The healthcare industry in the US is both growing and in flux. It is driving consolidation in the REIT sector, as Christopher O’Dea reports
Healthcare is a growing industry in the US – and one that’s in flux. Perhaps nowhere can investors more readily see the scope of change – and the attendant opportunities and risk – than in the healthcare REIT sector.
The issues are enormous, and the landscape is being remade, with a host of potential new entrants to public markets as the industry differentiates and new segments emerge to tap capital markets by offering property opportunities focused on distinct age groups, types of care, and residential settings.
Healthcare REITs are capitalising on rising demand for medical services from an ageing population and, although the sector’s NAV premium has dropped from the 70% level before the May 2013 taper tantrum, the prevailing premium of 31% – still above the 27% long-term trend – is providing ample financial heft for acquisitions.
The healthcare REIT sector is one of the more complex REIT sectors, if not the most complex, encompassing several sub-property groups – senior housing or independent living, skilled nursing facilities (SNFs), hospitals, medical office buildings (MOBs), and life science/lab space. Each sub-group has specific supply and demand dynamics affecting its risk-adjusted return potential.
Rating agencies, overall, see a stable industry, with strong balance sheets, healthy fixed-charge coverage ratios, moderate leverage and strong liquidity. Financial conditions reflect an expanding user base. “Beneficial long-term demographic trends are helping support demand for space in healthcare properties, which should continue for the foreseeable future,” says Fitch Ratings in its mid-year outlook.
Government is a big factor in the sector. Positive drivers include favourable proposals by the Centers for Medicare & Medicaid Services (CMS), which in 2013 increased reimbursements to SNFs by 1.3% for 2014. While most Fitch-rated REITs are increasing holdings of property that obtain the majority of revenue from private sources, Omega Healthcare Investors is a pure play on SNFs, where occupancy tends to be needs-driven. Similarly, the implementation of the Affordable Care Act is prompting physician groups and small medical businesses to affiliate with large hospital systems which, in turn, guarantee those groups’ leases at MOBs.
The sector’s fortunes turn on the outlook for senior housing options like SNFs. The other major component of senior housing is independent living facilities. According to Houston-based Chilton Capital Management, senior housing and skilled nursing facilities comprise over 70% of healthcare REITs’ NOI. Furthermore, the top three healthcare REITs by market capitalisation – Ventas (VTR), Health Care REIT (HCN), and HCP – have an average of 74% of their portfolios invested in the two property types. Since these three REITs represent over 80% of the market cap of the healthcare REIT sector, says Chilton, “it’s fair to say that the group’s performance is heavily influenced by senior housing and skilled nursing facilities”.
Rent growth is moderating for assisted and independent living assets, says Fitch – in Q1 2014, annual senior housing rent increased 1.6%, compared with 2.3% and 1.4% for first quarter of 2013 and 2012 respectively. SNF growth in the first quarter was 2.8%, about where it has been for the past six quarters, the agency says. One of the big three, Ventas, in a webcast in early June, said it believed 4-6% operating growth in senior housing was sustainable over the next two years, adding that SNF reimbursement rates remained an annual decision but the near-term outlook appeared positive.
Projected robust SSNOI growth in the senior housing sector over the past two to three years drove some healthcare REITs to increase exposure to transactions based on the REIT Investment Diversification and Empowerment Act (RIDEA) legislation. RIDEA is a form of senior housing ownership which allows the owner to participate in the performance of the underlying operator, in contrast to a ‘triple-net’ lease, where the owner receives a fixed payment agreed upon in the lease. In the near term, REITs with a larger portion of NOI from RIDEA assets are likely to benefit from NOI growth that outpaces that of traditional triple-net leases typically seen in the healthcare REIT sector, says Fitch. However, the growth is slowing and that cash flow volatility is expected to increase.
Ventas in June announced the acquisition of another healthcare REIT, American Realty Capital Healthcare Trust (HCT), for $2.6bn – a move that will solidify Ventas’s position as the global leader in MOBs and senior housing. Ventas’s share price suffered on the transaction announcement, dropping from nearly $67 per share to just above $64, and underperforming the REIT index by 445 basis points in the following week, according to Goldman Sachs.
Goldman says the dip was similar to the market reaction in December 2013 when multi-family REIT Essex announced it would acquire competitor BRE Properties. Essex underperformed the REIT index by 300 basis points the week after the BRE announcement, then outperformed by 900 basis points until the transaction closed in April of this year. The deal, which has been challenged by an HCT shareholder, is scheduled to close in late 2014. By late June, Ventas’s stock was still trailing the Dow Jones REIT index by about 500 basis points.
As healthcare REITs grow, the sub-sectors are starting to look more like distinct industries. Skilled-nursing property seems most likely to stand as a separate sector. Kindred Healthcare (KND), the largest skilled-nursing operator, rose more than 100% in the year to early June, says Goldman, suggesting improved valuations could lead to more consolidation. In mid June, Kindred launched an all-cash tender offer to acquire, at a 70% premium, all of the outstanding shares of common stock of Gentiva Health Services in a transaction valued at $1.7bn. The deal illustrates how the stakes are rising in healthcare REITS. Gentiva’s board recently adopted a poison pill, prompting Kindred to include Plan B – terms to amend its tender offer to purchase 14.9% of Gentiva common stock and become the company’s largest shareholder if Gentiva’s board refuses to redeem the poison pill.
Already one of the 150 largest employers in the US, with $5bn in revenue and 63,000 employees in nearly every state, Kindred isn’t letting one poison pill derail its bid to expand its leadership in the SNF sector. With the Gentiva transaction under way, Kindred in late June raised nearly $215m in proceeds from a stock offering. According to the pricing announcement, the funds make Kindred “even better positioned to continue investing in growth”.