Health Care Property Investors (HCP)

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Top Contributors Thomas Gaffney Related Articles Health Care REIT (HCN) Aging Baby Boomers Bond Investing 2007 Credit Crunch Health

2007 marked the close of HCP's repositioning of its investment portfolio, as the company completed $10B in acquisitions and divested $2.8B in assets from 2005 to 2007.^[2] The purpose of these moves was to weight HCP's investment portfolio towards assets with minimal exposure to state based government reimbursement (i.e. Medicaid) risk.^[3] State based government reimbursement is one of the most risky and variable types of revenue for health care facilities as reimbursement rates fluctuate with state budget deficits. In 2007 HCP estimated that 80% of its tenants' revenues were from private pay sources and not Medicare or Medicaid.^[4]

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 Health Care REITs|health care REIT]] by value, with a 14.0B enterprise value as of September 17th, 2007.^[5] HCP also had the highest revenue and operated the most properties among its competitors.

[edit] Business Financials

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.^[6] 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.

The five types of properties HCP invests in are presented below:^[7]

1. 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.^[8] 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.
2. 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.^[9]
3. Medical Office Buildings: These provide office space for physicians and hospitals.^[10] The individual practitioners in MOBs have the option of whether or not to accept Medicare or Medicaid government reimbursement.
4. Hospitals: HCP operates acute care hospitals, which provide long term care for patients with chronic illness, especially the elderly.^[11] Most hospitals accept government Medicare/Medicaid reimbursement.
5. 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.^[12] Skilled nursing facilities usually accept government reimbursement in the form of Medicare/Medicaid.

HCP has repositioned its portfolio over the last few years, weighting it towards assets with minimal exposure to state based government reimbursement (i.e. Medicaid) risk.^[13] During 2007 HCP completed $4.7B in acquisitions and sold 97 properties for $922M as part of this repositioning.^[14] The most significant of these was the $3.0B acquisition of Slough Estates, a life sciences portfolio located in San Francisco and San Diego, CA.^[15] The life sciences buildings acquired in the Slough transaction represent virtually all the life science buildings in HCP's portfolio.

^[16]

Going forward, HCP has identified four platforms it intends to use to fuel further growth.^[17]

1. Investment Management/Joint Ventures: During 2007 HCP begin rolling some of its properties into joint ventures. In these arrangements HCP contributes properties to a joint venture with an institutional investor in exchange for cash. HCP than manages the properties, for which it receives a fee. These joint ventures help the company raise capital and fund expansion. For example, in 2007 HCP contributed 25 properties valued at $1.1B with $686M in debt to a joint venture with an institutional investor. HCP gave the instructional investor 65% of the venture partnership units in exchange for $280M cash.^[18] HCP frees up capital by entering joint ventures while maintaining a partial ownership interest and generating management fees.
2. Development: As part of the acquisition of Slough Estates HCP received a $1.8B development pipeline requiring an estimated $1.2B in additional development costs over the next nine years to complete.^[19] This development is expected to significantly increase HCP's revenue in the life sciences sector.
3. DownREIT Transactions: In DownREIT transactions HCP partners with the seller, giving them cash or shares in HCP and a minority interest in a newly formed REIT which contains the seller's properties. HCP holds the majority interest in the REIT.^[20] DownREITs enable a seller to maintain some interest in their properties while also providing some liquidity. For HCP they are a way to purchase a partial interest in properties, which requires less capital than purchasing them outright.
4. Mezzanine Debt: During 2007 HCP began to invest in mezzanine debt for health care real estate companies. As of December 31, 2007 HCP had $1.3B invested in mezzanine debt.^[21] The majority of this was from a $900M mezzanine loan HCP made as part of the Carlyle Group’s acquisition of Manor Care, Inc. ^[22] Mezzanine debt is a way for HCP to diversify their risk, before its mezzanine debt investments HCP just owned the equity portions of its centers, which are inherently more risky than debt investments. They also provide HCP with some upside potential as their mezzanine debt investments usually have some sort of option to convert to equity at a given price.

