Healthy Outlook for Undervalued Landlord

We have a slightly downbeat view of  Ventas' (VTR) recently announced $3.5 billion worth of acquisitions, given the aggressive prices paid and the related dilutive equity issuance at a price below our fair value estimate. However, our skepticism isn't enough to change our overall opinion, so we're maintaining our $76 fair value estimate and our narrow Morningstar Economic Moat Rating. At its current stock price, Ventas appears to be a relative bargain among our overall real estate investment trust coverage.

Ventas' $3.5 billion in deals was spread out over two transactions. The first is a $2.6 billion portfolio acquisition of American Realty Capital Healthcare Trust , a health-care REIT with property concentrations in medical office buildings and senior housing facilities, both areas we like. We're generally not fans of these types of buyouts, however, because of the premium normally required for control. In this case, Ventas limited the premium to less than 15%, but it is still paying roughly $600 million (30%) more than the target's cost basis in the properties, all of which have been acquired in the past few years. Also, it is issuing shares at a price ($67) below our fair value estimate to help fund the deal, so it looks even costlier to us.

The second transaction involves the purchase of $900 million of senior housing communities in Canada, the operations of which will transition to Atria, a preferred Ventas partner.

Both transactions' initial yields are around 6%, which is lower than we'd like (reflecting a higher price than we'd like), but Ventas should be able to achieve greater-than-normalized growth from these properties over the medium term, given the portfolios' exposure to senior housing assets, which are generally experiencing robust growth. Senior housing assets represent roughly half of these deals, and Ventas expects 4%-5% growth for these assets, which we think is reasonable.

Favorable Tailwinds for Ventas' Business
With the advent of the Affordable Care Act in the United States, change is underway in the health-care industry. The reforms bring a renewed focus on constraining growth in health-care costs, while potentially introducing tens of millions of new insureds to the health-care system. Despite the uncertainty regarding current (and potential) changes to the industry, the bulk of health-care spending is nondiscretionary and often requires physical space--that is, real estate--for its delivery, favorable conditions for health-care landlords. We think Ventas will continue to benefit from in-place long-term leases, well-located senior housing properties, and future opportunities for profitable external growth with partners expanding their operations and by consolidating its industry.

In recent years, Ventas has added senior housing operating assets to its diversified portfolio. Given the direct impact of their operating variances on Ventas' financials, we view these operating assets as potentially introducing more variability to Ventas' results than its legacy (mainly triple-net leased) assets. However, Ventas is also immediately exposed to operating improvements at these properties, which can drive faster growth in strong markets. The firm's strategy in this area is sound, as it attempts to limit downside risk by owning high-quality assets in markets with favorable demographics that it expects to enjoy expanding demand over time. Ventas reports that its operating portfolio is in areas within its markets with higher average household incomes and higher home values, which--along with the aging of the population--should benefit demand for its senior housing operating assets. Early results of this effort are encouraging, as these assets have been some of Ventas' best performers of late.

In general, Ventas' business remains exposed to favorable tailwinds, such as a growing and aging population and additional users of the health-care system because of ACA. We expect inflation-plus internal growth from legacy assets. Also, the fragmented industry should provide further consolidation opportunities to drive external growth.

Higher Returns Restore Moat
After Ventas' massive balance sheet expansion a few years ago, we downgraded our moat rating to none from narrow. The high prices paid for its acquisitions resulted in low initial yields on investments and a drastic reduction in our estimate of Ventas' ROREA, or return on real estate assets, to a level below our estimate of its cost of capital. (We estimate ROREA, our preferred return metric for REITs, as EBITDA less maintenance capital expenditures, divided by the gross book value of revenue-generating assets.)

In the years since, however, Ventas has outperformed our expectations, resulting in higher levels of EBITDA, coupled with slightly lower capital expenditure outlays--especially in its senior housing operating portfolio. The net result is higher ROREA today than we expected and forecast ROREA that exceeds our estimate of Ventas' weighted average cost of capital by nearly 100 basis points at the end of our 10-year forecast, a comfortable level for a REIT.

