On October 3, 2013, HCP, Inc. (HCP) terminated CEO and Chairman of the Board James Flaherty and named Lauralee Martin as the new CEO. Previously an executive at Jones Lang LaSalle (JLL), Ms. Martin rose through the ranks at JLL from CFO and COO to the position of CEO of the America's division during her 13-year tenure. In addition Martin has served as an HCP board member for the past five years.
With the unanticipated removal of James Flaherty and sudden change in leadership, HCP stock sold off 6.5% over the next two days on above-average volume. Investors were left to ponder the company's strength and were quick to question the leadership capability of Ms. Martin, as well as management-transition risk associated with her appointment.
As an executive with over a decade of experience at a leading global real estate services and investment management firm, investors may have over-reacted to Ms. Martin's appointment. In this interview, I asked Martin about the prospects over at HCP, why she made the move and what her views are regarding trends in the healthcare real estate sector, impact from rising interest rates and HCP's strategy and business model.
What qualifies you to run a real estate investment trust (REIT)? Specifically, what experience do you bring to the healthcare sector of real estate investing?
LM: In my recent experience at Jones Lang LaSalle, we advised tenants and owners/operators of real estate on how to optimize their real estate for the best operating and financial success of their business. Our clients included companies in healthcare and life science, several of whom are also clients of HCP.
Having an operating company perspective, together with my real estate investment expertise and five years of Board experience at HCP, provides a well-rounded background to position the company to be a key capital provider to healthcare operators in today's changing landscape of healthcare and its delivery model.
How would you describe your board experience at HCP? Do you feel this gives you an advantage in running this company versus an outsider?
LM: As board members, our key responsibilities are strategy and talent succession. As a result, I was closely involved in and supported our value-creating '5x5' strategy and related investment decisions. Additionally, I knew the talent that executes our strategy and manages our investment portfolio for ongoing performance and profits. This knowledge and people familiarity has been invaluable for a quick immersion into the operations of the company.
Why does healthcare excite you today?
LM: Healthcare is the largest sector of the U.S. economy with expenditures representing over 17% of GDP. As our nation strengthens its fiscal discipline, we must become more efficient in managing healthcare costs without compromising quality of care.
The rapid changes and consolidations triggered by healthcare reform represent challenges, but at the same time will likely introduce significant growth opportunities for HCP while the industry shifts to a more efficient, integrated delivery model. I successfully navigated at Heller Financial the changes that came from the consolidation of the commercial finance industry and at Jones Lang LaSalle the consolidation and globalization of real estate service advisors.
Being at HCP, one of the largest real estate capital providers in the healthcare industry, I am excited about the opportunities to collaborate with our operating partners for their growth and success. HCP's strong balance and healthcare relationships allow us to be a strategic capital partner with our operators across five diverse segments: senior housing, post-acute, life science, medical office and acute-care hospital.
How would you qualify the current HCP business structure today versus your idea of the most efficient structure moving forward?
LM: HCP is unique to most of our competitors in that we use a largely outsourced services model making us highly efficient and nimble. This means that we maximize external market expertise and industry knowledge, can be flexible as to geography and property segments and focus our attention on asset management and market/industry underwriting for best results.
Regarding diversification, HCP is currently operating exclusively in the U.S. while other healthcare REITs are expanding to Canada and Europe. What are the costs and benefits of investing north of the border and abroad? Specifically, do you see HCP taking an international growth route during your tenure as CEO?
LM: We have also been active abroad and opportunistically invested over $400 million in the UK taking advantage of our debt investment platform within our 5x5 model. This approach has allowed us to learn a new market, its reimbursement policies, cultural delivery differences and key operators, while maintaining a margin of safety given our position in the capital structure of these investments. We believe there are attractive opportunities in international markets, but they need to be evaluated appropriately on a risk adjusted return basis.
One concern of late is that SNL Financial has measured healthcare REITs in the U.S. to be currently overvalued in relation to NAV (net asset value). In addition, SNL notes the entire U.S. REIT market as undervalued. How does HCP stand here versus REITs in general and the specific healthcare subsector?
