News and Analysis (June 2007)

HCP bounds big into bio



By John Mugford

And now, in one fell swoop – one very big swoop – Health Care Property Investors Inc. (NYSE:HCP), the country’s largest healthcare real estate investment trust (REIT) by market capitalization, has become one of the country’s largest bioscience landlords and developers.

On June 4, Long Beach, Calif.-based HCP announced that it reached an agreement to acquire Slough Estates USA Inc. (SEUSA), the Chicago-based unit of Slough, U.K.-based SEGRO plc, and its massive U.S. life sciences real estate portfolio for $2.9 billion. The deal is expected to close by the end of the third quarter (Q3).

The portfolio comprises 83 existing properties with a total of 5.2 million square feet, plus a development pipeline of 3.8 million square feet of bio properties, which represents 20 percent of the overall transaction. Most of the properties are in the San Francisco Bay and San Diego markets, even though HCP says it expects to expand its new portfolio to other U.S. bio hotbeds.

The core, existing portfolio is 82 percent occupied – increasing to a projected 89 percent in 2008 – and was acquired at a cap rate of 6.8 percent, based on expected 2008 net operating income (NOI). About 84 percent of the existing 83 properties are 95 percent occupied, meaning the remaining 26 buildings are in what HCP calls the “lease-up” phase and are about 48 percent occupied. Those buildings are expected to reach a “stabilized” occupancy level – in this case about 96 percent – within the next two years, according to HCP officials.

When combining the stabilized and lease-up properties, the overall cap rate for the existing properties was 6.3 percent, according to HCP officials.

The development pipeline includes a sizable chunk of space – about 500,000 square feet – that is 86 percent preleased. When the development portion of the portfolio is fully constructed, according to HCP officials, it will represent an investment of about $1.8 billion and will help fuel the company’s bio and lab space growth for years to come. HCP expects eventual stabilized NOI yields of between 8 percent and 11 percent on the development portfolio.

Because market conditions are expected to continue to strengthen, because the portfolio is largely located in high barrier-to-entry markets, and because rents in the existing portfolio are an estimated 17 percent below market value, HCP officials say the company should be able to significantly improve upon the portfolio’s first-year expected yields. In fact, HCP expects an annual NOI compound growth rate of about 14 percent through 2010.

Major tenants in the portfolio include two bioscience stalwarts with high credit ratings: South San Francisco, Calif.-based Genentech Inc. (NYSE: DNA) and Thousand Oaks, Calif.-based Amgen Inc. (Nasdaq: AMGN). Part of the transaction includes the transfer of warrants with equity stakes in a number of tenants, including Genentech and Amgen, from SEUSA to HCP.

When the acquisition closes, HCP will join the ranks of the country’s largest bioscience landlords. For some time now, the granddaddies of the industry have been two publicly traded REITs focused solely on bioscience: Pasadena, Calif.-based Alexandria Real Estate Equities Inc. (NYSE: ARE), with more than 12 million square feet of space, and San Diego-based BioMed Realty Trust Inc. (NYSE: BMR), which has more than 8.6 million square feet of existing space. Both REITs have more space in the development pipeline.

Changing the mix

The deal significantly alters HCP’s portfolio mix. Prior to the acquisition – as of March 31 – HCP had stakes in 730 properties, including 331 senior housing facilities, 264 medical office buildings (MOBs), 67 skilled nursing facilities, 39 hospitals and 29 other healthcare properties. Those figures do not include properties being held for sale.

After the SEUSA closing, the company’s portfolio would consist of: 26 percent life science/pharma facilities; 22 percent private-pay senior housing (non-Sunrise Senior Living REIT properties); 18 percent Sunrise Senior Living properties; 21 percent MOBs; and 13 percent of other properties, including government-reimbursed hospital and skilled nursing facilities (SNFs).

Many of the private-pay senior living properties came into the fold when HCP acquired CNL Retirement Properties Inc. for $5.6 billion in late 2006 – adding more than 270 senior housing facilities, MOBs and other medical facilities. (For more information on that transaction, please see “HCP-CNL merger closes” in the October 2006 edition of Healthcare Real Estate Insights).
When asked to comment during June 4 in a conference call with analysts on the cap rate and expected returns on the SEUSA investment, HCP’s chairman and CEO James F. “Jay” Flaherty III said: “If you step back and take a look at what our thought process was here, we’re looking at the stabilized component of this portfolio, we’re looking at a 6.8 cap rate on NOI going forward. If you compare that to what we’re seeing in private pay senior housing (that’s) a 125- to 250-basis point premium in terms of going in yields on stabilized assets.

