Vital Signs Fading

For investors seeking an alternative to the heart-stopping swings of equities, healthcare real estate investment trusts (REITs) may not be what the doctor ordered. Total returns for healthcare REITs are down this year by about 5%.

Owners of nursing homes, medical office buildings and assisted living developments are exposed to greater risks than investors in other real estate classes. That's because Healthcare REITs can rise or fall on that most capricious of forces — politics.

Whatever Washington and state governments decide about healthcare policy can affect returns for healthcare REITs. When the government cut Medicare reimbursements in the late 1990s, scores of healthcare operators found themselves struggling to pay the rent.

In 1999, sweeping Medicare policy changes applied stricter, HMO-style reimbursements to the skilled nursing sector. Nearly 70% of that sector relies on public pay, so the rigid new rules forced many operators into bankruptcy. In 2000 and 2001, a series of reimbursement add-ons were put into effect — but these additional reimbursements began to phase out last October.

Now, the federal budget is in deficit and Medicare reform remains a hot topic for Congress and the Administration. “This is a highly regulated industry and there are many inherent risks for investors,” says Lesia Bates-Moss, senior vice president at Moody's Investors Service. “Any real changes in policy or reimbursement can affect operators' ability to pay their rent.”

Exposure to the imponderables of policy fluctuations makes the sector outlook “volatile,” according to Bates-Moss.

But over the long term, demographics point to healthy demand for health care facilities — and not just nursing homes, says Bates-Moss. According to the 2000 Census, the number of Americans in the U.S. population ages 65 and older jumped 6% between 1990 and 2000 and now accounts for roughly 12% of the total population.

The oldest members of the giant baby boom generation will start hitting 65 in the next decade and life expectancy continues to rise, producing more demand over the coming decades.

In addition, there are currently 4 million Americans ages 85 and older, and that number is expected to rise to 6 million by 2010, according to Fitch Ratings.

Mixed Signals

Recognizing these trends, investors poured more than $1 billion of new equity and debt into the healthcare REIT sector last year, according to Fitch, with institutional investors contributing the largest chunk of capital.

Fitch's 2003 rating outlook for the healthcare REIT sector is mostly stable, with a negative outlook on earnings stability and growth. The stable outlook is supported by the emergence of improved healthcare service providers and stable healthcare REIT balance sheets with minimal leverage. Also, Fitch views a move toward diversification (by geography and property type) as a positive sign for healthcare REITs.

If one of these REITs has all of its properties concentrated in one state, any changes in that state's Medicare reimbursement policy can have a profound effect on tenants. By scattering their holdings across various states, these REITs are insulated from this exposure.

Another positive sign is a halt to the overbuilding of the 1990s. But several states, including Florida, Arizona and California, still have oversupply, hurting REITs with excessive exposure in those markets.

Performance Analysis

Equity healthcare REITs buy health care facilities such as hospitals, nursing homes, assisted living or outpatient facilities, and lease them to health care operators. On the debt side, they also hold the mortgages on these properties. These REITs do not provide health care services — their properties are leased to healthcare operators.

Last year was a milestone for healthcare REITs as an investment class. For the first time ever, healthcare REITs were included in the Morgan Stanley REIT Index. The inclusion sent a message to investors that healthcare REITs had arrived as a legitimate asset class.

But this year has proven to be a difficult one for several of the REIT sectors, including healthcare. Through Feb. 14, the total return for healthcare REITs registered a minus 5.80%, according to the National Association of Real Estate Investment Trusts (NAREIT).

For the 12 months ending Jan. 31, healthcare REITs' total return measured a negative 1.67%. While that's certainly better than the negative 15.48% total return registered by the beleaguered hotel sector, it's dismal compared with the high-flying retail sector, which is up 17.65% for the 12-month period.

Operational Concerns

According to Morgan Stanley, the performance of healthcare REITs is slipping. Nursing homes, a staple of many healthcare REITs, are under the budgetary knife in many states as extra federal reimbursements applied in the late 1990s have begun to expire. Since then, operators of nursing homes have seen revenues decline by nearly 10%.

Morgan Stanley predicts that the absolute level of reimbursements could fall further as more programs expire this summer, leading to more bankruptcies. State and federal budget shortfalls cannot help matters either, leading Morgan Stanley to predict more operator bankruptcies and greater earnings volatility for these REITs.

The most dangerous sign for healthcare REITs, perhaps, was the 2002 bankruptcy of Georgia-based Centennial, which operated 86 nursing homes in 19 states. It cited inadequate Medicare reimbursement for its financial woes, and its filing prompted the American Health Care Association (AHCA) to warn Congress against further Medicare cuts.

