By Lynn Novelli

Health Care REIT's vital signs look good thanks to a history of strong returns and its experienced management team

George L. Chapman, chairman and chief executive officer of Health Care REIT, Inc. (NYSE: HCN), can sum up his company in 25 words or less. "We have earned shareholders 17 percent total returns over 33 years and have just paid our 131st consecutive quarterly dividend," he says. "That may tell the entire story."

HCN was the first dedicated health care REIT when it was established in 1970 and is now the third-largest health care REIT in terms of equity market capitalization. The current portfolio, valued at $2 billion, consists of 328 facilities in 33 states, managed by 47 different operators. It includes 219 assisted-living facilities and 101 skilled-nursing facilities, comprising 92 percent of investments. The balance of the portfolio is made up of eight specialty care facilities.

		Upside-Downside Samplings of what analysts are saying about Health Care REIT, Inc.

The portfolio's broad geographic and operator distribution reflect HCN's philosophy of investment diversification, which Chapman considers an "essential element to long-term care investing." On the other hand, maintaining a tight focus on specific property types is also a key ingredient in HCN's success, he says.

"Assisted-living and skilled-nursing facilities are performing well," Chapman says. "They have been our focus for 33 years and will continue to be our [source for] growth. The demographics are compelling, and supply and demand are working in our favor."

A.G. Edwards health care REIT analyst John Sheehan echoes those thoughts. "The long-term demographics—the aging of the population—will influence all health care REITs over the next 15 to 20 years by impacting the need for this type of care," he notes.

While demand is growing, the rate of new construction of assisted-living facilities is slowing, for the past two years averaging less than half of the average during the mid- and late-1990s. This will favor increased occupancy in existing facilities. Similarly, occupancy for skilled-nursing facilities has increased by 5 percent in the last two years due to continued growth in the elderly population and a decreasing supply of skilled-nursing beds, which will have a potentially positive impact on HCN's revenue growth.

Growth Strategy

Since the mid-1990s, HCN has grown almost exclusively through acquisition, based on a strategic decision by the management team to limit development to 10 percent or less of the investment portfolio. Currently, 94 percent of HCN's portfolio is comprised of stable assets.

On April 13, the company reported that it had completed $87.3 million of gross investments during the first quarter of 2004. Investments to date have included the acquisition of two assisted-living facilities with a total of 177 units and 10 skilled-nursing facilities with 1,345 beds. The company has provided investment guidance of $200 million net new investments for 2004 and plans to adhere to that level, Chapman says.

Compared to investment activity in 2002 and 2003, "we are scaling back this year," Chapman notes. "Last year was one of unprecedented performance. We successfully accessed the capital markets, allowing us to book a record $500 million in net investments." HCN engaged in similar investment activity in 2002, for a total of more than $1 billion in investments over the two-year period.

HCN laid the groundwork for this intense investment activity back in 2000, at the time that the health care sector bottomed out. During this period, the HCN management team intensified its market research and financial planning and, when well-priced funds became available in the capital markets in 2001, they were poised to access them and move ahead.

The capital market picture has changed again in 2004, Chapman explains. "In 2002 and 2003 we were experiencing very good times to buy. Now, competition in the assisted-living and skilled-nursing environments has increased significantly, which will increase the cost of capital and the difficulty of attracting tenants. [As a result,] we expect 2004 to be an average time to buy and so we will be more limited and more selective in our investments," he says. "We take great care in investing and will sit out when necessary."

Being conservative when the sector shows signs of potential trouble helps maintain the quality and standards of the portfolio, which has paid off in total returns to shareholders over the years. Although HCN currently has $350 million in available capital, the management team does not feel compelled to make any significant investments or change its guidance for this year.

However, notes Deutsche Bank analyst John Perry, "Keep in mind that HCN's original investment guidance for 2003 was $200 million, and they ended up doing $500 million." Still, higher interest rates this year will make acquisitions less accretive in the long run, and increased competition could drive up prices, which would cause return on investment to decline, he adds.

