Healthpeak Strategically Pursues Being the Largest Medical Office REIT With Physician Realty Merger

Senior Equity Analyst

Kevin Brown

The top healthcare real estate stands to benefit disproportionately from the Affordable Care Act. With an increased focus on higher-quality care being performed in lower-cost settings, the best owners and operators in the industry, which can provide better outcomes while driving greater efficiencies, should see demand funneled to them from the best healthcare systems. Additionally, the baby boomer generation is starting to enter its senior years, and the 80-plus population, an age range that spends more than 4 times on healthcare per capita than the national average, should almost double in size over the next 10 years. Long term, the best healthcare companies are well positioned to take advantage of these industry tailwinds.

Given the significant challenges that the coronavirus presented to the senior housing industry, Healthpeak made the strategic decision in 2020 to dispose of most of the company's senior housing assets in multiple transactions for around $4 billion in total proceeds. As a result, Healthpeak’s life science and medical office portfolios are now prominently featured in the company's portfolio as the proceeds from the senior housing sales were reinvested into these two sectors. Healthpeak has high-quality assets in top markets that attract credit-grade tenants in both segments, so we believe it makes sense to strategically focus the company on the segments where it has an advantage. The company also completed a merger with Physicians Realty Trust in a $5 billion deal that closed in March 2024, adding 16 million square feet of high-quality medical office buildings that complements the company's own portfolio. Despite the possibility of further changes to the ACA, we think any changes will still result in a coordinated value- and outcome-based system that will provide Healthpeak’s current portfolio with strong tailwinds.

Business Strategy & Outlook

We don't believe Healthpeak has an economic moat. Senior housing has been one of Healthpeak’s largest segments, but we believe there are limited barriers to entry in this business, so it is too susceptible to supply growth that restricts excess economic returns. While Healthpeak is in sectors that use a triple-net lease structure that can have long contracts with annual rent increases, these contracts are often renegotiated if the underlying tenant operations are under pressure. Therefore, we don’t think the triple-net structure inherently confers a moat to those assets. Medical office and life science buildings have qualities that could support a moat for the highest-quality assets in both sectors, but the initial rents and rent increases from the high-quality properties compared with the initial capital investment produce returns that are well below Healthpeak’s weighted average cost of capital, leading us to conclude that they do not quantitatively support a moat. Healthpeak has historically shown an ability to drive higher internal operating income growth than peers in some sectors, but we see this as more of an attribute of the management team building relationships with top tenants than qualities inherent in the properties themselves.

Healthpeak’s triple-net leased portfolios (senior housing, hospital, post-acute/skilled nursing) have qualities that could lead to a narrow moat, but we think these qualities are undercut by recent events, leading us to think they have no moat. The portfolio’s triple-net leases are generally long term, with initial terms of 12-15 years or more, and often include extension options, place all responsibility for property operating expenses on the tenant, and include other tenant credit enhancements such as corporate guarantees or letters of credit. Furthermore, Healthpeak generally rents its properties under master leases, which group individual properties together under one lease. These master leases generally prevent tenants from dropping poorer-performing properties, as lease renewals are "all or none," and promote strong partnerships between Healthpeak and its various operators, making triple-net business relatively sticky. However, many of Healthpeak’s triple-net leases grow only at inflationary levels, as they are frequently tied to the Consumer Price Index (though they often have floors of 2% and ceilings of 3%). Additionally, if the underlying properties can’t maintain the rent bumps throughout the lease term, the leases will eventually need to be broken and new, lower terms will be forced onto the landlord. 

The situation with HCR ManorCare, an operator of skilled nursing and post-acute care facilities, is a great example of how high rent bumps can become unmaintainable despite all of the protections put in place for the triple-net lease structure. Healthpeak acquired HCR ManorCare and its portfolio of high-quality skilled nursing assets in 2011. The lease was set at a 7.75% initial yield at a 1.5 times EBITDAR coverage ratio (above the industry standard of 1.4) and split the assets into four pools. The pools had a lease term of 13-17 years with a 10- to 17-year extension option and had contractual rent increases of 3.5% in the first five years and 3% thereafter. However, shortly after the lease commenced, the federal government began to make cuts to Medicare and Medicaid reimbursement increases, reducing revenue growth and reducing profits to an even greater degree due to the thin margins for the industry. Cash flow coverage dropped quarter after quarter, with facility-level EBITDAR coverage dropping below 1.0 times in 2012 and sinking lower each quarter thereafter, which weighed heavily on the stock. Even after renegotiating a $68 million rent reduction in 2015, the facility-level EBITDAR coverage remained below 1.0. In 2016, Healthpeak chose to spin off the assets into a skilled-nursing-focused real estate investment trust, Quality Care Properties, as management recognized that another massive rent cut was required and separating the assets from the parent company would unlock the value of the rest of Healthpeak’s portfolio value. Despite all of the protections and guarantees in place in the original triple-net lease term, the initial rent was set too high, given the cuts the federal government was making, and the rent increases were unmaintainable, given the declining revenue in the underlying assets. Therefore, we conclude that, despite the positive attributes, a triple-net lease structure does not create a moat if the underlying assets don’t support the rent payments.

