Healthcare REITs

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Thomas Gaffney

This article is about the Health Care REIT industry. For the company, see Health Care REIT (HCN). To view the WikiData for this industry, see REIT - Healthcare Facilities

Health Care REITs are Real estate investment trusts that own health care properties. Like all REITs, Health Care REITs are required to pay out 90% of their taxable income in dividends. This increases shareholder return, but it also means that most Health Care REITs are unable to finance expansion from operating income, instead issuing equity and debt. This reliance on debt causes Health Care REITs to be particularly sensitive to changes in interest rates. Fluctuating interest rates can impact debt service payments on variable rate debt, decrease a REITs' stock price as bonds provide greater returns, or increase the cost of issuing new debt, slowing expansion.

Health Care REITs are also subject to legislation which prevents them from operating health care facilities. Most health care REITs lease their properties to third party managers such as Brookdale Senior Living (BKD), Kindred Healthcare (KND) and Sunrise Senior Living (SRZ) which typically operate multiple properties. These managers lease the entire facility on a "triple net" basis, paying the REIT owner a fixed rental fee while also paying all operating costs, maintenance and upkeep associated with the property.

Companies Involved

As of February 1st, 2008 there were ten publicly traded U.S. Health Care REITs.^[1] Of those, five accounted for 90% of the sector market capitalization. The following Health Care REITs are listed in descending order by market capitalization.^[2] The first three are in the Russell 1000.

• Health Care Property Investors (HCP): As of September 17th, 2007 HCP was the largest Healthcare REIT in the United States by capitalization, with $14.0B in enterprise value.^[3] HCP is the only Health Care REIT to operate life science centers, and one of the most acquisitive. Over the last three years HCP acquired over $10B in new assets, trying to position its portfolio towards private pay assets.^[4] As of December 31st, 2007 HCP owned 753 properties in 37 states.
• Ventas (VTR): The majority of VTR's properties cater towards the elderly. In 2007 VTR acquired Sunrise Senior Living, a portfolio of senior housing communities, for $2.0B. Over the past five years VTR has spent $5.0B on acquisitions trying to position its portfolio towards private pay assets.^[5] As of December 31st, 2007 VTR owned 519 properties in 43 states.^[6]
• Health Care REIT (HCN): In 2006 and 2007 HCN focused on establishing its Medical Office portfolio. In 2006 the company acquired Windrose Medical Properties, a portfolio of Medical Office buildings.^[7] In May 2007 it acquired Paramount Real Estate Services to act as property manager for the newly acquired Windrose Portfolio and 17 new medical office buildings from affiliates of the Rendina compines.^[8] HCN's revenue increased from $265M in 2005 to $486M in 2007 due to HCN's medical office acquisitions. HCN owns 638 properties, scattered across 38 states.
• Nationwide Health Properties (NHP): NHP owns skilled nursing, senior housing and long term care properties catering towards the elderly.^[9] The company was acquired 78 properties in 2007, the majority of which were senior housing or skilled nursing facilities.^[10] NHP operates its medical office buildings and leases all its other properties to operating tenants. As of December 31st 2007 the company had a diversified tenant base, with 83 different operating tenants. Only two tenants, Brookdale Senior Living (BKD) and Hearthstone Senior Services, accounted for more than 10% of rental revenue.^[11] As of December 31st, 2007 the company owned 560 properties in 43 states.
• Senior Housing Properties Trust (SNH): SNH owns senior housing and continuing care centers which cater to the elderly.^[12] Those properties include senior housing facilities where residents can receive various levels assisted living and health care services, skilled nursing facilities, and two rehabilitation hospitals.^[13] The company leases all its properties on a triple net basis, holding no operating properties. The company leases 2/3 of its properties to one tenant, Five Star Quality Care (FVE), and the majority of its leases extend through 2020.^[14] As of December 31, 2007 the company owned 220 properties in 32 states.

The following REITs make up 10% of Health Care REIT sector by market cap. They are listed in descending order by market cap.

1. Omega Healthcare Investors (OHI)
2. Medical Properties Trust (MPW)
3. LTC Properties (LTC)
4. Universal Health Realty Income Trust (UHT)
5. Cogdell Spencer (CSA)

Industry Overview

Health Care REITs typically own the following four types of properties.

1. Senior Housing: These include both assisted living and independent living communities for seniors, which provide access to health care on the premises.^[15]
2. Hospitals: Many health care REITs operate acute care hospitals, which cater to the elderly and patients that require long term, continuing care.^[16]
3. Skilled Nursing Facilities: These facilities provide long term care, primarily for elderly patients, that do not require the extra services of an acute care hospital.^[17]
4. Medical Office Buildings: One of the few types of health care properties that Health Care REITs can operate, these properties lease office space directly to physicians and hospitals.^[18]

This list is not exclusive. For example Health Care Property Investors (HCP) owns and operates Life Science Centers, which are offices and laboratory space for bio-tech and pharmaceutical companies.