In view of those risks, "being conservative probably is prudent," Perry says. "You don't want to see a dip in the quality of their portfolio just to hit some acquisition numbers."

Focus on Quality

HCN's veteran management team has proven its ability to successfully manage the company through difficult market cycles and is respected as one of the best teams in the business, according to Sheehan.

"Management teams with long tenures with their respective companies are generally an asset to shareholders. They are likely to be familiar with the properties the REIT owns and the markets where the properties are located and will have built up strong relationships with tenants, operators and vendors," Sheehan says. "Also, a long-tenured REIT management team will likely have guided the REIT through various economic and real estate cycles. We feel that the experiences gained by the management team should help it successfully navigate the REIT through future issues."

HCN's seven-member management team has 117 years of total experience in health care and real estate finance. Chapman, 56, has been with HCN since 1992. Raymond Braun, 46, president and chief financial officer, joined the company in 1992; Michael Crabtree, 47, treasurer, joined HCN in 1996; Charles Herman, Jr., 38, vice president of operations, worked in health care consulting for 10 years before moving to HCN in 2000; Erin Ibele, 42, vice president and corporate secretary, has held many positions with the company since 1986; J. Michael Stephen, 50, vice president of marketing, joined HCN in 1996 from Bell Atlantic Capital where he was Vice President of Health Care Real Estate Finance; and Scott Estes, 33, vice president of finance, joined HCN from Deutsche Bank Securities in 2003.

Chapman credits Braun, Stephen and the marketing team for HCN's success in maintaining high occupancy levels at virtually every property in the company's portfolio. "Marketing is a constant in this business," Chapman says. "The average length of residence is 31 months so that means you must constantly be marketing, and they do a good job of that."

Successful marketing in the health care industry depends in part on the quality of the facilities and their operators. HCN's management team utilizes a proprietary management information system to identify the highest quality assets in a target market and operators of the same caliber for each property. "We only work with operators who will be good business partners and provide great care," Chapman stresses. HCN owns 90 percent of the properties in its portfolio and typically purchases a facility then leases it to a regional or national operator such as Life Care Centers of America or Southern Assisted Living.

Although there are certain operators with which HCN has had a relationship for years, the company is always seeking quality operators to add to its roster. To pass muster by the HCN management team, an operator must have an experienced management team, regionally focused operations, substantial inside ownership interests or venture capital backing and significant growth potential.

Equally important, the operator must be interested in forming a strong relationship with HCN. Under HCN's relationship financing program, the company writes a master lease for all of an operator's properties in a specific geographic area. The contract usually specifies that HCN will invest in the facilities, and in return the operator will provide HCN a certain percentage of its business and will source new investments.

"The first deal we do with an operator is the riskiest on both sides," Chapman says. "After that happens successfully, we can tell an operator, ‘We want to do your next 10 deals.' The benefit is that our operators tend to stay with us for several years."

Strong Performance

The management team's experience and focus on quality operators has consistently enabled HCN to "meet or exceed [investor] expectations," according to Deutsche Bank's Perry. Last year was no exception, with HCN outperforming the health care REIT sector. Overall, the sector achieved FFO growth of 1.9 percent in 2003, while HCN's adjusted FFO increased by 7 percent over 2002 (from $2.59 per share to $2.70).

Further proof of HCN's strength: In 2003, the company was able to raise more than $600 million in new capital and raised an additional $69 million through an enhanced dividend reinvestment program (DRIP) that now allows investors to make optional cash purchases of up to $5,000 per month instead of per quarter.

Perry forecasts FFO of $3.00 for HCN in 2004, growing to $3.17 in 2005, although he cautions that competition is heating up for quality acquisitions. "There's basically more money chasing this property type, and that could impact FFO growth this year," he notes. In HCN's favor, however, is "their ability to source their acquisitions, stemming from their reputation for building relationships with operators."

