The latest milestone in a yearslong process of disentangling from a troubled major tenant — its second such workout in the last decade — has at long last put HCP Inc. in a better position to grow, analysts say.
A new agreement with Brookdale Senior Living Inc. will reduce Brookdale's concentration as a tenant to 7% of HCP's annual net operating income by the end of 2020, according to SMBC Nikko Securities America — down from roughly 16% before the deal and 35% in early 2016.
HCP, along with Ventas Inc. and Welltower Inc., its major peers among healthcare REITs, have labored to revamp their relationships with Brookdale and other tenants that operate seniors housing facilities, as revenues in that industry have slowed amid a glut of new construction. Yet the newest deal appears especially good for the landlord because it also stands to improve earnings in the short term, Robert W. Baird analyst Drew Babin argued.
"Usually anytime a lease is restructured, it's just basically a translation of, 'We lowered the rent, so now the coverage ratio is better,'" Babin said in an interview. Analysts and investors had worried before the deal that HCP would make a similar move, diluting earnings in the process, Babin said. As a result, he called the transaction that the companies actually worked out — with a small expected benefit to HCP's core funds from operations in 2020 — a pleasant surprise.
HCP achieved that result by structuring the newest deal around a swap: paying $510 million to buy out Brookdale's share of a joint venture that owns 15 continuing care retirement centers, while Brookdale is paying $405 million to acquire 18 underperforming seniors housing properties from HCP. HCP will also pay $100 million to terminate Brookdale's management of the continuing care centers.
The spread on yields between the two purchases is favorable for HCP. The continuing care center acquisition comes at a 9.7% capitalization rate after adjustments for the termination fee and management fee savings, while the sale of the seniors housing properties to Brookdale is priced at a 7.4% yield on in-place rent.
In another benefit for HCP, the company plans to shift management of the continuing care centers to Life Care Services, a leader in that industry, which will operate them on an incentive-based lease with lower up-front costs, saving the landlord roughly $7 million in the first year.
Brookdale, too, should benefit, SMBC Nikko Securities America analyst Richard Anderson argued in a note — by reducing its leverage, increasing the size of its portfolio, exiting the unpredictable continuing care center business and raising cash for capital improvements. Consequently, Anderson said the deal is a "win-win-win" that helps Brookdale's other landlords by giving them a healthier tenant.
In working out the deal, he wrote, "HCP is playing a (perhaps unintentional) charitable role here too."
Jonathan Litt, whose hedge fund Land & Buildings Investment Management LLC owns a stake in Brookdale and has urged the company to liquidate all of its owned real estate — and who is nominating former HCP CEO Jay Flaherty III for a seat on Brookdale's board — did not reply to an email for comment.

HCP and Brookdale launched their joint venture to own continuing care retirement centers in 2014 with a sense of optimism. HCP's management team at the time, led by Flaherty's successor, Lauralee Martin,
Their predictions do not appear to have come true: HCP is acquiring 12 properties out of a total of 15 in the venture, which has grown by only one property since it launched, and the companies plan to market the other three for sale. As for the assets' market value, Evercore ISI analysts say the venture acquired the portfolio at an 8% yield in 2014; the higher yield on the current transaction suggests that the properties' price is now lower relative to the amount of income they generate.
Still, while the new deal's pricing suggests that investors consider the asset class risky, Anderson said HCP is betting that cash flow in the facilities increases as the U.S. population ages and demand grows.
Moreover, some observers' favorable reaction to the deal is less about sector fundamentals and more about the belief that HCP is near the end of a long journey.
After acquiring the real estate of nursing home operator HCR ManorCare in a $6.1 billion deal in 2011, under Flaherty, the company derived roughly 41% of its net operating income, on an annualized basis, from skilled nursing properties. That move
HCP ended its business in the sector by spinning off its skilled nursing properties in 2016, and with skilled nursing gone, the next-largest relationship to resolve was with Brookdale. The new deal, which follows an earlier series of transactions announced in November 2017, is the company's latest effort on that count: It puts the company's remaining properties leased to Brookdale under a single master lease with 2.4% annual rent escalators, improving Brookdale's rent-coverage ratios on the properties in the process.
After the deal was announced, Fitch Ratings upgraded its ratings on HCP in what it called a reflection of the recent years' progress. While Fitch is not necessarily bullish on all of the property types in HCP's portfolio — it remains cautious on seniors housing — the company's portfolio is now diversified enough that it is less likely to see its cash flow disrupted, Fitch analyst Britton Costa said in an interview.
Also of critical interest, Costa said, was the question of whether the company's new management team, which took over in 2017 and 2018, would pursue a different approach from previous, big-deal-hunting leaders who effectively assembled the portfolio that the current leaders are now trying to unwind.
So far, the rating agency believes signs are positive.
"They have chosen to be much more conservative than what we saw previously out of HCP," Costa said. "Behaviorally, it seems like they are allocating capital on a much more risk-neutral basis than the previous management team had."
