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Thomas Gaffney

HCN AT A GLANCE

P/E ► 33.3 AVG EV/EBITDA ► 29.3 HIGH ROA ► 4.4% AVG ROE ► 4.6% AVG Debt to Equity ► 0.665 AVG Interest Coverage Ratio ► 2.53 AVG

 

 

 

 

 

 

This article is about the company, for the healthcare REIT industry, see the industry page on REIT - Healthcare

When it manages medical office properties, HCN is more exposed to a downturn in the economy, since leases on HCN's operating properties are typically with smaller tenants and have shorter terms than the triple net leases on HCN's investment assets. These short lease lengths lead to greater returns during boom times, as occupancy rates rise and rental rates increase more quickly, but a slowdown in the health care industry would hurt as tenants typically have less credit than large tenants at investment properties, leading to greater probability of default.

Business Financials

HCN earns revenue at all its properties by leasing space to health care companies. Because leases with fixed rental rates usually last at least five years at operating properties, and a decade or longer at investment properties, HCN focuses on expanding its portfolio in order to grow revenues. Towards that end, the company increased its net real estate investments at an annual rate of 27% over the past five years.^[1] Expansion in the last two years has been focused on the company's MOB portfolio. Major investments include the 2006 acquisition of Windrose Medical Properties Trust, the transaction which established HCN's medical office portfolio.^[2] Also, in May of 2007 HCN acquired Paramount Real Estate Services, giving the company the ability to manage its MOBs in-house.^[3]

HCN's acquisitions of Windrose and Paramount represent a new growth strategy for the company, shifting from a real estate owner to a real estate operator. This shift reduces HCN's dependence on large tenants who lease entire centers, diversifying the company's tenant base. HCN's top five tenants now account for only 26% of their investment portfolio, one of the lowest percentages among Health Care REITs.^[4] By operating its MOBs HCN is also able to exercise its operational expertise to increase the performance of its MOB portfolio. However, HCN's management of its MOB assets exposes it to the risks of an operator, including decreased occupancy, increased operating expenses and declining rental rates.

As of December 31st, 2007 HCN’s investment properties accounted for approximately 60% of the company’s total assets, with a net value of approximately $3.0B. ^[5] Leases on investment assets are generally long term, with an average lease length of 12-15 years, and “Triple-Net”, meaning the tenant pays for all costs associated with operating the property. ^[6] 87% of HCN’s investment properties function under a “Master Lease”, with multiple properties leased to one operator under a single lease.^[7] This benefits HCN, as a tenant is required renew or cancel a lease with all properties, not just elect to renew leases on the best performing properties.^[8]

As of December 31st, 2007 HCN’s operating properties accounted for approximately 26% of the company’s total assets with a net value of approximately $1.3B.^[9] HCN’s operating properties are almost entirely medical office buildings leased to health care providers, operated by Paramount Real Estate Services.^[10]

Below is a breakdown of HCN's revenues by property type. Medical Office Buildings produced just 23% of the company's revenues in 2007. Investment properties produced the majority of revenues, with skilled nursing and assisted living facilities accounting for over half of total revenues. The company's skilled nursing facilities, otherwise known as nursing homes, provide long term care, primarily for elderly patients, that do not require the extra services of an acute care hospital. Its independent and assisted living centers are both senior housing communities, houses or condominiums 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. They are divided into independent and assisted living facilities based on the level of support they provide. Many senior housing facilities are private pay assets, they do not accept or are not eligible for government reimbursement. Many practitioners in MOBs also do not accept government reimbursement as payment. In contrast, most skilled nursing facilities and hospitals do accept government reimbursement.

^[11]

The changes in operating income and revenues from 2006-2007 are due to the company's acquisitions of Windrose and Paramount. In 2007 the company's operating income as a percentage of revenue continued to fall due to increased depreciation and financing expenses caused by HCN's rapid expansion.

^[12]

Like all REITs HCN is subject to a federal requirement that it pays out 90% of its taxable income as dividends. HCN paid dividends of $2.28 per share in 2007.

Trends and Forces

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

• HCN's investment properties primarily cater to the elderly, including its skilled nursing facilities, senior housing and independent living facilities.
• Health Care is the single largest industry in the United States, based on percentage of GDP.^[13] 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. ^[14] 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.^[15] 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. ^[16] 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.

^[17]

The Demand For Medical Office Buildings Is Growing

• 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 operate.^[18]
• 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.^[19] 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 that 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.^[20] This trend provides HCN an opportunity to purchase MOBs at competitive prices while simultaneously leasing a high quality, long term tenant.

Governmental Regulation Negatively Impacts HCN's Collections of Rents From Tenants

• The federal government has typically refrained from regulating the senior housing industry. Since senior housing accounted for 36% of the value of HCN's property's in 2007, the company benefits from this freedom.^[21] In contrast, operators of skilled nursing and specialty care facilities, comprising 39% of the net value of HCN's buildings, are heavily regulated by the federal government.^[22]
• If one of HCN's properties fails to meet federal regulations, regulatory agencies have the option to deny Medicare or Medicaid reimbursements, or close the facility.^[23] Such a closure would result in a lease termination by the operating tenant causing a reduction in rents paid to HCN.
• When the operating tenant vacates a property, licensing regulation makes it difficult to sign a lease with a new tenant. Many states in which HCN operates have a licensing regulation called a Certificate of Need ("CON") law. This law requires a health care REIT to prove to a state licensing board that a facility is needed in a community, before giving a new tenant operating control.^[24] So any time HCN signs a lease with a new tenant, whether it is leasing a new center or signing a new tenant at an existing center, it must go through this legal process. HCN is unable to earn income from its property until the approval process is complete. Also, because of the specialized uses of many of HCN's buildings, if it is unable to show a need for that specific type of facility HCN will have to renovate the facility for another purpose before transferring it to another operator.^[25]

