United States: Healthcare Real Estate – Renewed Interest In RIDEA

While the REIT Investment and Diversification Act ("RIDEA") has been in existence since 2008, there has been a clear and recent trend among public healthcare REITS to capitalize on the opportunities the statute provides. Traditionally, REITs had been limited to more passive income and thus they largely depended upon triple-net lease structures. The triple-net lease structure has served the industry well over time; triple-net leases have rightfully been viewed as a safe means of achieving escalating rent payments – an important consideration when the bulk of REIT income must be paid out as annual dividends to investors. Under triple-net lease formats, REITs expect to achieve annual rent escalations in the 2-3% range. RIDEA, however, allowed REITS to change fundamentally the way they accounted for healthcare real estate income — RIDEA enabled REITs to share in the net operating income generated by their owned healthcare assets so long as a third-party manager were in place. The legal structure involves the creation of a Taxable REIT Subsidiary ("TRS"), with a lease between the landlord and tenant entities (both of which are owned by the REIT). Sharing in operating income provides REITs potential upside in the performance of their property investments, hence its appeal to REITs, particularly those with well-performing assets. Instead of steady rent escalations, REITs can benefit from market rent increases, occupancy increases and operational improvements or efficiencies. Indeed, a number of healthcare REITS have been able to achieve income growth of double the range of triple-net lease escalation provisions they previously employed.

The appeal of RIDEA tracks another well-established trend in the industry. Among institutional-caliber seniors housing investors, there has been a shift towards acquisition (as well as new development) of higher quality properties from which they expect to realize higher earnings. Indeed, in the recent past, the investment focus of many leading investors has been newer, private-pay assisted living facilities. RIDEA has given those investors a vehicle to seek increased earnings from their best assets. From being non-existent just 10 years ago, RIDEA portfolios now account for a substantial portion of the assets held by healthcare REITs. Indeed, among the "Big Three" – Ventas, Inc. (NYSE: VTR), Welltower (NYSE: HCN) and HCP, Inc. (NYSE: HCP), RIDEA relationships account for 60% of their property holdings. Within the past week, HCP announced its Q1 2018 earnings and at the same time announced that it is pursuing a strategy of becoming "a best in-class real estate operating company." To do so, HCP intends to review its triple-net seniors housing portfolios and convert those with high growth potential into seniors housing operating portfolio ("SHOP") assets. Incidentally, at the same time, HCP intends to diversify its portfolio to include a higher percentage of medical office building ("MOB") assets and life-sciences related assets.

Also driving these trends is the effort among operators and landlords to better align their interests. In the process of selecting which assets to contribute into a RIDEA structure, healthcare REITs are able to rely upon data and analytics that are more elaborate and content rich than prior to the enactment of RIDEA. Likewise, those REITs who have partnered with very high quality operators, such as HCP (which counts Sunrise Senior Living, Oakmont Senior Living and Aegis Living among operating partners), possess confidence that the converted portfolios will continue to perform well. Those relationships are particularly important in the current environment of record low occupancy rates and substantial supply of newly-constructed assets in the pipeline and entering the market. For HCP, the opportunity to focus on new SHOP portfolios is also welcome following its lengthy effort to reposition its portfolio by reducing exposure to Brookdale Senior Living (NYSE: BKD).

While RIDEA structures are not without risk (risk of declining operations and income without guaranteed rent from a credit tenant), REITS that have employed them tend to enjoy higher quality portfolios and improved property conditions than often occurs in triple-net lease scenarios. For example, tenant-operators generally invest the minimum capital expenditures required by their leases to maintain the landlord's real estate. This practice often leads to chronic underinvestment in maintenance and improvements needed to keep the assets competitive when new supply enters the market. REITS' CapEx obligations, however, are higher in RIDEA portfolios. Moreover, triple-net leases are not without risk for landlords. For example, when operations have become challenged, REIT landlords have been forced to cut rents, readjust lease escalation provisions and sell assets — witness the HCP-Brookdale experience.

Other factors supporting the trend toward RIDEA include the years of experience lenders now have in underwriting RIDEA portfolios and the greater flexibility over triple-net leases that landlords enjoy. While REITs will almost certainly maintain a healthy portion of triple-net leases in their portfolios to ensure diversification, the market is demonstrating renewed interest in RIDEA structures and the trend appears to be one that will last for years ahead.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.

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