UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-K
(Mark One)
For the fiscal year ended December 31, 2004
or
For the transition period from to
Commission file number 1-8895
HEALTH CARE PROPERTY INVESTORS, INC.
(Exact name of registrant as specified in its charter)
Registrant’s telephone number, including area code (562) 733-5100
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Name of each exchangeon which registered
Common Stock
7.25% Series E Cumulative Redeemable Preferred Stock
7.10% Series F Cumulative Redeemable Preferred Stock
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes x No ¨
State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter: $3,157,233,420.
As of February 28, 2005 there were 134,183,176 shares of common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the definitive Proxy Statement for the registrant’s 2005 Annual Meeting of Stockholders have been incorporated into Part III of this Report.
TABLE OF CONTENTS
PART I
Item 1.
Business
Item 2.
Properties
Item 3.
Legal Proceedings
Item 4.
Submission of Matters to a Vote of Security Holders
PART II
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Item 6.
Selected Financial Data
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 7a.
Quantitative and Qualitative Disclosures About Market Risk
Item 8.
Financial Statements and Supplementary Data
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosures
Item 9a.
Controls and Procedures
PART III
Item 10.
Directors and Executive Officers of the Registrant
Item 11.
Executive Compensation
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Item 13.
Certain Relationships and Related Transactions
Item 14.
Principal Accountant Fees and Services
Item 15.
Exhibits, Financial Statement Schedules and Reports on Form 8-K
Business Overview
Health Care Property Investors, Inc., a Maryland corporation organized in 1985, is a real estate investment trust (“REIT”) that, together with its consolidated subsidiaries and joint ventures (collectively, “HCP” or the “Company”), invests in health care related properties located throughout the United States. The Company acquires health care facilities and leases them to health care providers. Additionally, the Company provides mortgage financing on health care facilities.
References herein to “HCP”, the “Company”, “we”, “us” and “our” include Health Care Property Investors, Inc. and our consolidated subsidiaries and joint ventures, unless the context otherwise requires.
As of December 31, 2004, our total investment in our properties, excluding assets held for sale and including investments through unconsolidated joint ventures and mortgage loans, was $3.5 billion. Our portfolio, consisting of interests in 527 properties in 43 states, included:
You can access, free of charge, a copy of the periodic and current reports we file with the SEC on our website at www.hcpi.com. Our periodic and current reports are made available on our website as soon as reasonably practicable after these reports are filed with the SEC.
Business Strategy
We are organized to invest in income-producing health care related facilities. Our primary goal is to increase shareholder value through profitable growth. Our investment strategy to achieve this goal is based on three principles — opportunistic investing, portfolio diversification, and conservative financing.
Opportunistic Investing
We make real estate investments that are expected to drive profitable growth and create long-term shareholder value. We attempt to position ourselves to create and take advantage of situations where we believe the opportunities meet our goals and investment criteria. We invest in properties directly and through joint ventures, and provide secured financing, depending on the nature of the investment opportunity.
Portfolio Diversification
We believe in maintaining a portfolio of heath care related real estate diversified by sector, geography, operator and investment product. Diversification within the health care industry reduces the likelihood that a single event would materially harm our business. This allows us to take advantage of opportunities in different markets based on individual market dynamics. While pursuing our strategy of attaining diversification in our portfolio, there are no specific limitations on the percentage of our total assets that may be invested in any one property, property type, geographic location or in the number of properties in which we seek to invest or lease to a single operator.
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Conservative Financing
We believe a conservative balance sheet provides us with the ability to execute our opportunistic investing approach and portfolio diversification principles. We maintain our conservative balance sheet by actively managing our debt to equity levels and maintaining available sources of liquidity, such as our line of credit. Our debt is primarily fixed rate, which reduces the impact of rising interest rates on our operations. Generally, we attempt to match the long-term duration of our leases with long-term fixed rate financing.
In underwriting our investments, we structure and adjust the price of the investment in accordance with our assessment of risks. We may structure transactions as master leases, require indemnifications, obtain enhancements in the form of letters of credit or security deposits, and take other measures to mitigate risks. We finance our investments based on our evaluation of available sources of funding. We may incur additional indebtedness or issue preferred or common stock. For short-term purposes, we may utilize our revolving line of credit, or arrange for other short-term borrowings from banks or others. We arrange for long-term borrowings through public offerings or from institutional investors.
We may incur additional mortgage indebtedness on real estate we acquire through purchase, foreclosure or otherwise. Where properties are encumbered by debt, we may assume existing loans. We also may obtain non-recourse or other mortgage financing on unleveraged properties in which we have invested or may refinance properties acquired on a leveraged basis.