LM: Healthcare REITs, in particular those with diversified investments across multiple sectors, have historically been valued at a premium to NAV. Investors and analysts have different views as to why such a premium exists, and more importantly, how much of the premium is warranted for liquidity, balance sheet, operator relationships, management, accretive acquisition opportunities, etc.
We believe our portfolio warrants a solid NAV premium due to its consistent performance quality. However, while we do watch this corporate finance metric, among others, we focus on our long-term strategy and execute value-creating investments for our shareholders.
It seems that the economy and stock market did well in 2013, while the REIT market showcased negative momentum since the talk of the taper began. What are your views on rising rates versus economic growth in relation to REIT earnings growth?
LM: Rising rates are negatively impacting the view of fixed income streams from long-dated contracts. While a large majority of our investments are structured as triple-net leases, leading to the perception that we are susceptible to higher rates, there are several aspects of our portfolio that position HCP to benefit from rising rates and economic growth.
Our portfolio behaves like a "growing annuity" with contractual rent increases each year well above current inflation, and roughly 25% to 30% of our rent growth has ties to CPI increases. In addition, a more robust economy drives growth for our Medical and Life Science Office platform, which represents nearly one-third of HCP.
In particular, we are seeing strong tenant demand this year in the Bay Area life science market as a result of expanding biotech companies. We deliver both consistent dividend growth as a dividend aristocrat and profit growth for shareholders.
What are the major headwinds, other than interest rate risk and economic growth, facing the healthcare REIT sector over the short-term?
LM: Government reimbursement changes from budget pressures are always on the horizon. Obviously not a new risk to the sector, but it does continue to present an element of uncertainty as to its impact.
Do you believe there is lower risk in medical office buildings [MOBs] moving forward and if so, does HCP plan to increase its MOB portfolio in relation to the total portfolio?
LM: It is very important to have knowledge of hospital systems and how MOBs strategically fit into their delivery system, which is reflected in HCP's MOB portfolio with 94% located on-campus or affiliated with successful hospital operators. HCP's strong relationships and knowledge of the strategies of hospital systems enable us to evaluate risk against reward, allowing us to safely and profitably grow this portfolio.
With low interest rates, the ability to raise debt via long-term bonds set at attractive rates seems very prevalent in the sector. What do you see as the optimal level of debt in the HCP business model versus the current level of debt? Also, in terms of liquidity versus risk, when should equity REITs borrow at above-average levels?
LM: Speaking of low interest rates, in November 2013 we were pleased to complete an $800 million, 10-year bond issuance at an attractive coupon of 4.25%. We underwrite all investments based on a 60% equity/40% debt capital structure, with debt having a long-term, 10-year life. We are committed to our investment grade ratings and do not see value added by short term approaches to the balance sheet.
HCP is currently trading lower in terms of price to funds from operations (FFO) versus peers. Why the low relative valuation? One would imagine that the largest domestic healthcare REIT would deserve a premium valuation.
LM: We focus much more heavily on Funds Available for Distribution, or FAD, than FFO, and by evaluating FAD; you would find we trade comparable or better than our peers. We feel a metric like FAD better represents cash flow growth and returns on investment, which keeps us focused on sustainable value creation and dividend growth over accounting and financial engineering. We are proud of our membership in the S&P 500 Dividend Aristocrats index; in fact, we are the only REIT in this index joined by other blue-chip companies such as Coca-Cola (KO), Johnson & Johnson (JNJ) and Proctor & Gamble (PG).
While FAD is not a consistently defined and reported metric in the healthcare REIT industry, it is a much better measure of recurring cash flow than FFO because FAD excludes the benefit of non-cash income and takes into account the burden of recurring capital expenditures needed to maintain the quality of our real estate portfolio.
Other REITs have investment management departments that raise equity for non-traded REITs, then earn management fees through the non-traded REIT cycle. Do you have experience with non-traded REITs at JLL and do you see this as a conflict of interest, or is this a potential area where HCP can increase revenues?
