TWST: Please set the stage with a snapshot of your coverage universe.

Mr. Milam: At Sandler O'Neill, we cover 32 REIT stocks, along with the broader financial services coverage that we offer. I am the lead Analyst for the health care REIT stocks we cover, which are HCN (HCN), HCP (HCP), HR (HR), VTR (VTR), OHI (OHI), LTC (LTC) and SNH (SNH). That's not in any particular order.

TWST: What's your overall sentiment and outlook on the health care REITs right now and why?

Mr. Milam: I think, generally, the fundamental trends are very good for the health care REITs. They continue to have an advantage in terms of cost of capital over many of their private-sector peers. We have seen transaction pricing compress over the last 12 to 18 months, so it’s maybe been a little bit harder for them to win deals than when they were really dominant in 2011, but I still think the public capital markets are supportive of the acquisitions that these companies are doing.

Their balance sheets are in good shape, and they're able to take advantage of opportunities across a number of different health care sectors, from senior housing to medical office buildings and even life sciences, to some extent.

TWST: How are the valuations of the stocks trending?

Mr. Milam: The stocks have done pretty well this year. So far this year, the health care REITs are up almost 10%. Two of the leaders have been Healthcare Realty Trust and Sabra Health Care REIT (SBRA), which we don't cover. Over the last month, the stocks are up about 5%, and that compares to performance that hasn't been quite as strong across the rest of the REIT index, which is up about 1% over the last month, and the S&P 500, which is up 1% as well.

I think there are, as I said, good drivers behind the performance. For a number of the stocks, I think the valuations are pretty fair, but I do think there are opportunities in specific names where you maybe can get a little bit of extra value.

TWST: What are your top picks right now?

Mr. Milam: My top picks are LTC Properties, which we have liked for a while. It's a smaller company that's trading at a little bit of a discount to the group, which we think is partly related to size. But they're very disciplined in terms of how they execute their growth strategy.

They have a phenomenal balance sheet with very little leverage. They're essentially acquiring skilled nursing facilities, and also doing some standalone memory care development, which they can fund with low-cost debt, probably around 5%, and investment yields are around 9% or 10% for them. So that's a story we continue to like.

And then, we recently upgraded Senior Housing Properties Trust. They have a diverse portfolio of senior housing communities and medical office buildings. They have the least exposure to government reimbursement of any of the stocks we cover, and they trade at a substantial discount to the group. Just on a 2012 AFFO basis, SNH trades at 12.6 times, and the group average is over 16 times. So we think that the discount there is a little bit overdone, and we think that that valuation gap ought to close over time.

TWST: What kind of acquisition and development activity are you seeing in the space overall, and what are the growth prospects for the REITs you cover going forward?

Mr. Milam: Broadly speaking, the larger REITs have diverse portfolios, so they acquire across a variety of sectors. LTC and OHI are a little bit more focused in terms of what they do. They are essentially acquiring skilled nursing facilities where we're seeing some transaction activity driven by the REITs, which are essentially a capital source for the operators. If an operator wants to expand its business, one way to raise money to do that is to partner with a REIT, sell them title to the real estate, and then use that capital to fund their expansion.

For example, one of the recent acquisitions we saw was Genesis HealthCare, which is a large tenant of Health Care REIT. They announced their intention to acquire Sun Healthcare (SUNH), which is a publicly traded skilled nursing operator. One of the keys there is that they're trying to increase the economies of scale in what's likely to be a continued difficult reimbursement environment.

And on a smaller scale, a company like LTC or OHI is able to do that with a regional operator that also wants to expand its business but needs capital to grow. So for example, LTC is doing a deal now where they're building a new facility to replace an older facility that one of their operators has in Texas. They're going to move those licensed beds over into the new facility, and they’ve been able to also expand the number of beds there. So by funding the construction and owning the real estate, LTC helps the operator to expand its business.

There’s another area where LTC is involved that we're starting to see a little bit more of across the industry. Typically, Alzheimer's care or dementia care is provided in a locked wing of an assisted-living facility, or it can be provided in a skilled nursing facility. There have been some groups that think that there are specific methods of care that can be applied if you have a separate facility where all your focus is on dementia-care patients. They think you can actually provide them a better quality of life with more focused and targeted care.

LTC is starting to fund some development of those assets with operators that want to expand in this area. HCN probably has the premier operator in that space as a major tenant, Silverado Senior Living. They actually acquired the majority of that real estate last year.

And then, one interesting transaction that was done recently was HCP acquired the unsecured debt issued by a skilled nursing operator in the U.K. RBS (RBS) assumed ownership of the company in 2009, after funding a failed buyout in 2006. Now, Terra Firma is acquiring the company Four Seasons Health Care, and to fund that transaction they are issuing some secured debt and some unsecured debt. HCP is acquiring the majority of the unsecured debt that's being issued. So they will have an interest in a skilled nursing operator that is located in the United Kingdom, assuming the transaction closes as expected later this fall.

TWST: Generally speaking, is there interest to expand outside of the U.S.?

Mr. Milam: Yes. HCN did a deal with Chartwell (CWSRF) in Canada, so they've moved into Canada. Ventas has, from their acquisition of Sunrise Senior Living REIT in 2007, a small presence in Canada. And now, we see HCP going to the United Kingdom.

The one thing I would say is there are select opportunities, but just given the different reimbursement schemes and the way that the regulatory and political environment plays so heavily into the health care sector, I would say it's likely to be small, certainly over the near term. Maybe several years down the road, we could see it increase, but I think the health care REITs will be very careful about which markets they enter and how well they educate themselves about the different political and regulatory environments in those markets before they invest internationally in a big way.