Moats for medical office portfolios could hypothetically come from their proximity and connections to top health systems. Given the Affordable Care Act’s mandate, which encourages coordinated, value-based care between healthcare providers and a shift of patients to the types of lower-cost, consolidated settings that medical office buildings can provide, we believe there will be increasing demand for these types of assets from customers and healthcare partners. Premier medical office buildings are usually on campus or campus-adjacent to a hospital; with a hospital system that’s considered one of the top two or three in the region and one of the top 100 in the US; and in a large metro area with strong population and income growth. Demand for these types of assets will remain strong as patients seek the best treatments from the top health systems, driving consistent patient volumes to their affiliated assets and thus increasing the rents that can be charged to doctors’ groups that want to service these patients. Additionally, the top health systems often seek to work with stable, long-term, well-capitalized partners, creating an opportunity for a landlord to build a long-term relationship with the health system that benefits both parties. Healthpeak has established itself as a desirable partner with some of the top hospitals, as 94% of its medical office building assets are affiliated with a health system. However, the average quality of Healthpeak’s assets is not high enough to generate an intrinsic moat, and the assets haven’t generated an internal growth rate high enough to exceed the company’s weighted average cost of capital. Thus, Healthpeak’s medical office portfolio doesn’t have an inherent moat, either from better locations or from extracting excess returns from the relationships it has built. 

A life science portfolio could establish a moat by having high-quality properties located next to major research campuses with diversified, investment-grade-rated tenants on long-term leases. Research and technology companies benefit from forming research and innovation clusters where top researchers can collaborate and, upon completion of one project, can immediately find new opportunities without having to relocate. The top research campuses in the US are in Boston, San Francisco, San Diego, New York, Seattle, Maryland, and North Carolina. Class A properties in these markets attract high-quality, investment-grade tenants that can work on a number of research projects that don’t require the success of any single project for the tenant to remain financially solvent. Top tenants include academic and university research institutions, technology, biotech, and pharmaceutical companies, and venture capital firms focused on research and technology. Tenants often require custom-built laboratories and research office space for their specialized field of research, so there are significant switching costs to the tenant during the lease term, increasing the chance of tenant retention upon the lease’s maturity. Therefore, owning high-quality assets in these top locations allows for above-average rent increases to be passed on to tenants that should be able to absorb the higher costs, creating the possibility of a moat. Healthpeak has a strong presence in the top three markets (San Francisco, San Diego, and Boston) with a portfolio of about 30% of the total available square feet in the south San Francisco submarket. The company has an active development pipeline to further expand its presence in all three markets. Healthpeak has made relationships with several investment-grade partners in biotech (Amgen), technology (Google), and university research (Duke University). It has produced solid same-store NOI growth of about 4% over the last decade, which is above the average growth seen in the medical office building portfolios owned by the REITs but is slightly below the roughly 5% same-store NOI growth seen by life-science-focused Alexandria Real Estate Equities. While the life science portfolio is the strongest component of Healthpeak’s portfolio, the NOI generated by the life science portfolio isn’t high enough to generate an adjusted return on invested capital higher than the company’s WACC, given the company’s investment in the sector.

We use an adjusted ROIC calculation to determine if a company historically has shown or is forecast to have the characteristics of an economic moat. After adjusting the ROIC calculation to use maintenance capital expenditures instead of accounting depreciation, we calculate that over the past few years, Healthpeak has averaged an adjusted ROIC approximately 70 basis points below our 7.3% WACC. While the adjusted ROIC rises over our forecast horizon as the assets stabilize from recent transactions and developments, it does not exceed our WACC estimate. This affirms our view that Healthpeak’s portfolio should be assigned a no-moat rating.

None

Economic Moat

Healthpeak Properties Inc

Physicians Realty Trust is a real estate investment trust, which engages in the acquisition, development, owning, and managing of healthcare properties. Its principal investments include medical office buildings, outpatient treatment facilities, acute and post-acute care hospitals, as well as other real estate integral to healthcare providers. The company was founded by John W. Sweet, Jr. on April 9, 2013 and is headquartered in Milwaukee, WI.

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Healthpeak Properties, Inc. is a Standard & Poor’s 500 company, which engages in acquiring, developing, owning, leasing, and managing healthcare real estate across the United States. It operates through the following segments: Lab, Outpatient Medical, Continuing Care Retirement Community (CCRC), and Other Non-Reportable. The Lab segment refers to lab properties, which contain laboratory and office space. The Outpatient Medical segment includes outpatient medical buildings and hospitals. The CCRC segment deals with retirement communities that include independent living, assisted living, memory care, and skilled nursing units. The Other Non-Reportable segment consists of an unconsolidated joint venture with a sovereign wealth fund that owns 19 senior housing assets and loans receivable. The company was founded in 1985 and is headquartered in Denver, CO.

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