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As healthcare tenants struggle, REITs shake things up

On the broad strokes of the senior care real estate investment thesis, everyone seems to agree: The U.S. population is aging, and in the coming years, larger numbers of older people are going to need more services. Many will move into nursing homes or seniors housing facilities.

Beyond that simple logic, though, is the reality that several major operators — both in government-reimbursed skilled nursing and in private-pay seniors housing — have struggled to generate enough revenue in recent years to pay their rent.

For the real estate investment trusts that are the largest publicly traded owners of healthcare properties, that has meant scrambling to adjust to tenants' changing fortunes. Brookdale Senior Living Inc., the largest public seniors housing operator, reported a $457.2 million net loss for the first quarter. Several REITs in recent months have restructured their lease agreements with the struggling tenant.

Ventas Inc., the second-largest public healthcare REIT by market capitalization, in late April signed a new eight-year master lease agreement with Brookdale that shrinks the annual escalations in Brookdale's rent. Ventas will also provide Brookdale an average of $6 million in rent credits each year.

Brookdale's CEO said the Ventas agreement will give it much-needed short-term stability while it reorients its operations.

HCP Inc., the third-largest healthcare REIT, struck its own revised agreement with Brookdale in late 2017, and is taking steps to minimize its exposure to the operator by selling some properties and bringing in new operators to replace Brookdale at others.

Meanwhile, the largest healthcare REIT, Welltower Inc., is making an audacious bet that it has found a way to safely own skilled nursing properties, which have suffered in recent years as government reimbursement rules have changed. Welltower plans to acquire fellow REIT Quality Care Properties Inc., a pure-play owner of more than 300 skilled nursing facilities, and hold the properties in a joint venture with ProMedica Health System Inc. In a linked transaction, ProMedica is acquiring Quality Care's main tenant, the operator HCR ManorCare Inc.

Welltower executives' insistence on a conference call that the deal does not actually increase their exposure to skilled nursing was met with skepticism from analysts and investors. But in the days after the transaction was announced, as Welltower executives toured the country promoting the deal, several observers credited the REIT for trying something new, even while expressing continued reservations about the property type.

"It appears to be very well structured, and in a conservative manner," Wells Fargo bond analyst Thierry Perrein said in an interview. "That's very hard to dispute. But at the end of the day, it comes down to, you're still owning skilled nursing homes."

Unusual transaction

The Welltower deal hinges on the idea that the company's tenant is not a dedicated skilled nursing operator as HCR ManorCare was under its previous owner, Carlyle Group LP, but a diversified health system — ProMedica — that generates revenue from hospitals and a managed-care business. The transaction includes a corporate guarantee from ProMedica with covenants that compensate Welltower if ProMedica's high credit rating falls.

"When Welltower speaks to it not being a skilled nursing deal, what they're basically saying in that same breath is, 'We're getting a 15-year payment from ProMedica that's backed at the corporate level, so this is really in some ways a real estate-related loan to ProMedica,'" an equity investor who spoke with the REIT's management said in an interview.

Under the deal, even if ProMedica decides to walk away at the end of the lease — which would be a worse-than-expected outcome for the REIT — Welltower nonetheless would still have gotten 15 years of solid cash flow, the investor said. Moreover, Welltower has emphasized that it paid a relatively low price for the properties, roughly half of what HCP paid when it acquired the same portfolio from Carlyle in 2010.

"The skilled nursing assets still need to perform, that's important," the investor said. "But there's other aspects of the story that make it different from your typical skilled nursing acquisition. … I think there's something to it, but there's a lot of execution risk to go along with it."

A major challenge for healthcare REITs is securing a steady and growing income stream from the operators who are their tenants while being careful not to extract such high rents that the operators fall into distress. Both Welltower's ProMedica deal and Ventas' Brookdale deal contain specific provisions for spending to upgrade and maintain properties — precisely the kind of work that operators often defer when they are struggling to cover their rent.

Separately, Omega Healthcare Investors Inc., a REIT that owns skilled nursing properties, secured approval to transition 23 properties away from a bankrupt tenant, Orianna Health Systems LLC, and moved to prop up another operator, Signature HealthCARE LLC, with rent deferrals and a loan, among other payments.

"I always tell investors, 'You've got to work with your operators,'" Perrein said, citing Ventas' move to extend the Brookdale lease on less demanding terms for the tenant. "The last thing you want to do is push your tenant into bankruptcy, because you're making things worse."

HCR ManorCare is an embodiment of just how far off-track a landlord-tenant relationship can spin. The operator's entry into a planned bankruptcy proceeding in March followed a default on payments owed to Quality Care Properties and ultimately gave Welltower and ProMedica the opportunity to acquire the operator and the properties it was leasing, at depressed prices.

Vertical integration

Welltower is taking the risk of the new HCR ManorCare transaction in part because skilled nursing, uncertain as its payment model has been in recent years, will remain a key part of the U.S. healthcare system, observers say. The challenge for REITs, then, is to find operators that are likely to survive the current shakeout.

Britton Costa, an analyst at Fitch Ratings, said in an interview that the rating agency believes the strongest skilled nursing operators will be those with enough scale and financial stability to partner with health systems and receive a steady stream patient referrals. ProMedica's acquisition of part of HCR ManorCare takes that idea a step further by bringing the skilled nursing operator under the same corporate ownership as the health system, aligning both sides' interests.

Costa said the transaction illustrates a broader trend in which providers are seeking to invest in several different parts of the healthcare system, in order to diversify their income streams and draw income from the same patients in multiple different ways.

Welltower is gambling that a diversified tenant, in ProMedica, will be a strong enough tenant to deal with skilled nursing's ongoing uncertainties.

"It's all about integration now," Perrein said. "If these guys have a better mousetrap, so be it, and then Welltower will be the beneficiary at the end of the day."