By George Skoufis

Not too long ago the health care REIT sector seemed to be fighting an uphill battle. But things have changed. Over the past two years the health care REIT sector has avoided negative publicity and been among the more stable REIT sectors. Relatively calm conditions for operator/tenants and a more favorable government reimbursement environment have translated into ratings stability and greater capital flows into the sector.

However, health care REITs, the majority of which have meaningful exposure to the skilled nursing facility (SNF) sector, should not get overly comfortable, given historical reimbursement volatility and current budget concerns at the federal and state levels, as well as fierce acquisitions competition for all types of assets.

Health Care
# of REITs	12
Market Cap. (in thousands)	$13,373,960
Industry Market Cap. (in thousands)	$285,114,453
% of industry	4.7%
Yield	7.0%
YTD Total Return	-11.1%
One-Year Return	-7.8%
Three-Year Return	17.4%
Five-Year Return	28.7%
Average Monthly Trading Volume (Shares)	2,167,423
Weighted FFO Growth (Fourth Quarter, 2003–2004)	4.85%
Source: NAREIT. Data as of Mar. 31, 2005

Standard & Poor's currently rates eight health care REITs, which collectively have nearly $5.5 billion (or roughly 6 percent) of rated securities outstanding and own/or have interests in more than 2,300 properties nationwide. Standard & Poor's currently has a stable-to-modestly positive outlook for the sector. Ventas, Inc. (NYSE: VTR), Omega Healthcare Investors, Inc. (NYSE: OHI) and National Health Investors, Inc. (NYSE: NHI) have all been recently upgraded.

Property Breakdowns

While SNFs have historically been the key focus for health care REITs (and the operators they essentially finance), starting in the mid-to-late 1990s, companies began diversifying into private-pay asset types, particularly assisted living facilities (ALFs). The surge in capital invested in this segment resulted in a sharp and material oversupply of ALFs, which impacted ALF lease-up and performance, and also hurt existing SNFs as the healthiest patients migrated to ALFs. Oversupply conditions eventually dissipated, and for now, new construction is in relative balance.

In addition to ALFs, some health care REITs have diversified into ancillary hospital facilities, such as medical office buildings and outpatient rehabilitation/ surgery facilities. Health Care Property Investors, Inc. (NYSE: HCP) and Healthcare Realty Trust (NYSE: HR) both have meaningful investments in this facility type, which has seen material competition drive up prices and reduce going in investment yields.

Healthy Landscape

During the recent recession, health care REITs did not feel the pain experienced by other real estate sectors, such as office and multifamily, which are more closely correlated to employment and household formation. Health care REITs have also recently been in a steadier state in large part due to more stable conditions at the property level. The operators that lease facilities, and to a lesser extent, obtain mortgage financing, have themselves been more stable. Standard & Poor's offers outlooks on five rated nursing home chains: two are considered stable and three are rated positive. However, other than ‘BBB' rated Manor Care Inc., this sector has a ‘B' to ‘BB-' rated risk profile.

Medicare reimbursement today is more favorable than in prior years (up 6.26 percent in October 2003 and 2.8 percent in October 2004) and is expected to remain reasonably stable until 2006. Medicaid reimbursement, which represents the largest source of SNF revenue, experienced relatively flat rates in 2004, with similar expectations for 2005. However, Medicaid benefited from a $10 billion infusion by the federal government in 2004. Despite current stable conditions, uncertain future government reimbursement remains an inherent risk.

