Fall 2000
	Cover Story Doing the REIT Thing Western Properties’ Brad Blake and Bradley’s Tom D’Arcy put their shareholders first. Now they’re looking for work. Company Spotlight Failure to Communicate The "REIT Story" is a good one. Unfortunately, many companies haven’t done as good a job as they should have in telling it. Sector Spotlight Critical Conditions Opportunities among the healthcare REITs, but be careful out there. The New Economy Plugged In Making Money in the Internet Age Tracking The Market Bye, Bye Bear Market Blues After two of the worst years in their 40-year history, REITs have staged a strong comeback. By The Numbers Much Better, Thank You Real estate fund managers may never live down the 1998-99 bear market, but at least these days they can go out in public. Washington Wire Legislative Relief No legislation in the roughly 40-year history of REITs had the potential to alter the landscape more dramatically than the recently enacted REIT Modernization Act. Investment Basics Just How Safe Are REIT Dividends, REALLY? Yield-conscious investors drawn to REITs by their "rich" yields need to look beyond what’s printed in the stock tables of their daily newspapers. Investment Insight Opposites Attract It didn’t come as a surprise to portfolio managers at LaSalle Investment Management that REITs soared when tech stocks hit the wall this past spring. Investment Fundamentals NAV Growth: A Meaningful Performance Yardstick Growing FFO and enhancing shareholder value are not always one and the same. Focusing on NAV growth is a better, though not perfect, alternative suggests Green Street’s Mike Kirby and Jon Fosheim. Editor's Note The Journey Continues ... Parting Shot Wrestling With Net Asset Value The Penobscot Group’s Frederick S. Carr Jr. questions whether the market is telling investors that NAV is irrelevant. Newsline Urban To Be Acquired By Rodamco For $3.4 Billion Investor's Guide Questions Back Issues Feedback

by Barry Vinocur
Photographs by Peter Liepke

Best known for his insights on retail REITs, Prudential Securities’ Jim Sullivan’s work on lodging companies and healthcare REITs is often cited by institutional investors as being among the best on the Street.

Sullivan predicts that of the current crop of healthcare REITs, only four will be left standing once the current shakeout has run its course.

Which companies will be left standing and why? Where are the opportunities in the nursing home sector today? For answers to those and other pressing questions, we spoke with Sullivan by phone in mid-September.

The wheels came off the wagon in the healthcare sector. What’s behind the turmoil?

A couple of things are behind it. First, the introduction of Medicare PPS had a far greater impact on the system than people thought it would. Second, the negative impact of litigation on nursing home operators intensified in two respects. Number one, fraud and abuse litigation, the so-called whistle blower lawsuits, led to some substantial settlements that operators had to provide for. Number two, there was an explosion in litigation in certain jurisdictions-Florida being the major one-for wrongful death actions under the Patient’s Bill of Rights.

In the assisted living subsector-and the first three points I mentioned relate to the SNFs or skilled nursing facilities-there was too much new supply last year. That created a serious supply/demand imbalance, which led to disappointing investment returns on ALFs or assisted living facilities. At the same time, the so-called black box financing vehicles these companies used began to unravel.

Finally, to the extent that assisted living facilities take market share away from nursing homes-and clearly in some instances they do-that put more pressure on nursing home occupancy rates.

Didn’t Congress and the Health Care Financing Administration understand the impact that PPS would have on the system?

Congress charged the agency with making appropriate reductions in the rate of Medicare spending, and that’s what it tried to do. Keep in mind that what we’re really talking about is slowing the growth rate in Medicare spending. HCFA estimated that the introduction of PPS would reduce the rate of reimbursement by 17 percent. Since Medicare accounts for about 15 percent of nursing home revenues, HCFA estimated a combined overall reduction in revenue of about 2.6 percent. It seemed like a manageable number. Further, Medicare PPS was going to be phased in over a four-year period, so there would be time for operators to adjust to the reduction in their revenue.

They didn’t think that the overall reduction in revenue would be so severe that it would cause some operators to be in bankruptcy, as they are at this point.

What went wrong?