The performance of Health Care REITs is tied to the demand for healthcare in the United States. Important factors include the aging U.S. population and changing preferences for varying healthcare services. As the baby boomers age demand for Health Care in the United States will increase, as persons 75 years of age and older spend 60% more on healthcare than those 65-74 and 200% more than the population average.^[19] Though the aging population affects the demand for almost all health care properties, changing consumer preferences impact which type of health care properties are most lucrative.

In recent years, one of the most in demand sectors of health care real estate have been Medical Office Buildings (MOBs). MOBs provide office space for clinics, physicians and hospitals, demand for which is expected to rise over the next decade. Because the doctor's office is an individual's entry point into the health care system, an increase in the demand for all types of health care, from impotence treatment to chemotherapy, fuels an increase in the demand for doctors offices and the MOBs in which they locate.^[20] Also, due to the falling cost of complex medical equipment and advance of non-invasive procedures, there is an ongoing shift towards the delivery of care in an outpatient setting.^[21] Small doctors and clinics, many of which locate in MOBs, can now provide treatments that used to be available only in major hospitals. This is creating a shift towards smaller care centers, which is expected to fuel an increase in the demand for MOBs.

Trends and Forces

Declining Medicare and Medicaid Reimbursement Rates Affect Tenants’ Revenues and Their Ability To Pay Rents

• Medicare and Medicaid pay out reimbursements to medical operators based on pre-determined, fixed rates. These rates are determined by legislators, and are usually less than the rates operators receive from private pay sources. These reimbursement rates are also subject to frequent revision, as legislation changes and Federal and State governments try to tighten their budgets. For these reasons many Health Care REITs have been shifting their portfolios away from assets that rely on Medicare and Medicaid reimbursements towards assets that receive the majority of their revenues from private insurance or individual savings. For example, over the last few years HCP has invested $10B trying to reposition its portfolio towards private pay assets.^[22]
• Operators of senior housing facilities usually receive virtually no Medicare or Medicaid reimbursements, but operators of skilled nursing facilities and specialty care facilities receive a majority of their income from governmental sources.^[23] Reimbursements for Medicaid related services are usually paid out by both State and Federal Governments, and are subject to rates and caps. ^[24] These caps are subject to change when legislation is renewed or passed.
• The Deficit Reduction Act of 2005 reduced funding of the Medicaid program by $4.8B over the next five years, leading many to believe Medicaid will cut reimbursement rates over that period.^[25] Similarly, on January, 1st, 2008 the government undertook a study to determine the costs and outcomes of various treatments for patients discharged from hospitals, with an eye to changing Medicare reimbursements for those treatments.^[26] One focus of the study is skilled nursing facilities, so the results of this study are expected to impact expense reimbursement for these facilities.
• There is increasing political momentum to provide some form of Universal Health Coverage in the United States. Democratic candidates Hillary Clinton and Barack Obama have both laid out plans that would provide some sort of universal access to health care coverage.^[27] If these plans are implemented, more people would have government sponsored insurance plans, increasing tenants' percentage of revenues from government reimbursements.

An Aging Baby Boomers Population Is Likely To Increase Demand For Health Care Services and Health Care Properties

• Many Health Care properties cater to the elderly, including senior housing, acute care hospitals and skilled nursing facilities.
• Health Care is the single largest industry in the United States based on GDP.^[28] According to the National Health Expenditures report, released in January 2007 by the Center for Medicare and Medicaid Services (CMS), the healthcare industry is projected to represent 16.5% of the U.S.’s GPD in 2008. ^[29] The CMS projects this will expand to 22% by 2015 as the U.S. population ages and requires more health care services.
• The number of Americans 65 and older is expected to grow 36% between 2010 and 2020, compared to a 9% growth rate for the general population.^[30] According to the Center for Medicare and Medicaid Services, persons 75 years of age and older spend 60% more on healthcare than those 65-74 and 200% more than the population average. ^[31] An increase in the number of older Americans is expected to fuel a large increase in demand for health care services and health care properties.

^[32]

Governmental Regulation Negatively Impacts Property Owners' Collections of Rents From Tenants

• Operators of assisted living and independent living facilities are typically regulated by the State Governments in which they operate and are subject to minimal regulatory oversight.^[33] In contrast, operators of skilled nursing and specialty care facilities are typically regulated by the Federal Government and are subject to much more stringent regulation.^[34]
• If a health care property fails to meet Federal regulations, regulatory agencies have the option to deny Medicare or Medicaid reimbursements or close the facility.^[35] If the facility’s closure results in a lease termination by the operating tenant, it will cause a reduction of rents paid to the property owner.
• If an operating tenant vacates a property, regulatory delays are likely as the property owner searches for a new tenant. Many states have Certificate of Need ("CON") laws which require a property owner to show need for a facility before transferring operating control.^[36] This presents a challenge as many states are tightening their CON laws, making it more difficult for a property owner to show the need for its facility.^[37] Because of the specialized uses of many health care buildings, if the property owner is unable to show a need for a specific type of facility the owner will have to renovate that facility for another purpose before transferring it to another operator.^[38] So changes in operating control result in a long, bureaucratic process for Health Care REITs.

