By John J. Kriz

Albeit slow to materialize, there is a turnaround happening in the health care REIT industry. In recent years, much of the health care property market was under pressure from troubled operators, several of which were in bankruptcy. Operators faced adverse shifts in government health care payments that unfavorably affected the skilled nursing sector, a large segment of health care REITs' property portfolios. There was also overbuilding in the assisted-living sector, another large component of the industry.

But that was then. Currently, Moody's Investors Service has a modestly positive rating outlook for health care REITs, with recent rating activity being consistently positive. No health care REIT has a negative outlook, with National Health Investors (NYSE: NHI) having a positive outlook, and Omega Healthcare Investors (NYSE: OHI) on review for upgrade. Health Care REIT (NYSE: HCN) was upgraded this summer one notch to Baa3 for senior debt–investment grade.

The rating upgrade for Health Care REIT recognized the success the company has had in sourcing and executing profitable growth, its good asset and tenant monitoring, its consistently modest level of secured debt in its well-laddered capital structure, and improved performance in its large assisted-living property portfolio, among other factors. Omega Healthcare Investors, which experienced significant stress in recent years, has recently reinstated both its preferred and common stock dividends. New management has a sound business plan, and has had success in reducing its exposure to troubled tenants and in culling its portfolio of weak assets. National Health Investors has enjoyed success in working out difficulties with troubled tenants and investments, and in improving its coverages and reducing its debt. It has little secured debt, and has no material debt maturities for several years—a plus for its liquidity.

While those are just a few specific examples of improving characteristics within individual companies, there has also been a broader improvement in capital market access by health care REITs—debt, common stock and preferred stock. Even infrequent issuers, such as LTC Properties (NYSE: LTC), have successfully tapped the markets—in LTC's case for preferred stock. There was also a health care REIT IPO in August 2002 by Windrose Medical Properties Trust (NYSE: WRS). All of these factors are encouraging signs for the returning health of the sector.

Sustaining Good Health

Why do we have this positive momentum? For one, today's health care industry is characterized by greater stability in the government payment reimbursement environment. Adverse shifts in these payments in recent years, earmarked by the Balanced Budget Act of 1997, hurt operators' profitability, as well as performance at the property level, especially in the key skilled-nursing facility sector. Several operators went bankrupt, and many of those that did not were still under stress. This stress also made it more difficult for REITs to find alternative operators.

Health Care
# of REITs	13
Market Cap.*	$10,926,210
Industry Market Cap.*	$205,626,168
% of Industry	5.30%
Yield	7.25%
YTD Total Return	31.38%
One-Year Return	32.32%
Three-Year Return	33.58%
Five-Year Return	13.14%
Weighted Average Daily Volume (shares)	1,616,235
Weighted FFO Growth (2002—2003)	-1.08%
*These figures represented in thousands. Data as of Oct. 31, 2003. Source: NAREIT

Now, several operators have successfully emerged from bankruptcy and are on the mend (Kindred Healthcare emerged from bankruptcy in 2001, and Mariner and Assisted Living Concepts emerged in 2002.) Operator health is a big issue for health care REITs because of the triple-net leases that represent most of their property investments, and the mortgage financing provided by REITs to operators. While there are still operators wrestling with financial difficulties, things are looking up for them.

Unlike other property sectors, the health care real estate environment has shown strong resilience during this economic downturn. This is largely due to a reflection of the essential nature of health care services, and the relative immunity to economic swings that tend to affect most other property sectors, such as residential, industrial and office. Supply/demand fundamentals for the skilled-nursing segment benefit from stringent regulatory barriers, too. For example, certificates of need must be obtained for new skilled nursing facilities in most states, and this puts a governor on rapid overbuilding, in contrast to assisted-living facilities.

The assisted-living property sub-sector has also seen a rebound. The late 1990s saw an increase in construction that oversaturated the market. This growth started to substantially trail off in 2000, giving operators a key opportunity to stabilize their properties and push rents. The concept of assisted-living facilities has also become better known to would-be residents and their families, and this greater acceptance of the benefits of this type of elder care continues to positively drive performance. The sub-sector also has a private-pay resident model, and this helps health care REITs to avoid the risks of sharp shifts in government payments, and to diversify their core revenue base.

However, let's not give the sector a clean bill of health just yet. Labor issues and rising liability costs remain critical ongoing challenges for operators and providers of health care. Labor is a key operator cost. This sharply affects property-level profitability that, in turn, affects property-level coverages for REITs. In turn, that impacts the likelihood that tenants will not renew expiring leases or will give properties back to landlords if they enter bankruptcy, as well as the rent-pricing power of landlords. Operator liability issues can be troublesome and volatile, and have made some states unattractive to operators. Associated insurance rates have also been high.

Ventas To Acquire ElderTrust In late November, Ventas, Inc. (NYSE: VTR) entered into an agreement to acquire ElderTrust’s (NYSE: ETT) outstanding shares at $12.50 each, making the net purchase price valued at $152 million. Once the deal closes, Ventas will own ElderTrust’s 18 health care and senior housing assets. According to Ventas, this transaction will add five to seven cents to its fully diluted funds from operations (FFO) per share. The company plans to fund the $101 million equity portion of the purchase price from cash on ElderTrust’s balance sheet, proceeds from the sale of 10 facilities to Kindred Healthcare, Inc. (Nasdaq: KIND), and/or draws on Ventas’ revolving credit facility. “We view this merger between Ventas and ElderTrust as a good first step in achieving industry consolidation in the health care REIT space and as a continuation of our focus and diversification plans,” says Debra A. Cafaro, chief executive officer, chairman and president of Ventas. “We think we’ve crafted a merger that creates value for both Ventas and ElderTrust shareholders.”

Continuing Success?

There are several key factors that will lead to the continued positive performance of health care REITs. The companies that best exhibit the following characteristics are likely to experience positive ratings action:

• Identifying and executing profitable growth. Successful REITs are those that can grow profitably.
• Substantial portfolio diversification by facility type, operator and geography. The importance of this was demonstrated in the healthcare property downturn. Health Care Property Investors (NYSE: HCP) and Healthcare Realty Trust (NYSE: HR) serve as positive examples. Ventas, Inc. (NYSE: VTR) is also making progress here, highlighted by its planned acquisition of ElderTrust (NYSE: ETT).
• Avoidance of secured debt. This is a key characteristic of investment-grade healthcare REITs. Also unencumbered property portfolios were a key resource several REITs used to help see them through troubled times. Properties could be pledged to obtain mortgages for debt refinance, and unencumbered assets are more easily sold.
• Laddered debt maturities. Bunching of maturities weakens REITs' capacity to deal with adversity elsewhere in their businesses.
• Strong internal research, underwriting and asset/operator monitoring capacity. Recent stresses have demonstrated the importance of running the business tightly. Health Care REIT's efforts here were a key component that drove its rating upgrade.
• Success in addressing remaining operator and property-level difficulties. While much has been achieved, more remains to be done.

---

John J. Kriz is managing director of the Real Estate Finance group at Moody's Investors Service.