Real estate companies have demonstrated a sound ability to confront the often-overwhelming challenges facing the health care industry over the past few years. As a result, the health care REIT sector is expected to continue improving and achieve credit stability over the near term. However, the pace of improvement may not be as rapid as once expected. The stable, slowly improving credit outlook also recognizes the positive trends in the health care industry on health care REITs’ financial performance.
The caution revolves around a number of potential risks that could impact health care operators and providers over the longer term. For example, following September 11 there is a potential risk that Medicare and Medicaid payments could be reduced by virtue of a shift in federal spending, and that a recession could cause a reduction in states’ revenues. These risks could contribute to a deterioration in the credit profiles of health care providers, and in turn heighten the credit risks of real estate companies in this sector.
Moody’s Investors Service witnessed the impact of Medicare reimbursement cuts and deteriorating operator/ provider credit quality on some health care REITs’ credit profiles. Those real estate companies with material exposures to skilled nursing facilities were most vulnerable. Now, other segments of health care, such as assisted living, are being challenged. Although supply has leveled off, the occupancy of assisted living beds remains sluggish overall, and is likely to remain so through late 2002. Competition could prevent some tenants from maintaining or improving occupancy at some of their facilities, which heightens the risk of default under leases.
Preventive Medicine
On a positive note, a number of real estate companies have implemented sound strategies to confront difficult health care industry challenges. Companies have implemented aggressive monitoring and workout procedures with tenants, as well as asset dispositions to reduce debt and scaled-back acquisition plans. To improve operations, some companies have hired an independent contractor (as required by REIT tax laws) to reclaim/acquire facilities from bankrupt tenants that were unable to pay contractual rent.
Although the degree of impact from these challenges varies by firm, most companies now recognize that they are not immune to challenges confronting the health care industry. Moody’s believes that health care REITs will be more selective and cautious about tenant credit quality and balance sheet management in the future, thereby reducing an element of historic ratings volatility. Another preventative treatment is diversity by property type. Several real estate companies have used mergers and acquisitions as a way to diversify risk and to reduce earnings volatility.
Financial Outlook
Results from firms’ efforts have been positive. Financial performance stabilized in 2000, and we continue to see improvement in a number of health care REITs’ credit profiles. Equity performance is rebounding and investor appetite for unsecured debt is increasing.
Improving tenant credit quality, a key credit consideration, also supports stability in health care real estate companies’ credit profile. Health care operators are benefiting from better government and private-pay reimbursement levels for health care operators/providers; a declining adverse financial impact from cuts imposed by the Balanced Budget Act of 1997. Many owners and operators have re-evaluated their business model to streamline operations and shed financially unsuccessful businesses. Another positive for operators is that patient demand for health care service is also rising. This increase in demand should bode well for health care REITs over the long term as operators’ demand for facility financing increases.
Long-Term Diagnosis
Despite these positive trends, the health care industry continues to face challenges. Among the leading concerns are a national nursing labor shortage, which is creating wage pressures and litigation risk. Because compensation expenses represent such a large component of a health care facility’s operating costs, continued wage pressures could inhibit some tenants’ ability to pay rent and weaken profitability for some health care facilities. Furthermore, the events of September 11 and the weakening economy could negatively affect operators/providers in the longer term. In particular, labor and non-labor costs could exacerbate due to limits on availability of staff and certain supplies from delays or restrictions on the ability to enter the U.S.
Nonetheless, the stability of the health care industry is supported by its essential nature, which attenuates cyclicality. This bodes well for health care real estate over the long term as the demand for health care and the level of service delivery continue to increase.
When the challenges around Medicare cuts and declining tenant quality unfolded a few years ago, Moody’s predicted that those REITs with proven track records, diversified portfolios by facility type, location and tenant, strong balance sheets and low refinancing requirements were best positioned to manage through difficult times. We also predicted that the challenges facing the industry would result in a weeding out of the marginal players as some firms have experienced and continue to experience deteriorating credit quality.
The best defense will continue to be a good offense for health care REITs trying to meet the challenges facing the health care industry. As always, the focus will be on real estate companies’ performance at the facility level, managements’ track records, and REITs’ ability to adapt to an evolving healthcare situation. Scale, liquidity, diversification and tenant quality will become increasingly important credit considerations. Given the rigorous and complex operational infrastructure for health care, real estate management teams must exhibit a resolute focus on having the right corporate infrastructure, knowledge and skill sets required to manage their real estate portfolios to protect their competitive positions.
Lesia Bates is vice president/senior credit officer in Moody’s Investors Service’s Real Estate Finance Team.
