Health Care Property Investors (HCP)

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Thomas Gaffney

Andrew Lewis

HCP is a real estate investment trust investing in real estate serving the health care industry in the United States.^[1] Because of regulations that prevent REITs from operating health care properties, HCP does not manage most of its properties, instead leasing them to operating tenants on a triple-net basis. Also, like all REITs federal regulations require HCP to pay out 90% of its taxable income in dividends. HCP has historically paid out a stable dividend.

Demand for HCP's properties, like that of all healthcare REITs, is tied to the demand for healthcare in the United States. Factors affecting demand for HCP's properties include the aging U.S. population and changing government health care legislation. On the competitive landscape, HCP is the largest healthcare REITS by value.^[2]

Business Overview

HCP earns its revenue by leasing properties to tenants. Because of federal regulations which prevent REITs from operating health care centers, most of HCP's properties are structured under triple net leases, where the tenant pays for all operating costs associated with the property.^[3] This minimizes HCP's operating expenses but concentrates tenant credit and vacancy risk in a smaller number of large operating tenants. A notable exception is HCP's medical office buildings (MOBs) and life science centers. Federal regulation permits REITs to operate MOBs and life science centers, and HCP actively manages these properties, collecting rents directly from tenants and paying all operating expenses. Leases on HCP's operating properties are typically signed by smaller tenants and have shorter terms than the triple net leases on HCP's investment assets. These short lease lengths lead to greater returns during boom times, as occupancy rates rise and rental rates increase more quickly than at HCP's triple net properties. However, a slowdown in the health care industry hurts these properties' revenues more, as the shorter lease lengths at operating properties enable tenants to cancel their leases or negotiate lower rental rates.

Business & Financial Metrics^[4]

In 2009, HCP generated a net income of $109.1 million on $1.12 billion in total revenues. This represents a 74.4% drop in net income on a 0.3% increase in revenues from 2008, when the company earned $425.4 million on revenues of $1.15 billion.

Business Segments^[5]

The five types of properties HCP invests in are presented below:^[6]

• Senior Housing: Assisted living communities for seniors which provide access to on premise health care, have support staff on call, and offer various levels of community activities for its senior residents.^[7] Residents typically live in apartments or condominium units and the level of service provided is lower than that of a nursing home. Many senior housing facilities are private pay assets, they do not accept or are not eligible for government reimbursement.
• Life Science: Acquired in the Slough Acquisition (discussed below) these are laboratories and office space for biotechnology and pharmaceutical companies, governmental agencies and other scientific institutions.^[8]
• Medical Office Buildings: These provide office space for physicians and hospitals.^[9] The individual practitioners in MOBs have the option of whether or not to accept Medicare or Medicaid government reimbursement.
• Hospitals: HCP operates acute care hospitals, which provide long term care for patients with chronic illness, especially the elderly.^[10] Most hospitals accept government Medicare/Medicaid reimbursement.
• Skilled Nursing Facilities: Otherwise known as nursing homes, these facilities provide long term care, primarily for elderly patients, that do not require the extra services of an acute care hospital.^[11] Skilled nursing facilities usually accept government reimbursement in the form of Medicare/Medicaid.

^[5]

Trends and Forces

HCP Is Highly Levered, Increasing The Risk of Interest Rate Fluctuations and Difficulties Refinancing During the Credit Crunch

• As interest rates rise, HCP sees a decrease in its stock price as alternative investments provide greater Return on investment (ROI). This occurs because as rates rise, fixed income instruments such as bonds provide higher returns. Since investors are able to earn a higher risk-adjusted return on fixed income instruments, they shift their investment out of HCP's stock and into these fixed income products. When the number of people wishing to hold HCP's stock decreases, the stock price falls.

• If HCP is unable to refinance maturing debt due to the Credit Crunch it will have to repay its debt in other ways. One option is to issue equity. However, if equity is issued at low prices it would dilute the ownership stake of existing shareholders. HCP could also sell some of its properties to raise cash. However, if HCP is forced to sell assets before they can reach their full potential, it will fail to meet its target return on those assets. A lack of credit also creates a lack of able buyers which creates difficulty when finding a buyer for distressed properties.

An Aging Baby Boomer Population Is Likely To Increase Demand For Health Care Services and HCP's Properties

• Many of HCP's properties cater to the elderly, including its senior housing, hospitals and skilled nursing facilities.
• Health Care is the single largest industry in the United States based on GDP.^[12]
• 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.^[13] 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. ^[14] 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.

The Demand For Medical Office Buildings Is Growing

• HCP has a large Medical Office Building (MOB) portfolio. Unlike other types of health care properties, HCP is able to operate as well as lease its MOBs, maximizing its returns from these investments.
• 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 treament to chemotherapy, fuels an increase in the demand for doctors offices and, therefore, the MOBs in which they locate.^[15]
• Due to the falling cost of complex medical equipment and advance of non-invasive procedures, there is an ongoing shift to the delivery of care in an outpatient setting.^[16] 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.
• Many hospitals who want to free up capital have begun selling their MOBs to Health Care REITs and then leasing them back from the REIT on a long term basis.^[17] This trend provides HCP an opportunity to purchase MOBs at competitive prices while simultaneously leasing a high quality, long term tenant.