“And if you compare that to what we’re seeing in terms of on-campus medical office buildings where you’re seeing cap rates starting to bounce off a 6 metric, we’re picking up 75 basis points there. This is a fantastic opportunity for our shareholders.”

For SEGRO, which recently changed its name from Slough Estates, selling the U.S. assets allows the company to focus on its flexible business space model in the United Kingdom and Continental Europe. SEGRO’s CEO, Ian Coull, said in a prepared statement that the company’s U.S. endeavors have no synergies with its European businesses. The company holds $10 billion and 43 million square feet in assets.

The planned transaction is to include the assumption or refinancing of about $1.2 billion in SEUSA’s outstanding debt. After the deduction of the estimated debt and taxes, net cash proceeds receivable will be about $1.1 billion.

“SEGRO has built a successful business in the biotech market, but one which is materially different from, and has no synergy with, our activities in Europe,” Mr. Coull said in a statement. “We believe Slough Estates USA will thrive under its new owners, who are themselves well established in the U.S. healthcare property market.”

Diversification is key
Of course, a couple of questions on industry observers’ minds might be: Why did HCP make the leap into bio? And, does it know the industry well enough to succeed?

As for the second question, Mr. Flaherty said during the conference call that the company plans to retain SEUSA’s Marshall Lees and his team in Chicago. Mr. Flaherty called Mr. Lees and his group the “prime architects” of SEUSA’s bio real estate platform during the last 20 years.

“They are well-known to HCP,” Mr. Flaherty said. “Mr. Lees plans to join HCP as executive vice president of the company’s new unit, the life sciences group, which will be based in Chicago.”

During the conference call, James Kumpel, an analyst with Arlington, Va.-based investment bank, brokerage and asset management firm Friedman Billings Ramsey Group Inc. (NYSE: FBR), asked Mr. Flaherty why the occupancies for the SEUSA portfolio were in the 80 percent to 82 percent range in 2005 and 2006.

“I think you’ve got to look at as they continued to grow the development pipeline,” Mr. Flaherty answered. “So as they’ve developed properties, they’ve leased up into the high 90s and shrewdly, in hindsight, they’ve continued to create additional development pipelines which have occupancies along the lines of the lease-up assets I’ve referred to, at about 48 percent (occupancy).

“That’s one of the nice things about this – it’s not a static pipeline. We’ve created a platform here with a development infrastructure that will continue to provide development opportunities for our shareholders and our capital partners.”

As Mr. Lees and his team look for ways to build the portfolio, they plan to look beyond San Francisco and San Diego in both developing and, possibly, acquiring additional bio real estate, according to Mr. Flaherty. He mentioned markets such as Seattle, Boston/Cambridge, the Research Triangle in North Carolina, Washington, D.C. – “You basically follow where the NIH (National Institute of Health) funding grants go.”

As Mr. Flaherty explained the reasons for the acquisition, he said the deal gives the REIT “newly constructed, higher-growth properties with very low government reimbursement exposure.”

HCP has made it clear in recent years that it is moving away from owning properties that are vulnerable to government reimbursement policies, such as skilled nursing facilities (SNFs) and certain types of hospitals. The company, in fact, in the last year or so decided to sell about $500 million worth of older, government-reimbursed assets and reinvest the proceeds into newer institutional-quality, high-growth portfolios – such as the Slough Estates USA portfolio.

“For those of you who have followed our company for the past two to three years, you may recall our vision to establish a fifth bucket, or property sector, within our real estate portfolio,” he said.

“SEUSA represents the strategic move we have been pursuing for almost four years,” Mr. Flaherty continued. “In fact, we first initiated discussions with SEUSA’s parent during the summer of 2003. For the past three-and-a-half years, there has been considerable interaction between the organizations.”

Even so, HCP acquired SEUSA through a competitive bidding process that, according to reports, had about 20 entities submit initial bids. SEGRO had announced last November that it was exploring strategic options for its U.S. portfolio and SEUSA.

Prior to reaching an agreement with Slough Estates USA, HCP had taken several big steps and made big acquisitions to reposition its portfolio away from properties that rely heavily on government reimbursements.

“Over the last four years, we have grown our MOB and private pay senior housing sectors aggressively and essentially swapped our skilled nursing facility concentration for a Sunrise Senior Living concentration and swapped our hospital concentration for the premier platform in life sciences,” Mr. Flaherty said.

“As we have discussed with you extensively since our CNL acquisition, this strategy further repositions HCP’s portfolio to real estate assets, characterized by newly constructed higher growth properties with very low government reimbursement exposure.

“A majority (55 percent) of SEUSA’s tenants are rated investment grade and will become the highest-rated credit tenants in HCP’s portfolio, with the exception of our modest exposure to General Electric. In fact, the SEUSA portfolio represents the highest rated credit tenant concentration in the entire healthcare REIT industry.”

