Social infrastructure assets, such as hospitals, fire stations and day care centres, continue to draw a considerable amount of attention from real estate investors despite the challenging situation on the Finnish real estate market. Drawing from our past experience in real estate transactions in the social infrastructure space as well as insights from leading commercial advisors in the market, this article discusses the background for such interest as well as provides practical insights for both municipalities and real estate investors interested in either divesting or acquiring such assets.
What’s the healthcare and social services reform about?
An extensive healthcare and social services reform entered into force in Finland on 1 January 2023. As a result of the reform, the responsibility for organising these services was transferred from municipalities to wellbeing services counties (in Finnish: hyvinvointialue), which were established in connection with the reform. The key objective of the reform was to improve the availability and quality of basic public services throughout Finland.
Implications of the reform to the use and possession of social infrastructure assets
As a result of the reform, Finnish municipalities have turned into real estate investors instead of being users of the social infrastructure assets that they own. This can be an undesirable situation for municipalities, as owning real estate without having any connection to the services provided by the municipality is not a statutory purpose of municipalities. For this reason, municipalities have begun to divest such assets by way of concluding sale and leaseback transactions with professional real estate investors. A large number of public-use social and healthcare properties were sold already before the reform took effect, often as large real estate portfolios. In connection with these transactions, the municipalities entered into long-term lease agreements as tenants and when the reform took effect on 1 January 2023, these leases were automatically transferred from municipalities to wellbeing services counties by way of statutory law.
“Purchasers could have a better chance of obtaining debt financing for future acquisitions of social infrastructure assets.”
Statutory break option and its implications
Even though the terms of such leases were pre-negotiated and generally are in line with Finnish market practice, all of them contain one very exceptional clause. The Act on the Temporary Restriction of Certain Contracts of Municipalities and Joint Municipal Authorities in Healthcare and Social Welfare (548/2016, as amended, “the Restriction Act“) required municipalities to include a break option entitling wellbeing services counties to terminate the leases prematurely at 12 months’ notice during the years 2024 or 2025. The purpose of this statutory break option was to prevent municipalities from entering into long-term commitments which could later become a burden to the wellbeing services counties.
Notwithstanding the statutory break option, professional real estate investors have been attracted by such assets, most likely due to the strong solvency of the public tenants as well as the availability of long lease terms. The transaction volume of all public use properties was very significant in 2022, being EUR 1.5 billion out of a total transaction volume (including all asset classes) of EUR 7.2 billion in Finland. At least as far as larger properties were concerned, investors have deemed the break option to constitute only a minor risk. The bigger portfolios inevitably include also smaller assets which may have a greater likelihood of the wellbeing services counties exercising the break option, but since such assets normally represent only a small percentage of the net operating income of the portfolio, investors have not deemed this risk to be an issue. The existence of a break option has, however, impacted on the willingness of banks to provide debt financing for such transactions, meaning that purchasers and sellers have been compelled to resort to creative and innovative solutions in order to reach a deal. For example, a deferred purchase price mechanism was used when the City of Jyväskylä sold a large social and healthcare service facilities portfolio to the Nordic infrastructure investor Infranode. Dittmar & Indrenius advised the purchaser (Infranode) in the transaction.
Situation as of 1 January 2023
The wellbeing services counties now occupy the properties needed to provide healthcare and social services, either as tenants of private real estate investors or as tenants of Finnish municipalities. Because the Restriction Act was repealed as of 1 January 2023, any new lease agreements concluded after that date no longer need to include a statutory break option. This means that purchasers could have a better chance of obtaining debt financing for future acquisitions of social infrastructure assets.
Statutory “3+1” year lease term and rent level
Even though we expect municipalities to continue divesting their public-use social and healthcare properties, there are legal considerations which should be taken into account when planning such transactions. According to the Act on the Implementation of the Health and Social Services Reform (616/2021, the “Implementation Act”), wellbeing services counties and municipalities were required to enter into fixed-term lease agreements which are in force from 1 January 2023 until 31 December 2025. After the initial fixed term, the wellbeing services counties have the right to extend the leases by one year by notifying the municipality thereof at least 12 months prior to the expiry of the lease. Furthermore, according to the Implementation Act, the rent paid by the wellbeing services countries to the municipalities shall cover reasonable capital and maintenance expenses. According to a Governmental Decree issued on the basis of the Act (272/2022, the “Decree”), the rent is to be a gross rent consisting of capital rent and maintenance rent. The capital rent is to be based on a 6.0% yield calculated on the technical value of the building.
