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A Thesis on Health Care REIT (HCN)



August 06, 2011 – Comments (1)

In real estate investment trusts (REITs), I'm attracted to boring and stable. REITs, to recap, must pay out 90% of the funds they receive from their operations (FFO) to investors, and are exempt from corporate income tax. Their dividends are treated as income, rather than true dividends, so they don't qualify for the 15% rate.

Some REITs run triple net leases. In these, the tenant is responsible for the property taxes, insurance and maintenance. The REIT isn't at risk for any maintenance costs of the property. This lease style offers maximum predictability to the REIT, although obviously the REIT doesn't charge as much in rent as it otherwise would. Many triple net leases have inflation adjustment built in.

Most of Health Care REIT's leases are triple net. HCN operates health care and residential care properties. Unlike its competitor, HCP, most of its portfolio is residential care, rather than nursing homes (aka skilled nursing facilities). This means that HCN's payer mix is tilted towards private pay, rather than government payers. (See explanation at the end.) This means more predictability.

HCN and other REITs, not to mention nursing homes, took a tumble when Medicare made a (an entirely justified, imo, see explanation) significant cut to reimbursement rates. There were worries that some nursing homes would breach their lease covenants.

However, HCN is far less heavy in nursing home tenants than other health care REITs. They have one large nursing home tenant which accounts for about a quarter of their revenues, but I'm confident that the lease was underwritten with sufficient margin of safety. The tenant is not likely to go under because of the payment cut.

Overall, HCN is operating with the wind at its back. The demand for residential care facilities can only grow as the population ages. HCN has solid underwriting, a strong balance sheet, good tenant diversity, and good management. I bought on the dip - I'd been eyeing this company for a while but didn't have the funds in my IRA.


Residential care refers to housing with services like meals, help managing medications, or help with tasks of daily living like bathing or dressing. Residential care is a care setting for seniors who are growing increasingly disabled.

At this point, most residential care is private pay. In contrast, skilled nursing care, which is rehabilitation for after surgery and is delivered in nursing homes, is primarily paid for by Medicare. "Custodial care" (outdated term) is mainly Medicaid and secondarily private pay.

One issue that Medicare has faced is that it pays more for skilled nursing patients who require therapy. However, many nursing homes, especially the big for-profit chains, have really piled into therapy patients, especially the ones who require the most therapy. Furthermore, they've engaged in upcoding - because they get paid more for patients with more severe needs, they have an incentive to code the same patient as severely as they possibly can. Meaning someone who would normally be assessed as needing an hour of therapy a day might get assessed for 1.5 hours a day.

This has resulted in increased costs to Medicare. Medicare failed to anticipate how heavily nursing homes' behavior would change with a new coding scheme they recently put out. The cut was designed to recoup these payments. It's clear that the nursing homes got overpaid, and I'm pretty sure the CEOs of the chains would agree. Personally, I'd have recouped the payments over 2 years, but I'm not especially sympathetic to the chains - they're a business and they'll live. 

One issue with Medicaid is that they pay everybody too little, nursing homes included.

1 Comments – Post Your Own

#1) On August 07, 2011 at 8:43 AM, dbjella (< 20) wrote:

Great analysis! 

One issue with Medicaid is that they pay everybody too little, nursing homes included.

Thanks for the chuckle :) 

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