Winds of change at HCN

REIT PLANS $877M MERGER WITH WINDROSE

By John Mugford

 

Coming into 2006, officers with Windrose Medical Properties Trust had no plans for the company to merge with another firm, or to be acquired.

Yet, in recent weeks, Indianapolis-based Windrose was part of a big deal – a very big deal, in fact, that’s made big news in the healthcare real estate industry. “It could be the deal of the year, at least for us it certainly is,” says Fred Farrar, Windrose’s COO.

In recent weeks, Toledo, Ohio-based Health Care REIT Inc. (NYSE: HCN) announced that it is in the process of acquiring Windrose (NYSE: WRS) and its portfolio of 92 outpatient properties – about 75 percent of which are medical office buildings (MOBs). The deal includes Windrose’s development arm, Hospital Affiliates Development Corp. (HADC), based in Brentwood, Tenn.

The price tag of the acquisitions is an estimated $877 million, including the assumption of Windrose’s outstanding debt of about $426 million. The acquisition is taking the form of an exchange of Windrose common stock for Health Care REIT common stock.

Quite a massive company with a massive portfolio is to be created if the acquisition closes as planned by the end of 2006 or in early 2007. In fact, after the merger, Health Care REIT would have a portfolio of more than 550 properties valued at an estimated $4 billion. The total enterprise would be worth an estimated $5 billion.

Even more important for the industry is the fact that officers say the new company will continue to be aggressive in acquisitions, dispositions and the development of new healthcare facilities. While company officials will not say the merged firm will be more aggressive than the two entities were in the past, they have indicated that the “synergies” created with the acquisition should lead to more relationships throughout the country and in additional sectors of healthcare real estate.

Ray Braun, president of Health Care REIT, says the merged company plans to outline its expectations and goals for 2007 during a February quarterly earnings call.

“It is clear that when you have more players and more resources, you can do more things and explore more areas than you could before,” Windrose CEO Fred Klipsch told Healthcare Real Estate Insights^™ in an exclusive interview several days after the announcement of the pending merger.

Casting a wider net

If the merger is completed as planned, the spectrum of medical facilities on its list of potential acquisitions and development deals will run quite a gamut.

That’s because Health Care REIT’s portfolio, which has been exclusively composed of senior healthcare facilities since its founding in 1970, would include Windrose’s MOBs, outpatient treatment facilities, specialty hospitals and ambulatory surgery centers.

According to officers of both firms, Windrose would become a division of Health Care REIT and continue looking for outpatient acquisitions and development opportunities. In fact, Windrose’s officers are already being given the opportunity to make acquisitions with a $125 million line of credit provided by Health Care REIT until the merger is finalized.

Health Care REIT plans to continue, for now, with its 2006 stated guidance of investing $525 million to $600 million annually in healthcare facilities. That figure includes acquisitions and advancements on existing assets of up to $350 million as well as new developments valued at between $175 million and $250 million, says Mr. Braun of Health Care REIT.

Windrose’s goal has been to acquire about $100 million worth of facilities annually and to develop, through HADC, about $50 million annually.

Windrose officials – both during a conference call concerning the merger in mid-September, as well as in subsequent one-on-one interviews with HREI^™ – indicated that they were excited to have the backing of more capital to help them do their jobs of looking for outpatient acquisition possibilities.

“In today’s low-cap rate environment, we at Windrose will be able to pursue opportunities that we might have been challenged to pursue before,” said Mr. Farrar. “Dan Loftus (Windrose’s secretary and general counsel) and I will be freed up from the distractions of having to raise capital and looking for debt sources when we look for and make acquisitions.”

Also as part of the agreement, Windrose’s “two Freds” – as in the aforementioned CEO Fred Klipsch and COO Fred Farrar – will remain with the merged firm for a minimum of two years. Mr. Klipsch will serve as vice chairman while Mr. Farrar will be an executive vice president and the president of the Windrose division. Mr. Klipsch will also join Health Care REIT’s board of directors. George Chapman of Health Care REIT remains the CEO of the merged company.

Officers also indicated that Windrose will maintain its office in Indianapolis while HADC maintains its office near Nashville, Tenn.