HCN's relationship financing program does give the company an edge over the competition, Chapman says. "The investments we make depend on the acquisitions our operators can find for us. That means that we have 47 operators who work as extensions of our operating team," he says. "They are always looking for new deals for us and, since they apply our underwriting criteria, what they bring us tends to be high quality."

Based on what they perceive as HCN's strengths, Deutsche Bank Securities analysts were among the first to upgrade HCN's stock rating, changing it from "Hold" to "Buy" in August 2003 with a price objective of $41. "We saw that the current operating environment was stable to moderately improving for health care REITs and specifically for HCN," Perry says.

Deutsche Bank's upgrade came on the heels of Moody's Investors Service upgrading HCN's rating last July from Ba1 to Baa3, making HCN investment-grade rated with all three nationally recognized agencies. "In a matter of a week following this change, their cost of capital lowered significantly," Perry adds.

The next round of upgrades came in April when rising interest rates, prompted by positive employment reports, caused an abrupt decline in REIT stock prices. As a result, several brokers upgraded their rating on HCN from "Hold/Conservative" or "Neutral" to "Buy."

Legg Mason recently changed its rating on HCN to "Buy/Average Risk," reports Jerry Doctrow, managing director of equity research. As of May 3, Legg Mason reported the weighted average health care REIT dividend yield was 7.2 percent, and that several companies, including HCN, are expected to increase dividends in the next 12 months. HCN's dividend yield as of May 3 was 7.6 percent. "The fact that they are going to increase their dividend is certainly a plus," Doctrow says.

However, opinions on Wall Street are still split as other analysts have maintained a "Neutral" or "Hold/Conservative" rating not only on HCN but also on the health care REIT sector overall.

Prudential Financial analysts James Sullivan and Robert Belzer predict, "The health care REIT sector appears on track to generate steady earnings growth through 2005," in its March 23 "Healthcare REITs Research Report." However, due to serious price erosion across the sector, including HCN, they maintain a "Neutral" rating on HCN and other health care REITs. HCN's share price declined 17 percent as of May 3, with total returns of 3 percent, compared with a 19 percent decline in price across the sector and a 4 percent total return for the first two quarters.

Prudential Financial maintains a $30 price objective, based on a 9.5X multiple of its 2005 FFO estimate of $3.02 per share. "Our target multiple remains below the company's current multiple, which we believe is warranted because it is exposed to weak senior housing operators and has a relatively high amount of straight-line rent included in FFO," Sullivan and Belzer report.

But HCN's multiple may be exhibiting the beginnings of a downward trend, starting with fourth quarter 2003, Chapman notes. The company's adjusted FFO growth of approximately 7 percent was strong enough to drop the adjusted FFO dividend payout ratio to 81 percent, compared with 85 percent a year ago. The Prudential analysts estimate a 2004 FFO/dividend payout ratio of 80 percent.

Cautious Optimism

Despite these encouraging financial indicators, analysts are still watching HCN's FFO very carefully because of its large straight-line rent component, notes Perry. "In their case, funds available for distribution (FAD) may actually be a better indicator of performance."

Investors also should keep an eye on the spread between cost of capital and return on investment in this sector, he adds. "A significant narrowing of that spread could mean trouble."

Fortunately for the health care REITs and their investors, major changes in Medicare and Medicaid reimbursement are not on the radar screen, at least for the short-term. During fourth quarter 2003, HCN derived approximately 32 percent of its real estate revenues from skilled-nursing facilities. According to HCN, approximately 15 percent of those residents received financial assistance from Medicare.

"A potential reduction in Medicare or Medicaid would be cause for concern," Perry notes. "But the situation looks stable to moderately improving. Remember that Medicare is a political hot button, and this is an election year."

More important to investors than the short-term ups and downs of FFO, multiples and other indicators, Chapman says, is the long-term view. "When we talk to prospective investors, we emphasize our experience and focus," he says. "Thirty-three years experience in running a public company dedicated to long-term care should make the difference."