Lowering the Rent Shouldn't Hurt This Health-Care Landlord

The move to reduce HCR ManorCare's rent by $68 million a year combines with HCP's previously announced plan to sell 50 HCR-operated facilities to address substandard rent coverage. Despite the lower rent payments, though, HCR ManorCare's rent coverage remains below comfortable levels, in our opinion. Also, there remains a mismatch between the annual rent growth escalators near 3% and the lower growth rate we expect in government reimbursement for the services provided by the majority of HCR ManorCare facilities. As such, while this deal largely removes any immediate risk of further changes to the HCR ManorCare relationship, there are longer-term risks concerning its tenant exposure.

That said, HCP's lease with HCR ManorCare is a master lease agreement with a corporate-level guarantee, where coverage metrics look better because of HCR ManorCare's incremental revenue and profit streams from businesses beyond the walls of the facilities included in the HCP master lease.

The changes to HCR ManorCare's master lease agreement include a number of puts and takes, with HCP largely trading lower rent receipts for better rent coverage, a slight decline in exposure to HCR ManorCare to 25% of income, a small shift in HCR ManorCare-operated facilities toward assisted living from post-acute care, and a five-year extension of the master lease's average term to 2030. HCP will get nine new assets (valued at $275 million), the positive rent impact of which is included in the $68 million rent reduction. HCP also receives a lease receivable with an initial value of $250 million, which would become payable should HCR ManorCare recapitalize, and the lease agreement requires HCR ManorCare to either retain or use any excess cash flow to reinvest in its business, which we think protects HCP against unwanted capital payouts to shareholders. HCP continues to own 9.4% of HCR ManorCare.

HCP expects to report a $481 million impairment charge in 2015, but this noncash charge doesn't directly affect our analysis.

Opportunity Remains for HCP in Uncertain Health-Care Industry With the Affordable Care Act in the U.S., change is underway in the health-care industry, introducing tens of millions of newly insured people to the system and bringing a renewed focus on constraining costs. Despite the uncertainty in the industry, the bulk of health-care spending is nondiscretionary and often requires physical space (real estate) for its delivery, favorable conditions for health-care landlords. We think HCP will continue to benefit from its long-term leases and find opportunities for profitable growth.

HCP's “5x5” investing strategy enables it to invest in a range of health-care property types (senior housing, post-acute care/skilled nursing, life science, medical office, hospital) via a range of investment products (sale-leaseback purchase of real estate, development, joint venture, debt, RIDEA). We think HCP's industry heft will ensure it a seat at the negotiating table for future deals in the fragmented health-care industry, and its broad approach to investing in health-care real estate allows it to contemplate transaction structures that best suit its partners' preferences.

RIDEA investments, named after the REIT Investment Diversification and Empowerment Act of 2007, are relatively new to the health-care REIT sector and essentially expose landlords directly to the underlying performance of the operations within the properties since the full profit and loss statements and balance sheets become the responsibility of the landlord. We like HCP's shift away from RIDEA to triple-net leases, in which tenants are responsible for rent, with annual increases, and all property-related expenses, including property upkeep.

A Strategy That Works HCP has largely stuck to its traditionally successful strategy of renting health-care properties under long-term, triple-net leases that provide steady and slow-growing cash flow. These leases impose switching costs on HCP's tenants and lead to a stable, narrow moat.

HCP's triple-net leases with operators of its senior housing, post-acute-care/skilled nursing, and hospital facilities, which comprise more than 70% of its portfolio, require the tenants to be responsible for all costs associated with operating 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, generally, with initial terms of 12 to 15 years, followed by one or more renewal options. Furthermore, HCP rents its properties under master leases, which group individual properties together under one lease and prevent tenants from dropping poorer-performing properties since renewals are all-or-none. These attractive lease characteristics have resulted in a steady stream of rental income that can grow organically at the rate of inflation or higher, which we think can continue.

Furthermore, HCP's medical office building portfolio is concentrated (more than 90%) among assets that are either located directly on or are affiliated with hospital campuses. We think these well-located medical office buildings provide HCP intangible benefits that drive demand to those tenants, resulting in superior performance of its investments in those medical office buildings.

Although HCP’s assets are well-positioned to benefit from the health-care industry's tailwinds of a growing and aging population, we don't expect that to materially strengthen or weaken its moat sources. Also, although HCP may change the mix of its portfolio over time to either increase or decrease the relative contribution of the assets we favor, this type of potential mix shift does not impact our moat trend.

Nearly 30 Years of Dividend Growth We view HCP's stewardship as Exemplary. Although the board removed Jay Flaherty in 2013, we expect current CEO Lauralee Martin to stick to the strategy that has been successful for the firm historically, and we were impressed with Martin while she was at Jones Lang LaSalle. HCP's sound strategy and investing discipline has contributed to an impressive record of dividend growth, and the company is included among the Dividend Aristocrats, S&P 500 constituents, with 25 years or more of increased dividends. With HCP's 3.8% dividend increase to $2.18 per share in 2014, the firm has increased its dividend 29 consecutive years. HCP's dividend growth has averaged roughly 2.5% annually for the past 10 years or so, a level of growth we think the firm can maintain, if not exceed.

Along these lines, we appreciate HCP's measured approach to investments in operating assets under the RIDEA structure. While we have nothing against the RIDEA structure, we generally prefer the stability and predictability of the industry's traditional triple-net sale-leaseback transactions. HCP is increasing its RIDEA exposure somewhat to roughly 10% of net operating income, but this remains lower than many of its peers.