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February 28and, Healthcare Realty (HR) has entered into an agreement to purchase Healthcare Trust of America (HTA) for per share consideration equal to one share of HR and a special dividend of $4.82. The combined entity would be the dominant pure-play REIT for medical practices in terms of market share.

Given where these companies are listed today, this opens up a clear arbitrage opportunity.

HTA and HR price comparison table

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

We could lock in this trade-off by being long HTA and short the proportional amount of HR; however, I personally lean towards playing the long side of arbitrage because I think the linked pair will rise over time.

The long thesis

Holding 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 is incumbent upon any trader to understand the future value of the combined entity.

I postulate that HR is significantly undervalued while having strong fundamentals and is therefore more likely to go up than down. This conclusion was drawn from our pre-existing human resources assessment from January of this year, updated to take into account the change in value following the 4and quarterly report and of course the merger itself.

HR fundamentals and valuation

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

Pre-merger HR has a consensus net asset value 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’s a massive discount and particularly surprising given the strength of HR fundamentals. The company has a long history of steady growth. Its comparable store NOI has steadily increased.

HR store net operating income bar chart

SNL Financial

And analysts expect continued growth going forward in both FFO/share and AFFO/share.

FFO/share and AFFO/share estimates

SNL Financial

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

As such, pre-merger, I believe HR is worth at least its net asset value of $34.38.

Change in value following the merger

There’s a lot going on in this merge with some aspects that I really like and some that are clearly negative. Overall I think it’s about neutral and I’ll explain how I came to that conclusion.

I’m going to look at it from both a quality and a cash flow perspective with the put and sell options in each.

Aspects that reduce cash flow/sharing

The price of the merger represents a cap rate of 4.8%, which seems to me to be a very fair price for both parties. High-quality medical practice assets traded right next door, with individual assets closer to 5% and asset portfolios in the 4-4 range. Given the size of HTA, it certainly qualifies for the portfolio bonus.

As such, I don’t think HR is overpaying, but buying it with undervalued stocks. My biggest gripe with the merger is that the reduction in net asset value that HR is trading at makes it a very expensive currency to buy a business from.

So, in essence, HR is using its 5-year average implied cap rate stock to buy HTA at a 4.8% cap rate. This makes the merger dilutive at a basic level before synergies are considered. That said, there are some great synergies.

Aspects that increase cash flow/share

HTA, which was just embroiled in the as-yet-undisclosed scandal that led to the departure of its CEO, was a rudderless ship. Their interim CEO, Peter Foss, was thrust into the job and graciously agreed to step in, but doesn’t seem to really want to be CEO at 77.

This configuration allows the merger to have very own G&A synergies. HR has a fully staffed management team at management and property level, while HTA is a bit disorganized in this department. As such, it’s fairly simple to eliminate a lot of the G&A that was associated with HTA and HR will take over.

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

Presentation

TIME

This will be the main aspect of the merger increasing the FFO/action.

HR suggests that it will be around 2% accretive to FAD/share when this saving is combined with the dilution from issuing shares. I would be very happy if it ends up being the case, but I suspect it will come closer to the apartment. These things tend to shake a little weaker than expected for 2 reasons:

  1. Closing has costs that are not always obvious in advance
  2. Share dilution occurs immediately after the merger completes, while G&A savings will take up to 12 months to realize.

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

Advantages and disadvantages of quality

HR has grown slightly faster than HTA in terms of rental spreads and indexation. HTA rental spreads in 2021 were 2.0% compared to 3.4% for HR.

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

Note that HTA’s wallet is of high quality, just slightly below the quality of HR’s wallet.

The same goes for leverage. 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 negative aspects of quality can be weighed against the various advantages of scale.

There is significant geographic overlap between the HR and HTA portfolios.

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

TIME

In the majority of metros, the merged company will have a significantly increased market share. One such example is Atlanta.

An aerial view of part of Atlanta showing the HTA and HR properties

TIME

This is probably an example chosen by the company because of the visual evidence that it will now have an overwhelming market share in the region, but it is true in a wide range of markets.

From a strategic perspective, this will give the combined company increased bargaining power, so it can secure better rental rates.

Occupancy should naturally increase as we emerge from the pandemic era where healthcare providers were reluctant to lock in leases.

Finally, scale offers cost saving synergies when it comes to real estate operations. The HR team of a given sub-market will be able to manage the operations of the combined portfolio so that some of the real estate opex of HTA 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 extent of the impact that scale will have on organic growth, but given that HTA’s growth is only about 1 percentage point lower, I am confident that these factors will offset or will improve.

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

I want to take a little to acknowledge how much more important HR is going to be. HTA was actually the larger of the 2 companies.

HR has a market capitalization of around $4 billion, but after the merger it will have an enterprise value of around $18 billion. on a market capitalization basis, it grows by around 150%, which will have significant implications for its investor base.

The larger size will automatically attract significant ETF ownership, and it will also unlock investment for larger institutions.

So here is my merge dashboard:

Category

Metric impact

Impact on HR value per share

FFO/share and ADF per share

Day 1 negative, slight positive by year end

Neutral

Property quality

Slight negative

Slight negative

Leverage

From 5.4X to ~6.2X debt to EBITDA

negative

Organic growth

Slightly positive

Positive

Diversification

Positive

positive

Climb

Big scale increase

Slightly positive

Globally

Neutral in the short term, slightly positive in the long term

Strategically, the merger makes a lot of sense. If HR had been properly valued before the merger, it would have been very beneficial, but since they use their undervalued stocks to buy a company at a fair capitalization rate of 4.8%, the dilutive cost offsets a large part value gains. I still think this will be good for HR shareholders in the long term, but there will be short term growth pains.

Fair value of the combined entity

For the reasons discussed above, I believe the fair value of the combined entity will be approximately the same as before the merger. The net asset value of HR is around $34, which is also supported by a cash flow assessment. $34 would put HR at 18.7x estimated FFO for 2022, which is appropriate for the growth rate.

ETS or HR?

There is quite a large arbitrage spread in favor of HTA. We track the spread continuously on the Portfolio Income Solution Arbitrage Tracker. At the time of this writing, the gap is about 5.7% in favor of hypertension.

The merger is expected to close in mid-2022 and the termination fees are quite high, 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 pulls out, they would have to pay $291 million.

I think HTA is quite opportunistic here.

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

So getting $34 in fundamental value plus $4.82 in net cash each HTA share of approximately $38.42 in total value or a 30% return in the process of trading the combined entity to its value liquidation. It is not common to see discounts of this magnitude on blue chip and large cap stocks.