As part of its repositioning and expansion, HCP has seen a huge increase in revenues from 2002 to 2007. However, as they expanded expenses increased as well, causing the company's operating income to decline. Operating income as a percentage of revenue, a measure of the company's ability to control expenses and convert revenue to net income, plummetted over those five years. However, as HCP pays down debt acquired in the Slough Acquisition (decreasing interest expense) and revenues increase as the Slough properties operate for a full year, operating income is likely to rise.

^[23]

[edit] Trends and Forces

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

• In repositioning its portfolio between 2005 and 2007, HCP needed large amounts of capital. Because of the requirement that REITs must pay out 90% of their taxable income in dividends, HCP had to finance much of its expansion with debt. As of December 31, 2007 the company had about $7.5B in total debt outstanding. This includes a $1.35B bridge loan, due in July of 2008 (with two 6 month extension options) that HCP used to finance its Slough acquisition. ^[24]
• Approximately 38%, or 2.8B, of HCP's debt was variable interest rate debt. HCP also holds $1.0B in variable rate mezzanine loans receivable.^[25] In 2008, 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.^[26] This is equivalent to a 30% decrease in 2007 operating income.
• 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.
• HCP has $500M in debt maturing in 2008 and $1.6B maturing in 2009, together representing 30% of the company’s total debt.^[27] If interest rates rise HCP will have to refinance this debt at higher rates. In the case of fixed rate debt, this will mean higher interest payments over the life of the loans.
• 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.

[edit] An Aging Baby Boomers 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.^[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]

[edit] The Demand For Medical Office Buildings Is Growing

• HCP has a large Medical Office Building (MOB) portfolio; in 2007 MOBs accounted for 34% of HCP's revenues. 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.^[33]
• 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.^[34] 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.^[35] This trend provides HCP an opportunity to purchase MOBs at competitive prices while simultaneously leasing a high quality, long term tenant.

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

• Operators of senior housing communities, which accounted for 36% of HCP's revenues in 2007, and medical office buildings, 34% of HCP's 2007 revenues, are typically subject to minimal government regulation. Alternatively, life sciences centers, hospitals and skilled nursing facilities, accounting for 10%, 15% and 5% of 2007 revenues, respectively, are typically subject to strict government regulation.
• 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.^[36]
• 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.^[37] 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).^[38] If HCP fails to show a need for its facilities under CON laws, it would result in a revocation of the facilities operating license.^[39] 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. HCP's two largest life science tenants, Amgen and Genentech, each accounted for 5% of life science segment revenues in 2007. These companies 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.^[40][41] The FDA's approval process is long and expensive, and requires substantial investment before a company begins earning revenues.^[42] 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.

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

• In 2007 private pay sources, including private insurance companies, accounted for 80% of HCP's tenants’ revenues.^[43] The remainder of tenants’ revenues were from government reimbursement (i.e. Medicare/Medicaid) sources. Over the last few years, HCP has invested $10B trying to reposition its portfolio towards private pay assets.^[44]
• 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.^[45]
• 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.^[46] As reimbursement rates for Medicaid/Medicare fall, individuals will not be willing to pay as much for drugs produced by life science tenants. Rent from life science centers accounted for 10% of HCN's revenues in 2007, and that number is expected to increase as the properties from the Slough acquisition operate for a full year in 2007.^[47]
• There is increasing political momentum for some form of universal health coverage in the United States. Hillary Clinton and Barack Obama have both laid out plans that would provide universal access to health care coverage.^[48] If these plans are implemented, more people would have government sponsored insurance plans, increasing HCP’s tenants collections of government reimbursements and impacting their total revenues.

[edit] Competitors

HCP is the largest health care REIT in the United States, larger than its competitors in terms of revenues, market cap and operating properties.^[49] 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, 34% in 2007 compared with 3% for VTR and 23% for HCN. 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, 5% in 2007 compared with 20% for VTR and 32% for HCN. 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.^[50] 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. The table below provides competitive data comparing HCP with some of its close competitors.

