By Allison Landa

Over the past year, the health care REIT sector entered a new trend of merger and acquisitions. Two healthcare mergers in 2006, valued at $6.2 billion, jumpstarted a new merger movement: Health Care Property Investors, Inc. (NYSE: HCP) acquired CNL Retirement Properties, Inc. for $5.3 billion and Health Care REIT (NYSE: HCN) acquired Windrose Medical Properties (NYSE: WRS) for $877 million.

Health Care
# of REITs	12
Industry Market Cap. (in thousands)	$22,201,004
% of Industry	5.6%
Yield	5.22%
YTD Total Return	39.29%
Three-Year Return	55.57%
Five-Year Return	56.93%
Average Daily Trading Volume (Shares)	482,878
Data as of Dec. 14, 2006.

Analysts view this M&A activity in 2006 as just the beginning of a new era of mergers for the health care REIT sector. Analysts say it is likely that health care companies will continue to combine in order to grow. Analysts also say that several factors are fueling this new trend: a desire for affordable expansion, an attempt to diversify holdings and the lure of aging baby boomers that present an unprecedented demand for health care services.

Means of Expansion

Many health care REITs are seizing M&A opportunities as a chance to grow without dipping into development, according to analyst Heather Smith of Morningstar, Inc.

"What's driving this is that public health care REITs only own 2 percent of the U.S. health care real estate market, which is estimated to be $750 billion," Smith says. "Thus, it makes sense that these public REITs would want to pursue acquisitions as opposed to development, which is quite pricey for a health care REIT, considering the specialized nature of some of these properties."

This preference was demonstrated by the Oct. 5, 2006 purchase of CNL Retirement by Health Care Property. The largest health care REIT in terms of market capitalization and revenue, Health Care Property's portfolio consists of independent- and assisted-living communities, health care facilities and medical office buildings.

Medical Office M&A

These days, analyst Rich Anderson of BMO Capital Markets is seeing a good bit of activity around medical office space. "For a while, we were expecting to see some consolidation in the medical office arena," he says. "It finally came to fruition with Windrose selling itself to Health Care REIT."

Announced Sept. 13, 2006, this transaction will create a health care REIT with more than 550 properties in 37 states. Those assets are worth approximately $4 billion, with an enterprise value of approximately $5 billion.

The deal also heralds Health Care REIT's expansion into the medical office field; this type of space comprises 88 percent of Windrose's square footage and 81 percent of its net operating income. Health Care REIT's portfolio already includes 35 independent living/continuing care retirement communities, 203 assisted-living facilities, 213 skilled nursing facilities and 13 specialty care facilities.

Smith says the diversification offered by such a deal is another heavy factor behind the sector's consolidation activity. "Some portfolios have been weighted heavily toward properties that were reimbursed by Medicare and Medicaid," she says. "By buying private-pay properties, which include assisted-living facilities and medical office buildings, health care REITs can lower their exposure to Medicare and Medicaid, which improves their credit outlook and increases their ability to raise rents."

One example of this type of deal is Cogdell Spencer's (NYSE: CSA) September 2006 acquisition of Consera Healthcare Real Estate LLC, a medical office building management company.

Smith provides coverage of Cogdell Spencer for Morningstar. "We think this is a good fit for Cogdell Spencer, considering Consera manages 38 properties in the Southeast, where Cogdell's regional focus is," she says. "We also like how the company has tried to move out of the Southeast to diversify its portfolio, buying medical office buildings in Indiana and California."

Activity in Assisted-Living

Deutsche Bank analyst Lou Taylor sees much of the health care M&A activity as part of the sector's typical growth cycle. "It's pretty standard," he says. "Companies don't have much internal growth, and they've been generating it through external activity. They've got long-term leases that are generally fixed, and rent growth has really been modest, at best, over the last 10 to 15 years, so there's really no growth from their existing portfolios."

During the 1990s, Taylor notes, many health care REITs entered the assisted-living arena, which lead to significant overbuilding. "A number of properties did very poorly and went back to lenders," he says. "Now they're returning to that activity since this particular niche has matured. It's more in equilibrium. I see it continuing, and this next component will include increased development. Assisted-living is going to have a disproportionate amount of focus across the board."

Anderson says the Health Care REIT-Windrose merger is a sign of more consolidation to come in assisted-living, which is enjoying a boost from aging baby boomers and their families. "For many people, the assisted-living alternative certainly is more preferred than a nursing home," he says.

Anderson also sees the general health care REIT sector poised to benefit from baby boomer demand. "The population is aging. Boomers are getting ready to retire," he says. "If they are in one of these facilities, one day they can watch a medical report on Oprah and decide to run in and see their doctor. This aging generation will affect the health care real estate spectrum."

Challenges and Constraints

Though health care REITs often favor private-pay properties to shield them from the financial uncertainty of Medicare and Medicaid reimbursement, they aren't necessarily a "silver bullet."

"Some health care REITs have talked about slowing their rate of acquisitions in the low-cap-rate environment," Smith says. "Some of these private-pay property purchases have had cap rates below 7 percent, which is rather low for the health care REIT industry."

Some health care sub-sectors are more influenced than others by Medicare and Medicaid, according to Anderson. "You're always sitting on the edge of your seat waiting to see how Medicare and Medicaid reimbursement rates might impact nursing-home property types," he says.

However, like Taylor, Anderson sees continued growth in the assisted-living sector, due partly to the baby boomer influx and partly to the relative ease in building such facilities. "If I had to make the choice, I'd rather put a parent into assisted-living, instead of an institutional-looking nursing home," he says. "There are constraints on new supply in the nursing-home segment. There is a process that you have to go through to prove a need for a nursing home that's not required for assisted-living."

Anderson says that the merger trend in the health care sector will continue. "Many of the health care REITs have expressed interest in consolidation. Those acquiring properties now have expressed interest to get more."