Time is of the essence when it comes to the rate of return realized from RIDEA deals versus triple-net lease transactions for healthcare real estate investment trusts (REITs), according to a recent report from investment research firm Morningstar.
The REIT Investment Diversification and Empowerment Act (RIDEA) of 2007 enabled REITs to transform themselves from landlords that merely accepted rent checks to entities exposed to the financial performance and healthcare operations of the properties they acquire. However, there exist both advantages as well as some disadvantages to the RIDEA structure.
While REITs have experienced robust growth through RIDEA-structured deals, there are several areas where these types of transactions fall short of their triple-net lease counterparts.
Lower initial cash flow
RIDEA introduces the potential for faster cash flow growth, however, the initial yields are lower compared to triple-net lease transactions.
Though initial cash flow yields have been comparable between RIDEA and triple-net transactions, Morningstar finds that initial cash flow yields on RIDEA deals have been roughly 50 basis points lower, as a result of capex that REITs are responsible for under the terms of the deal structure.
But with health care REITs willing to accept lower initial cash flow yields on these types of deals, they must also achieve greater growth out of the RIDEA portfolios in order to make them pay off longer term.
Using data compiled on recent notable RIDEA and triple-net transactions—including, initial yields, expected growth rates, and initial expectations of maintenance capex—Morningstar estimates that a typical RIDEA deal, if completed at the same initial NOI yield as a triple-net transaction, would take seven years to achieve cash flow parity.
However, extending cash flow growth assumptions over 40 years, Morningstar estimates the cumulative present value of cash flows for the RIDEA transactions would be 8% greater than that of the triple-net lease.
“[S]enior housing occupancy and cash flow may decline in weak economic environments, and we think it’s unlikely that the RIDEA cash flows will grow uninterrupted at a 4% rate over a 40-year period,” states the report.
Higher maintenance expenses
Whereas triple-net lease agreements require tenants to pay for property maintenance and repairs, under a RIDEA structure this burden falls to the REIT. However, the expenses may not be entirely cumbersome.
“While this represents incremental cash outflow for REITs relative to triple-net leases, expected outlays for maintenance capital expenditures are generally not overly burdensome,” Morningstar writes.
Usually, expenditures can fall in the range of as little as $500 per unit per year for newly constructed properties, to $2,000 or more per unit per year for older, more expensively built assets, the report suggests.
Relative to triple-net leases, Morningstar estimates that the incremental maintenance capex for Ventas (NYSE: VTR) falls in the range of $45 million to $50 million—using $1,800-$2,000 per unit per year, and near $60 million per year for Health Care REIT (NYSE: HCN), using $1,700 per unit per year.
Additionally, maintenance capex expectations can rise over time as properties age, adding more risk to the equation for RIDEA-owned assets.
“While we don’t expect the heady growth rates implied by these historical expectations changes to persist, we recognize that continued high growth rates related to maintenance capex are a potential risk to the returns on the RIDEA-owned assets,” Morningstar writes. “And we generally expect maintenance capex requirements to increase moderately over time.”
Whether RIDEA cash flows experience faster, slower, or even negative growth relies on the variability in operating metrics of the properties as well as changes in maintenance capex requirements.
To date, Morningstar notes that health care REITs’ RIDEA assets have generally been delivering the highest levels of internal growth among their various property portfolio holdings.
Among the big-three, internal growth of the RIDEA portfolios of Ventas, Health Care REIT and HCP (NYSE: HCP) has averaged an estimated 6.5% to 7% per year during the past three years, according to Morningstar.
Conversely, triple-net portfolios have not enjoyed the same level of “robust growth,” the report notes, but the range of growth since 2008 has been tighter and the average triple-net growth rate of the three REITs has always been positive during the past six years.
“Although we believe in the long-term growth drivers for senior housing units, we think the sector’s RIDEA internal growth trajectory of the past few years is unlikely to continue unabated indefinitely,” writes Morningstar.
Though Morningstar sees no immediate concerns, it believes there will be years where cash flows in these portfolios declines by a “meaningful amount.”
“While we have nothing against the RIDEA structure, recent triple-net transactions appear, on average, to offer a better combination of initial yield, cash flow growth, and predictability than the recent RIDEA deals, in our view,” writes Morningstar.
Though RIDEA deals may promise faster growth, they are also susceptible to future cash flow declines in challenging economic environments and potentially higher-than-expected maintenance capex requirements.
Written by Jason Oliva