Some Health Care REITs are Highly Levered, Increasing The Risk of Interest Rate Fluctuations and Difficulties in Refinancing During a Credit Crunch

• Like all REITs, Health Care REITs are required to pay out 90% of their taxable income in dividends. Because of this requirement, in order to fund expansion REITs need to issue equity or debt. This causes many REITs to accumulate large debt balances in periods of expansion. Large debt balances increase the risk a company will be unable to re-finance that debt and, in the case of variable rate debt, the risk that fluctuations in interest rates will increase a company's debt service payments.
• For example, HCP has been undergoing an overhaul of its assets in the last few years, which has caused the company to accumulate huge amounts of debt. As of December 31, 2007 the company had about $7.5B in debt outstanding, including $1.35B of a bridge loan due in July of 2008 (with two 6 month extension options) HCP used to acquire Slough Estates. ^[39] Of that $7.5B, approximately 38% or 2.8B was variable interest rate debt. HCP also holds $1.0B in variable rate mezzanine loans.^[40] As of December 31, 2007 a one percentage point increase in the interest rates on HCP's variable rate debt and variable rate loans would lead to a net increase in interest expense of $28.0M.^[41] This is equivalent to a 30% decrease in operating income for 2007.
• Fluctuating interest rates also create risk when a company is refinancing. For example, HCP has $500M in debt maturing in 2008 and $1.6B maturing in 2009. This represents approximately 30% of the company’s total debt maturing within the next two years.^[42] If interest rates rise HCP will have to refinance at higher rates, which, in the case of fixed rate debt, will create higher interest payments over the life of the loans.
• If Health Care REITs are unable to refinance maturing debt due to the Credit Crunch they will have to repay the debt in other ways. One option is to issue equity. However if equity is issued at low prices it would dilute the ownership interests of current shareholders. Another option would be to sell assets; but if assets are sold before they can reach their full potential, the REIT will fail to meet its target return on those assets decreasing the total return available for distribution to shareholders. A lack of credit also creates a lack of able buyers, which makes finding a buyer for a property more difficult.

Market Share

As of February 1, 2008 there were ten REITs in the United States dedicated to owning health care related properties. The largest five represent approximately 90% of the gross value of health care properties owned by health care REITs.^[43][44] The health care industry is highly fragmented; as a sector, health care REITs account for less than 4% of the gross value of U.S. health care real estate.^[45][46] In the chart below, properties measured include skilled nursing facilities, medical office buildings, senior housing and specialty/acute care hospitals.

^[47][48]

The following presents the value of U.S. Health Care assets by property type. As of December 31, 2007 no health care REIT accounted for more than 2% of the value any particular property type or 1% of all U.S. health care real estate.

^[49]

References

1. ↑ NAREIT
2. ↑ As of May 3rd, 2008 Google Finance
3. ↑ HCP Investor Presentation, September 17th, 2007 Page 3
4. ↑ 2007 Annual Report, Letter to Shareholders
5. ↑ Investor Presentation, April 2008, Pages 14, 17
6. ↑ Reuters
7. ↑ HCN Investor Presentation, February 2008, Page 29
8. ↑ 2007 Annual Report, Letter to Shareholders, Page 11
9. ↑ Reuters
10. ↑ Reuters
11. ↑ Reuters
12. ↑ Reuters
13. ↑ Reuters
14. ↑ Reuters
15. ↑ Reuters
16. ↑ Reuters
17. ↑ Reuters
18. ↑ Reuters
19. ↑ 2007 Form 10-K Page 2
20. ↑ NAREIT, February 1st 2008
21. ↑ NAREIT, February 1st 2008
22. ↑ HCP 2007 Annual Report, Letter to Shareholders
23. ↑ 2007 HCN Form 10-K Page 8
24. ↑ 2007 HCN Form 10-K Page 11
25. ↑ HCP 2007 Form 10-K, Page 14
26. ↑ 2007 Form 10-K Page 10
27. ↑ Factcheck.Org
28. ↑ HCN 2007 Form 10-K Page 1
29. ↑ HCN 2007 Form 10-K Page 1
30. ↑ Forbes.Com "Sector Snap-Health Care REITS", Associated Press
31. ↑ 2007 Form 10-K Page 2
32. ↑ Investor Presentation, September 17th, 2007 Page 3
33. ↑ HCN 2007 Form 10-K Page 8
34. ↑ HCN 2007 Form 10-K Page 8
35. ↑ 2007 Form 10-K Page 9
36. ↑ HCN 2007 Form 10-K Page 9
37. ↑ VTR 2007 Form 10-K, Page 11
38. ↑ HCN 2007 Form 10-K Page 28
39. ↑ HCP 2007 Form 10-K, Page 19
40. ↑ HCP 2007 Form 10-K, Page 65
41. ↑ HCP 2007 Form 10-K, Page 65
42. ↑ HCP 2007 Form 10-K, Page 65
43. ↑ NAREIT, February 1st 2008
44. ↑ Google Finance
45. ↑ Google Finance
46. ↑ 2007 Form 10-K Page 41
47. ↑ Google Finance
48. ↑ 2007 Form 10-K Page 41
49. ↑ 2007 Form 10-K Page 41