HCP: Waiting Until FFO Is Fo'Sure
Summary
- HCP has made progress reducing its Brookdale portfolio and has begun the process of selling its UK assets.
- Despite an increase in 2017 guidance, FFO is still expected to be flat to down next year.
- Even with a 5%+ yield, we believe there is more downside risk to the stock and prefer to wait for better visibility.
HCP (HCP) is the 3rd largest Healthcare REIT with $23B Enterprise value and $15B Market Cap. It maintains a diversified portfolio across 3 core segments: Medical Office (23%), Life Science (23%), and Senior Housing (44%). HCP effectively de-risked its portfolio by spinning off the SNF business in late 2015. This move eliminated direct SNF exposure and allowed the company to focus on its 3 core segments characterized by high-quality assets and a 95% private-pay clientele.
Source: Company Presentation
HCP owns 799 properties in the top markets per segment: NIC-99 for Senior Housing, Top-50 MSAs for Medical Office, and 2 of the Top 3 Life Science Markets.
HCP Strategy
The main idea is to pursue development or redevelopment in the core segments and to remove non-core assets, such as by exiting the residual UK portfolio and progressing activities on the previously announced Brookdale 25.
HCP outlines crucial actions for each of the 3 core segments.
For Senior Housing, reduction of reliance on Brookdale takes precedence. The aim is to reduce Brookdale concentration to <20% through sales or transitions and foster relationships with 10-12 other operators. The sale of interest in the Brookdale portfolio in Jan 2017 and the disposition of 64 Brookdale assets in Mar 2017 contribute to this end. Amid these transactions, HCP also looks to zero in on select development opportunities in top markets, as well as capitalize on redevelopment opportunities.
For Medical Office, the imperative is to remain disciplined as pricing expectations continue to rise, while growing relationships with top hospitals and health systems and pursuing on-campus opportunities and select off-campus assets (i.e. those with strong hospitals and health systems). Currently, the company has ties with 83% On-Campus and 95% Affiliated institutions, by which it has enjoyed an 80% retention rate for the last 5 years.
For Life Science, the mandate is to remain focused on core Life Science markets and assemble clusters of assets through acquisitions, development and redevelopment, while continuing to grow existing relationships by providing expansion opportunities to tenants, for example by adding properties to existing campuses. The Tenant base comprises mostly Biotech and Pharma companies, where HCP has established deep industry relationships.
2Q Performance
The strength of Life Science and stability of Medical Office combined with the Senior Housing triple net upside (from the Sunrise lease) softened the blow of SHOP's underperformance and allowed HCP to achieve year-over-year three- and six-month SPP Cash NOI growth of 2.1% and 3.1%, respectively. Life Science performed extremely well, enjoying 97% occupancy, and enabling HCP to efficiently backfill space and collect better rents than initially projected, delivering year-over-year cash NOI growth up 3.7% thanks to lease escalators and leasing activity.
Medical Office had a strong and steady showing with 87% tenant retention, better than expected leasing, and 92% occupancy, and ultimately, delivering same-store cash NOI growth of 2.6% (driven by contractual rent steps) – thanks to a high proportion of on-campus properties, a longstanding portfolio, and a management team with some of the best relationships in the sector. Senior Housing triple net produced more rent than expected due to positive performance at Sunrise, incidentally due to a rent distribution mechanism inherited from a prior acquisition (CNL).
Source: Company Presentation
Medical Office, Life Sciences, and Senior housing triple-net performance prompted the increased guidance for full year 2017 SPP NOI in these segments and enables HCP to meet its full year FFO target as adjusted.
SHOP Problems
SHOP underperformance was reflected in an 11% decrease in occupancy in the Brookdale portfolio, and consequently contributed to a 3% decline in the full year 2017 SPP NOI guidance for SHOP from 2% to 3%. It did not help that above-average operational expense in CCRCs nullified what was a strong 4% aggregate rate growth.
Source: Company Presentation
Underperformance has been attributed to external factors (i.e. new supply, higher compensation cost, and a bad flu season) and internal factors (i.e. all pertaining to Brookdale - delays in sales and marketing spend, high turnover in sales directors, and the ongoing process regarding a corporate strategic alternative) that largely affected 6 problematic assets.
Such attribution and the further qualification that “If we were to remove these half a dozen assets from our SPP portfolio, our SHOP guidance range would be about 150 basis points higher” paint the picture that underperformance is a specific, isolated, and addressable incident. As may be expected, HCP is in collaboration with Brookdale to turn performance around via Key Performance Improvement Initiatives, mostly addressing internal factors, oriented towards generating and executing on leads (1-4), as well as optimizing operational spend (5). The initiatives are around:
(1) Providing and mobilizing the needed sales resources to generate and execute on leads. The needed resources are in terms of expertise (i.e. “Floating” sales specialists, dedicated to HCP’s SHOP assets, to temporarily backfill community Sales Director roles until vacancies can be filled) and numbers (i.e. by adding additional sales resources to assets with low occupancies to broaden referral base, generate leads and increase occupancy).
