Dividend Stocks

[gfp927z]

>>> A Matter of Time for Health-Care REITs


We prefer the yield, stability, and growth prospects of the triple-net structure over RIDEA.



By Todd Lukasik, CFA

08-15-14



http://news.morningstar.com/articlenet/article.aspx?id=661040&SR=Yahoo



Until the introduction of the REIT Investment Diversification and Empowerment Act of 2007, health-care real estate investment trusts simply owned property and rented it to tenants. RIDEA, however, allows REITs to directly expose themselves to the financial performance of the underlying health-care operations, instead of just collecting rent checks. RIDEA has brought changes to health-care REITs' profitability, cash flows, and return prospects--some cosmetic and others meaningful. Although triple-net leases have dominated health-care REITs' results historically, the rapid adoption of the RIDEA structure since 2010 has resulted in portfolio exposures of as much as 34%. The new structure has been a financial boon lately, as RIDEA-structured assets have enjoyed robust growth. However, RIDEA introduces the potential for variability in health-care REITs' cash flows and makes REITs responsible for additional expenses relative to traditional triple-net assets. Also, RIDEA transactions have generally been priced more aggressively than triple-net deals, which implies that faster cash flow growth is required to make the RIDEA structure pay off. As a result, we generally favor the yield, stability, and growth characteristics of the triple-net deals.


The Basics: RIDEA vs. Triple Net

Before the introduction of RIDEA, health-care REITs stuck to a simple model: Buy property and rent it to tenants. Since 2007, however, health-care REITs have had the option to buy property and--instead of simply collecting rent from a tenant--be financially responsible for the success of health-care service operations conducted in the property.

This was a major change for health-care REITs, because--for the first time--it allowed them to be directly exposed to the underlying property operating fundamentals, including changes in occupancy and rental rates, instead of just collecting rent checks from tenants.

RIDEA allows REITs to form a taxable REIT subsidiary to oversee the management of the health-care operations within the property, which generally means hiring a third-party manager. While the third-party manager is generally motivated to run the property in alignment with the REIT's interests, it is the REIT that retains the most exposure to the financial success (or lack thereof) of the property operations. Third-party managers are generally paid a base management fee (generally 5% of property revenue) plus incentive fees (generally 1%-2% of property revenue or linked to property income growth or cash flows above a certain threshold).

While neither the triple-net nor RIDEA structure is inherently moatier than the other, we generally prefer the yield, stability, and predictable growth of the triple-net structure. Also, recent notable senior housing transactions in both the RIDEA and triple-net structures have had similar initial net operating income yields, but initial cash flow yields (returns on real estate assets) on RIDEA assets have been lower by an average of 50 basis points or so. While each RIDEA deal is unique and needs to be evaluated with regard to property location and quality, manager, and overall growth prospects, the lower initial cash flow yields of RIDEA assets require faster future cash flow growth to achieve parity with similar triple-net transactions, all else equal.

The attraction of the RIDEA structure for senior housing assets derives from health-care REITs' bullish view on the prospects for this property type, particularly in the top metropolitan areas across the United States and Canada. Strong tailwinds for senior housing are provided by the aging of the population and a recovery in home values, the stock market, and employment. The aging of the population provides incremental demand for senior housing space, while rising home and equity values provide financial resources for seniors to pay senior housing rent and fees. Higher levels of employment put adult children back in the labor force, with less free time to provide care for their senior parents.

By utilizing the RIDEA structure with senior housing properties, REITs are directly exposing themselves to the robust growth expectations associated with the category. Under the RIDEA structure, if these robust cash flow growth expectations play out, the benefit will accrue directly to the REIT as opposed to the tenant operator.

Although Ventas (VTR) was the first health-care REIT to adopt the RIDEA structure with its 2007 acquisition of Sunrise Senior Living REIT, Health Care REIT (HCN) has been the most active since, with RIDEA transactions involving Sunrise, Revera, Benchmark, Belmont Village, Chartwell, Senior Star, Merrill Gardens, Brookdale, and Silverado. As a result, among our coverage, Health Care REIT currently has the highest portfolio concentration allocated to RIDEA at 34% of NOI. HCP (HCP) has not been as aggressive, but it converted a small portfolio of senior housing assets to the RIDEA structure under a new manager (Brookdale) when its original triple-net tenant (Horizon Bay) was in default on a loan. Similarly, HCP has entered agreements with Brookdale, expected to close in the third quarter, that will convert some its Brookdale and Emeritus assets from triple-net leases to RIDEA joint ventures with Brookdale.

We expect relative RIDEA exposures to remain similar, although HCP may eventually increase its exposure to 10%-15% of NOI, provided it can find the right assets with opportunistic characteristics to improve operating performance and achieve an acceptable risk-adjusted return. (We estimate HCP's RIDEA exposure will approximate 10% following the implementation of its proposed deal with Brookdale-Emeritus.)

Although Health Care REIT has called for a balance in its portfolio, we would not be surprised if it increased its RIDEA exposure beyond its current 34% of NOI, if the right deal (or deals) came along. In our opinion, Health Care REIT has been the most aggressive with the RIDEA structure to date, and we think it will remain very interested in future RIDEA opportunities.

Any future shift in RIDEA exposures may be good, bad, or indifferent for these REITs' shareholders, depending on the specifics of each transaction. Although we generally prefer the triple-net structure, the RIDEA investments of Health Care REIT and Ventas have delivered robust cash flow growth recently, and the capital these firms have invested in their RIDEA assets has been well deployed, in our opinion.

Although our take on initial return on real estate assets yields for the RIDEA deals Ventas and Health Care REIT struck from 2007 to 2011 generally fell in the range of 5.5%-6.5%, we estimate current ROREA yields are tracking in a range of 6.2%-7.9%. Thanks to continued cash flow growth expectations, we estimate five-year forward ROREA yields are likely to be 8%-9% for the majority of these deals, a range that looks attractive relative to our mid-7s estimates for these firms' weighted average cost of capital.

Financial Statement Implications of RIDEA vs. Triple Net
Most financial statement differences between RIDEA and triple-net transactions are cosmetic, in our view. Two meaningful implications of RIDEA deals, however, are increased maintenance capital expenditure requirements for the REIT and potentially increased cash flow variability.

Triple-net leases carry very high profit margins for landlords (around 100% NOI margins), because tenants are responsible for all property operating expenses, leaving minimal--if any--expense load for the landlord. Because RIDEA transactions, on the other hand, essentially make the REIT responsible for the property-level revenue and expenses of the health-care operations conducted in the property, NOI margins on these RIDEA assets are much lower (generally 30%-40%).

As Ventas (28% of NOI exposed to RIDEA) and Health Care REIT (34%) have brought RIDEA assets onto their balance sheets, for example, overall company EBITDA margin at these firms has fallen. HCP, with its minimal exposure to RIDEA (3%), has maintained a higher overall EBITDA margin.

Similarly, other health-care property types and leasing models have varying levels of NOI margin, generally 60%-75% for medical office buildings and 70%-80% for life science properties. We attribute the different levels of 2013 EBITDA margin among HCP, Health Care REIT, and Ventas mainly to their different business mixes.

<<<