The SeniorCare Investor: Largest Deal of 2008 Cancelled

Health Care REIT Terminates 29-Property Acquisition

As we all know, the seniors housing acquisition market is in a funk. Buyers are waiting for sellers to accept the new market environment, and sellers are clinging to the hopes for a better market with low cap rates and the giddy bidding process that was so commonplace more than a year ago, with lenders often being more competitive than the buyers. Meanwhile, lenders are wondering what their cost of funds is and whether they really have the funds to lend. Unfortunately, we haven’t found anyone who thinks we will see those times again anytime soon, and a consensus is building that "soon" will be sometime in 2010, at the earliest. That means that we are going to have a long, quiet road ahead of us, but perhaps not as quiet as some may believe.

Just two months ago, Health Care REIT (NYSE: HCN) announced what would have been the largest transaction of the year in seniors housing, the $643.5 million acquisition of Arcapita’s 90% interest in 29 seniors housing properties managed by Sunrise Senior Living (NYSE: SRZ). Based on a 100% interest, the price came in at $343,000 per unit and a 6.6% cap rate on 2009 pro forma numbers. While this may have been considered a little on the rich side in 2006 and into 2007, with some people even considering it to be completely "on mark" for those exuberant times, by late 2008 it definitely raised some eyebrows. Health Care REIT was taking advantage of the new investment rules for REITs, as prescribed in the REIT Investment Diversification and Empowerment ACT (RIDEA), which now allows REITs to own properties and participate in property-level cash flows, as opposed to just collecting rents from their tenants. On the flip side, it also allows them to participate in the direct risk of underperformance, something which is entirely new to the health care REIT world.

It looked like the proverbial "done deal," with nearly 50% of the purchase price being paid by the assumption of debt with an average interest rate of 5.2%, and within a week of the announcement HCN had sold more than $300 million of common stock to raise the cash for the other half of the purchase price. The communities averaged 94% occupancy—at least they did as of June 30—and all but a few were the Sunrise mansion prototype in attractive major metro markets. What could go wrong? Well, how about a 29% drop in the Dow Jones Industrial Average in the subsequent weeks and a complete shut-down of the capital markets, just for starters.

In the middle of October, Health Care REIT announced that it had received a two-week extension to complete its "due diligence," which everyone but those living in caves took to mean that either the portfolio’s financial performance had deteriorated or HCN was trying to renegotiate a lower price, and quite possibly both. We assumed they were looking for a lower price, because if the agreed upon value was even a little rich the first week of September, after weeks of market gyrations it made little economic sense even with the new RIDEA rules. Even though HCN could have closed, with its financing already done, we suspect they realized that the rules of the game had abruptly changed in just six weeks, and a 6.6% cap rate on 2009 numbers certainly wasn’t a home run, let alone a single, or perhaps a sacrifice fly.

So, on the last day of the extension period, Halloween as it turned out, Health Care REIT punted (just to get in the right season) and made the announcement that due to "uncertainty in the capital markets," the transaction was not in the best interests of its shareholders "under the original terms." At the risk of being accused of being a tea-leaf reader, the wording of this announcement says to us that what was happening in the capital markets essentially drove the value down, despite not having to go to the capital markets to finance it, and that they almost certainly had tried to obtain a lower price. Before this last announcement was made, we had heard that Arcapita was unlikely to lower the price and would either put the portfolio back on the market or wait out this dismal market environment. If it had been offered, we think Arcapita should have taken a price reduction of at least $40 to $50 million and still left the table with a sizable return.

The reality is that the back-up bids were obviously lower than Health Care REIT’s original offer, and since we assume the others did not have financing in place, that financing became much more expensive, if even available, during the intervening two months. Consequently, everyone else’s new bid would be lower as well, and would possibly drop in proportion to whatever new price HCN may have offered. Second, the economy and housing markets are probably going to get worse before they get better, so we don’t know what would compel another bidder to come within 5% of the original offer. Third, given all the problems that Sunrise is experiencing, there is certainly no guarantee that the financial performance of this portfolio will not deteriorate over the next few months (or years), or even that Sunrise will be around two years from now in its present configuration. After all, a year ago who would have thought Lehman Brothers and Bear Stearns would be gone, not to mention Merrill Lynch swallowed up? The point is that this was definitely a bird in the hand situation for Arcapita, and the two in the bush will be harder to catch, not to mention with fewer feathers.

Given everything that we had heard in the last two weeks, we assumed Health Care REIT would make the announcement it did, and we believe it was the right decision, especially given the events of the past two months. We also think it was a decision that will benefit the overall acquisition market, as non-intuitive as that may sound. First, if it had gone through as originally priced, every potential seller from here to Timbuktu would be using the pricing as a basis for deriving what their property should sell for, regardless of the comparable quality or profitability. How many buyers and brokers have heard the "me too" for a 6% cap rate over that past few years? The problem of irrational expectations in the market has been a big one, and this transaction would have exacerbated it. As of now, however, Dorothy is on her way back to Kansas, but we’re not sure exactly what scene she will wake up to.

Second, the fact that it was terminated is showing a certain degree of restraint, and is the second "public" deal where someone stood up and listened to the "just say no" chant of the crowd. The message should be received by other potential sellers that in "real estate," the first offer is usually the best, and holding out for something more in this market is just plain foolhardy. Consequently, the fact that this transaction did not go through may actually help to break the logjam, known as the pricing disconnect, in the current market and force people to realize that even though there is limited market data to support it, cap rates have in fact increased and may continue to do so. While that is little consolation to investors and potential sellers, it may bring some liquidity back to the market, in terms of deal flow, and that will be a good development. So without realizing it, Health Care REIT’s disciplined decision to walk away from a pricey deal may have an impact on the market much larger than they ever would have expected.