According to the Implementation Act, the wellbeing services counties and the municipalities may agree to deviate from the above-described lease term of 3+1 years. However, the fact remains that wellbeing services counties are under no obligation to extend the terms of lease beyond 31 December 2025. On the other hand, the Implementation Act can be interpreted to mean that the parties (i.e., municipalities and wellbeing services counties) may not agree to deviate from the rent level specified in the Decree during the transitional period of 3+1 years.
We expect that real estate investors and banks will deem a lease term of 3+1 years to be inadequate in most cases. Consequently, we see the following three main alternatives in order to facilitate future transactions:
|The municipality negotiates and enters into a new long-term lease agreement with the wellbeing services county before the asset is sold to an investor. As the long-term agreement would be negotiated by the municipality as a pre-sale item, it is possible that the lease would not meet the expectations and requirements of the investor. This risk can be mitigated by way of retaining competent advisors who will participate in the lease negotiations and ensure that the lease will not contain any unexpected or onerous terms.
|The investor negotiates directly with the wellbeing services county a new long-term lease agreement, which will take effect upon the closing of the transaction. The provisions of the Decree concerning rent level would not have to observed in the lease negotiations, but in practice, the wellbeing services counties may be hesitant to agree to a higher rent level.
|The investor obtains sufficient comfort through due diligence that the wellbeing services county will need the property in question also after the transitional period of 3+1 years has expired, meaning that the transaction is closed without negotiating a new long-term lease agreement. Deals for major healthcare centres located in larger Finnish cities could fall into this category. Here, the investor would negotiate a new long-term lease agreement with the wellbeing services county on a post-closing basis before the 3+1 year transitional period has expired. However, as noted earlier, obtaining debt financing for deals falling into this category is likely to be challenging.
Commercial insights for future transactions
For our article we have interviewed Director Erkki Hakala from Catella Corporate Finance, who has extensive experience in Finnish social infrastructure transactions.
According to Mr Hakala, real estate investors will continue to deem social and healthcare properties to be a very interesting asset class due to long lease terms, indexed rents, financially solid tenants and in many cases also good asset locations. However, negotiations for new deals are currently progressing slowly due to the generally challenging market conditions. It is also clear that wellbeing services counties have only started analysing which properties are needed in the long run and may, accordingly, not yet be ready to enter into new long-term lease agreements. The eagerness of municipalities to divest such assets is high and will increase further towards the end of the transitional period of 3+1 years. After the expiry of the transitional period, municipalities will become full-blooded real estate investors and will, as a rule, be obligated to spin off properties which they do not use or need to fulfil statutory purposes into separate real estate companies. This is a scenario which municipalities would prefer to avoid.
According to Mr Hakala, the question of whether to wait towards the end of the 3+1 transitional period, or whether it would make sense to complete the deals sooner, is complex and depends on the properties in question as well as on whose perspective the situation is assessed (seller vs. purchaser). However, Mr Hakala foresees problems if sales processes are postponed indefinitely. A large number of social infrastructure properties will be out for sale simultaneously towards the end of the 3+1 year transitional period, even though only a limited number of investors will be interested in such assets. For this reason, it is possible that municipalities will not find a purchaser for all assets, in particular for such assets which are smaller and therefore less attractive from an investor perspective. Also the availability of competent advisors may be limited at that time. On the other hand, the most attractive properties will very likely be sold regardless of the timeframe for concluding the deal, especially if a new long-term lease agreement has been negotiated with the wellbeing services county before the sale.
As far as the three transaction types (a., b. and c.) described above are concerned, Mr Hakala believes alternative a. would be the most feasible one in most situations. Here, it will be of utmost importance to retain competent real estate professionals to advise in the lease negotiations as a poorly negotiated lease agreement could scare investors off and become a deal breaker. On the other hand, alternative b. would ensure that the lease is satisfactory from an investor perspective but will likely result in a longer transaction process and additional transaction costs in comparison to alternative a. Alternative c. could be an option when the most attractive properties are put out for sale, but bidders would probably have to finance such a deal with equity.