Description

Description

The Healthcare REIT (ticker: HCN) has a portfolio of independent living facilities and continued-care-retirement-centers that have rapidly deteriorating fundamentals, a development pipeline of $967 million, skilled nursing facilities at risk to state & federal reimbursement cuts, and hides a half a billion bank with a problem loan portfolio. HCN is primarily viewed by the street as a safe, triple-net lease operator with little earnings risk. We believe that HCN's assets embed significant risk that the market is not pricing into HCN's valuation.

HCN is currently trading at 15.2x P / consensus 09 FFO and 14.3x P / consensus 10 FFO. Prior to 2006, HCN traded between a low of 6x trailing FFO to a high of 13.5x trailing FFO. Given the risk to earnings and potential asset impairments, we believe that HCN should trade at 10x P / 2010 FFO or $32.

Healthcare REIT is a real estate investment trust that invests in senior housing and health care real estate. HCN has a broadly diversified portfolio consisting of: assisted living facilities (ALF) - retirement centers where residents require assistance with daily activities; independent living facilities (ILF) - age-restricted multi-family properties; continuing care retirement communities (CCRC) - retirement communities that include a combination of detached homes, an independent living facility and an assisted living facility and/or a skilled nursing facility; skilled nursing facilities (SNF) - facilities that are licensed daily rate or rental properties where the majority of patients require 24 hour nursing and/or medical care; specialty care facilities - acute care hospitals, long term acute care hospitals and other similar properties; medical office buildings (MOB) - designed for use by physicians or other health care personnel who provide services to patients.

HCN is primarily a triple net lease operator. The company's tenants are required to repair, rebuild and maintain leased properties. HCN's top 5 tenants constitute 29% of HCN's revenue and these tenants are much smaller and more regional than HCN's peers like Ventas, Nationwide and HCP.

Bulls like HCN because they believe HCN has a clean balance sheet (5.4x net debt / TTM EBITDA with no major near term maturities) and dry powder (undrawn $1.2 billion revolver that matures 2012) to take advantage of the downturn and make accretive acquisitions. Given that most properties are in triple lease structures, the street views this as a low risk investment with optionality should management make acquisitions.

Independent Living Facilities / Continuing Care Retirement Centers

ILF and CCRC portfolios have struggled this year. Seniors fund their retirements through investment portfolios and/or selling homes. Despite a recovery from March, the S&P 500 is down 24% for the decade as investors have suffered through two stock market bubbles. While house prices appear to be bottoming, house prices are still down 30% from their peak in 2006. This makes it difficult for seniors to pay for ILF/CCRC rentals, especially as many CCRC and combination ILF/ALF properties have entrance fees in the six-digits.

On top of this, ILF/CCRC portfolios are competing against substitute products. With unemployment at 10% and underemployment at 17.2%, some former wage earners are opting to care for parents at home in order to economize on a budget that would have otherwise been spent on a retirement home. ILFs attract healthier seniors who do not have special needs. The rapid drop of home prices, especially in markets like the Florida condo market, have drawn healthy seniors that would have otherwise selected an ILF unit; ILF portfolios are competing against short sales and bank REO.

HCN's stabilized ILF/CCRC portfolio has a wafer thin TTM EBITDAR coverage ratio of 1.09x. In 3q09, HCN deferred $2.4 million in rent for nine CCRC portfolios resulting in a -14.5% same-store-growth for its stabilized ILF/CCRC portfolio. This problem is likely to repeat over the next few years as HCN delivers product from its development pipeline: there is a $103 million CCRC property coming online in 4q09, a $111.4 million CCRC property coming online in 2q10, $61.9 million entrance fee ILF/ALF property coming online in 4q09, and a $56.2 million entrance fee ILF/ALF coming online in 2q10.

Bad Bank

HCN has $494.9 million in gross loans receivable to its operators and has accrued $7.6 million in allowances for loan losses. As of September 30, 2009, $72.4 million in loans receivable were classified as non-accrual, i.e., HCN has reserves for 1.5% of gross loans receivable and 14.6% of loans are classified as non-accrual.  Non-accruals grew rapidly during the heart of the financial crisis although allowances for loan losses remained relatively flat in dollar terms, despite a 29% increase in gross loans between 1q08 and 3q08.