Increased Governmental Regulation Affects HCP's Collection of Rents From Tenants

• If one of HCP's properties fail to meet federal regulations, the state and federal government can deny Medicare or Medicaid reimbursement or close the facility.^[18]
• If an operating tenant vacates a property, government regulations typically cause significant delays in finding a new operator for the property. States in which HCP operates have increasingly been passing Certificate of Need ("CON") laws.^[19] These laws require a health care property owner to show need for a facility before transferring operating control (i.e. signing a lease with a new operating tenant).^[20] If HCP fails to show a need for its facilities under CON laws, it would result in a revocation of the facilities operating license.^[21] Even if it does show a need for the property, the approval process is often long and arduous.
• HCP's entrance into the life sciences sector exposes it to a new kind of government regulation. Amgen (AMGN) and Genentech (DNA), HCP's two largest life science tenants, are established and successful pharmaceutical companies. However many of HCP's life science tenants are not established. Some of HCP's pharmaceutical tenants do not even have a product approved by the FDA.^[22][23] The FDA's approval process is long and expensive, and requires substantial investment before a company begins earning revenues.^[24] If a tenant’s product fails FDA approvlal, the tenant will find itself without a source of revenue, increasing the risk that the tenant will default on their lease payments to HCP.

Declining Medicare and Medicaid Reimbursement Rates Affect HCP's Tenants’ Revenues and Therefore Their Ability To Pay Rents

• Though the pharmaceutical companies which occupy life science centers typically receive little revenue directly from Medicare and Medicaid, they do face risk that Medicaid/Medicare reimbursement rates will decrease. Pharmaceuticals often sell their products to distributors, such as hospitals and pharmacies, which then sell the drugs to consumers. Many of these consumers pay these hospitals and pharmacies for the drugs using Medicare/Medicaid. Pharmaceutical companies, though receiving a small portion of their income directly from Medicaid/Medicare, see demand for their product fluctuate with the reimbursement rates of Medicare/Medicaid.^[25] As reimbursement rates for Medicaid/Medicare fall, individuals will not be willing to pay as much for drugs produced by life science tenants.
• There is increasing political momentum for some form of universal health coverage in the United States. If a radical plan is implemented, more people would have government sponsored insurance plans, increasing HCP’s tenants collections of government reimbursements and impacting their total revenues.

Competitors

Some of HCP's biggest competitors include Health Care REIT (HCN), Ventas (VTR), and Nationwide Health Properties (NHP).

HCP is the largest health care REIT in the United States, larger than its competitors in terms of revenues, market cap and operating properties.^[26] HCP and its competitors all operate on a national scale, and have between $300M and $1B in revenues. HCP is distinguished from its competitors by its new entrance into the life sciences sector. HCP also receives a large portion of its revenues from medical office buildings. Combined, this means HCP receives much more of its revenues from assets the company actively manages than its competitors. This increases HCP's upside potential on these assets, allowing the company to exercise operational expertise to increase earnings. It also exposes the company to operational risks, however, including decreased occupancy and declining rental rates.

HCP also receives a much smaller percentage of its revenues from skilled nursing facilities. This is significant as skilled nursing facilities usually receive a larger percentage of their revenues from government reimbursement programs than many other types of health care properties.^[27] HCP's minimal focus on skilled nursing facilities decreases the company's reliance on government reimbursements.

HCP operates in fewer states than its competitors, leaving it more open to geographic risk. The most significant of these risks are changes in state Medicaid reimbursement rates, which have been fluctuating especially at the state level.

References

1. ↑ 2007 Form 10-K Page 1
2. ↑ Investor Presentation, September 17th, 2007 Page 3
3. ↑ 2007 Form 10-K, Page 7
4. ↑ HCP 2009 10-K pg. 39  
5. ↑ ^{5.0 5.1} HCP 2009 10-K pg. 10  
6. ↑ Reuters
7. ↑ Reuters
8. ↑ Reuters
9. ↑ Reuters
10. ↑ Reuters
11. ↑ Reuters
12. ↑ HCN 2007 Form 10-K Page 1
13. ↑ Forbes.Com "Sector Snap-Health Care REITS", Associated Press
14. ↑ 2007 Form 10-K Page 2
15. ↑ NAREIT, February 1st 2008
16. ↑ NAREIT, February 1st 2008
17. ↑ NAREIT, February 1st 2008
18. ↑ 2007 Form 10-K, Page 13
19. ↑ 2007 Form 10-K, Page 16
20. ↑ 2007 Form 10-K, Page 16
21. ↑ 2007 Form 10-K, Page 28
22. ↑ 2007 Form 10-K, Page 9
23. ↑ 2007 Form 10-K, Page 13
24. ↑ 2007 Form 10-K, Page 13
25. ↑ 2007 Form 10-K, Page 14
26. ↑ Investor Presentation, September 17th, 2007 Page 3
27. ↑ 2007 Form 10-K, Page 27