In some cases, the estimate of the impact of PPS was too low. In particular, the numbers I gave you in terms of Medicare spending, the decline of the rate vs. the percentage of Medicare revenues, was a pretty simplistic way of trying to get to the total revenue decline. On top of that, many of the nursing home operators had very substantial third party therapeutic businesses, ancillary service businesses, which is where the real hit took place, and after all is what PPS was supposed to do-cut the third party therapeutic businesses more severely. What probably wasn’t recognized going in was how large the third party businesses of some operators had become. People thought they would be able to adjust to the new payment scheme and that just wasn’t the case.

As a result, many of the operators, particularly the faster growing bigger operators-especially those that had grown by acquisition-found themselves with balance sheets that were totally unprepared for the reduction in revenues and margins that they experienced.

What about new legislation?

There was intense lobbying throughout the second half of last year. This took place at the same time that major operators began to file bankruptcy. And, as the year progressed, it looked as if most of the major nursing home operators were heading for bankruptcy. The response was the Balanced Budget Refinement Act. The final package provides some meaningful relief. It took effect in the second quarter of this year. That legislation does a number of things.

First, for what they call the higher acuity patient-and this is one of the big problems with PPS, it really reduced the daily rate that Medicare would pay for the higher acuity patient-the payment rate went up by 20 percent on April 1. According to the Congressional Budget Office that translates into increased Medicare payments totaling roughly $1.5 billion.

Part of the relief that was provided in the Balanced Budget Refinement Act was to increase the reimbursement rates for certain higher acuity patients. That had the impact of increasing the potential occupancy rates for the operators, because now they would be encouraged to take those patients. And what we’ve seen out of Washington over the last couple of months is a recognition that the BBA and PPS went too far in cutting back the reimbursement rates in the higher acuity patients. The relief that was initially temporary looks more and more likely to be permanent for this category of patients, which is obviously good for the census and good for the revenue line for these operators. Now they’ll be able to accept these patients and make money by taking care of these patients-that’s going to be good for all the nursing home operators.

Second, part of the phase in of PPS was that there would be a current rate and a federal rate. This means a per diem rate and the federal rate. Generally speaking, the rates were going to be lower than the then-current rates, which would result in a reduction in the per diem rate that would be reimbursed over a three-year period. In year one, 1999, there was going to be a blended rate, which was going to be what they call 25 percent facility and 75 percent federal, that would keep shifting in 25 percent increments so that it would be 50/50 this year.

Under the Balanced Budget Refinement Act, effective January 1, operators could choose between the current or the federal rate, and, according to the CBO estimate, that will result in increased payments to operators of $700 million over two years. This is a temporary measure that may be extended.

The third piece was what’s called the annual-the part B cap-and this is the capped rate on rehabilitation services. HCFA, somewhat arbitrarily, set the annual part B cap at $1,500, so you could only reimburse $1,500 per patient per year for part B Medicare payments. And this was very arbitrary because there are some patients who require a much higher level of rehabilitation services. Those annual payments could run into the thousands-$5,000 to $10,000. Again, as of January 1, there’s going to be a two-year moratorium on instituting that $1,500 per year cap. The CBO estimates that over the two-year period that will increase Medicare payments by $600 million. If you combine those three elements, you have $2.7 billion with a lot of it being front end loaded.

When will investors become more positive about healthcare REITs?

The concern today is that you have complete collapses by some-the LTCs and the NHIs of the world-and they’re facing immediate liquidity crunches now. The four companies that we have positive readings on retain, officially, investment grade ratings. Moody’s continues to have a negative outlook on the industry, and it’s Moody’s position that this portion of the sector is not out of the woods yet. There is a fear out there that these companies could continue to have problems and that their cost of financing on the debt side-and their access to financing on the debt side-could get worse before it gets better (see table below). And that leads them to have concerns about estimate revision and therefore concerns about dividend coverage.

In the examples of LTC and NHI, which haven’t been able to renew their lines (and we don’t think they’re going to be able to renew their lines), they’ve already had dividend cuts and there is some residue of feeling that there remains risk in the sector and that the tide definitely hasn’t clearly turned to the positive in the minds of some investors. We think the signs are very clear that conditions are turning up...but I think we’re probably a bit early in talking about this. The market is not convinced that those signs are as strong and as clear as we think they are.