But what are these loans composed of? On the 2q09 conference call, Jim Sullivan of Greenstreet asked the company what operators have used loan proceeds for. The CEO replied: "Our loan packages have been for any number of reasons. I mean, one that we've talked about earlier had been when Emeritus repurchased some of our facilities, giving us a large gain and we took back financing as did NHP and I think HCP, doing very similar things. Others related to a very substantial company on the East Coast that helped more with the corporate infrastructure as well as particular improvements to facilities. So they're all over the board, Jim." HCN offers loans in order for its operators to purchase properties, to fund operators' G&A and for improvement to properties. In the event of a default, it may be difficult to recover improvements in a tenant's "corporate infrastructure".

The rapid increase in non-accrual loans and under-accruing for potential losses is a negative sign, especially in light of the fact that HCN has had to reduce rent the company charges to its CCRC operators. If HCN's tenants are not paying loans, this raises questions as to the health of HCN tenants and whether HCN is overstating its tenants EBITDAR coverage ratio.

Development Pipeline

HCN has a development pipeline of $967 million, of which $329 million is unfunded. HCN is unlikely to face any issues funding the remaining construction. Between two equity offerings this year HCN was able to raise $525.9 million and the company has ample room on its $1.2 billion revolver. However, 46% of construction is either CCRC entrance fee properties or combination ILF/ALF entrance fee properties. As noted above, this market is extremely weak and there is risk that when these projects are delivered to the market that they too will require rent reductions.

Skilled Nursing Facilities

HCN's SNF portfolio derives 51% of its revenue from Medicaid, 30% from Medicare and 19% from private payers. For most states, Medicaid is the single largest expense and, given parlous state finances, states are cutting reimbursement levels or raising fees on SNFs. For example, Massachusetts is raising fees on the 450 nursing homes in state by $23 million; Ohio is doubling the per bed tax on SNF's to $12.01 per day from $6.25 per day which is resulting in the average facility in Ohio paying an additional $210,240 per year to the state; and other states are just cutting reimbursement levels. As states continue to struggle with budgets in 2010, there is little reason to believe that the reimbursement environment will get better. The current healthcare bill in the Senate cuts Medicare reimbursement to nursing homes by $15 billion over 10 years.

While HCN's SNF portfolio has an average TTM EBITDAR to rent plus interest coverage of 1.64, the cuts to reimbursement levels and fee increases will pressure operators and HCN's ability to raise rents. There is a risk that an expansion of Medicare and Medicaid cohorts through healthcare reform crowds out the more profitable private payer mix. Ultimately, the risk is that SNF's will be worth less if operators struggle.

CPI Escalators

The street expects a resumption of low single-digit rent increases next year.  Roughly 2/3 or HCN's properties have rent escalators tied to CPI. This has retarded rent growth in FY2009 for HCN's stabilized portfolio. Owners' equivalent rent (OER), an abstract concept that quantifies "If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?", will decline for 2010 based off of the Bureau of Labor Statistics' methodology. As OER constitutes 1/3 of CPI, CPI is likely to be muted or negative throughout 2010 unless there is a significant recovery in apartment rental rates and could shave 5-6c off of consensus estimates next year.

Interest Rate Sensitivity

While not key to our investment thesis, HCN, like any REIT, offers protection if the current low interest rate environment normalizes. If interest rates rise, cap rates will rise in conjunction. As we are currently sitting in the lowest interest rate environment for over 50 years, this is not a trivial risk for any REIT.

Risks

HCN may be able to make attractive acquisitions which can increase earnings in FY2010. This is somewhat mitigated by the fact that most street analysts pencil in a generic $100-200 million in new development and acquisitions.

If house prices begin to substantially recover seniors will be able to better fund retirement home rentals and competition from cheap substitutes subsides.

If the stock market continues to rally then seniors may be able to better fund retirement rentals through retirement funds.

Yields on HCN's pipeline may surprise to the upside in a robust economic environment.

Catalyst

Continued stress in the ILF/CCRC portfolio.

Recognition of losses on loan portfolio.

Higher interest rates.

Medicaid/Medicare cuts to nursing homes.