Health care REITs: focus on long-term care.

The leading investor describes its policies and processes

Health care REITs (real estate investment trusts) own or finance approximately 1,500 of the nation's 17,000 nursing homes. As a group they have been in existence since 1985, the year the majority of the 13 REITs investing exclusively in health care properties were formed. Meditrust is by far the largest of the 13, with an $1.8 billion portfolio of health care properties. Health care REITs invest in acute care hospitals; rehabiliation facilities; psychiatric hospitals; substance abuse treatment centers; medical office buildings; assisted and retirement living facilities; and nursing homes. Of the 295 properties in which Meditrust is invested, 245 are nursing homes.

Two factors combine to make us bullish on the nursing home industry. First there are the demographics. The over-85 population in the United Stated practically doubles every ten years. Long-term care is a market with seemingly ever-increasing demand. The second factor is supply. While there is a need for about 100,000 new nursing-home beds each year, only 10,000 beds are currently being built. Certificate-of-need (CON) regulations found in the majority of states virtually guarantee that, for the foreseeable future, the supply of nursing home beds will not outstrip demand. Supply and demand thus conjoin to give the holder of a long-term care license an exclusive franchise in the marketplace.

For nursing home operators, healthcare REITs are an alternative form of financing offering greater flexibility for expansion. Unlike banks and most other financing vehicles, all we do is provide capital to the health care industry. We have prior experience in actually operating health care facilities, which helps us to better understand the financing needs of the operator. Also, since the savings-and-loan debacle, the business lending policies and practices of banks have come under increased cautionary pressure, both regulatory and shareholder-based. As a result the banks have had a tendency to run hot and cold on the healthcare industry. That has made it difficult for nursing home operators to rely on a stable bank relationship to fulfill anticipated expansion plans.

Additionally, REITs are able to offer long-term financing for maturities not always available from banks. Three- to five-year money is usually available at a lower rate from a bank. However, when it comes to ten- or 15-year money, REITs are not only competitive in their rates, they are far more likely than banks to make loans for longer maturity.

Further, REITs such as Meditrust are able to offer operators the sales/leaseback financing alternative. In a sale/leaseback transaction, the REIT actually acquires the nursing home and then leases it back to the operator. This arrangement can be particularly attractive to publicly held nursing home operators and to private companies about to go public. It removes the asset and debt from the balance sheet and depreciation expense is eliminated from the income statement. The result should be an increase in the share price of a company being judged on a multiple of earnings and a reduction in the company's balance sheet leverage. All of these factors have combined to make REITs increasingly attractive to nursing home operators seeking expansion financing.

The economics for a sale/leaseback transaction are basically the same as for a mortgage, and once we complete a transaction we don't treat it any differently within our portfolio. It is really up to the operator whether they want to go the route of a mortgage or a sale/leaseback. In fact, about half of the portfolio are mortgage transactions and half sale/leaseback transactions.

Nursing home operators looking at REITs as potential sources of financing need to consider carefully what the REIT is likely to be looking for. For Meditrust the ideal investment property is a long-term care licensed facility that may have either a subacute or an assisted living wing or an adjacent building in a campus environment. The nursing home typically has a CON, so it has the exclusive franchise - and we can't overstate how important that is.

Meditrust finances an operator's expansion through the acquisition of existing properties and the construction of new facilities. In the case of new facilities, we finance the construction and then, once they are completed, we always do the permanent financing. We generally do not do development and construction financing unless we are going to do the permanent financing, and typically we do construction financing only with companies that already have cash flowing facilities in our portfolio.

When we are analyzing whether or not to finance an operator, we do background checks in the states in which they do, or have done, business. Management's financial performance should have a good track record. We analyze the facility and the quality of care. We have thorough environmental checks performed and visit the facility to make sure that it is in good physical condition. If not, and we still wish to go ahead with the deal, we will require that the operator hold back financing proceeds to upgrade the facility.

The demographics of the market must be strong. The services offered must match the needs of the population base. Cash flow should be approximately 1.5 times the mortgage or, in the case of a sale/leaseback deal, the lease payment. We also look at the financial position of the operator. We also like to finance multiple facilities with an operator; we won't do a single property financing unless we know the operator is going to be growing. We'll take a look at an operator's other properties with an eye to financing them as a group, because we like to be able to cross-collateralize, cross-default.

Cross-default provisions are important, because if a facility we have financed is doing poorly, we want the operator to use income from other properties to meet the obligation to us. From our point of view, this is best done when default puts at risk more than the single property.

Meditrust reviews about $3 billion of financing in an average year and underwrites between $300 and $350 million. The long-term care industry has been our investment focus for at least five years and will continue as such. We will continue to invest in traditional custodial-care facilities, and we will finance standalone, higher-acutiy facilities, but our preference is for facilities which combine traditional nursing homes with subacute care operations or assisted living. We expect to increase our investments in assisted living centers going forward. We, like most of our fellow REITs, are looking at the full continuum of long-term care and its potential for growth.

David Benson is President of and Lisa McAlister Chief Financial Officer of Meditrust, the nation's largest healthcare REIT, stock symbol: MT on the New York Stock Exchange.