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Tenant's bad news is boon for Quality Care Properties' stock

For many real estate companies, a Friday evening disclosure that a major tenant's financial status was in doubt would be cause for investor panic.

As recent events make clear, Quality Care Properties Inc., which spun off from HCP Inc. in late 2016, is not one of those companies.

The REIT said after trading closed March 31 that HCR ManorCare — a private equity-owned nursing home operator with a long history of trouble paying rent — had failed to provide recent financial disclosures, despite repeated requests and an agreement between the two sides that requires them.

The tenant accounted for 94% of Quality Care's 2016 revenue, but its troubles apparently amounted to a buy signal for Quality Care investors: Shares of the REIT rose 3.7% on the next trading day.

The reasons may lie in the REIT's shifting investor base, and the complex and sometimes counterintuitive set of incentives that underlie its relationship with HCR ManorCare. Quality Care's rally after the ManorCare news — plus a 2.6% gain on the day the REIT said it was lending ManorCare money and renegotiating their master lease agreement — suggests that some investors are rooting for the two sides' relationship to come to a head.

In contrast with the relatively staid names atop the list of HCP's top owners, Quality Care's biggest shareholders now include opportunistic and event-driven hedge funds such as Abrams Capital Management L.P. and HG Vora Capital Management LLC, both of which dip relatively selectively into REIT investing and occasionally take activist positions.

Neither firm responded to requests for comment, but the logic behind a Quality Care investment is somewhat unusual, in part because the company was formed largely as a vehicle to remove properties linked to ManorCare from HCP's portfolio. In its spinoff, the REIT also inherited a minority equity stake in the operator, which is majority owned by Carlyle Group LP.

In comments leading up to the spinoff, HCP executives said Quality Care would be better equipped than HCP to deal with the vagaries of the ManorCare relationship. In part, that meant that the smaller REIT's executives could confront the full range of outcomes from the tenant — including a rent cut or a ManorCare bankruptcy — without having to worry about the relationship dragging the rest of HCP's relatively blue-chip portfolio down.

Of course, that thinking also implies that Quality Care may have to confront unpleasant realities about its tenant, and may not remain a REIT for long itself.

ManorCare does not have much to offer Quality Care if it wants to negotiate lower rent payments, but one thing it could give up is equity ownership. In one scenario, Carlyle could cede majority control of the operator to Quality Care. Such a transaction would give Quality Care control over ManorCare's direction, but would likely require it to give up REIT status to avoid running afoul of regulations that limit REITs' non-real-estate income.

Alternately, Quality Care could choose to fight: declare ManorCare out of compliance with the lease agreement, foreclose on the properties and seek out new operators. This approach, though, would likely involve a long battle in bankruptcy court, substantial legal fees and possible deterioration in the nursing homes' operations during the battle.

Finally, middle paths exist in which Quality Care could sell off some ManorCare-operated properties, shrinking the portfolio and lowering ManorCare's total rent, or it could shift some underperforming properties to a new operator. In the process, the REIT could take on a larger equity stake in the operator, but one that is still small enough to allow it to keep REIT status.

Neither Quality Care nor ManorCare responded to requests for comment. Whichever course Quality Care chooses, what some investors may crave most is clarity. That clarity is likely months away — the REIT is still awaiting ManorCare's financial disclosures, due under their agreement by April 10, and the two sides plan to discuss a restructuring of their relationship until July 5 — but the disclosure of ManorCare's continued troubles may at least point toward a resolution.

The process of sorting out the ManorCare relationship may not be pretty. But the good news for some investors, judging by the REIT's share price, is that the process seems to have begun.