Biggest Losers in the Brookdale-Emeritus Deal: The Big 3 REITs

The agreement to acquire Emeritus Corporation (NYSE:ESC) for nearly $3 billion is the sort of deal that’s right up the alley of the largest healthcare REITs. Instead, Brookdale Senior Living (NYSE:BKD) is the acquirer, leaving the Big 3 out in the cold—and less well-positioned for future growth, analysts say.

“We believe investors will view the Emeritus purchase as an acquisition that the REITs might normally win (if marketed),” write Stifel Nicolaus analysts Daniel Bernstein and Rob Mains in a recent industry update on the merger’s winners and losers. “We think the announced merger will reinforce the view that REITs will continue to struggle to compete for large transactions.”

Once the $2.88 billion deal closes, the combined Brookdale-Emeritus company will be able to access lower-cost capital sources to fund growth than what they could get from REITs, Stifel says. And although REITs are expected to continue to have a capital cost advantage over Brookdale, the senior living operator will have added benefits of operating synergies and the ability to add ancillary services, which could make it a “formidable competitor.”

“At a time of worries about their pipeline of accretive investments due to higher capital costs, more competition for deals, and low cap rates, Emeritus (and, for that matter, Brookdale) represents a showcase portfolio that will not contribute to a REIT’s earnings,” Bernstein and Mains said in another research note. “This, we believe, will underscore investors’ concerns about the REITs’ ability to grow externally.”

Following the merger announcement, all three of the largest healthcare REITs underperformed relative to their smaller-cap REIT peers on Friday. Part of that, says Stifel, was due to concerns the combined Brookdale/Emeritus entity will exercise purchase options on leased assets when it makes sense.

“It is worth noting that there is significant embedded value in the purchase options (management estimates as much as $350 million-$400 million, or $2.00-2.30 per share, pro forma),” says a RBC Capital Markets research note on Brookdale, which calls the Emeritus acquisition “strategically and financially attractive.”

While some purchase activity will likely occur, according to Bernstein and Mains, it won’t necessarily be game-changing for the healthcare REITs.

“Emeritus and especially Brookdale were in a position to exercise purchase options before the combination; the merger doesn’t change that,” says the update. “HCP, the REIT with the largest exposure to Brookdale and Emeritus, has rents subject to purchase options equal to just 1.2% of total revenues in 2014, 3.2% in 2015, and 2.3% in 2016. Brookdale and Emeritus purchase options, several at fair market value, represent only a fraction of this total, with several Emeritus leases not subject to purchase options for several years.”

Because of that, Stifel sees only limited near-term incremental risk to the Big 3 from the combined operator entity exercising purchase options. The operator-to-operator deal is not expected to pressure a REIT-to-REIT transaction—hinted at during NAREIT’s REITWorld event last December—as they generally depend on how much value and synergies could be achieved, says Fitch.

“It’s typically hard within REIT-to-REIT mergers to arbitrage a lot of value; it’s more like, ‘what can a [combined] larger company achieve that two companies can’t achieve individually?'” says Steven Marks, a Fitch analyst who covers REITs.

On the smaller-cap healthcare REIT side, not much is expected to change.

“Small cap REITs have limited exposure to the operators and generally have pursued acquisitions that are outside the two large operators’ sweet spot,” Stifel writes in an industry update. “We see little change in the environment for smaller healthcare REITs and other senior housing operators.”

There is still the possibility that a healthcare REIT could disrupt the deal, expected to close in the third quarter of 2014, analysts note.

“The biggest threat to deal completion appears to be the potential that a [healthcare] REIT might be interested in owning the real estate,” says Kevin Fischbeck, an analyst with Merrill Lynch, in a Monday update. “…We do not believe that there is another strategic acquirer for ESC, given that no other operator appears large enough to complete a deal of this size.”

Written by Alyssa Gerace