Health Care REIT Makes Big Buy

September 5, 2008

September 5, 2008
Taking advantage of the newly enacted legislation, called the REIT Investment Diversification and Empowerment Act (RIDEA), which allows REITs to participate in property-level cash flows as opposed to just collecting rents from their tenants, Health Care REIT announced its agreement to purchase a 90% interest in 29 seniors housing properties managed by Sunrise Senior Living. A 90% interest in these assets was acquired by Arcapita in 2003, with Sunrise keeping the remaining 10%, which it will continue to own. Health Care REIT is paying approximately $643.5 million for the 90% interest, implying a value of $715.0 million for the portfolio. We believe the price paid five years ago was just over $400 million, but the make-up of the portfolio and timing seemed to be a moving target at the time.

Is this a good deal for Health Care REIT? Yes and no. It is acquiring relatively new properties in major metro markets across the country with an average 94% occupancy rate (although nine are closer to 90%). In addition, all but a few of the properties are the traditional Sunrise model, which seems to be popular with investors and consumers, and almost half the purchase price is being paid with assumed debt at a current 5.2% average rate. But the price, which is just over $343,000 per unit for the full 100% value and represents a 6.6% cap rate on 2009 pro forma numbers, seems a bit rich in this market. In 2006 and early 2007, this would have hardly raised an eyebrow, but the market is different now, both in valuations and psychology, not to mention the state of the economy.

If occupancy stays where it is or increases, and recent rate increases can continue to be implemented, then the cash flow growth that will go directly to Health Care REIT under the new rules will be a win for the REIT. But at the price being paid, there doesn't seem to be much of a margin for error if there are a few hiccups in the next year or two, especially if the assumed debt becomes more costly since about half of it is floating rate. One thing that REITs, and their investors, could count on in the past was a steady increase in cash flow from lease escalators. Now, their results will be impacted more by the ups and downs in the industry when all "excess" cash flow goes to the REIT in this new structure. In good times, the cash flow growth will certainly exceed the growth from lease escalators; in bad times, however, it will be anyone's guess. These are obviously attractive assets in good markets, but the Health Care REIT team will have to really stay on top of the operating results, down to watching the "street" rents compared with any discounts offered to new residents at each facility to get them in the door. That's a new ball game for them.

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