Ruling could lead to moving experience for doctors; hospitals-owned medical buildings face new strictures.

Hospital-owned medical buildings face new strictures

The earthquake that rumbled through Los Angeles on Jan. 17 created highly publicized problems for hospitals, including the severe damage it wreaked on a medical office building owned by Kaiser Permanente. But such damage may be localized and short-lived compared to the far-reaching problems that many California hospitals could face as a result of a recent decision handed down by Riverside County Superior Court.

The decision, handed down last September, applies to all hospitals that own medical office buildings and are leasing space in those buildings to doctors at below-market rates.

The decision stemmed from a lawsuit involving medial offices which were owned by Corona Community Hospital but were sold to Vista Hospital Systems Inc. in late 1992.

When Vista bought Corona Community Hospital and its adjacent medical office building, which it has since renamed Corona Regional Medical Center, the new owner notified doctors that it wanted them to sign new leases at higher rates because it considered their existing leases illegal.

Vista contended that the leases it inherited from the former owners violated state and federal laws prohibiting hospitals from offering financial incentives to doctors in exchange for patient referrals.

But when Vista tried to cancel the existing leases, a group of doctors balked. The doctors filed a lawsuit asking the court to decide whether or not the leases were legal.

The court's September ruling declared the old leases illegal and stipulated that the doctors either sign Vista's new leases or face eviction.

That little-publicized decision has significant ramifications for any hospitals that own medical office buildings, sources said.

Ron Spoltore, national director of health care services at accounting firm Kenneth Leventhal & Co., said the ruling means that hospitals that own medical office buildings "should look closely at how they have established their lease rates and make sure they would hold up if challenged."

A non-profit hospital found to be charging below-market rents could lose its tax-exempt status, he said, and for-profit facilities might have their leases declared void.

"This puts a lot of hospitals potentially at risk regarding the lease structures in their medical office buildings," Spoltore said. He said the court ruling obviously would apply any time one hospital sells a medical office building to another hospital. But he said it opens the door for anyone -- whether it's another doctor or a competing medical office building landlord -- to challenge the leases in a medical office building owned by a hospital. "I'm not suggesting that hospitals have cut deals that are incentives to physicians, but now that this ruling has come down, they will have to be very careful about substantiating any lease agreements that are lower than prevailing market rates," Spoltore said.

Christopher Jensen, a Riverside attorney who represented the doctors in their suit against Vista, said that whether the court decision affects any individual hospital depends on whether that hospital owns medical office buildings and whether it is leasing space to doctors at below-market rates. But Jensen said the suit could have far-reaching affects because well over 50 percent of California hospitals own medical office buildings.

Jensen contended that his clients' leases, which carried average monthly rental rates of 75 cents per square foot, weren't below fair market value. Some of the doctors had up to nine years remaining on their old leases, he noted. Current monthly rents at the medical building, which Vista has since improved, are now $1.15 to $1.25 per square foot.

Jensen said that the old rates, at first glance, "might look ridiculously low" by comparison. But he added, "If you saw the buildings before the new owners improved them, you'd see why the rents were so low. The buildings are old, there's a lack of parking and there are some other problems. I don't think you can justify full market value in that case."

The doctors' suit argued that, even if the rates were below market, the doctors hadn't done anything illegal because there was nothing in their leases about low rates in exchange for patient referrals.

"Our doctors had no knowledge that any arrangement existed to lower the rates in exchange for patient referrals," Jensen said.

The court actually found the doctors innocent of any wrongdoing, but it ruled that the hospital's former management "clearly had an illegal intent to keep the doctors happy and get their referrals by keeping their rents low," Jensen said. The court declared the old leases illegal and said doctors would have to agree to new leases at fair market rates.

Jensen said he would have liked to appeal the case because he disagrees with the court decision. But the doctors and the hospital reached a confidential financial settlement rather than go through an appeals process that would have been bitter and costly for both sides.

There is no question that state and federal anti-kickback statutes stipulate "you can't coerce, induce or entice anybody to refer a patient in exchange for any type of financial consideration," Jensen explained. But he said he believes the court's decision went beyond the intentions of state and federal legislators.

Commented Jensen: "The testimony in this case was that having doctors in buildings next to hospitals as a general business practice means that doctors will be more likely to send patients to the hospital because it's convenient. That's why hospitals have always built medical buildings nearby. The former hospital didn't want the building to be a profit center; it just wanted the building to cover its costs.

"The court found that by intentionally not raising the rents to a fair market value -- with the understanding that more likely than not they were going to get the patients from the doctors -- the hospital was doing something illegal," Jensen continued. "I don't believe that Congress or the state Legislature intended that hospitals couldn't engage in a simple, common-sense business practice like that. There was no tie-in where the hospital was agreeing to give some kind of a rent reduction based on the number of patients a doctor referred to them."

According to Spoltore, the ruling comes at a bad time for doctors, who are trying to hold down costs because of uncertainty about how national health care reform will affect their earnings.

"Doctors are clearly seeing a change in their ability to charge the fees they historically have charged. So, they are looking at ways of reducing their operating costs. When their leases come up for renewal, they're asking for less space, and it's creating a little excess capacity in a market that has always been generally tight."

Spoltore suggested that hospitals could structure leases to offer non-financial advantages -- such as access to the hospitals' computerized information systems or preferred scheduling for laboratory work and diagnostic tests. "Hospitals should be creative in developing lease incentives that have no monetary value," Spoltore said. As examples of non-monetary incentives, he cited the concierges and retailers that some commercial office buildings provide to "enhance the work environment" for their tenants.

According to David Knowlton, a broker with commercial brokerage firm Grubb & Ellis Co. in Anaheim, lease rates at medical office buildings tend to be slightly higher than rates for comparable non-medical space for two primary reasons. First, medical space typically requires a higher parking ratio than standard office space, which means there is more real estate involved, which hikes the cost of building the space. Second, medical offices require more expensive tenant improvements, sometimes including highly specialized laboratories and equipment.

"These have to be paid for either by the doctor, out of pocket, or by the owner, and then amortized into the rent," Knowlton said.

Knowlton said there was a flurry of construction in medical office buildings a few years ago to meet what was then a shortage, but construction has since fallen off because the demand has been filled.

"I also think the market might be slowing down right now because of what's going on with Clinton's health plan," Knowlton added.

Jensen said the recent court ruling represents no problem for medical office building owners who don't also own hospitals. "General landlords" can adjust rates however they like to remain competitive, he said, as long as they don't also own hospitals.

"But if you have an ownership interest in a hospital, and you also are a landlord of a medical office building, you should be quite concerned," Jensen said. "If there's one judge in the state who will rule this way, there are probably others."