Last fall HCP acquired the full interest in a portfolio of MOBs that it owned jointly for several years with GE Healthcare Financial Services (GE HFS). The price was $141 million for the 59-building, 4 million square foot portfolio.

Paying down debt

HCP plans to finance the acquisition, which includes the assumption or refinancing of $1.2 billion in debt, with a $3 billion bridge loan priced at LIBOR plus 70 basis points from Banc of America Securities LLC, Barclays Bank plc and UBS Investment Bank.

Mr. Flaherty noted in the conference call that HCP plans to quickly and aggressively reduce the balance on the loan through selling assets and forming joint ventures – although he noted that such dispositions are not likely to involve any assets that are part of the new SEUSA portfolio. He also noted that most of the joint ventures would be formed in projects in the development pipeline.

“You will primarily see the disposition activity coming from the existing HCP core portfolio,” Mr. Flaherty said. “We expect minimal, if any, dispositions coming out of the Slough portfolio.

“Really when you think about that Slough portfolio, that’s gold. That’s South San Francisco, San Diego – credit tenancy and recently constructed… (We’ve) got nice, below market rents in high barrier-to-entry markets. And we think that real estate portfolio will form a significant foundation to generate dividend growth for HCP shareholders for the years to come.”

When asked why HCP does not plan to form joint ventures in the ownership of some of the high-occupancy, stabilized bio facilities, Mr. Flaherty said: “Again, we’ve got a couple of different things we’re doing here. We obviously want to create a sustainable and attractive growth trajectory for our shareholders. This is a unique opportunity for us to rebalance some of our credit metrics, particularly that secured leverage ratio, which got a little out of whack from our historical preference when we did CNL…

“There are things that we can do, like, for example if we lever out to do an acquisition, I think at this point we’ve got a fair amount of credibility that we will – we can – de-lever quickly. We can certainly increase our fixed strategy coverage ratio by virtue of an increased profitability that comes off our joint venture platform.”

Mr. Flaherty said the plan for paying down debt on the SEUSA acquisition, in a way, resembles the company’s actions following its acquisition of CNL and the paying down of that debt.

“We’re going to move pretty aggressively to knock down that bridge a la what we did on the CNL bridge (loan), although we’re going to focus on asset dispositions and joint venture contributions,” Mr. Flaherty said. “And I think we’re hoping to make some pretty quick headway here. So that’s how we’re initially going to target. We anticipate no common stock issuance for the remainder of 2007.”

When asked for more details about the company’s plans to retire the bridge loan, Mr. Flaherty said: “Here’s our thought process. We’re sitting on a balance sheet that has no outstanding debt on our revolver and $116 million of cash. I think what we’d like to do is demonstrate to the market that we can get the equity component done, and I think with our existing cash balances (and dispositions)… and some additional joint venture contributions, we can accomplish that away from any primary issuance of common stock. And I think once you see us do that, we would be better off accessing the debt capital markets after we had proven to Wall Street that we are able to do that.”

He added that HCP is likely to eventually enter the debt markets.

“But I think the first thing we want to do is demonstrate to the Street is that we’ve got the equity component, if you will, which in this case is not going to be primary common stock issuance, but property dispositions, existing cash balances and joint venture contributions… We’ll get a better debt market execution as well, that way.”

Underwriting the risk

One analyst, David Cohen of the New York-based investment bank Morgan Stanley (NYSE: MS), asked Mr. Flaherty how HCP did the underwriting of the risk involved in the SEUSA acquisition.

“A lot of the big companies – Vornado (Realty Trust, NYSE: VNO), Boston Properties (Inc., NYSE: BXP) – have looked at this type of space and they just can’t get their arms wrapped around the risk profile,” Mr. Cohen said. “Can you just talk about how you underwrote the 6.8 rate cap rate (for the stabilized properties) and the 6.3 (cap rate) for the entire portfolio?”

“We look at four things, primarily,” Mr. Flaherty answered. “We look at replacement costs, we look at cap rates, we look at IRRs (internal rates of return), both unlevered and levered, and then we look at the impact to our FFO (funds from operations). And this transaction pencils out at a 9 percent unlevered IRR – kind of a 10.6 percent metric… If you assume a levered but just levered for on the balance sheet given what I said is our likely hold strategy here. We tend to model everything on balance sheet at a 50:50.”

“These are very, very good returns for us,” Mr. Flaherty continued, “and the development pipeline that we get is going to do some nice things for us in the years to come. I think it helps to continue to build a wall around our profile as the institutional capital partner of choice in the healthcare space given the opportunity we’ll have to feed those relationships with this development pipeline. And then hopefully we’ll be able to take this platform and arm Marshall with some additional capital. And see if we can penetrate some additional markets. For us it was – that was our thought process.”