“The unfortunate bankruptcy involving Centennial serves as a dangerous red flag to Congress and the Administration that there is a serious human cost from the $1.8 billion in Medicare cuts,” says Charles Roadman, M.D., president and CEO of AHCA. “There is now reason to worry that we may be on the brink of returning to the horrendous situation of just three years ago when nearly 2,000 facilities serving some 200,000 frail, disabled and elderly were driven into bankruptcy by similar Medicare cuts.”

Company Strategies

There are other signs of stress. According to Morgan Stanley research, healthcare REITs account for 19% of all dividend cuts by property type since 1995. By comparison, the multifamily sector was responsible for 22% of all dividend cuts, with retail REITs rounding out the high-end of the list at 23%.

One participant in that trend was Health Care Property Investors (NYSE: HCP), which owns more than 28 million sq. ft. of healthcare properties in 43 states, and leases space to hospitals, nursing homes, physician groups, rehab hospitals and medical offices. In 2002, HCP completed $417 million worth of new healthcare real estate investments, with equity real estate investments and loans accounting for 66% and 34%, respectively. One-third of HCP's property holdings are used for assisted living facilities, and less than 20% are medical office buildings.

For 68 consecutive quarters, HCP had raised its dividend, but that changed earlier this year when HCP announced it would not increase its common dividend for the first quarter. Morgan Stanley expects that HCP's dividend growth will be stymied this year. The stock traded at about $35 per share in mid-February, down from its 52-week high of $45.08. HCP declined to speak with NREI for this article.

The next wave of demand will be for outpatient facilities, predicts Fred Farrar COO of Indianapolis-Ind. based Windrose Medical Properties Trust (NYSE: WRS). His firm, an equity healthcare REIT that is active in that area, was one of only two REITs to go public last year. “With assisted living it was thought, ‘Build it and they will come.’ Now we are seeing outpatient care increase three-fold over the past few years,” Farrar says.

Emphasis on Diversification

According to Bates-Moss of Moody's, the real challenge for healthcare REITs is finding growth opportunities. “Where do you find the opportunities and how do you finance them?” she asks.

For now, many REITs are focusing on diversification, limiting their exposure in states where healthcare operators are plagued by lawsuits. “States like Florida, Indiana and Illinois are very litigious, so healthcare REITs aren't looking to acquire many new properties there,” says Brian Phillips, senior director at Fitch Ratings.

When a healthcare operator declares bankruptcy, the process isn't the same as with other businesses, says Phillips. “If you are a nursing home, the bankruptcy court won't just force the property to go dark,” he explains.

Consequently, many REITs with nursing home assets gain leeway when their health care operator declares Chapter 11. During the late 1990s, when overbuilding led to a string of bankruptcies, this leeway allowed many healthcare REITs to gradually find new operators for these facilities rather than evict the current ones.

Last October, the Department of Justice filed a lawsuit against Tenet Health Care (THC), which owns acute-care centers, for allegedly submitting fraudulent Medicare claims. The scandal cut Tenet's stock price by 70% last year. Tenet was responsible for 16.3% of HCP's revenues at year-end 2002, and Morgan Stanley is concerned that the scandal will reduce annual payments to facility owners.

Despite the litany of issues facing the sector, health care REIT management teams are adept at understanding and working with legislators on healthcare issues.

“These guys are not just bricks-and-mortar experts,” explains Phillips of Fitch Ratings. “They know how this business works better than most, and it's a very technical business.”

That may explain why many investors tend to view this sector as something other than real estate. Nowadays, with real estate fundamentals slipping throughout all classes of property, this split identity may even attract investors.

As Jerry Doctrow, managing director at Legg Mason, says: “For real estate investors who understand this business, which is really subject to government policies, it's a good place to invest, especially if they are worried about real estate fundamentals deteriorating. Healthcare REITs may rebound first.”


Percentage change in total returns*
YTD Feb. 14, 2003 1-Year Totals Feb.1, 2002 to Jan. 31, 2003
Retail -0.16% 17.65%
• Regional Malls 0.61% 17.89%
• Shopping Centers 0.61% 17.89%
• Freestanding -2.02% 15.66%
Industrial -3.03% 15.88%
Office -5.11% -7.66%
Apartments -5.69% -3.75%
Healthcare -5.80% -1.67%
Lodging/Resorts -17.48% -15.48%
*Total return includes share price appreciation/depreciation plus reinvested dividends. The returns by sector not only take into account equity REITs, but also mortgage and other hybrid REITs. About 95% of all REITs are equity REITs.
Source: National Association of Real Estate Investment Trusts (NAREIT)

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