REITs on hospital hunt: Capital-hungry operators given enviable choice as real estate prices rise

In an era of nontraditional partnerships, the sale of for-profit hospital chain Ardent Medical Services to Ventas this year stands out.

For Ventas, a real estate investment trust, the deal marked its first entry into the hospital market after limiting its holdings to senior housing, medical office buildings and post-acute-care facilities. The $1.75 billion deal was one of the largest transactions between a hospital operator and a REIT.

Three months later, hospital operator Capella Healthcare disclosed that it would sell its real estate, too, making a $900 million deal with Medical Properties Trust, a Birmingham, Ala.-based REIT.

In both transactions, the REIT planned to separate the real estate from the operations and retain a stake in the new operating company.

“Our thesis is that the acute-care hospital will always be at the top of the food chain,” said Edward Aldag, Medical Properties' CEO. “When you look at the overall revenue, clearly there's been a shift from inpatient to outpatient. But it hasn't been a move away from the hospital. So we don't view that as a bad thing.”

The Capella deal also is the largest buy for Medical Properties, which has specialized in acute-care assets since its founding. Hospitals currently account for 70% of its portfolio, but it aims to increase that number even further.

The healthcare real estate market has been booming, driven by the convergence of several trends. The shift of care from inpatient to outpatient has increased demand for on- and off-campus medical space. Providers, who are hungry for capital to invest in new care-delivery models, can raise money by selling off real estate. And low interest rates have driven up the price of those real estate assets across the country.

Health systems, with their bloated real estate portfolios, have been more than willing to partner with REITs to gain access to some of the capital locked up in the $1 trillion healthcare real estate market. REITs see partnerships with not-for-profit health systems as a primary area for future growth.

REITs “have been pretty effervescent in the M&A market,” said Mindy Berman, a healthcare practice lead in the capital markets group of JLL, an investment management firm specializing in real estate. “They're going to benefit from increases in rental rates and from investing in operations.”

However, the high price tags that healthcare real estate assets are commanding in today's market are raising some concern a bubble may be forming, which could pop with rising interest rates or a general slowdown in the economy. An interest rate hike, considered imminent by most Federal Reserve Board watchers, would deliver a double whammy. First, it would make debt more expensive to take on, which would depress REIT stocks and encourage investors to move their money into bonds (since bond prices fall as interest rates rise). And it would also cause real estate prices to either moderate or fall.

Senior housing in particular is sensitive to the larger real estate market because demand is dependent on seniors' ability to sell their current residences. In addition, acute- and post-acute-care providers are susceptible to cuts in reimbursement, which affects the willingness of providers to pay higher rents for the buildings they no longer own.

“We participate completely in the ups and downs of the economy,” said Tom DeRosa, CEO of Welltower, formerly known as Health Care REIT. While the perception is that healthcare facilities have long-term leases, the reality is that 35% are actually shorter-term operating leases. “Interest rates going up do affect our cost of capital both on debt side and equity,” he said.

But those threats aren't dissuading deal-hungry REIT operators from scouring the states for new opportunities. Deal volume for healthcare REITs is on track to increase significantly in 2015 compared with the previous year. REITs invested in 41 publicly disclosed transactions, mostly for post-acute care and senior housing assets, in the first three quarters of 2015, compared with 25 transactions during the same period in 2014, according to Modern Healthcare's M&A database.

Welltower has its assets concentrated in major markets such as New York, Washington and San Francisco, where property values have been increasing. Many of these booming cities also need to build the infrastructure to care for aging populations. “The island of Manhattan basically has no memory care” facilities, DeRosa said. “We need to be prepared for a population that will have different needs.”

Many health systems lack the outpatient centers they will need as more care shifts outside the hospital walls. Partnering with a REIT allows them to increase their service offerings at a lower cost. “We see that as the future of the acute-care industry,” DeRosa said. “The hospital of the future will be a much smaller hospital with outpatient facilities.”

Welltower's strategy does not include owning acute-care facilities. “We stop at the front door of the hospital,” DeRosa said.

But other players such as Ventas are enticed by factors such as an aging population, higher levels of insurance coverage and positive volume trends to acquire hospital facilities. Ventas plans to use its acquisition of Ardent—its first foray into the acute-care space—as a platform to make more buys in the market, said CEO Debra Cafaro. Like Welltower, it intends to find ways to use its scale to help operating companies realize savings, for example, through group purchasing.

Yet while the number of hospital real estate buyouts is expected to grow, there's still skepticism about whether the practice will be widespread. Among not-for-profit health systems, such as academic medical centers, the idea of selling their real estate isn't being widely discussed, said Torrey McClary, a Los Angeles-based healthcare M&A attorney at law firm Hogan Lovells. “If you're talking about universities, they're not going to sell their dirt,” she said.

But she has seen interest in inviting outside investors to develop ancillary assets such as mediplexes or medical malls—the one-stop-shop outpatient centers that combine diagnostic and pharmacy space, physician offices, and community health and education facilities. “I'm generally seeing more innovation in terms of partnerships,” McClary said. “I'm starting to see more flexibility with whom providers are starting to partner.”

The looming question for the entire real estate industry, of course, is what will happen once the Federal Reserve raises interest rates, which is expected to happen by year-end. Historically low interest rates have made it cheaper to finance real estate transactions while also increasing demand for commercial real estate overall.

“The low interest rate environment has certainly helped drive up the value for all asset classes,” said Robert Milligan, chief financial officer of Healthcare Trust of America, a Scottsdale, Ariz.-based REIT. “We're seeing a lot more deals getting done. We're seeing a lot more high-quality deals.”

The potential for a rate hike could slow down some of that activity, REIT executives acknowledged. The stock market downturn also has depressed the market capitalizations of many publicly traded REITs.

But industry players insist that the long-term changes in healthcare delivery and demographics offer a compelling outlook that will supersede the financing environment.

“The appetite for (different) property types will shift depending on the regulations,” Berman said. “We may go through cycles with healthcare. But the direction is only up.”