Acquisition Treadmill Presents Problems for Big 3 REITs

The growth of the Big Three health care REITs is clear, as they have flooded the senior housing space with a slew of recent deals. But this continued rapid growth highlights risks that may force REITs to change their investment strategies, Fitch Ratings suggests.

Recently, the REITs have shuffled the industry with billion-dollar transactions focused on higher risk assets, lower cap rates and RIDEA-structured deals that offer unpredictable growth.

Health Care REIT Inc.’s (NYSE:HCN) $2.3 billion deal last week with HealthLease Properties REIT (TSE:HLP.UN) and Mainstreet Property Group, specifically, point to a growing interest in the post-acute space, which has largely remained untouched by health care REITs.

Ventas, Inc.’s (NYSE:VTR) $2.6 billion acquisition of American Realty Capital Healthcare Trust (NASDAQ:HCT) and $900 million acquisition of 29 Canadian Holiday Retirement properties were priced at one of the lower cap rates to date, with a combined unlevered cap rate of 6%.

Finally, HCP, Inc.’s (NYSE:HCP) $1.2 billion deal with Brookdale created a 49-community RIDEA joint venture, which increases the REIT’s exposure to properties with operating risk versus triple-net leases.

The series of acquisitions by health care REITs call attention to the risk that REITs may end up paying premium pricing, pursuing higher yielding—and higher risk—assets, or employing more leverage to maintain its growth.

“They’re starting to push the boundaries a little bit in terms of risk,” says Britton Costa, director in Fitch Ratings’ REITs group. “The biggest challenge that health care REITs face over the longer term is continuing to find sufficient acquisitions to justify the growth expectations that underpin their equity valuation.”

Despite Fitch’s concerns about the health care REITs’ recent acquisitions in the sector, some analysts say they are comfortable with the moves and that it’s a normal course of business.

“While we don’t know what future acquisitions will bring, we’ve generally been comfortable with the recent transactions of the three health care REITs we cover, HCP, Health Care REIT and Ventas,” says Todd Lukasik, senior analyst at Morningstar. “Initial yields tell part of the story, and we think investors should also consider the potential cash-flow growth from the assets, which can boost yields over time.”

The comments add to the long-standing discussion of whether there will be a slowdown of these large portfolio deals in the future. Some say there will be fewer, while REITs maintain that there are still big deals out there and that they continue to keep an eye on them. But these large-scale transactions could create challenging issues for REITs.

Acquiring large portfolios at a cap rate higher than the stock’s implied cap rate has resulted in immediately accretive returns, driving net asset value (NAV) higher and fueling shareholder expectations of continued growth. But continuing to satisfy these expectations may prove challenging, and health care REITs’ share prices have begun to waver as the market questions whether growth would be harder to come by.

“There’s a lot of growth expectations that underpin their share prices trading at a premium to NAV. If you have three REITs growing rapidly, it creates a very competitive environment for them,” Costa says.

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 REIT growth, the feedback cycle was self-sustaining—the shares were traded at a premium to NAV to reflect future growth expectations. If this cycle were to reverse, it would create 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, Fitch notes. Their access to and cost of capital is thus one of the key determinants of an issuer’s creditworthiness, as it must consistently issue equity to grow and issue debt to refinance maturing obligations.

In addition, unlike those in other sectors, health care REITs don’t engage in portfolio optimization when acquiring large portfolios, electing to keep the weaker assets. The lack of asset sales relative to acquisitions could prove to be a problem for health care REITs down the road.

“Most REITs in other sectors engage in portfolio optimization — that is, capital recycling — whereby they sell weaker assets to fund acquisitions and development. Health care REITs haven’t done that for the most part,” Costa says. “You have to sort of question ‘why’ when you think about large portfolio transactions that presumably must include some below-average properties. Why not sell those below-average assets? If they could do so at or near the cap rates that their equity valuations imply, this would validate private market valuations.”

Still, if the market can support their “accelerating acquisition treadmill,” then health care REITs should continue on their upward growth path.

Written by Emily Study