Diversification is key

As noted earlier, while both Windrose and Health Care REIT are involved in medical real estate, their focus in the industry has been quite different. Since its founding 36 years ago, publicly traded Health Care REIT has concentrated on senior healthcare facilities, including assisted living facilities, continuing care retirement communities, skilled nursing facilities and specialty care properties.

Windrose, on the other hand, has made quite a splash in the medical real estate arena in recent years with an aggressive record of acquiring outpatient facilities. Formed through an initial public offering in 2002, Windrose’s goal was to acquire $100 million worth of outpatient facilities annually.

Since its founding, Windrose has actually spent about $724 million on medical properties, including its most recent acquisition in August: three specialty hospitals in Texas, Louisiana and Oklahoma for $26.2 million.

Through its taxable subsidiary, 29-year-old HADC, Windrose has also had a goal of developing about $50 million worth of outpatient facilities annually.

Both HCN and Windrose executives say that they expect to use HADC for in-house development projects, including outpatient facilities and senior healthcare facilities.

“Now, we’ll be able to leverage a variety of products that can be done in-house,” said Mr. Klipsch during a conference call concerning the merger in mid-September. “Currently, HADC is completing about $140 million in third-party developments before the end of the year, and once those are complete it will be free to develop in-house and contribute to the company’s core assets.”

Critical mass

Health Care REIT executives pointed to several reasons why they pursued Windrose. Perhaps first and foremost was that they had, at the onset of 2006, expanded their investment strategy to include, among others, MOBs and acute-care facilities. Acquiring Windrose ushered HCN into the MOB arena in one fell swoop.

During the conference call, Mr. Chapman said Health Care REIT “obtained critical new mass” in acquiring Windrose. He informed listeners that it would have taken the firm four to five years to develop a portfolio similar in size and composition to the one that Windrose brings to the merged firm.

He also noted that diversifying Health Care REIT’s portfolio with MOBs and outpatient facilities leaves it less vulnerable to changes in federal reimbursements, including Medicaid and Medicare.

“This acquisition will increase our non-government regulatory component to 55 percent to 60 percent of our total portfolio,” Mr. Chapman said.

‘Frees up’ Windrose

In addition to decreasing Health Care REIT’s vulnerability to federal reimbursement changes, the merger and acquisition “frees up” Windrose’s team when it goes looking for strategic assets to acquire, according to Messrs. Klipsch and Farrar.

“Whenever we’ve made acquisitions at Windrose, we’ve been asked how we were paying for it,” Mr. Farrar told HREI^™. “Now, with the additional capital behind us, we won’t have to answer that question anymore.”

In the conference call, Mr. Farrar said: “We’ll be free to pursue the fun parts of the business, which is to find good deals, find new operators to work with, and form new relationships as opposed to the aspect of having to raise capital.”

Mr. Klipsch notes that because MOBs have garnered such attention recently from big institutional investors, prices have risen and capitalization rates – annual rates of return on projects – have fallen.

“I think the timing is right for Windrose to be acquired because I don’t think we’re big enough to compete. Now we not only have a stronger balance sheet but a strong infrastructure,” Mr. Klipsch says, “and Health Care REIT gets a company with people who understand the acute-care side of the business, which is critical in today’s market. And another thing that all of us like is that we’re two Midwestern firms that form a good cultural fit.”

Mr. Chapman, Health Care RETI’s CEO added: “I envy what Fred and Fred will be able to do. They’ll be more free of the bureaucracy and reporting that was such a big part of their jobs before.”

In addition to looking for acquisition prospects, Mr. Chapman said the two firms “have similar philosophies” when it comes to acquisitions and dispositions. The newly merged company will, in fact, not only be looking for assets to acquire but will “cull the portfolio to determine whether some assets should be disposed or redeployed, whether it’s in the MOB space or in long-term care and senior housing.”

Coming together

Even though the healthcare real estate industry is rather small community, not all firms have personal relationships. But the principals with Health Care REIT and Windrose certainly did.

In fact, principals with the two companies became acquainted back in 1993. At that time, HADC was the construction management firm on an assisted living community in Birmingham, Ala., that was being developed by National Guest Homes, of which Messrs. Klipsch and Farrar were principals. Mr. Klipsch, who owned both HADC and National Guest Homes at the time, had a four-hour meeting with the officers of Health Care REIT, during which time he convinced them to invest in the assisted living project.

