A Commentary: Important Tangential Factors Facing The Healthcare REITs

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Summary

We published this content with permission from Mizuho Securities.

In this report, we provide a few standalone thoughts that apply specifically to the healthcare REITs.

Overall we remain cautious on the sector as these and other issues work through to some form of resolution.

Summary

In this report, we provide a few standalone thoughts that apply specifically to the healthcare REITs. We believe there are areas of granular detail that may not be widely known by the REIT investor community that includes: a) The de-emphasis on bundled payment programs; b) Declining hospital volumes; c) Potential tax reform “pay-fors” that could impact healthcare providers; and d) One important DOJ misstep that may have farther-reaching consequences. Overall we remain cautious on the sector as these and other issues work through to some form of resolution. Buy ratings on HCP and HTA.

KeyPoints

■ Winners/Losers: We discuss each of the issues with enough detail to build an understanding from the REIT perspective. In each case, we identify our read on who could be the beneficiaries, and who could face headwinds, when looking at each factor in isolation. For example, US tax reform “pay-fors” could create a disruption for not-for-profit hospitals, but may simultaneously open the door for REITs that invest in medical office buildings (MOBs). Separately, it is hard to find any “winners” from the potential $1.5 trillion reduction to Medicaid and Medicare, even over a ten-year period.

■ Bundled Payments: Value-based payment programs within conventional Medicare are aimed at saving costs by bundling an episode of care among the healthcare providers. This has been a concern for the skilled nursing (NYSE:SNF) industry, mainly because facility-based post-acute care was at risk of being circumvented in the process. Under the Trump administration, these bundled programs have been de-emphasized. And while SNFs may be a net-winner from this political reversal, the growth of Medicare Advantage (MA) may be a countering disruptive force over a longer period of time.

■ HCR ManorCare Avoids Lawsuit: The Department of Justice (DOJ) recently announced it has dropped a Medicare fraud lawsuit against one of the largest SNF operators in the country, privately-owned HCR ManorCare. It appears to us that the DOJ erred in its process which, in turn, created a stroke of luck for HCR ManorCare. We think this could take some of the stress out of the system for other SNF operators, as the HCR ManorCare situation was thought to become the poster child for future settlements and lawsuits. However, it was interesting to us the QCP stock (the REIT that owns HCR ManorCare-operated real estate) barely budged on the news.

Healthcare Considerations for 2018

As we begin to contemplate how to invest in the US REITs industry overall next year, we provide a few standalone thoughts in this report that apply specifically to the healthcare REITs. We believe there are a few areas of detail that may not be widely known by the REIT investor community, which could help provide a canvas from which to make alpha-generating investment decisions next year including: a) The de-emphasis on bundled payment programs; b) Declining hospital volumes; c) Potential tax reform “pay-fors” that could be disruptive to the healthcare industry (but also present some opportunities); and d) One important DOJ misstep that may have farther-reaching consequences. While this report is somewhat educational in nature, the overriding conclusion of this exercise is there are numerous areas of mixed signals to consider, with some netwinners and some net-losers when looking at these four issues in isolation. However, it remains early in the game with no definitive answers to work with yet, given the uncertainty of how the political chips will fall.

  • We Remain Cautious: As such, we continue to suggest caution for the healthcare REIT sector, which remains plagued by unresolved issues on several fronts – some internal to the group (such as pending asset sales, which we have discussed in previous reports) and some from external forces (such as those we highlight in this report). We currently have Buy ratings on two healthcare REITs: HCP (as it works through its Brookdale concentration issues, but now with more clarity as to a final outcome) and HTA (the more economical way to own medical office buildings, in our view – a property type that continues to benefit from pushing patients into lower cost settings).
  • Watching Rates: We would also note that a tax reform outcome could results in rising interest rates at all durations of the curve, if accomplished successfully – a flight to equities and away from bonds. In our view, healthcare REITs are among the more vulnerable to rising interest rates, simply given the 150bps premium average dividend yield versus the overall US REIT industry. During previous bouts with a rising 10-year Treasury yield, the healthcare REIT sector took a disproportionate amount of the hit (along with Net Lease and other yield-oriented sub-sectors).

What follows are expanded observations on the four topics introduced above, all of which we believe require full consideration from investors when contemplating the healthcare REIT sector going into 2018.

1. Bundled Programs De-Emphasized

(Our Read: SNFs a Net Winner)

Value-based payment programs within conventional Medicare are aimed at saving costs by bundling an episode of care among the healthcare providers treating the patient. This has been an area of concern over the past few years for the skilled nursing (SNF) industry, mainly because facility-based post-acute care (like SNFs) was at risk to being circumvented in the process – potentially in favor of a lower cost home health setting. Under the Trump administration, these bundled programs have been de-emphasized, and continue to be even after Tom Price resigned from his post as HHS director. In particular, the number of markets included in the mandatory pilot known as the Comprehensive Care for Joint Replacement (CJR) was reduced from 67 to 34, and the cardiac pilot was postponed from implementation (maybe indefinitely). A discussion of these changes can be found here. Here are a few additional points:

  • Assuming conventional Medicare accounts for roughly two-thirds of a SNFs Medicare census, it would stand to reason this pull-back from bundled programs is a good outcome for the SNF industry. Perversely, SNFs may get a save from a reversion back to inefficiency.
  • However, Medicare Advantage (MA), which is provided by the private sector, continues to push forward with programs that substantially mimic bundled programs. MA may represent less than a third of the current Medicare (i.e., post-acute care) census for SNFs, but is growing at a faster rate than conventional Medicare. In addition, conventional Medicare often requires relatively expensive “Medigap” coverage to fill in coverage voids, driving even more people toward the MA option.

