[August 20, 2014]

Fitch: Healthcare REIT Deals Highlight Risks to Continued Growth

The most recent series of acquisitions by healthcare REITs highlight the segment's continued rapid growth and the risk that REITs may end up paying premium pricing, pursuing higher yielding assets (i.e. higher risk), or employing more leverage to maintain this growth, Fitch Ratings says.

Last week, Health Care REIT (HCN) announced two sizable, multipart acquisitions, including a $2.3 billion deal for HealthLease Properties REIT and other properties, as well as a second deal with Gracewell Healthcare. HCN's acquisitions follow Ventas, Inc.'s (VTR) ARC Healthcare & Holiday Retirement transactions and HCP, Inc.'s Brookdale transaction. While HCN's transactions focused on higher risk skilled-nursing assets and the rights to acquire future developments, VTR's was priced at one of the lower cap rates to date, and HCP's deal increases its exposure to properties with operating risk versus triple-net leases.

So far, healthcare REITs' growth has been funded conservatively and largely on a leverage-neutral basis, driven by opportunistic equity raises at substantial net asset value premiums. We believe the premiums reflect shareholders' expectations of continued growth, and continuing to satisfy these expectations may prove challenging. Large transactions are required to meaningfully increase earnings via external growth as the average enterprise value of HCP, VTR and HCN is nearly $30 billion. This dynamic may also drive REITs to employ higher leverage levels or pursue higher yielding, lower quality assets to make transactions accretive, especially as capitalization rates compress due to the competitive acquisition environment.

During the initial stages of growth, the feedback cycle was self-sustaining. That is, the shares traded at a premium to NAV to reflect future growth expectations. Thus, when a large portfolio was acquired at a cap rate higher than the stock's implied cap rate the deal was immediately accretive, driving NAV higher. In turn, the demonstrated success fuelled shareholders' expectations of continued growth. Recently, we have seen healthcare REITs' share prices waver as the market began to question whether growth would be harder to come by.

If this self-sustaining feedback cycle were to reverse, it would create challenging capitalization and transaction issues for these REITs. This is because REITs cannot retain meaningful amounts of operating cash flow due to distribution requirements for tax purposes. Their access to and cost of capital is therefore one of the key determinants of an issuer's creditworthiness, a it must consistently issue equity to grow and issue debt to refinance maturing obligations. This accelerating acquisition treadmill is reminiscent of the FFO growth treadmill that some REITs with merchant buildings and other noncore businesses struggled to stay on during the last cycle.

Should share price premiums to NAV narrow or turn into discounts, the companies would need to sell equity below NAV to fund additional acquisitions on a leverage neutral basis, reduce acquisition volumes or sell assets. The latter two scenarios could impair growth expectations, thereby reducing share prices further and putting the REITs' equity valuations on a downward trajectory. In essence, the feedback cycle has the potential to become self-sustaining in reverse as well.

We believe healthcare REITs' sensitivity to their NAV is further exemplified by the lack of asset sales relative to acquisitions. Intuitively, large portfolio transactions likely include lower quality and less desirable assets, yet healthcare REITs have not engaged in the portfolio recycling activity that most other REIT sectors have. If healthcare REITs did in fact begin to sell lower quality assets, we believe that could result in the equity markets upwardly resetting cap rates, thereby triggering reductions in NAV.

That said, if the market for healthcare acquisitions is deeper than other commercial real estate sectors and can support a consistent level of acquisition opportunities, healthcare REITs should continue on their upward growth path. Further, if healthcare REITs embark on portfolio optimization by disposing of assets at or near the cap rates their equity valuations imply, this would validate private market asset valuations.

For more information on this topic, please see the following reports, "2014 Midyear Outlook: U.S. Equity REITs," "Health Care REIT's Acquisition of Health Lease Credit Neutral," "HCP's Deal with Brookdale Swaps Reinvestment for Operating Risk; Ratings Unaffected" and "Fitch Affirms Ventas, Inc.'s IDR at 'BBB+' Upon ARC Healthcare & Holiday Retirement Transactions."

Additional information is available on www.fitchratings.com.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article, which may include hyperlinks to companies and current ratings, can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.

Applicable Criteria and Related Research:

2014 Midyear Outlook: U.S. Equity REITs

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=748688

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