[edit] Market Share

HCP is the largest health care REIT by property value, but its properties still account for a very small portion of total U.S. health care real estate. HCP accounts for 32% of the gross value of health care properties owned by health care REITs, but just over 1% of the total value of U.S. health care real estate. 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.^[67][68] 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.^[69][70] In the chart below, properties measured include skilled nursing facilities, medical office buildings, senior housing and specialty/acute care hospitals. The value of HCP's life science centers are excluded because they are not comparable to competitors' properties or properties used in calculating the total value of U.S. health care real estate.

^[71][72]

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.

^[73]

[edit] References

1. ↑ 2007 Form 10-K Page 1
2. ↑ 2007 Annual Report, Letter to Shareholders
3. ↑ 2007 Annual Report, Letter to Shareholders
4. ↑ 2007 Form 10-K, Page 14
5. ↑ Investor Presentation, September 17th, 2007 Page 3
6. ↑ 2007 Form 10-K, Page 7
7. ↑ Reuters
8. ↑ Reuters
9. ↑ Reuters
10. ↑ Reuters
11. ↑ Reuters
12. ↑ Reuters
13. ↑ 2007 Annual Report, Letter to Shareholders
14. ↑ 2007 Form 10-K, Page 45
15. ↑ 2007 Form 10-K, Page 45
16. ↑ 2007 Annual Report, Letter to Shareholders
17. ↑ 2007 Annual Report, Letter to Shareholders
18. ↑ 2007 Form 10-K, Page 46
19. ↑ Investor Presentation, September 17th, 2007 Page 15
20. ↑ Find Law
21. ↑ 2007 Form 10-K, Page 7
22. ↑ 2007 Form 10-K, Page 45
23. ↑ 2007 Annual Report, Letter to Shareholders
24. ↑ 2007 Form 10-K, Page 19
25. ↑ 2007 Form 10-K, Page 65
26. ↑ 2007 Form 10-K, Page 65
27. ↑ 2007 Form 10-K, Page 65
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. ↑ NAREIT, February 1st 2008
34. ↑ NAREIT, February 1st 2008
35. ↑ NAREIT, February 1st 2008
36. ↑ 2007 Form 10-K, Page 13
37. ↑ 2007 Form 10-K, Page 16
38. ↑ 2007 Form 10-K, Page 16
39. ↑ 2007 Form 10-K, Page 28
40. ↑ 2007 Form 10-K, Page 9
41. ↑ 2007 Form 10-K, Page 13
42. ↑ 2007 Form 10-K, Page 13
43. ↑ 2007 Form 10-K, Page 14
44. ↑ 2007 Annual Report, Letter to Shareholders
45. ↑ 2007 Form 10-K, Page 14
46. ↑ 2007 Form 10-K, Page 14
47. ↑ 2007 Form 10-K, Page 14
48. ↑ Factcheck.Org
49. ↑ Investor Presentation, September 17th, 2007 Page 3
50. ↑ 2007 Form 10-K, Page 27
51. ↑ Google Finance
52. ↑ Google Finance
53. ↑ Reuters
54. ↑ 2007 Company 10-K Page 36
55. ↑ Google Finance
56. ↑ Google Finance
57. ↑ Reuters
58. ↑ Reuters
59. ↑ Google Finance
60. ↑ Google Finance
61. ↑ [1]
62. ↑ [2]
63. ↑ Google Finance
64. ↑ Google Finance
65. ↑ Reuters
66. ↑ Reuters
67. ↑ NAREIT, February 1st 2008
68. ↑ Google Finance
69. ↑ Google Finance
70. ↑ 2007 Form 10-K Page 41
71. ↑ Google Finance
72. ↑ 2007 Form 10-K Page 41
73. ↑ 2007 Form 10-K Page 41