Competition
Our properties are subject to competition from the facilities of other landlords and health care providers. The landlords and operators of these competing properties may have capital resources substantially in excess of some of the operators of our facilities. The occupancy and rental income at our properties depend upon several factors, including the number of physicians using the health care facilities or referring patients to the facilities, competing properties and health care providers, and the size and composition of the population in the surrounding area. Private, federal and state payment programs and the effect of other laws and regulations may also have a significant influence on the profitability of the properties and their tenants. Virtually all of our properties operate in a competitive environment with tenants, patients and referral sources, including physicians, who may change their preferences for a health care facility from time to time.
Investing in real estate is highly competitive. We face competition from other REITs, investment companies, health care operators and other institutional investors when we attempt to acquire properties. Increased competition reduces the number of opportunities that meet our investment criteria. If we do not identify investments that meet our investment criteria, our ability to increase shareholder value through profitable growth may be limited.
2004 Overview
Real Estate Transactions
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Financing Transactions
Other Events
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Portfolio Summary
Our portfolio of investments at December 31, 2004 includes direct investments in health care related properties, mortgage loans, and investments through joint ventures. Our properties include hospitals, skilled nursing facilities, assisted living facilities and CCRCs, medical office buildings and other health care facilities. As of December 31, 2004, our property interests consist of the following (dollars in thousands):
Property Type
2004
Revenue
LessOperatingExpenses(3)
Owned properties:
Hospitals
Skilled nursing facilities
Assisted living facilities and CCRCs
Medical office buildings
Other health care facilities
Total owned properties
Mortgage loans:
Total mortgage loans
Unconsolidated joint ventures:
HCP MOP—medical office buildings
Total unconsolidated joint ventures
Total
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Unconsolidated Joint Ventures
The following is summarized unaudited information for our unconsolidated joint ventures (dollars in thousands):
Health Care Sectors and Property Types
We have investments in hospitals, skilled nursing facilities, assisted living and CCRCs, medical office buildings and other health care facilities. The following describes the nature of the operations of our tenants and borrowers.
Hospitals. We have interests in 29 medical and surgical general and long-term acute care and rehabilitation hospitals. General hospitals offer a wide range of services such as fully-equipped operating and recovery rooms, obstetrics, radiology, intensive care, open heart surgery and coronary care, neurosurgery, neonatal intensive care, magnetic resonance imaging, nursing units, oncology, clinical laboratories, respiratory therapy, physical therapy, nuclear medicine, rehabilitation services and outpatient services. Long-term acute care hospitals provide care for patients with complex medical conditions that require longer stays and more intensive care, monitoring, or emergency back-up than that available in most skilled nursing-based sub-acute programs. Services are paid for by private sources, third party payors (e.g., insurance and HMOs), or through the Medicare and Medicaid programs.
Rehabilitation hospitals provide inpatient and outpatient care for patients who have sustained traumatic injuries or illnesses, such as spinal cord injuries, strokes, head injuries, orthopedic problems, work related disabilities and neurological diseases, as well as treatment for amputees and patients with severe arthritis. Rehabilitation programs encompass physical, occupational, speech and inhalation therapies, rehabilitative nursing and other specialties. Services are paid for by the patient or the patient’s family, third party payors (e.g., insurance and HMOs), Medicaid or Medicare.
Skilled Nursing Facilities. We have invested in 171 skilled nursing facilities. Various health care providers operate these facilities. Skilled nursing facilities offer restorative, rehabilitative and custodial nursing care for people not requiring the more extensive and sophisticated treatment available at hospitals. Ancillary revenues and revenue from sub-acute care services are derived from providing services to residents beyond room and board and include occupational, physical, speech, respiratory and intravenous therapy, wound care, oncology treatment, brain injury care and orthopedic therapy as well as sales of pharmaceutical products and other services. Certain skilled nursing facilities provide some of the foregoing services on an out-patient basis. Skilled nursing facilities are designed to supplement hospital care and depend to some degree upon referrals from practicing physicians and hospitals. Skilled nursing services are paid for either by private sources, or through the Medicare and Medicaid programs.