LM: I am very familiar with the non-traded REIT space as Jones Lang LaSalle had both non-traded REIT clients and also developed in LaSalle Investment Management (subsidiary Asset Management company of JLL) a significantly lower than the broader industry up-front fee non-traded REIT product. It is possible HCP may find portfolios to acquire as non-traded REITs seek liquidity exits, however we will be highly selective given our focus on high-quality operator relationships, asset quality and price points competitive to replacement costs (HCP acquired CNL Retirement Properties in 2006, a non-traded senior housing and medical office REIT, as it grew its 5X5 portfolio so has knowledge and experience).
What are your current priorities at HCP?
LM: We want to make sure that we continue to deliver on our history of value creation to shareholders. This means we will remain a critical capital partner to our operators as the unfolding changes in healthcare delivery provide opportunity to grow our portfolio profitably.
What is your executive compensation plan and how does that differ from Flaherty? As a shareholder, do you bring more value than your cost?
LM: HCP's compensation program for senior executives, including me, is strongly weighted to stock ownership and share performance of HCP, meaning consistent long-term growth is favored versus short-term only performance, which provides strong alignment with our investors.
What are the chief differences between HCP and competitor Ventas, Inc. (VTR)?
LM: We recognize and respect both Ventas and Healthcare REIT (HCN) as our peers. We have chosen to pursue several strategic and execution differences from them. As previously mentioned, 1) HCP has a model for efficiency and nimbleness, 2) we have a more diversified product mix with a 7.5 million sq. ft. Life Science portfolio and a track record in debt investments both for return and optionality to asset ownership and 3) we focus heavily on FAD per share as an important investment hurdle as demonstrated by our selective approach to RIDEA and its asset pricing.
Ventas is expected to have a higher level of 2013-2014 FFO growth versus HCP. At current debt levels is HCP able to employ resources efficiently to increase long-term FFO growth to higher levels?
LM: As previously mentioned, we focus on FAD growth. Our focus year-in and year-out is to asset manage our same-store portfolio and source new investments that are additive to our FAD per share growth trajectory. We continue to increase our transparency to help investors make the appropriate investment decisions for consistent long term performance.
Currently FFO is used as a standard metric for evaluating REIT investment, however adjusted funds from operations (AFFO) seems favored by several companies. As AFFO does not seem to be regulated, should investors be concerned using this metric or is AFFO comparable on a valuation basis?
LM: AFFO or FAD is not a standardized metric, which makes it more difficult for investors and analysts to perform relative valuation. However, as I just mentioned, we believe FAD is a much better measure of cash flow and thus ability to sustain dividends and dividend growth. Investors should demand consistent transparency.
As a previous CFO, which method of accounting is better for REITs? Would you argue for a standardized accounting system for the AFFO or FAD metric? What would the benefits of standardization be?
LM: I believe a standard and requirement for disclosure of AFFO or FAD will be very helpful to investors and analysts, particularly as healthcare REITs take on more RIDEA investments.
HCP is an environmental leader on several fronts. How are you qualified to oversee this aspect of the business model? Do you plan to continue with such a focus moving forward?
LM: I proudly recognize Jones Lang LaSalle as one of the earliest leaders in sustainability in the real estate industry. I led the JLL commitment decision as our C-Suite Sustainability sponsor to not just be sustainable in our own actions but educate and change the real estate industry. HCP similarly is a leader in sustainability, having established partnerships with and received recognitions from CDP, GRI reporting, GRESB, NAREIT Leader in the Light, LEED, Energy Star, Dow Jones, etc. I encourage you to visit our website and learn more about our strong commitment to sustainability.
Do you have any closing remarks or ideas you would like to share with the investment community?
LM: I believe the healthcare industry represents a large opportunity for a company with the balance sheet strength, operator knowledge and investment expertise of HCP. I am joining at a time when not having historic paradigms of the industry and viewing our opportunities more broadly than real estate deals and transactions should challenge us to maintain our leadership in transforming our role in the industry.
Thank you for your time and interest in sharing your insights with the public.