HCN's Tenants Receive Income From Government Reimbursements

• Operators of assisted living and independent living facilities usually receive almost no Medicare or Medicaid reimbursements, while operators of skilled nursing facilities and specialty care facilities receive a majority of their income from government sources.^[26] In 2007 12% of revenues at senior housing facilities came from Medicare and Medicaid, compared with 81% of revenue at skilled nursing facilities.^[27] On January, 1st, 2008 the federal government initiated 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.^[28] One focus of the study is skilled nursing facilities, and the results of this study will impact the reimbursements HCN receives for procedures at these facilities.
• Reimbursement for Medicaid related services are usually paid out by both state and federal governments, and are subject to rates and caps.^[29] These caps are subject to change as legislation is renewed or passed by either state or federal governments.
• As of December 31st, 2007 65% of tenants’ revenues came from private sources, decreasing their exposure to varying levels of government reimbursement.^[30] However, there is increasing political momentum for universal health coverage in the United States. Democratic presidential candidates Hillary Clinton and Barrack Obama have each laid out plans that would provide some sort of universal access to health care coverage.^[31] If these plans are implemented, they will cause tenants’ revenues to become more heavily weighted towards government reimbursements. If these reimbursements are below market value, revenues will suffer.

HCN Has Some Access To Financing, Even In the Midst of The Credit Crunch

• HCN, like all REITs, is required to pay out 90% of its taxable income in dividends. This requirement makes it unlikely HCN can fund all its growth from operating income. To finance growth the company also relies on debt or equity capital, and must negotiate favorable rates on this debt. The company's credit line expanded in 2007, to $1.15B from $850M, and renewed the line until mid 2011.^[32] As of December 31, 2007 the company had $307M drawn on its line of credit.^[33] HCN's borrowing capacity means that even if the company is unable to get any new loans, it can finance some new growth using its line of credit.
• HCN faces little refinancing risk, as only 8% of the company's $2.4B in debt matures before 2012.^[34]
• If the credit crunch causes interest rates to rise, HCN will likely see 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 HCN's stock and into these fixed income products. When the number of people wishing to hold HCN's stock decreases, the stock price falls.

Competitors

All of HCN's competitors operate on a national scale, and have between $300M and $1B in revenues. Skilled nursing facilities made up a greater portion of HCN's 2007 revenue (32%) than either Health Care Property Investors (HCP) (5%) or Ventas (VTR) (20%). Because these facilities usually receive a larger portion of their revenues from government reimbursement programs, this exposes HCN to more government reimbursement risk.

The table below provides competitive data comparing HCN with some of its close competitors.

Market Share

HCN accounts for 18% of the gross value of health care properties owned by health care REITs, and slightly less than 1% of the nation's health care properties. 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% the gross value of health care properties owned by health care REITs.^[51][52] 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.^[53][54] In the chart below, properties measured include skilled nursing facilties, medical office buildings, senior housing and specialty/acute care hospitals.

^[55][56]

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.

^[57]

References

1. ↑ HCN Investor Presentation, February 2008, Page 29
2. ↑ 2007 Form 10-K Page 3
3. ↑ 2007 Annual Report, Letter to Shareholders, Page 11
4. ↑ HCN Investor Presentation, February 2008, Page 11
5. ↑ 2007 Form 10-K Page 6
6. ↑ 2007 Form 10-K Page 6
7. ↑ 2007 Form 10-K Page 6
8. ↑ 2007 Form 10-K Page 6
9. ↑ 2007 Form 10-K Page 7
10. ↑ 2007 Form 10-K Page 6
11. ↑ 2007 Form 10-K Page 41
12. ↑ 2007 Form 10-K Page 39
13. ↑ HCN 2007 Form 10-K Page 1
14. ↑ HCN 2007 Form 10-K Page 1
15. ↑ Forbes.Com "Sector Snap-Health Care REITS", Associated Press
16. ↑ 2007 Form 10-K Page 2
17. ↑ Investor Presentation, September 17th, 2007 Page 3
18. ↑ NAREIT, February 1st 2008
19. ↑ NAREIT, February 1st 2008
20. ↑ NAREIT, February 1st 2008
21. ↑ 2007 Form 10-K Page 8
22. ↑ 2007 Form 10-K Page 8
23. ↑ 2007 Form 10-K Page 9
24. ↑ 2007 Form 10-K Page 9
25. ↑ 2007 Form 10-K Page 28
26. ↑ 2007 Form 10-K Page 8
27. ↑ 2007 Form 10-K Pages 10-11
28. ↑ 2007 Form 10-K Page 10
29. ↑ 2007 Form 10-K Page 11
30. ↑ HCN Investor Presentation, February 2008, Page 10
31. ↑ Factcheck.Org
32. ↑ HCN Investor Presentation, February 2008, Page 18
33. ↑ 2007 Form 10-K Page 81
34. ↑ 2007 Form 10-K Page 82
35. ↑ Google Finance
36. ↑ Google Finance
37. ↑ Reuters
38. ↑ Reuters
39. ↑ Google Finance
40. ↑ Google Finance
41. ↑ Reuters
42. ↑ 2007 Company 10-K Page 36
43. ↑ Google Finance
44. ↑ Google Finance
45. ↑ [1]
46. ↑ [2]
47. ↑ Google Finance
48. ↑ Google Finance
49. ↑ Reuters
50. ↑ Reuters
51. ↑ NAREIT, February 1st 2008
52. ↑ Google Finance
53. ↑ Google Finance
54. ↑ 2007 Form 10-K Page 41
55. ↑ Google Finance
56. ↑ 2007 Form 10-K Page 41
57. ↑ 2007 Form 10-K Page 41