“It was Health Care REIT’s first investment in an assisted living property,” recalls Mr. Farrar, noting that today assisted living composes about 35 percent of the company’s portfolio. In fact, since then, Health Care REIT has “completed over $700 million in assisted living development,” says HCN’s Mr. Braun.

Prior to that, in 1990, Messrs. Klipsch and Mr. Farrar had started National Guest Homes, which owned and developed assisted living facilities throughout much of the 1990s. The company was sold to Marriott International Inc. (NYSE: MAR) in 1996. Marriott sold its Senior Living Services unit to Sunrise Senior Living Inc. (NYSE: SRZ) in 2003.

“Fred Klipsch had actually educated the folks at Health Care REIT about assisted living back then, and we’ve certainly known each other since then,” says Mr. Farrar.

No intentions to be bought

As noted earlier, Windrose’s principals did not go looking for a firm with which to merge. Even so, Mr. Farrar notes that Windrose’s officers were not surprised when Health Care REIT came calling early in 2006. At first, they approached Windrose with a “concept” acquisitions proposal.

“Several analysts had reported that we were good takeover bait,” Mr. Farrar says. “In fact, Jerry Doctrow (an analyst with investment firm Stifel Nicolaus & Co.) even suggested it. And it was not much of a surprise when one looks at what’s taking place in the REIT market; there’s been a fair amount of M & A (merger and acquisitions) activity.”

A number of healthcare REITs that had historically focused on senior living facilities have been buying their way into the medical office sector during the past two years by acquiring MOB development firms, portfolios of MOBs or entire companies. In the biggest deal to date, Health Care Property Investors Inc. (NYSE: HCP) announced May 2 that it had reached an agreement to acquire CNL Retirement Properties Inc. for $5.2 billion. (For more on that pending transaction, please see “HCP changes the game” in the May edition of HREI^™.) CNL had itself bought into the MOB space in August 2004 with its $206.5 million acquisition of a 26-MOB portfolio, plus 55 percent of DASCO Cos., one of the largest medical real estate firms.

In the case of Health Care REIT and Windrose, Mr. Farrar says that, following the “conceptual” talks, the negotiations “got pretty serious later in the spring.

“Things really went past the exploratory stage in the middle of May,” he says.

Mr. Farrar says the merger would provide a strong diversification for Health Care REIT’s real estate portfolio, noting that at least two analysts have indicated they are considering upgrading their recommendations concerning the REIT’s stock.

Leading the change

During the conference call, one analyst asked Mr. Chapman what he thought about off-campus MOBs. The question was in reference to Windrose’s portfolio, which the analyst noted was heavily “off-campus.”

“Of the 92 buildings in the Windrose portfolio, roughly 40 percent are not on or near a hospital campus,” says Mr. Braun of Health Care REIT.

During the conference call, Mr. Chapman responded to the question. “The early answer is that you’d rather have an on-campus MOB connected to a hospital with a master lease. But the truth is that healthcare is changing and is going to change drastically in the future.”

Mr. Chapman noted that a growing number of MOBs are offering surgical procedures. He added that at some point in the future a variety of healthcare facilities will be brought together in “virtual village”-like settings. These could include not only senior healthcare facilities, but MOBs and other facilities as well.

Mr. Klipsch added that off-campus, outreach MOBs, especially when “strategically located” in growing suburban communities and perhaps affiliated with a hospital system, can have as much value as on-campus facilities.

“Just drive around any metro area, out in the growing areas, and you’ll see locations where hospitals are going to want to have feeder systems for their main facilities,” says Mr. Klipsch. “They’re not always going to need or want a new hospital out there, but they need to have a presence there, perhaps an MOB with a surgery component, to keep up with supply and demand.”

Mr. Klipsch notes that in the future he foresees medical campuses composed of independent living housing, assisted living facilities, nursing homes, MOBs, surgery centers and perhaps smaller, specialty hospitals – all of which he says the new, bigger Health Care REIT could be involved in.

Mr. Chapman agrees.

“The functions of healthcare facilities are changing and I think we’re going to see combinations of platforms,” he said in the conference call. “And with our resources, I see us being at the forefront of the many changes that might occur in healthcare real estate over the next 10 to 15 years.” q