M&A Fuels Earnings for Growing Healthcare REITs

By Lori Marks, Vice President & Senior Analyst, Commercial Real Estate Finance, Moody’s Investors Service

The three largest healthcare REITs – Ventas Inc., HCP and Health Care REIT—have grown so large in recent years that in order to sustain their earnings growth, they must steadily increase their acquisition activity.  Healthcare REITs are driving earnings growth by acquiring real estate at yields in excess of their capital costs.

At the same time, competition for healthcare real estate is intensifying, driven by the multitude of buyers – including unlisted REITs and private equity funds – that are flush with capital they need to invest. That is driving up pricing for larger portfolios. Seniors housing and medical office building assets are particularly in demand, due to their private-pay focus and attractive business fundamentals.

Given this competitive backdrop, we expect the largest healthcare REITs will continue to strive to acquire their smaller REIT peers as well as healthcare operators. There is a limited number of potential buyers with the strategic interest and financial capacity to execute large healthcare real estate deals, thus paving the way for REITs as acquirers. Ventas’ recently announced plans to acquire publicly traded American Realty Capital Healthcare for $2.6 billion is only a precursor of a consolidation trend we expect to accelerate as long as capital costs remain attractive. Healthcare REIT equity prices rose 14 percent year-to-date through July 31, 2014, according to SNL Financial’s U.S. REIT Healthcare Index, while senior unsecured debt remains readily available at historically low rates, facilitating profitable deal making.

M&A is typically credit positive for acquirers because it enhances their scale and often offers diversification benefits, as well. The healthcare real estate market remains highly fragmented, but becoming bigger offers substantial advantages. First, the REIT would have an expanded pool of operator tenant relationships, which is an important source of future acquisitions as operators look to consolidate within their respective industries. Second, increased size enhances the acquiring REIT’s cost of capital advantage, creating an even larger gap between it and its smaller peers. Cost of capital is key for healthcare REITs, as it determines their ability to compete for even more transactions.

We caution, however, that these transactions are only credit positive as long as a REIT’s drive for scale does not compromise its asset quality or balance sheet discipline. Large portfolios could include a mix of assets that we would characterize as subpar due to their reimbursement profile or their inability to compete within the changing healthcare landscape. The healthcare REITs could look to sell such non-core assets, but would still be susceptible to market risk. Also, should interest rates rise faster than expected, healthcare REIT stock prices would likely suffer accordingly, possibly incentivizing REITs to increase leverage in an attempt to enhance their returns.