By Lynn Novelli

Health care REITs, which represent just 5 percent of all U.S. REITs, are attracting more than their share of attention from investors and analysts in 2008. “There is a time and a place for most sectors, and health care REITs make sense as a defensive strategy in this economic environment,” says BMO Capital Markets Senior REIT Analyst Richard Anderson.

Health care REITs, driven primarily by a combination of demographics, government regulation and reimbursement, are holding their own in the current economic slowdown. Insulated from the impact of factors such as employment, consumer confidence and housing, health care REITs “possess an appeal that is different than any other property group,” says Green Street Advisors analyst Jim Sullivan. “So far, total returns on health care REITs have been strong and will continue to be strong if the economic forecasts are correct.”

Part of the appeal is that the sector’s unique drivers make demand a non-issue for this sector. “As baby boomers age, there is built-in demand for the next 20 years,” Anderson says. “In fact, it’s on an upward trajectory.” The U.S. Census Bureau estimates that the over-65 population in the United States will increase three times as fast as the nation as a whole in the next several years and the number of seniors will increase 35 million by 2030.

Analysts still discuss health care REITs by property subsectors—medical office buildings, long-term care and assisted living are the main ones—but few health care REITs are exclusively invested in any single property subsector any more, says Moody’s Investors Service Assistant Vice President Lori Marks. The diversification trend started a few years ago, and she anticipates it will continue in 2008, despite the credit crisis, because REITs will increase their range of tenants and revenue sources.

“That’s good from our perspective because it gives health care REITs more opportunity for growth, helps them maintain a stable cash flow and helps build the franchise,” she says.

Retail
# of REITs	11
Industry Market Cap (in thousands)	$24,955,000
% of Industry	8.0%
Yield	5.64%
YTD Total Return	-3.52%
One-Year Return	2.13%
Three-Year Return	14.54%
Five-Year Return	22.79%
Average Daily Trading Volume (Shares)	784,316
Source: NAREIT data as of Feb. 1, 2008

Medical Office Buildings

Medical office buildings (MOB) currently are the most in-demand property subsector, says Credit Suisse research analyst John J. Stewart. “A doctor’s office is the first point of entry for boomers entering the health care system,” he says. “They are the drivers of this segment as they turn 60 in droves. By 2030 they will be 80 and require a more acute level of care, shifting the focus again.”

Another strong driver for growth in this subsector is the ongoing shift in delivery of care to the outpatient setting, Marks adds. She also notes that hospitals seeking to free up capital for other purposes are eager to partner with REITs. “A lot of the demand in this sector has to do with relationships,” she says. “Hospitals are looking to monetize their real estate, and REITs offer them a vehicle to do that.”

That’s true, says Green Street’s Sullivan, but he anticipates that more REITs will be developing medical office space away from hospital campuses.

Success of off-campus space is more dependent on the demographics of the specific market, he says. “The past few years have seen the emergence of off-campus medical office buildings developed in conjunction with, or at least in proximity to, senior housing, and I think this trend will continue in 2008 and beyond,” he says. Even with REITs exploring these new sites for medical office buildings, Sullivan says that supply and demand will be in balance through the rest of 2008.

“Everybody is trying to increase their presence in MOB right now,” he says. “Over time, their stability in terms of cash flow growth is becoming more appreciated.” Of all the property subsectors within health care REITs, Marks sees medical office buildings as presenting the greatest opportunities. “The key challenge is competition for these assets,” she says. “The credit situation will create opportunities for REITs’ involvement in these types of properties by allowing REITs to be more competitive.”

Long-term Care

Growth in both supply and rents in long-term care are both subject to government restrictions, which will continue to constrain this property subsector.

REITs operate skilled nursing and long-term care facilities on a triple-net lease basis, which typically translates to modest year-over-year rental growth, but the overarching limits on growth are set by federal Medicare reimbursement regulations. In 2007, Congress approved a 3.3 percent increase in Medicare skilled nursing reimbursement for 2008, “so expect continued steady performance for the rest of the year,” Marks says.

Expectations for supply expansion are also low. Most states require a Certificate of Need (CON) prior to construction of a skilled nursing facility. Although demand for this type of care continues to rise, the CON program will keep supply in the sector limited. Any small changes in new supply in 2008 will be readily absorbed.

Government involvement in this property subsector has led several health care REITs to diversify their portfolios with other property types. HCPI, Inc. (NYSE: HCP) is the most notable example, shifting its portfolio from almost exclusively long-term care facilities into senior housing, medical office buildings and medical laboratory space while changing its name from Health Care Property Investors in the process.

Look for other health care REITs to follow suit, analysts say, as they seek to lessen their exposure to reimbursement pressure and diversify their revenue streams.

Assisted Living

In contrast to the slow growth in long-term care, “there is a lot of capital flowing into assisted living and there is a lot of development,” Sullivan says. Positive demographic trends and low barriers-to-entry mean that assisted living and retirement living periodically experience periods of oversupply, Anderson says. He does not anticipate that problem for the near future, though.

“Right now we are seeing a slight uptick,” he says. “So far, there seems to be enough demand to mop up supply, but it’s something to watch, because there are some economic sensibilities in that property subsector.”

“Supply has picked up, but it is still manageable, and we expect this property subsector to continue to do well for the next 18 months,” Marks says. “Demand is good, the demographics are positive and there is increasing consumer awareness of this type of living.”

Assisted living residences operate on a triple-net lease basis, with long-term leases and annual rental growth pegged at inflation or inflation plus. Looking ahead, 2008 will be no different, with analysts generally expecting REITs to realize a 1.5 percent to 2 percent growth in net operating income (NOI) from these properties for the year.

Trends for 2008

Analysts agree that the sector’s long-term leases, an aging population and stability in health care reimbursement policy are positive trends for health care REITs in 2008 and well beyond.

However, the constraints of government regulation and triple net leasing keep the sector’s internal growth moderate at best, meaning that health care REITs must rely on external growth. In the current economic climate, that could be problematic, Stewart says. “External growth of health care REITs in 2008 is subject to the same credit constraints that affect the rest of the real estate universe,” he says. Without access to reasonably priced capital, health care REITs’ external growth will slow, he concluded.

“Health care REITs will continue to do okay, even in a tough environment, because they are at least two times removed from the impact of the subprime and credit markets,” Anderson says. “They provide a safe haven for REIT investors.”