Is it a case of too little, too late on the part of the federal government?

At the end of the day, based on what we know about the industry right now, we think there will only be four survivors. The rest of the companies either are going to have to consolidate, or they’re going to become de facto liquidation stories.

The four survivors are going to be Healthcare Realty, ticker HR-that’s the only company we have a strong buy rating on; Health Care Property Investors, ticker HCP; Health Care REIT, ticker HCN; and Nationwide Health Properties, ticker NHP. We don’t see how any of the other companies are going to survive.

Let’s talk about those survivors.

Each of the four has, well, sort of a unique profile. Healthcare Realty has minimal exposure in the senior housing industry, the SNFs and ALFs. You have probably the best SNF player, we think, in Nationwide Health. NHP has disciplined underwriting and it’s a good manager. The market doesn’t seem to have a lot of confidence that NHP’s dividend won’t get cut. We feel pretty good about the dividend, so we have an accumulate rating on NHP. Health Care REIT focused on assisted living to a greater extent than anybody else. The company has proven itself to be pretty nimble and has managed to get itself out from under some difficult situations. HCN understands that business very well; it underwrites it carefully and thoroughly. Finally, there’s HCP. As a result of its merger with American Health, it’s more diversified, with more medical office building and hospital exposure. HCP has reduced its senior housing exposure, and the company has underwritten its portfolio similar to the way NHP has. It has been very, very disciplined.

We think these four companies will be the survivors and the only names of any institutional investor interest, and their year to date share price performance validates that. Year to date, NHP is up 22 percent and the RMS is up 19.9 percent.

In NHP’s case, you currently have a dividend yield of 11.5 percent, and in the case of HCN you have a dividend yield of 12.7 percent. HCN has delivered a 30 percent total return already this year. These stocks are up off the bottom, but the yields are still at levels that tell you the market isn’t totally comfortable with the safety of these dividends. In fact, all four REITs that we have positive ratings on-and they are one strong BUY on HR and three accumulate ratings-the dividend yields are all over 10 percent.

These four stocks are collectively outperforming the REIT Index year to date, and in the case of HR it’s almost double the total return on the RMS. On the other hand, the companies that we said [early in this year] had a slim chance of survival are in fact totally collapsing, whether it is Omega, Senior Housing, LTC, or NHI-their share prices are all down between 25 and 60 percent. Dividends have been cut, and more dividend cuts are likely.

In the case of both LTC and NHI, they’re facing the severest of liquidity crunches now, with lines of credit that mature next month [October], and at the moment they have been unable to renew those lines. Both companies have indicated that they might have to file for Chapter 11.

What is the outlook for the future?

Looking out to 2001, the numbers are still negative. The current consensus for Omega is a 20 percent decline in FFO per share; for Senior Housing, a 12 percent decline; NHI minus 4 percent; and LTC minus 2.5 percent. Those numbers for LTC and NHI are going to get worse before they get better as the result of renegotiation or perhaps a bankruptcy filing.

We’re going to continue to see this process work its way out for the LTCs and the NHIs of the world. Is there a light at the end of the tunnel for the Omegas and the Senior Housings in the industry? At the moment we don’t see one because we still haven’t been able to quantify the negative impact on the value of their nursing homes in contrast to the stronger operators.

The Omegas and the Senior Housings, their problem was that they were not well diversified. Number one, they were overweighted in nursing homes; and number two, they leased properties to the most troubled public operators who eventually filed for Chapter 11.

This year, for example, 2000 market-cap weighted average growth rate for all the healthcare REITs is a minus 3 percent. Within the group, however, you had the best performer, HCP, with a 4 percent growth rate in per share FFO, and the worst performers are severely negative. Omega’s FFO per share was down 56 percent, Senior Housing was down 34 percent, NHI was down 10 percent, and LTC was down 8 percent-so you have some severe negative comparisons. Remember that there is a one-quarter lag when healthcare REITs report their statistics. Therefore the second-quarter reports for the healthcare REITs give the operating statistics for the first quarter. With the third-quarter statistics, we should see the second-quarter operating margins.

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