The SeniorCare Investor

Health Care REITs: Ready To Fund The Rebound?
Health care REITs have been relatively quiet in the senior care market after fueling the explosive growth of the 1990s. This slumbering giant in the financing market is about to wake up. See
page 1

Acquisition Market
It’s the end of another quarter, and Sunrise Senior Living closes on two sale/ manage back transactions at very different price levels. See page 5

Other ALF Deals
Salem Equity closes on the purchase of two facilities in Pennsylvania, the first of five Manorhouse sales goes through, plus several more one-off deals. See page 8

Congregate Care Market
The Carlyle Group enters the senior care market with a large purchase, and Aspen Retirement expands in Ohio. See page 10

Skilled Nursing Market
Beverly sells 12 SNFs in California; Illinois and Texas see some action. See page 11

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The incredible growth of the senior care market in the 1990s, particularly of the larger chains, was made possible by two financing sources: the public equity market and health care real estate investment trusts (REITs). While finance companies, banks and government agencies obviously played an important role as well, equity allowed companies to borrow more money to fuel the growth, and REITs, as a result of their willingness to provide highly leveraged financing, often acted as providers of quasi-equity capital.

It can be argued, however, that some of this excess leverage contributed to the ultimate meltdown of the sector by the end of the decade, not to mention the role of the various shades of black box financing structures that became symptomatic of an industry that got too smart for itself. But ever since the implementation of the Medicare prospective payment system for nursing homes, and the end of the construction boom in the assisted living sector, health care REITs have been nearly invisible, at least in terms of new financings, in the senior care market.

For many of the REITs, their time was spent in the past few years licking the wounds caused by the bankruptcies of their major tenants, and a few came close to going out of business themselves. But as interest rates headed to a 40-year low, the return requirements of REITs caused them to lose their competitiveness in a market where borrowers were finding financing alternatives at rates well below the dividend yields the REITs provide their own investors. As a result, new investment opportunities with a reasonable return became more difficult to find.

The problem can be seen by looking at the balance sheets of the health care REITs from the end of 1999 through the middle of this year. Although nothing to brag about, Health Care Property Investors (NYSE: HCP), the largest REIT in the sector, has seen an 11% growth in total assets since the end of 1999. Starting from a much smaller base, Health Care REIT (NYSE: HCN) has grown by almost 40% in the same time period. But most of the other REITs have either seen little or no growth in their assets, or have suffered an actual decline as a result of terminated leases and asset dispositions. This trend may be changing in the near future, as both the nursing home and assisted living sectors emerge from their turmoil of the past three years, and health care REITs position themselves to fund the growth that will soon return to an industry so recently in disarray.

What is fascinating about the health care REIT sector is that despite the turmoil of the past three to four years, and the minimal amount of net new investments, as a group their stock prices have done remarkably well. And this has been in an overall environment when the major indices declined for three years in a row, something that has not happened since the years preceding World War II. Since the end of 1999, six health care REITs have provided positive returns (including dividends) to shareholders in every year, with most producing double-digit returns. In two years, 2001 and 2003 through the third quarter, all 12 REITs produced double-digit returns. In 2001, nine of the 12 had total returns in excess of 50% each. The best explanation for this performance is that investors, with returns so low in most other income producing investments, have turned to REITs in search of the yields that have eluded them for the past few years.

So what do we do with his information, other than kicking ourselves for not investing in Ventas (NYSE: VTR) a few years ago when it was under $3.00 per share and Omega Healthcare Investors (NYSE: OHI) under $2.50 per share, or more recently, Health Care Property Investors when it got down below $34.00 per share last March? With not much new activity on the left hand side of the balance sheet, the REITs have been taking advantage of the market environment to enhance the right hand side.

In the past year, health care REITs have raised more than $500 million of new equity, taking advantage of their rising share prices. More can be expected, and Healthcare Realty Trust (NYSE: HR) recently filed a shelf registration to raise up to $300 million of debt or equity. So far, the funds raised have been used to either pay down existing debt, usually lines of credit that are used for their own financing activities, or for new investments, either transactions about to be completed or new ones down the road. Taking advantage of the lower interest rate environment themselves, they have also refinanced high-cost debt with lower cost debt, often saving 100 basis points or more. In a similar type of refinancing, Health Care REIT saved 100 basis points by issuing new preferred stock to redeem more expensive preferred shares. The point is that the health care REIT sector appears to be positioning itself for a new round of investing activity, and the timing could not be better.

As outlined in our Audio Conference on September 9 called, "Where is the senior care investment market headed?", our conclusion was that we have already hit bottom in the senior care market and that both debt and equity capital are poised to fuel a major comeback in the acquisition market, especially as the number of distressed sales diminishes and higher quality assets are attracted to a market with higher prices and increasing liquidity. We fully expect health care REITs to take advantage of this market upswing.

This is not say, however, that several of the REITs do not still have some warts (they always will). Even after the flood of bankruptcies, there are well-hidden problems, some of which have been kept at bay because low interest rates in general have helped keep some companies afloat. For example, a 200 basis point increase in interest rates could jeopardize some companies with floating rate debt as the higher interest costs would eat away at their cash flow, and limit the overall cash available to pay other fixed charges, such as leases.

But the health care REIT sector is in its best financial shape in several years, an example of which is the decision by Omega Healthcare Investors to pay accumulated dividends to preferred shareholders last July and the recent announcement to reinstate its common stock dividend, starting at $0.15 per quarter. OHI posted a second quarter profit, the first one in a while, and the shares hit a four-year high last month of $8.35 per share. For the year, the shares have more than doubled in price through September 30, leading the pack in terms of total return for the year.

Obviously, much of this is catch-up, but health care REITs need to show growth (and want to as well), and with their improved balance sheets and lower cost of capital, we expect their investment activity to greatly increase in 2004 and beyond. Health Care REIT has been averaging more than $300 million of net new investments per year and expects that to continue in 2004. Meanwhile, the private REIT, CNL Retirement Properties (CNL), expects to make upwards of $1.0 billion of senior care investments next year, which will most likely be tops in the sector, as was its investment activity in 2003.

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