Standard & Poor's Health Care REIT Outlook
					Investment Concentration**
Company	Ticker	Rating/Outlook	Rated Securities*	SNF	ALF/ILF	MOB	Hospital	CCRC
Health Care Property Investors, Inc.	HCP	BBB+/Stable	$1.3 billion	20%	27%	24%	22%	—
Healthcare Realty	HR	BBB-/Stable	$600 million	10%	13%	68%	8%	—
Nationwide Health Properties, Inc.	NHP	BBB-/Stable	$732 million	33%	53%	—	3%	10%
Health Care REIT, Inc.	HCN	BBB-/Stable	$1.2 billion	39%	54%	—	—	—
Senior Housing Properties Trust	SNH	BB+/Stable	$423 million	14%	83%	—	3%	—
Ventas, Inc.	VTR	BB/Stable	$491 million	55%	21%	—	21%	—
Omega Healthcare Investors, Inc.	OHI	BB-/Stable	$528 million	93%	4%	—	3%	—
National Health Investors, Inc.	NHI	BB-/Stable	$101 million	71%	23%	3%	2%	—
*Comprises debt and preferred stock securities. **Includes share of joint ventures, if applicable. Source: Standard & Poor's
Credit Strengths:				Credit Weaknesses:
• Portfolio diversification (by operator, facility, revenue source and geography) is a meaningful contributor to operating stability. As companies grow their portfolios, many focus on reducing reliance upon government reimbursement; • Reduced exposure to mortgage investments should lower volatility. REITs fare better (in situations of operator/borrower distress) when they own health care facilities subject to leases because the lease structure requires the acceptance or rejection of a lease (enabling the REIT to often gain control of the facility faster). • Supply/demand fundamentals for SNFs benefit from the requirement, in most states, for a certificate of need. Similar barriers to entry do not exist for ALFs, which suffered overbuilding in the 1990s, though operators today are behaving more rationally. • Demographics are favorable for health care investment, largely due to the aging of the baby boomer generation. According to the U.S. Census Bureau, the 65 and over age group will grow by nearly 20 million, or more than 50 percent, between 2000 and 2020. Furthermore, the 45-64 age group will grow by more than 20 million, or more than 30 percent, over the same time frame. • Health care REIT balance sheets are moderately leveraged, with modest secured debt levels and manageable debt maturity schedules, which should provide some cushion to weather future challenges.				• Despite a currently more favorable environment, government reimbursement policies have been and will remain volatile, which can impact operator profitability; • Current market prices for assets will impact future profitability, if REITs do not prudently underwrite and finance acquisitions up-front, especially those reliant on government reimbursement; • Growing exposure to private pay assets insulates companies from reimbursement risks, but these assets are also more closely linked to market and economic conditions that may affect a patient/ resident's income; • Investments in facilities located on or near hospital campuses (and their ongoing value) will be very strongly tied to the strength of that hospital system, which could strengthen or weaken over the course of an investment cycle.

However, health care REITs and their operators may be better positioned to manage the impact of future reimbursement cuts. For one thing, REIT portfolios are generally diversified and comprise better quality facilities. Many troubled investments have been worked out through disposition, lease/mortgage restructuring, and/or retenanting.

At the operator level, SNF operators, who have been the leading cause of stress over the past six years, as well as ALF operators, have cleaned up their acts. A few reasons for their improved health include: improved balance sheets, some through the bankruptcy process; divestiture of poorly performing non-core businesses, and weaker/unprofitable facilities, including the shrinking or complete exit from more challenging markets with high litigation costs (i.e. Florida and Texas). Portfolio diversification is also better today due to evolving REIT investment strategies and restructurings that have reduced the size of and exposure to the larger SNF operators. However, the shift toward ALF and independent living facility (ILF) investments is not risk free, as this segment will remain vulnerable to periodic overbuilding.

Perhaps the hottest property niche has been ancillary hospital facilities, namely medical office buildings (MOBs). Select REITs and other investors have invested heavily in this segment, which is driving up prices. HCP and HR target MOBs/outpatient facilities that are on or close to hospital campuses. This segment is supported by the relative stability of physicians as tenants, due to their desire to locate on or near a hospital campus, as well as the growing trend toward outpatient services versus more expensive inpatient stays. This investment category has been active for a variety of reasons, including the increased flow of capital to real estate in general and healthcare specifically (as credit quality of sector participants has stabilized or improved), and an increase in available assets as hospital systems monetize their real estate holdings to better focus on operations.

The outlook for the sector remains fairly positive. A currently more favorable government reimbursement environment, along with more stable portfolios and tenant bases support this position. While reimbursements are today more favorable, Standard & Poor's will keep an eye on the horizon in light of federal and state level budget deficits. Mitigating some of this concern is the diversity exhibited at the property level, including facility types, and growing revenue sources that are less reliant on government reimbursement.