Lower reimbursement levels and a rapidly changing healthcare market continue to pose difficulties for operators of healthcare facilities, thus creating challenges for U.S. healthcare properties and healthcare REITs. Although, at Moody's, our outlook is currently negative for the healthcare REIT sector, longer-term prospects are more upbeat. We should see credit stability in the long run as the dust settles around healthcare reform. Favorable demographic changes—the aging of the Baby Boom generation—and a growing demand for cost-effective healthcare should ultimately support a healthier long-term credit profile.

Many healthcare REITs are concentrated in the long-term care subsector, and we believe that uncertainty arising from the weak financial profiles of many long-term care operators and their rapidly shifting strategies should keep downward pressure on the REITs' outlooks. Managements of these operating companies are changing their strategic approaches sometimes faster than these changes can be implemented. These adjustments are reactions to increased competition as well as revenue pressure caused by government and managed care payers.

Other healthcare segments are also being challenged. For example, hospitals are being challenged to either complete or dismantle past merger and integration initiatives and to improve adversarial relationships between payers and providers. These challenges will likely result in continued weakening of debt protection measures along with lower earnings and more hospital bankruptcies over the near-term.

Short Term Cash Flows

The Balanced Budget Act of 1997 and the implementation of Medicare PPS for long-term care and outpatient facilities could further erode the profits of healthcare operators, and lead them to cut spending. These spending cuts, in turn, have and will likely continue to compress the cash flow of certain REITs. The weakening fundamentals and recent bankruptcy filings of some healthcare operators, especially the large, publicly traded operators are also of growing concern.

With future cash flow growth limited, it is likely that healthcare operators will become more reliant upon debt as a means to fund their future capital requirements. Greater dependence on debt will dilute the capital structures of some companies.

For those healthcare operators that can effectively address these near-term risks, there are several recent developments that could, in combination, result in some credit stabilization. These developments include focusing on internal issues like cost controls vs. growth strategies; modest relief in cutbacks imposed by the Balanced Budget Act; and a more favorable pricing environment, characterized by rising insurance premiums.

Our negative rating outlook for U.S. healthcare REITs is underpinned by the Medicare squeeze, deteriorating operator profiles, and difficult access to both public and private REIT capital markets. Continued competitive pressures from other lenders, notably banks and insurance companies, which provide financing to many healthcare facilities, also bear watching.

Diversification & Liquidity

Moves towards greater portfolio diversification and liquidity could help to reverse this negative trend in the long run. Some REITs, such as Health Care Property Investors and Healthcare Realty Trust, have used mergers and acquisitions as a way to diversify risk and to reduce earnings volatility. Another trend we've noticed is the decision by some operators and REITs to pursue growth in alternative formats, such as assisted living, congregate care, and outpatient care facilities. These efforts are a wise response to cost containment pressures.

Nonetheless, these strategies have their own sets of challenges, including integration and, in the case of new property types, weaker barriers to entry. If U.S. healthcare REITs can successfully navigate the risks associated with these strategies, their credit outlooks may well improve. Healthcare REITs have historically benefited from long-standing relationships with tenants, limited risk of overbuilding in their core markets due to high barriers to entry in several subsectors, and good access to capital.

RMA Should Help

In addition, new rules for healthcare REITs passed as part of the REIT Modernization Act (RMA) (a section of H.R. 1180, the Work Incentive Improvement Act of 1999) allowing greater flexibility for expiring leases are a plus, especially given the healthcare industry's challenges.

The new rules will allow REITs to operate a facility for 90 days, and then to hire an independent contractor for a two-year grace period (extendable for up to six years) following the expiration of a lease. Under the old policy, REITs were required to release the property to another operator immediately upon the expiration of the lease. The new rule alleviates some of the regulatory pressures, thus allowing REITs the ability to strike better deals with lessees, and should reduce disruptions in patient care. The RMA's new rules will also broaden the pool of permissible independent contractors by allowing healthcare operators that lease properties from a REIT to serve as independent contractors on other properties held by the REIT (such as properties affected by foreclosures and lease expirations).

Well Managed & Capitalized Companies Will Do Best

As always, we will continue to focus on REITs' performance at the facility level, managements' track records, and REITs' ability to adapt to an evolving healthcare environment. Financial flexibility, proactive asset management, and portfolio diversification are among the key attributes healthcare REITs must possess to meet these challenges given the difficult operating environment.

We expect that many of the better-managed and more highly-capitalized REITs will be able to preserve their current rating levels.