TWST: In the meantime, it seems these REITs continue to have ready access to capital, and low-cost capital, to finance any growth.

Mr. Milam: Yes, that's correct. In the last couple of weeks, Ventas has been in the market with an equity offering. HCP also did one, coincidental with the investment in the U.K.

But the way the markets have been trading, the stock prices are still attractive for raising equity, the unsecured debt markets are still open, even for a company like LTC that is not an investment-grade issuer, that has access to unsecured debt through some relationships they have with insurance companies. So funding new investments is not a concern at this point. There is definitely ample liquidity for them to continue to grow.

TWST: Let’s talk about the upcoming Supreme Court decision and what impact, good or bad, you may expect to see for the companies you cover.

Mr. Milam: I think the overarching theme is that, I think there is still a tremendous amount of room for the health care REITs to be part of consolidating real estate ownership in the health care industry. Regardless of what the Supreme Court rules, service providers are going to continue to focus on ways to provide better care more efficiently and at a lower cost, and really look for the best setting in which to do that. So I think, as a strong capital source, the health care REITs ought to do well.

Either way, whatever the Supreme Court decides, I think that the health care REITs will continue to be able to expand. Over the near term, hospital systems, as they continue to focus on being more efficient and providing better and more integrated care, there are things they are doing, including acquiring physician practices and upgrading technology systems for things like electronic medical records, all of which is going to require additional capital, which can be raised by monetizing real estate.

For example, if a hospital system owns a medical office building, they can sell the MOB to a health care REIT, and invest that capital back into their business. Hopefully, the hospital systems are better at providing health care than they are at managing real estate, especially compared to what a professional manager like a REIT can do.

Obviously, again, regardless of what the Supreme Court decides, there are still issues in terms of the political and regulatory environment that are going to persist. The sustainable growth rate doesn't have a permanent fix, and there is a lot of stuff going on in terms of sequestration and the fiscal and tax cliff that's coming after the end of the year. Regulatory issues aren't going away regardless of what the Supreme Court decides. Despite that, one potential benefit is that acquisition and leasing velocity could pick up after the court’s decision, just because one piece of major uncertainty will be removed.

In terms of potential negatives, one of the ways that the Affordable Care Act will change the health care system is by giving access to insurance for about 30 million more consumers. Half of those are going to be covered under an expansion of Medicaid. Obviously, Medicaid is already under pressure.

And then in 2016, the federal government support for the Medicaid expansion starts to decline. So over time, potentially what that means is that — although it should be good in theory, because you have more demand from people with additional coverage — what's likely to happen is you're going to have more pressure under Medicaid reimbursement rates, and that potentially exacerbates an existing headwind in terms of what health care providers already have to deal with.

There are some REITs that have some meaningful exposure to Medicaid in the skilled nursing facilities that they own, but for the most part health care REITs have tended to invest away from higher Medicaid exposure over the past few years.

The last caveat to that is part of those reimbursement pressures, as we talked about with Genesis and Sun, is driving some acquisition activity as these companies seek more economies of scale, and that's giving the health care REITs opportunity to expand their portfolios.

TWST: Are there any other big trends you're paying attention to, whether it's from the health care industry or more from a real estate investment point of view?

Mr. Milam: I touched on it earlier, but there is certainly a regulatory and political overhang that I think we're going to experience through the second half of the year, as we have a number of issues that come to a head in January from a political perspective.

There's the tax cliff that we talked about and sequestration. And it's a little disconcerting as more time goes by. If Congress can't come together and figure out a solution before the election, I'm not sure what the impetus is in a lame-duck session for people to all of a sudden work harder and sacrifice their holidays when potentially they're out of a job within a month and a half anyway. Obviously the presidential election puts a little bit more uncertainty into what the political environment is going to be next year as well.

And then, Europe is a challenging situation as the fiscal and banking situations there continue to weaken. Potentially, that creates some problems in the capital markets here, and that can be a risk.

So I do think there is a pretty fair amount of uncertainty, despite the fact that when we look at what's happening at the property level for REITs in the U.S., the trends continue to remain strong, at least this far into the year.

TWST: What will you be paying most attention to in the next round of quarterly earnings announcements?

Mr. Milam: I think the big thing is really the property-level trends. The fundamentals have been good so far this year, and the question will be, "Will they continue?" As we saw the capital markets weaken in May, did that impact property-level fundamentals? At least indications so far have been that for medical office buildings and for senior housing properties, leasing trends continue to be strong as care providers are continue to take space. So everything sounds like it's been moving along.

But as we saw last year, the question is just, "With the capital markets falling off, do business activity and spending follow?" So far, indications are no, but the proof is in the pudding, and that's what we're going to keep our eye on.

TWST: Is there anything I didn't ask about that you wanted to be sure to include?

Mr. Milam: I always ask that question when I meet with companies, and I usually don't get much of an answer, but it's always a good question to ask. I think it's been pretty straightforward. It's just amazing to me that the property fundamentals have remained so strong, even though we've had all this volatility in the capital markets.

And I wonder if our seat in New York, and being so tied to the capital markets industry, if we're not a little farther away from the reality on the ground from our perspective up here. But again, that's what we're going to keep our eye on — is the apprehension we are experiencing going to trickle down into what's going on in the real estate, or are we just maybe paying attention to things that don't necessarily impact the day-to-day of what's going on at the property level.

TWST: Thank you. (MN)

Note: Opinions and recommendations are as of 06/25/12.

James Milam

Associate Director

Sandler O'Neill + Partners, L.P.

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