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Morningstar | Mixed Third Quarter for HCP as Life Science Surprises While Senior Housing Disappoints

HCP had a mixed third quarter in our view, and as a result we do not anticipate changing either our $27 fair value estimate or no-moat rating. Same-store net operating income for the total portfolio was up 1.7%, beating our estimate of 0.9% growth. The beat was driven by 2.6% same-store NOI growth in the life science portfolio, above our estimate of down 0.6% as HCP increased occupancy for the total portfolio sequentially by 150 basis points to 96.3%. The senior housing triple-net portfolio was up 1.6% and the medical office portfolio was up 2.3%, both in line with our estimates. However, the senior housing operating portfolio was down 6.3% year over year in the third quarter, below our estimate of down 1.1%. HCP broke down this performance into its core portfolio of 32 properties being up 4.1% while the portfolio of 16 properties that it is either transitioning to new operators or have marked for sale was down 24.8%. Additionally, there are 47 properties that are not in the same-store pool as these have been recently transitioned, and the performance on these properties is worse than the same-store portfolio. The company's total margin for the senior housing portfolio has dropped 330 basis points sequentially and 740 basis points year over year to 23.4%. As a result of expenses in the non-same-store portfolio being higher than expected, HCP reported normalized funds from operations of $0.44, missing our estimate by a penny. We think that HCP can improve upon the performance of these underperforming assets and it should meet our long-term outlook for the sector, but in the short-term the positive gains made by the life science portfolio are more than offset by the weakness of the senior housing portfolio.

HCP announced a $1.0 billion life science disposition of the 800,000-square-foot Shoreline Technology Center campus located in Mountain View, California, at a 3.5% cap rate, significantly below the 5.5% cap rate we assign to its overall portfolio. We think it has unlocked tremendous value from this disposition. While the short-term plan is to retire debt at a 3.5% average interest rate and that won't create any FFO accretion, that should lower the company's Net Debt to EBITDA ratio from 6.5 times at the end of the third quarter to the low-5s, improving the company's balance sheet and risk. The company has stated that it may then look to free up $400 million to pursue additional acquisition, development, and redevelopment opportunities that would be accretive to shareholder value and would raise the company's net debt to EBITDA ratio to the high-5s, which is more in line with the company's long-term goals. We appreciate that management has demonstrated a willingness to sell even high-quality assets if the price is right and if it can create shareholder value.

While we recognize that the senior housing market is going through a period of weakness and that stronger growth is likely only a few quarters away, we don't like the continued decline in the company's EBITDAR cashflow coverage ratio for its senior housing triple-net portfolio. The ratio for the total portfolio declined to 1.03 times from 1.06 times last quarter. While HCP is managing this partially by transitioning some of the underperforming Brookdale assets to the operating portfolio, the pro forma portfolio still declined to 1.07 times from 1.10 times last quarter. Additionally, the percent of the company's total cash NOI that is performing at less than 1.0 times coverage increased to 5.5% from 4.5% last quarter. While none of the leases mature in the next two years and HCP has a guaranty on 62% of the rents that are underperforming, we will monitor how the coverage ratio moves over the next few quarters and may need to assume rent reductions if operating results don't push these leases back over 1.0 times coverage by the time they do come due.

Finally, we are encouraged that HCP received a ratings upgrade from S&P Global Ratings to BBB+ with a stable rating from BBB with a stable rating. S&P cited that it improved the credit rating after HCP successfully executed on a disposition plan that improved average portfolio quality, reduced tenant concentration, and reduced the company's leverage. As a result of the upgrade, HCP's credit facility spread drops to 87.5 basis points from 100 basis points and the facility fee drops to 15 basis points from 20 basis points.