|[August 20, 2014]
Fitch: Healthcare REIT Deals Highlight Risks to Continued Growth
NEW YORK --(Business Wire)--
The most recent series of acquisitions by healthcare REITs highlight the
segment's continued rapid growth and the risk that REITs may end up
paying premium pricing, pursuing higher yielding assets (i.e. higher
risk), or employing more leverage to maintain this growth, Fitch Ratings
Last week, Health Care REIT (HCN) announced two sizable, multipart
acquisitions, including a $2.3 billion deal for HealthLease Properties
REIT and other properties, as well as a second deal with Gracewell
Healthcare. HCN's acquisitions follow Ventas, Inc.'s (VTR) ARC
Healthcare & Holiday Retirement transactions and HCP, Inc.'s Brookdale
transaction. While HCN's transactions focused on higher risk
skilled-nursing assets and the rights to acquire future developments,
VTR's was priced at one of the lower cap rates to date, and HCP's deal
increases its exposure to properties with operating risk versus
So far, healthcare REITs' growth has been funded conservatively and
largely on a leverage-neutral basis, driven by opportunistic equity
raises at substantial net asset value premiums. We believe the premiums
reflect shareholders' expectations of continued growth, and continuing
to satisfy these expectations may prove challenging. Large transactions
are required to meaningfully increase earnings via external growth as
the average enterprise value of HCP, VTR and HCN is nearly $30 billion.
This dynamic may also drive REITs to employ higher leverage levels or
pursue higher yielding, lower quality assets to make transactions
accretive, especially as capitalization rates compress due to the
competitive acquisition environment.
During the initial stages of growth, the feedback cycle was
self-sustaining. That is, the shares traded at a premium to NAV to
reflect future growth expectations. Thus, when a large portfolio was
acquired at a cap rate higher than the stock's implied cap rate the deal
was immediately accretive, driving NAV higher. In turn, the demonstrated
success fuelled shareholders' expectations of continued growth.
Recently, we have seen healthcare REITs' share prices waver as the
market began to question whether growth would be harder to come by.
If this self-sustaining feedback cycle were to reverse, it would create
challenging capitalization and transaction issues for these REITs. This
is because REITs cannot retain meaningful amounts of operating cash flow
due to distribution requirements for tax purposes. Their access to and
cost of capital is therefore one of the key determinants of an issuer's
creditworthiness, a it must consistently issue equity to grow and issue
debt to refinance maturing obligations. This accelerating acquisition
treadmill is reminiscent of the FFO growth treadmill that some REITs
with merchant buildings and other noncore businesses struggled to stay
on during the last cycle.
Should share price premiums to NAV narrow or turn into discounts, the
companies would need to sell equity below NAV to fund additional
acquisitions on a leverage neutral basis, reduce acquisition volumes or
sell assets. The latter two scenarios could impair growth expectations,
thereby reducing share prices further and putting the REITs' equity
valuations on a downward trajectory. In essence, the feedback cycle has
the potential to become self-sustaining in reverse as well.
We believe healthcare REITs' sensitivity to their NAV is further
exemplified by the lack of asset sales relative to acquisitions.
Intuitively, large portfolio transactions likely include lower quality
and less desirable assets, yet healthcare REITs have not engaged in the
portfolio recycling activity that most other REIT sectors have. If
healthcare REITs did in fact begin to sell lower quality assets, we
believe that could result in the equity markets upwardly resetting cap
rates, thereby triggering reductions in NAV.
That said, if the market for healthcare acquisitions is deeper than
other commercial real estate sectors and can support a consistent level
of acquisition opportunities, healthcare REITs should continue on their
upward growth path. Further, if healthcare REITs embark on portfolio
optimization by disposing of assets at or near the cap rates their
equity valuations imply, this would validate private market asset
For more information on this topic, please see the following reports,
"2014 Midyear Outlook: U.S. Equity REITs," "Health Care REIT's
Acquisition of Health Lease Credit Neutral," "HCP's Deal with Brookdale
Swaps Reinvestment for Operating Risk; Ratings Unaffected" and "Fitch
Affirms Ventas, Inc.'s IDR at 'BBB+' Upon ARC Healthcare & Holiday
Additional information is available on www.fitchratings.com.
The above article originally appeared as a post on the Fitch Wire credit
market commentary page. The original article, which may include
hyperlinks to companies and current ratings, can be accessed at www.fitchratings.com.
All opinions expressed are those of Fitch Ratings.
Applicable Criteria and Related Research:
2014 Midyear Outlook: U.S. Equity REITs
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