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Given that we now expect Ventas to achieve ROREA that exceeds our estimate of its cost of capital, the firm is once again eligible for a narrow moat rating, which we think it sources from intangible benefits associated with owning quality assets in markets with strong demand characteristics, particularly in its senior housing operating and medical office building portfolios, as well as customer switching costs stemming from its triple-net lease portfolio.

Ventas' senior housing operating portfolio (27% of net operating income) is concentrated in top metropolitan areas with higher average household incomes and higher average home values than the country in general. Moreover, Ventas' properties in these markets are in more affluent areas that exhibit higher average household incomes and home values than their broader metropolitan areas. We expect these favorable characteristics, combined with the general desirability of living in population centers and the aging of the population, to drive above-average demand for Ventas' senior housing operating portfolio over time, resulting in pricing power for Ventas.

Similarly, we think Ventas' medical office building portfolio (17% of NOI) also enjoys intangible benefits associated with owning quality properties in desirable areas. Specifically, 96% of Ventas' MOB portfolio is located directly on a hospital campus or is affiliated with a hospital campus. We think the potential for tens of millions of incremental Americans joining the ranks of insureds because of the ACA, the aging of the population, and an industry trend toward serving patients in lower-cost settings will in combination provide a tailwind for demand for health-system services, and Ventas' well-located on-campus and affiliated MOB properties are positioned to benefit from this expected increase in demand.

Ventas' triple-net leases with operators of its senior housing, skilled nursing, and hospital properties (54% of NOI) impose high switching costs on its tenants. The triple-net structure makes the tenants responsible for all costs associated with the operation of the properties, including repairs, maintenance, real estate taxes, insurance, and utilities in addition to paying rent, which generally escalates annually at rates that keep up with--or exceed--inflation. These leases are long term, with initial terms of 12-15 years or more, followed by one or more renewal options. Furthermore, Ventas generally rents its properties under master leases, which group individual properties together under one lease. These master leases generally prevent tenants from dropping poorer-performing properties, as renewals are all or none. Other tenant credit enhancements may include corporate guarantees or letters of credit.

Overall, Ventas' different property types and leasing models afford it competitive advantages, which should result in a steady stream of rental income that can grow organically at rates approximating inflation or more over time.

Expansion, Customer Concentration Bring Risks
Ventas roughly tripled in size in 2011, changing its property and business mix and expanding its business to include assets it also operates. However, Ventas has exposed itself to the upside potential in its best assets (that is, operating assets) through the RIDEA (or operating) structure, while protecting itself somewhat from the potential fluctuations in results at its lesser properties by leasing them to operators on a triple-net basis. This strategy makes sense, but relative to its historical triple-net-heavy model, which resulted in historically stable and growing cash flow, Ventas has introduced a greater degree of potential variability into its results, in our opinion.

Ventas has significant customer concentrations relative to other REITs. Atria Senior Living, Kindred Healthcare , Sunrise Senior Living, and Brookdale Senior Living (BKD) operate or manage large chunks of Ventas' properties, and they represent 15%, 13%, 11%, and 9% of Ventas' NOI, respectively. Competitor Health Care REIT (HCN) is a partial owner of Sunrise, and Ventas is currently trying to find a new tenant for a portion of Kindred-operated properties that Kindred no longer wants.

Recently, roughly 16% of Ventas' NOI was attributable to facilities where its tenants receive reimbursement under the Medicare and Medicaid government health-care programs, indirectly subjecting Ventas to pressure on Medicare and Medicaid reimbursement levels.

Health-care inflation has run roughly 2.5 times the overall inflation rate historically, which can't continue indefinitely. When rates of health-care inflation normalize, the entire health-care industry will re-evaluate spending. Health-care landlords like Ventas, which have historically enjoyed a strong tailwind from outsize growth in health-care spending, may suffer.