So while we conclude SNFs may be a net beneficiary from reduced use of bundled programs, it is not a linear discussion. And as MA increases as a percentage of the total Medicare pie, the business of nursing homes could see growing headwinds over the longer term – more glacial, less immediate. That being said, we think a SNF’s star rating will increasingly matter, as the competitive landscape for new post-acute patients becomes more challenging over time.

2. Declining Hospital Volumes

(Our Read: Hospitals and SNFs are Net Losers; MOBs the Winner)

As a general rule of thumb, hospital patient volumes continue to decline as insurers demand lower cost (and often outpatient) settings, such as medical office buildings (MOBs). Meanwhile, preventive care initiatives are simultaneously reducing emergency room visits in favor of pre-emptive visits to the doctor (e.g., during normal business hours). Since about 25% of emergency room visits translate into hospital admissions, the ongoing drive for cost efficiencies from payers is further magnifying the vulnerability of the acute care hospital model.

  • The hospital industry overall takes the direct hit from this dynamic, in our view. MSUSA Healthcare Services Analyst Sheryl Skolnick characterized the hospital business as “dicey”. Not all hospitals will close or merge, of course, but careful selection related to market share and the local economy may go a long way in picking the ultimate winners and losers. Unrated MPW and (to a lesser degree) Neutral-rated VTR are the biggest REIT players in the hospital space. We believe one can draw a logical straight line from declining hospital volumes to declining SNF volumes, adding another question mark to the nursing home sector.
  • We are currently in a relatively dull demographic spot with regard to the US elderly population. This is because birth rates declined dramatically during the Great Depression (circa 1935). People entering the age of 80+, and hence greater utilization of nursing homes and medical facilities in general, should begin picking back up in late 2019.
  • The elderly population of today is simply healthier than past generations. Greater emphasis on physical activity and nutrition is a great thing, but could contribute to fundamental headwinds for hospitals and SNFs nonetheless.
  • While we would conclude that MOBs are the net winner when looking at declining hospital volumes in isolation, they are far from riskless. MOBs are themselves tethered to acute care hospitals, and stand at risk in the event a hospital is closed or consolidated away.

3. Opportunities and Risk of Potential Tax Reform Pay-Fors

(Our Read: Hospitals and SNFs are Net Losers; MOBs the Winner)

The US tax reform debate currently making its way through Congress presents a risk of an increased federal deficit, by as much as $1.7 trillion over 10 years. While it is currently too early to draw complete conclusions given that the bill remains under debate, there are various potential “pay-fors” aimed at reducing the impact on the deficit. Among them could be the elimination of tax-exempt Private Activity Bonds that not-for-profit hospital companies use to expand their business, improve technology and (importantly) build out their real estate infrastructure of outpatient facilities. In addition, there is talk of a $1 trillion cut to Medicaid and a $500 billion cut to Medicare (both over the same 10 year timeframe) as another means to finance lower tax revenues.

  • On Private Activity Bonds . . . We think this could actually create incremental business activity for REITs that traffic in the MOB sector, and another one of those “perverse positives” for the group. Welltower (HCN) has recently been speaking about substantially expanding its outpatient medical business, in part by introducing its vast network of senior housing residents as a feeder network into care centers. It is possible the potential loss of the Private Activity Bond option is behind this line of thinking.
  • On Medicaid and Medicare Cuts . . . In some respects, Medicaid represents a pillar of stability for the SNF industry – more or less a breakeven element of an average nursing home, but helps to keep heads in beds. Meanwhile, Medicare represents the main profit center of a SNF. A combined cut of $1.5 trillion from these two programs could be a meaningful stress to the system, on top of everything else we discuss in this report. Furthermore, we note that these cuts could be subject to the Senate’s Reconciliation process, meaning it would require only 51 votes for passage.

4. HCR ManorCare Escapes Lawsuit

(Our Read: SNFs a Net Winner)

Finally, the Department of Justice (DOJ) recently announced it has dropped a Medicare fraud lawsuit against one of the largest SNF operators in the country, privately-owned HCR ManorCare. While the details behind this process are beyond the scope of this report, it appears to us that the DOJ erred in its process which, in turn, created a stroke of luck for HCR ManorCare. We think this could take some of the stress out of the system for other SNF operators, as the HCR ManorCare situation was thought to become the post-child for all future settlements and lawsuits. However, we found it interesting that around the time the news was breaking (early November), there was no noticeable reaction from Quality Care Properties (QCP), which is the REIT spun off from HCP that calls HCR ManorCare its primary tenant. QCP and HCR ManorCare are currently wrangled in their own negotiations given the non-payment status of rental income. Said differently, the stock market seemed to illustrate that there are bigger fish to fry when it comes to the difficulties facing both entities, and the industry overall.

We published this content with permission from Mizuho Securities.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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