The SeniorCare Investor: NHC Bids For REIT Sibling--

 

Health Care REIT Market Has Best Showing Since 2003

Just two months after Andy Adams, the chairman of National Healthcare Corp. (AMEX: NHC) and the CEO of National Health Investors (NYSE: NHI), made a $30 per share bid for NHI, which was immediately rejected by the NHI board as inadequate, NHC announced in late December that it had reached an agreement to buy (merge with) its sister company, National Health Realty (AMEX: NHR) for approximately $24.75 per share.

If the names sound too similar to each other, it is not a coincidence as both NHR and NHI are REITs and had their origins from NHC, the original operating company. We have not heard much since the October 10 disclosure regarding Mr. Adams’ spurned offer and the NHI board’s decision to hire The Blackstone Group as its financial advisor to assist in evaluating that particular offer as well as any others that may pop up. But Mr. Adams still owns 9.9% of NHI’s outstanding shares.

Meanwhile, the pricing of the proposed merger between NHC and NHR had already been negotiated and approved by both boards before the announcement, unlike the apparent disconnect with Mr. Adams’ offer for NHI. In the current transaction, each NHR share not already owned by NHC will be converted into one share of NHC convertible preferred stock with an $0.80 per share preferred dividend and a $15.75 liquidation preference, plus $9.00 in cash for a total value of $24.75 per share. Each preferred share will be convertible into 0.24204 shares of NHC stock, representing a conversion price of $65.07 per share, or a current premium of about 18%. After the transaction was announced, NHR’s shares jumped by more than 18% and topped $25.00 per share, perhaps on the expectation of a higher offer (naïve as that may have been), but have settled down just below the offer on the table.

National Health Realty was spun off from NHC in 1997 and it owns 16 skilled nursing facilities with 1,811 beds, six assisted living facilities with 523 units and one retirement center with 93 units. Most of the facilities are located in Florida (9), South Carolina (7) and Tennessee (5), and NHC leases them or guarantees the leases. These facilities were built in the 1990s, and the total lease payments are about $17 million annually. By removing the lease payments, NHC’s annual cash flow will increase substantially, even after making the preferred stock dividend payments. With more than $200 million of cash and short-term investments on the balance sheet as of September 20, 2006, NHC will have no problem coming up with the almost $90 million cash portion of the purchase price, and the transaction should be accretive to NHC.

We had been wondering what NHC would do with its bulging cash horde of more than $16 per share, and now we know. The only thing we don’t know is why they didn’t do it earlier, and at a cheaper price. The transaction is expected to close in the second quarter of 2007, and Avondale Partners advised NHC while 2nd Generation Capital advised NHR.

There currently are just nine publicly traded health care REITs with significant investments in senior care and housing properties, but by the end of this year it may be down to seven, or even fewer. It is all about access to capital and match funding, and the stronger and more diversified a REIT is, the lower its cost of capital and the more competitive it becomes in what has become an incredibly competitive acquisition and financing market. The REITs with a market cap under $1.0 billion are particularly vulnerable, but even those in the $1.0 to $2.0 billion range may seek a partner. And the joke a few months ago was that when the two CEOs of Health Care Property Investors (NYSE: HCP) and Ventas (NYSE: VTR) go to their next Notre Dame reunion, a deal may be struck over a few drinks, creating by far the largest health care REIT in the world with a very diverse asset base. The question would be, however, who ends up being the king or queen of the castle?

Many of the health care REITs got their start from a sponsoring operating company, usually a skilled nursing facility operator. They grew rapidly in the 1980s and early 1990s, expanding with other operators, primarily because they were the most knowledgeable source of capital in the market, and at times and for some deals the only source. Initial lease rates of 12% and 13% (and sometimes higher) were common, partly because interest rates were much higher back then but also because SNF operators had little choice when looking for 90% to 110% financing. But other lenders and investors caught up on the learning curve, and despite the somewhat embarrassing stumble in the late 1990s, there are more sources of capital competing for the same deals than ever before.

There was even some talk after the 1990s that health care REITs might become an anachronism, as operators would not want to pay the relatively high lease rates, lose the real estate appreciation and succumb to those dastardly annual rent escalators. But a funny thing happened on the way to their funeral. Health care REITs not only survived, but they are thriving in this competitive market, having made new investments last year of several billion dollars. While some deals still get priced at 10% to 11% initial lease rates, they are now in the minority, with most transactions between 8% and 10%, and even as low as 7.75%. But the lower the initial rates, the higher the annual escalators in most cases.

The name of the game today appears to be asset diversification, both in terms of operator concentration and property type. The skilled nursing facility-oriented REITs used to tout their growing assisted and independent living portfolios as having no government reimbursement risk, and now medical office buildings (MOBs) seem to be the property of choice to meet asset diversification goals. Health Care REIT (NYSE: HCN) recently completed its acquisition of MOB REIT Windrose Medical Properties Trust, and both Health Care Property Investors and Nationwide Health Properties (NYSE: NHP) have been expanding their MOB portfolios. The MOB market is very different, not having the long term, triple-net lease characteristics associated with seniors housing and care, but REITs are focusing on the growing health care industry and its office needs as well as the lack of reimbursement risk.

During much of 2006, while the market was focused on the Ventas rent reset with Kindred Healthcare (NYSE: KND), investors kept on pushing up the share prices of all health care REITs, especially during the fourth quarter. Equity analysts tend to value REITs based on the growth in funds from operations and a dividend discount model, and all investors like to see the dividend increase every year. But the hidden value has been the asset appreciation that has taken place in the past two years. True, the value to the REITs is the current lease rate, but with cap rates dropping and acquisition prices rising, the “market value” of many of the assets in the REIT portfolios has increased dramatically, especially for assisted and independent living properties. A case in point is the recent Nationwide Health Properties resale of many properties back to Brookdale Senior Living (NYSE: BKD) at a huge profit.

We doubt this is what sent health care REIT shares soaring last year, but they put in their best performance since 2003. When the lowest total return for the year of the 11 REITs we cover was 26.8%, and everyone else topped 30%, you know it was a good year. It was only the fourth time in nine years that every health care REIT posted a positive return; further, in only one of the past four years were there any negative total returns. The best year was 2001, when the total returns ranged from 28% to 228%, compared with the more modest 26.8% to 52.5% in 2006. Senior Housing Properties Trust (NYSE: SNH), after jumping by 12% in December, edged out Health Care Property Investors for a total 2006 return of 52.5%, compared with 50.7% for HCP. Not a shabby year for all concerned, but it will be difficult to match in 2007.