Healthcare Trust Of America Is An Advantaged Way To Buy Healthcare Realty

Summary

  • M&A often creates interesting buying opportunities.
  • In this case, it is a merger of 2 independently strong companies and at current pricing there is a significant arbitrage.
  • The going forward entity looks fundamentally strong and has significant upside.
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On February 28th, Healthcare Realty (NYSE:HR) entered into an agreement to buy Healthcare Trust of America (HTA) for a consideration per share equal to one share of HR and a $4.82 special dividend. The combined entity would be the dominant medical office pure-play REIT by market share.

Given where these companies are priced today, it opens a clear arbitrage opportunity.

HTA and HR price comparison table

Portfolio Income Solutions Arbitrage Tracker

HTA is trading at $29.36, but the converted value of what it will receive in the merger is $31.05 indicating an arbitrage upside of 5.76% to those who own the HTA leg.

One could lock in this arbitrage by being long HTA and short the proportional amount of HR; however, I am personally leaning toward just playing the long side of the arbitrage because I think the linked pair will rise over time.

The long thesis

In owning HTA today and assuming the merger completes, one is to get the 5.76% arbitrage spread plus or minus the change in value of HR. Thus, it behooves any arbitrageurs to understand the going forward value of the combined entity.

I posit that HR is significantly undervalued while having strong fundamentals and therefore it is more likely to go up than down. This conclusion was drawn from our pre-existing valuation of HR from January of this year updated for value change as a result of the 4th quarter report and of course the merger itself.

HR fundamentals and valuation

HR pre-merger has a consensus NAV of $34.38, so at $26.23 today, it is trading at 76% of NAV.

HR pre-merger has a consensus NAV of $34.38

SNL Financial

In contrast, the average REIT is trading at 97.3% of NAV and the average healthcare REIT is trading at 110.7% of NAV.

That is a massive discount and particularly surprising given how strong HR’s fundamentals are. The company has a long history of stable growth. Its same store net operating income has consistently ticked up.

HR store net operating income bar chart

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And analysts are calling for continued growth into the future in both FFO/share and AFFO/share.

FFO/share and AFFO/share estimates

SNL Financial

The 4th quarter seems to be a continuation of the strong leasing trend with weighted average cash leasing spreads of +3.4%. Combined with roughly 3% average annual escalators on in-place leases, I believe HR is well-positioned to continue growing.

As such, pre-merger I think HR is worth at least its NAV of $34.38.

Value change from merger

There is quite a bit going on in this merger with certain aspects that I really like and others that are clear negatives. Overall, I think it is roughly value neutral and I will explain how I arrived at that conclusion.

I will be looking at it from both quality and cashflow angles with the puts and takes in each.

Aspects that reduce cashflow/share

The merger price represents a 4.8% cap rate which strikes me as an entirely fair price for both sides. High quality medical office assets have been transacting right around there with individual assets closer to 5% and portfolios of assets in the mid to high 4s. Given the size of HTA, it certainly qualifies for the portfolio premium.

As such, I don’t think HR overpaid, but they are buying it with undervalued stock. My biggest gripe with the merger is that the discount to NAV at which HR trades makes it a very expensive currency with which to buy a company.

So in essence, HR is using its mid 5s implied cap rate stock to buy HTA at a 4.8% cap rate. That makes the merger dilutive at a base level before synergies are considered. That said, there are some nice synergies.

Aspects that increase cashflow/share

HTA, having just been involved in the still undisclosed scandal that led to their CEO’s departure, was a ship without a rudder. Their interim CEO, Peter Foss, was thrust into the position and graciously agreed to step up, but doesn’t seem to really want to be CEO at 77 years old.

This setup allows the merger to have very clean G&A synergies. HR has a fully decked out management team at both the executive and property level while HTA is a bit disorganized in that department. As such it is quite straightforward to eliminate a large portion of the G&A that was associated with HTA and HR will take over.

HTA’s G&A was cycling at just over $10 million per quarter and it looks like HR will be able to eliminate almost all of that with anticipated G&A savings of $33-36 million as per the merger presentation.

Presentation

HR

This will be the primary aspect of the merger increasing FFO/share.

HR suggests that it will be about 2% accretive to FAD/share when this savings is combined with the dilution from the share issuance. I would be very happy if that ends up being the case, but I suspect it will come in closer to flat. These things tend to shake out a bit weaker than calculated for 2 reasons:

  1. Closing has costs that are not always obvious up front
  2. The share dilution happens immediately upon the merger finalizing whereas the G&A savings will take up to 12 months to be realized.

