowing the Hospital to have a "last look" at the final offer between the MOB Owner and a third party purchaser.  If the terms of such offer are materially different from the offer that the MOB Owner made to the Hospital, then the MOB Owner is obligated to offer the MOB to the Hospital at the same price and terms.  Including this language in a ROFO provision motivates the MOB Owner to offer the MOB to the Hospital on terms that are generally consistent with the market.  This "last look" concept is almost universal in ROFOs, but some MOB Owners will argue it is not necessary.  Nothing would prevent the Hospital from making an offer after the MOB is taken to market, and if the Hospital is the high bidder, the MOB Owner will still end up selling the MOB to the Hospital.

Hospitals generally do not want to rely solely on a ROFO provision in their ground leases, because it takes away some of their control over who the next MOB Owner is.  For example, if, pursuant to a ROFO the MOB Owner offers the building to the Hospital and the Hospital turns it down, then the Hospital is generally out of the loop for any sale of the MOB by the MOB Owner to a third party (unless the ROFO contains a "last look" provision), and would have no knowledge or control over what third party acquires the MOB.  If, however, the ground lease also includes a ROFR provision or a Purchase Option, the MOB Owner would have additional layers of protection, and other chances to acquire the MOB.  

However, from the MOB Owner's perspective, the Hospital should be sufficiently protected by the "permitted transferee" and "precluded transferee" provisions typically in these ground leases.  Permitted transferee provisions allow the MOB Owner to transfer its leasehold interest and/or the MOB to one or more pre-approved parties either without the consent of the Hospital, or at least some less restrictive consent standard.  Typically, permitted transferee provisions allow transfers to affiliates of the MOB Owner or third parties who have some combination of ownership and management experience and financial wherewithal.  Some ground leases will also include precluded transferee provisions, which prohibit the sale or transfer of the MOB Owner's leasehold interest and/or the MOB to certain third parties, including competitors of the Hospital and parties who are not in good standing with Medicare or Medicaid.  The protections notwithstanding, a Hospital will seldom be satisfied with permitted transferee and precluded transferee provisions as the sole backstop to a ROFO, and will almost always insist on coupling a ROFO with either ROFR or Purchase Option provisions, or both, as the last line of defense if the Hospital does not want a particular buyer to become the MOB Owner.

C.  Right of First Refusal

ROFRs are generally viewed as a much stronger right for the Hospital than a ROFO, but still not quite as strong as an ongoing Purchase Option.  A ROFR allows a Hospital to react to the market rather than trying to negotiate a market price on its own through the ROFO process.  As discussed above, if the MOB Owner offers the MOB to the Hospital pursuant to a ROFO the Hospital and the MOB Owner must negotiate and agree on a price. However, with a ROFR, the MOB Owner has already taken the MOB to the market, and the price and terms that the Hospital must accept if it desires to purchase the MOB are in theory reflective of FMV because it is the price an unaffiliated third party has agreed to pay for the MOB in an arm's length transaction. 

ROFRs also give Hospitals a defensive weapon if it does not like the potential purchaser presented by the MOB Owner.  In a typical ROFR provision the MOB Owner would be required to give the Hospital a copy of the material terms and conditions for the sale of the MOB and/or leasehold interest along with the identity of the prospective purchaser.  If the prospective purchaser satisfies any permitted transferee/precluded transferee requirements and the Hospital does not have the ability to disapprove of the transfer to the prospective purchaser, then the ROFR is the Hospital's last line of defense and gives them the ability to simply step in and buy the MOB pursuant to the terms of the ROFR. 

D.  Are Preferential Rights Necessary?

Many Hospitals will take the position that ground leases should include a Purchaser Option, a ROFR and a ROFO, although many are willing to negotiate and agree on a structure that is not overly burdensome on the MOB Owner.  MOB Owners will want the most flexibility in their ability to convey the MOB and as few restrictions as possible on their ability to receive the highest possible purchase price.  The interests of the Hospital can be reasonably protected without all three rights, although different Hospitals will value each of the three preferential rights differently, so MOB Owners who negotiate these rights with different Hospitals will end up with different combinations of them from deal to deal.   The Purchase Option generally provides the Hospital with the most power to protect its interests and control the hospital campus, and if a Hospital understands and values the power the Purchase Option affords them, they may push hard for it.  However, the Purchase Option also presents the path of greatest resistance to the MOB Owner's ability to sell the MOB, so the MOB Owner will likely push back with equal intensity.  Of the three types of preferential rights, the ROFO is clearly the most desirable for the MOB Owner because it provides the least amount of control for the Hospital and the most flexibility for the MOB Owner's exit strategy.  If, however, the MOB Owner is not successful eliminating the ROFR and Purchase Option in their entirety, the MOB Owner can protect its interest by drafting the preferential rights provisions to include the limitations beneficial to MOB Owners discussed in this article.

Conclusion

In conclusion, the growing trend of Hospitals exercising preferential rights under their ground leases is something that is expected to continue, especially as Hospital real estate departments become more sophisticated and medical real estate continues to grow as a preferred asset class in commercial real estate – after all, Hospitals as a group are still the largest owners of MOBs in the county.  A thorough understanding of how each of these preferential rights works and the common pitfalls associated with each type of provisions is critical in negotiating and understanding a ground lease for an MOB. 

Contacts:

Andy Dow | 214.745.5387 | adow@winstead.com

Cole Gearhart | 214.745.5285 | cgearhart@winstead.com 

Kirstyn Kelley | 713.650.2714 | kkelley@winstead.com


Disclaimer: Content contained within this article provides information on general legal issues and is not intended to provide advice on any specific legal matter or factual situation. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this information without seeking professional counsel.

Media Contact

Stephen Hastings
Director of Communications & Media Relations  
713.650.2485 Direct
832.343.4228 Mobile
shastings@winstead.com

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