Health Care REIT (HCN)

TOP CONTRIBUTORS

Thomas Gaffney

Andrew Lewis

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

HCN is an equity based Real Estate Investment Trust that focuses on health care properties. Because of federal regulation that prevents REITS from operating health care centers, HCN contracts with third party managers to run its investment properties, which include skilled nursing facilities, senior housing and acute care hospitals. However, over the past two years HCN has focused on establishing its medical office buildings (MOB) portfolio. Because it manages as well as owns these operating assets, HCN has greater control over the returns on its investment and revenue potential.

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 Overview

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.

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. 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.

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.

Like all REITs HCN is subject to a federal requirement that it pays out 90% of its taxable income as dividends.

Business & Financial Metrics^[1]

In 2009, HCN generated a net income of $171.2 million on revenues of $569.0 million. This represents a 34.2% decrease in net income on an 8.1% increase in total revenues from 2008, when the company earned $260.1 million on revenues of $526.4 million.

Business Segments^[2]

HCN operates through two business segments.

• Investment Properties (83.6% of revenues): This segment simply buys land to leases buildings under long-term contracts. It does not participate in property management.^[3]

• Medical Office Buildings (13.6% of revenues): This segment manages multi-tenant properties leased to health care providers.^[4]

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.^[5]
• 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.^[6] 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. ^[7] 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

• 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.^[8]
• 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.^[9] 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.^[10] 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. In contrast, operators of skilled nursing and specialty care facilities are heavily regulated by the federal government.^[11]
• 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.^[12] 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.^[13] 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.^[14]

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.^[15] 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.^[16] 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.^[17] These caps are subject to change as legislation is renewed or passed by either state or federal governments.
• 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.^[18] 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.

Competition

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

References

1. ↑ HCN 2009 10-K pg. 42  
2. ↑ HCN 2009 10-K pg. 50  
3. ↑ HCN 2009 10-K pg. 5  
4. ↑ HCN 2009 10-K pg. 6  
5. ↑ HCN 2007 Form 10-K Page 1
6. ↑ Forbes.Com "Sector Snap-Health Care REITS", Associated Press
7. ↑ 2007 Form 10-K Page 2
8. ↑ NAREIT, February 1st 2008
9. ↑ NAREIT, February 1st 2008
10. ↑ NAREIT, February 1st 2008
11. ↑ 2007 Form 10-K Page 8
12. ↑ 2007 Form 10-K Page 9
13. ↑ 2007 Form 10-K Page 9
14. ↑ 2007 Form 10-K Page 28
15. ↑ 2007 Form 10-K Page 8
16. ↑ 2007 Form 10-K Page 10
17. ↑ 2007 Form 10-K Page 11
18. ↑ Factcheck.Org