Thus, from a strictly earnings/cashflow perspective I would value HR about the same post-merger as pre-merger. Let’s take a look at quality.

Quality benefits and negatives

HR was growing slightly faster than HTA in terms of leasing spreads and escalators. HTA’s leasing spreads in 2021 were 2.0% compared to 3.4% for HR.

I think HTA’s portfolio is also of slightly lower quality as it has more off campus or unaffiliated properties that would tend to higher cap rates.

Note that HTA’s portfolio is high quality, just slightly lower than the quality of HR’s portfolio.

The same is true with regard to leverage. Both HR and HTA are conservatively leveraged companies with investment grade ratings, but HTA has slightly higher leverage so the merger will increase HR’s leverage.

These negatives to quality can be weighed against the various benefits of scale.

  • Market share within key submarkets
  • Rental rates and leasing negotiations
  • Property operating costs

There is a substantial amount of geographic overlap between the HR and HTA portfolios.

map showing substantial amount of geographic overlap between the HR and HTA portfolios

HR

Across the majority of metros the combined company will have significantly enhanced market share. One such example is Atlanta.

An aerial view of a portion Atlanta showing HTA and HR properties

HR

This is likely a cherry picked example by the company because of how visually obvious it is that they will now have overwhelming market share in the area, but it is true across a wide range of markets.

Strategically speaking, this will give the combined company enhanced negotiating power such that they can get better lease rates.

Occupancy should rise naturally as we exit the pandemic era where healthcare providers were hesitant to lock in leases.

Finally, the scale provides some cost saving synergies with regard to property operations. HR’s team in a given submarket will be able to handle the operations of the combined portfolio such that some of HTA’s property opex can be eliminated alongside the G&A.

So while HTA’s slightly lower organic growth rate would initially slow growth, the strategic advantages of scale serve to enhance growth. It is difficult to determine the magnitude of impact scale will have on organic growth, but given that HTA’s growth is only lower by about 1 percentage point, I feel comfortable that these factors will offset or better.

From a capital markets and balance sheet perspective, the higher leverage would tend to cause HTA to trade at a lower multiple. However, larger companies tend to trade at higher multiples so again there is an offset.

I do want to take a bit to acknowledge how much bigger HR is going to be. HTA was actually the larger of the 2 companies.

HR has a market cap of about $4B, but after the merger it will have an enterprise value of approximately $18B. on a market cap basis, it is growing by about 150% which will have significant implications for its investor base.

The larger size will automatically pull in significant ETF ownership, and it will also unlock investing for larger institutions.

So here is my merger scorecard:

Category

Impact to metric

Impact to HR value per share

FFO/share and FAD per share

Negative day 1, slight positive by the end of the year

Neutral

Property quality

Slight negative

Slight negative

Leverage

From 5.4X to ~6.2X debt to EBITDA

negative

Organic growth

Slight positive

Positive

Diversification

Positive

positive

Scale

Big increase in scale

Slight positive

Overall

Neutral in near term, slight positive in long term

Strategically the merger makes a lot of sense. If HR was fairly valued going into the merger it would have been strongly beneficial, but since they are using their undervalued stock to buy a company at a fair cap rate of 4.8%, the dilutive cost balances out much of the value gains. I still think it will be beneficial to HR shareholders in the long run, but there will be some near-term growing pains.

Fair value of combined entity

For the reasons discussed above, I think the fair value of the combined entity will be roughly the same as it was pre-merger. HR’s NAV is somewhere around $34 which is also backed up by cashflow valuation. $34 would place HR at 18.7x 2022 estimated FFO which is appropriate for the growth rate.

HTA or HR?

There is quite a significant arbitrage spread in favor of HTA. We are tracking the spread continuously on the Portfolio Income Solution’s Arbitrage Tracker. At the time of this writing the spread is about 5.7% in favor of HTA.

The merger is expected to close mid-year 2022 and there are termination fees that are quite lofty which will strongly encourage both parties to go through with it. If HR divorces HTA they would have to pay them $163 million and if HTA backs out they would have to pay $291 million.

I think HTA is quite opportunistic here.

At the time of this writing HTA is priced at $29.36. Assuming the merger goes through, each share of HTA gets $4.82 in cash and 1 share of HR.

So getting $34 in fundamental value plus $4.82 in cash nets each HTA share about $38.42 in total value or a return of 30% in the process of the combined entity trading up to its NAV. It is not often to see discounts of this magnitude on blue chip, large cap stocks.

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This article was written by

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Disclosure: I/we have a beneficial long position in the shares of HTA either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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