Bullish on bio

As for HCPs strategy for the future of the bio real estate portfolio, Mr. Flaherty said that the Chicago-based life science unit, led by Mr. Lees, would determine when to develop and when to acquire properties. But he noted that embarking on new development leads to growth – a formula that SEUSA used to successfully grow its portfolio.

“(SEAUSA) had to self-fund any new investment,” Mr. Flaherty said. “And I think, shrewdly, Marshall (Lees) and his team elected to, A, to focus on development and B, when they sold assets … take those proceeds and reinvest them in development. We think with our access to the capital markets we’ll be able to take Marshall and his team and begin to look at markets outside of San Francisco and San Diego, which would be another way to reduce the concentration risk in those two markets. This is great stuff.”

Even though the firm plans to look outside of the San Francisco and San Diego bioscience real estate markets, those markets are showing marked improvement recently. According to data from commercial real estate data service provider CoStar Group Inc., the vacancy rate for properties with biotech and lab space in the San Francisco Bay area has dropped to about 13 percent from 60 percent in 2004 – due in large part to a building boom. In San Diego County, the vacancy rate has fallen to about 10 percent from about 18 percent in 2004.

As HCP enters the bio real estate arena in a big way, Mr. Flaherty believes the company is on the cusp of something big. Even though the bio sector has some major players in Alexandria, BioMed, Cleveland-based Forest City Enterprises Inc. (NYSE: FCE), Baltimore-based Wexford Science + Technology, and others, he hinted that HCP might be leading a new wave of interest into the asset class.

“I do believe the life science/pharma space is not going away tomorrow and has very interesting growth properties,” Mr. Flaherty told analysts.

In responding to a question about how much more HCP intends to invest in the industry, Mr. Flaherty said: “We’re opportunistic… history shows that we tend to attract a crowd.”

“Four years ago we announced our first ever joint venture,” Mr. Flaherty continued, noting that JVs have now become a common practice in healthcare real estate. “And then we started talking about the coming institutionalization of healthcare real estate. That’s now a sound bite now that you’ll see on most of the healthcare REITs’ Web sites. Then we moved hard into private pay senior housing as we saw it bouncing off 70 percent industry-wide occupancies at the end of ‘02 and ‘03.”

Then, in late 2003 HCP dove into MOBs when it acquired MedCap at a cap rate of about 9.25 percent, Mr. Flaherty said.

“And now, here we are in life sciences,” he added. “So, you see what’s happened. We think life science is, from our standpoint… core assets and we are going to (experience) real estate core-plus returns. So, to the extent we can see that tradeoff in other markets, we will certainly take advantage of that.”

When asked whether HCP will need to add more people or another company to continue building the life sciences platform, Mr. Flaherty answered: “Well, look at the MedCap analogy…

“When we acquired MedCap, (the portfolio) was just under 6 million square feet. Today it sits as the largest owner/manager of medical office buildings in the United States at 17 million square feet.

“So right now… (the) SEUSA (portfolio) has got in terms of stabilized square footage… 5.3 million square feet and you’ve got a 3.8 million square foot development pipeline. Were we to double that over the next 12 to 18 months … I think it would be smart for us and Marshall (Lees) and his team to kind of build out some additional infrastructure to allow them to scale that platform.

“We’ll be smart about that. But we’ve done this with MedCap, too.”
A win after loss

HCP’s acquisition comes on the heels of its losing proposition to acquire Toronto-based Sunrise Senior Living REIT and the 74 private-pay, senior living communities in that portfolio. Sunrise REIT was acquired by the country’s second largest healthcare REIT, Louisville, Ky.-based Ventas Inc. (NYSE:VTR) for a reported $2.15 billion.

Even though HCP offered $18 (Canadian) per share for the Toronto-based owner of 74 senior living communities after Ventas reportedly entered an agreement with Sunrise REIT, Louisville, Ky.-based Ventas gained control of Sunrise REIT for C$16.50 per share, or C$2.28 billion ($2.15 billion). The deal closed April 26. That’s because the Ontario Superior Court of Justice ruled that HCP was subject to a standstill agreement it signed as part of the bidding process for Sunrise REIT. Therefore, the court ruled, HCP could not submit an offer after Ventas reached an agreement to acquired the portfolio. The Court of Appeal for Ontario dismissed subsequent appeals submitted by HCP.

Ventas has since initiated a $100 million lawsuit against HCP, alleging it interfered with the Sunrise REIT deal. HCP officials say the claims are without merit. q

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