(2) Rapid repricing by way of more frequent evaluation of market rates at underperforming communities to balance rate and occupancy to drive total revenue.
(3) Increased targeted marketing and advertising spend to drive leads and spur occupancy.
(4) Reducing key sales talent turnover by conducting ongoing wage analyses for critical community leadership positions, monitoring local-market trends and adjusting when necessary.
(5) Aligning community labor hours and staffing resources with changes in occupancy.
On the external challenge posed by new supply, HCP’s response is to prime its properties for competition by investing in CapEx as needed and ensuring its sales teams, especially sales directors, are available (i.e. “not poached”) and well-equipped.
All these initiatives are expected to positively impact performance, with consideration to “a lag time associated with the ability to actually get that performance.” Interestingly, even as it affirms its current collaboration with Brookdale and acknowledges the latter’s efforts to improve performance, HCP leadership holds that “regardless of what direction it goes, that we will be proactively working to improve our position over time.”
There is no uncertainty that HCP will exercise its prerogative – if insufficient or no improvement is seen – to handle the situation in accordance with its strategy, whether it be to reposition or dispose of a portion or the entirety of that problematic portfolio.
Developments And Redevelopments
HCP has committed $849 M worth of ground-up developments benefitting primarily Life Sciences.
A $720 M Life Science development is in South San Francisco, called The Coves, which has reportedly been well-received, with the 1st and 2nd Phases 100% leased, the 3rd Phase under construction with leasing activity in progress, and the 4th Phase already attracting interest. Additionally, pre-development activities have begun and are advancing for Sierra Point, a premier multi-building waterfront site spanning 600K square feet. Meanwhile, Medical Office developments are 70% leased and affiliated with/anchored by strong health systems (i.e. Memorial Hermann and HCA).
As for Redevelopment, HCP expects to increase the size of its current pipeline to target $100+ M of projects per year over the next several years, with target cash-on-cost returns of 9-12%. An example is the $40M project to reposition 3535 Market, a well-located, urban medical office building adjacent to the University of Pennsylvania.
On top of these, HCP keeps an active process and pipeline with several off-market and marketed deals in the $200 M to $1 B range. The company anticipates a mix of stabilized and development prospects worth $500 M-$750 M to come in in the 3rd and 4th quarters, with an eye more towards stabilized properties and looking at the Medical Office and Life Science segments, with Senior Housing to a lesser extent.
HCP’s Investment Committee takes into account impact on FFO as adjusted and FAD, with the aim to grow cash flows, but also recycle capital. Ultimately, the end-game is to have a high-quality portfolio centered in these three private pay segments without having to overpay.
Way Forward
Having isolated circumstances regarding a handful of Brookdale properties as the root cause of 2Q underperformance and set in motion remedial actions, HCP is positive that it is well-positioned to take advantage of favorable market conditions. For one, healthcare expenditure as part of GDP is expected to grow within the next 10 years.
Source: Company Presentation
Further, there is that forthcoming upsurge in senior demographics bringing with it a corresponding level of healthcare concerns and, therefore, spending. This “senior demographic tsunami” will inevitably require more of senior housing offerings, and will spur demand for adjacent healthcare services, which HCP will be ready to cater to through its other 2 core segments (Medical Office and Life Sciences)
Third Quarter Results
The company reported 3Q 2017 same-property NOI of 3.2% including 5.3% in the SHOP Portfolio, leading to FFO of $0.48 per share. It also raised adjusted FFO guidance and reaffirmed same property cash NOI growth while making progress towards reducing its Brookdale exposure to 15.7% through the sale of six assets for $275MM.
Source: Company Presentation
The companies also agreed to terminate the management agreements on 36 senior housing operating properties and leases on 32 triple-net leased communities. The intent is either to transition the assets to other operators or sell the 68 properties – which would generate an anticipated $600MM to $900MM of net proceeds. The company also entered the sales process for its UK holdings, mentioned above – getting closer to the targeted pro-forma business segment breakdown below.
Source: Company Presentation
The new guidance for 2017 AFFO is $1.92 to $1.96 per share, which was a $0.02 per share increase from prior guidance, while same property cash NOI is expected to increase between 2.5% to 3.5%. The table below shows the breakdown of NOI guidance by business segment. Life Sciences is exhibiting the strongest growth and is a testament to the company’s reentry into the Boston Life Science Market – with the acquisition of a $228MM value-add life science campus.
Our Take
We’re in a holding pattern with HCP. FFO is forecasted to decline for two straight years (2017, 2018) before recovering and our analysis indicates that the price of the stock has historically moved in line with FFO changes.
We see a heightened and more likely risk of a pullback than any price appreciation from these levels. Despite a relatively attractive 5.5% dividend yield (is it in danger of being reduced?), we will sit this one out until visibility improves.
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