The impact of New York's profit caps on nursing home development

A nursing home resident receives a shot of the coronavirus disease (COVID-19) vaccine,. REUTERS/Yuki Iwamura

December 28, 2021 - As we get ready to turn the page to 2022, one hesitates to continue to discuss the COVID-19 pandemic. However, the fallout continues, with fresh ramifications for the long-term care industry. The industry continues to receive heightened scrutiny following the pandemic, and New York's legislative answer to the concerns are set to hit nursing home businesses in New York as of Jan. 1, 2022, with a cap on allowable profits. The impact on capital outlays and acquisitions remains to be seen.

Both legislatively and through executive action, the State of New York began introducing fresh proposals impacting nursing homes in March 2021. The goal of the legislation was to ensure nursing homes, which receive government funding, spend at least 70% of their revenues on direct resident (patient) care, 40% being utilized directly to pay staffing costs for resident-facing staffing such as registered nurses, licensed practical nurses and nursing aides, with requirements on the minimum number of hours such staff need to spend with a patient per day.

Additionally, which is the larger concern of the two items, New York decided that nursing home businesses should not be operated for profit and, effective Jan. 1, 2022, it has capped allowable profits for nursing home businesses at no more than 5%, as determined by revenue and expenses reported on Medicaid cost reports.

The 5% profit cap excludes revenues that are considered extraordinary gain. Examples of expenses that will not be allowed for inclusion in the profit calculation are (i) any related party transaction or compensation if the value received from the transaction is greater than fair market value, and (ii) compensation for employees who do not actively work in or for the nursing home facility. Any profits received above the 5% amount will need to be remitted to the State of New York by Nov. 1 in the year following the year in which the expenses are incurred. These funds are to be deposited into the Nursing Home Quality Pool pursuant to Section 2808(2-c)(d) of the New York Public Health Law.

The New York Department of Health has been tasked with establishing civil penalties for facilities that are out of compliance with the spending requirements beginning April 1, 2022. The regulations set forth by the department provide for penalties of up to $2,000 per day for each day the facility is deemed to be out of compliance. These penalties can be reduced to no less than $300 per day if there are mitigating circumstances, as set forth in the regulations and determined by the department.

In determining whether to impose penalties, the Department of Health may also consider mitigating factors, including catastrophic events that require unanticipated expenses, frequency (or infrequency) of non-compliance by a provider, and the existence of acute regional labor shortages, which has been a continuing concern for many facilities in the last two years.

Nursing home real estate and operations financing, as with certain other commercial real estate financing, is dependent on cash flow from the operations of the property tenant, operations often made possible by such financing. However, New York's new spending requirements do not permit the inclusion of debt service, rent and leases, capital costs, capital depreciation or many administrative costs to be included in the expenses counted toward the required spending levels for nursing homes. This puts pressure on tenants under standard triple net leases, where tenants are responsible for paying all of the expenses of a property, as the tenant operators of the nursing homes — the licensed nursing home providers — may have to choose between suffering penalties or having sufficient cash flow to pay the rent required by the property owner's lender to cover debt service, real estate taxes, capital expenditures, and other excluded expenses.

Another issue with the cap on profits is what this does to the value of the property. This matters from both an acquisition and a financing perspective. From an acquisition perspective, the inability of the for-profit business developed or acquired by the current owner to continue to be reasonably profitable going forward likely diminishes the anticipated appreciation of the going concern, making it a less appealing business model in the State of New York for experienced nursing home operators.

On the financing side, borrowers and lenders alike will have to evaluate how this new law will affect loan-to-value covenants. Cash flow projections are key to appraising the value of a nursing home business. If cash flow is capped at levels less than projected when a loan is obtained, this could potentially put a borrower in default due to its need to comply with the law.

Aside from the spotlight the COVID-19 pandemic shone on the nursing home industry, this new law appears to be justified by the fact that nursing homes are the recipients of state Medicaid funding. However, revenues are also derived from private insurance, private resident pay, and Medicare. These sources of revenue are not taken into account in the cap on profits and recoupment of excess monies by the State of New York above the 5%. Time will tell, therefore, whether this law will be able to withstand expected legal challenges based on a regulatory takings theory.

There are many factors that complicate the analysis of the impact this new law may have as the clock rolls over to 2022. One thing is clear, however: New York has become a less-friendly environment for nursing home businesses at a time when the population in need of such services is only increasing.

Perhaps direct care spending, a requirement that emanates directly from the desire of officials to ensure adequate staffing exists for the required level of care, should have been analyzed on its own without combining it with the cap on profits. Eliminating the incentive to invest in infrastructure to meet the existing and future demands of the senior population may have unintended consequences.

Opinions expressed are those of the author. They do not reflect the views of Reuters News, which, under the Trust Principles, is committed to integrity, independence, and freedom from bias. Westlaw Today is owned by Thomson Reuters and operates independently of Reuters News.

Kyra Fischbeck Howell is counsel in the Nashville office of Bradley Arant Boult Cummings LLP, where she practices in the area of commercial real estate and finance transactions in the firm's Real Estate and Finance and Healthcare Practice Groups. She has been involved in closing over $2 billion in financing transactions in the long-term care industry, for which she is involved in purchases, refinances, bridge-to-HUD loans and HUD loans. She can be reached at khowell@bradley.com.