Skilled nursing facilities generally provide patients with accommodation, complete medical and nursing care, and rehabilitation services including speech, physical and occupational therapy. As a part of the
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Omnibus Budget Reconciliation Act (OBRA) of 1981, Congress established a waiver program under Medicaid to offer an alternative to institutional skilled nursing services. The provisions of OBRA and the subsequent OBRA Acts of 1987 and 1990 allow states, with federal approval, greater flexibility in program design as a means of developing cost-effective alternatives to delivering services traditionally provided in the skilled nursing setting. This was a contributing factor to the past increase in the number of assisted living facilities, which adversely affected some skilled nursing facilities, as some individuals chose the residential environment and lower cost delivery system provided in the assisted living setting.
Assisted Living Facilities and CCRCs. We have investments in 110 assisted living facilities which are leased to operators, who offer studio, one and two bedroom apartments on a month-to-month basis primarily to individuals who are over 75 years of age with various levels of assistance requirements. More ambulatory residents are provided meals and eat in a central dining area; they may also be assisted with some daily living activities with programs and services that allow residents certain conveniences and make it possible for them to live independently. Staff is also available when residents need assistance and for group activities. Services provided to residents who require more assistance with daily living activities, but who do not require the constant supervision other skilled nursing facilities provide, include personal supervision and assistance with eating, bathing, grooming and administering medication. Charges for room and board are generally paid from private sources.
We have investments in nine CCRCs, which are large, residential communities in a congregate care and continuing care living setting combined with onsite amenities and services. Residents are provided various services which eliminate the need to seek other living accommodations or arrangement for alternative levels of care. Ancillary and health care services are available at these properties that provide nursing and assisted living care. The full continuum of senior living environment includes independent living apartments and cottages, assisted living and, in some communities, skilled nursing and Alzheimer’s care. Various accommodation terms are available to residents, including monthly rentals, rental life care, fully refundable entrance fees, non-refundable endowments, cooperatives, and condominiums.
Medical Office Buildings. We have interests in 184 medical office buildings, including 94 MOBs owned by HCP MOP. We have a 33% ownership interest in HCP MOP. Many of these buildings are located adjacent to, or on the campus of, acute care hospitals. Medical office buildings contain physicians’ offices and examination rooms, and may also include pharmacies, hospital ancillary service space and day-surgery operating rooms. MOBs require more extensive plumbing, electrical, heating and cooling capabilities than commercial office buildings for sinks, brighter lights, special equipment and biological waste mechanisms required for the proper operation of a medical office. Most of our owned MOBs are managed by third party property management companies and 22 are leased on a single-tenant triple net basis while 68 are leased under gross or modified gross leases to multiple tenants under which we are responsible for certain operating expenses.
Other Health Care Facilities. We have investments in nine health care laboratory and biotech research facilities. These facilities are typically located on research campuses of major universities. The facilities are designed to accommodate research and development in the biopharmaceutical industry, drug discovery and development, and predictive and personalized medicine.
We also have investments in nine physician group practice clinic facilities and six health and wellness centers that are leased to five different tenants and, a single tenant, respectively, under triple net or modified gross leases. The physician group practice clinics generally provide a broad range of medical services through organized physician groups representing various medical specialties. Health and wellness centers provide testing and preventative health maintenance services.
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Investment Products
Leases
As of December 31, 2004, of our 401 owned properties, 324 are single-tenant properties under triple net leases with 80 health care providers. We leased 77 properties pursuant to gross or modified gross leases with multiple tenants. Under a triple net lease, in addition to the rent obligation, the tenant is responsible for all operating expenses of the property such as utilities, property taxes, insurance and repairs and maintenance. Under gross or modified gross leases, we are responsible for a share of property operating costs. Certain leases provide for additional rents that are based upon a percentage of the facility’s revenue in excess of the revenue for specific base periods or other thresholds. Others have rent increases based on inflation indices, fixed escalators, or other factors.
The first year annual base rental rates on properties we acquired during 2004 ranged from 9% to 11% of the purchase price of the property. Rental rates vary by lease, taking into consideration many factors, such as:
Our hospitals, skilled nursing facilities, and assisted living facilities and CCRC’s are typically leased to operators on a triple-net basis with initial terms that range from five to fifteen years, and generally have one or more renewal options. The weighted average remaining initial term on these triple-net leases as of December 31, 2004, is approximately seven years. Our medical office buildings are leased on a gross, modified gross, and triple-net basis, and typically have an initial term ranging from one to fourteen years, with a weighted average remaining term of five years as of December 31, 2004.
The following table reflects the annual impact, by year, in terms of 2004 revenue for single tenant properties resulting from lease expirations (in thousands):
Year
2005
2006
2007
2008
2009
Thereafter
Development
We provide development services and construction financing on projects that are typically pre-leased. Upon completion, the assets are placed in service and included in our portfolio of directly owned properties or held by joint ventures. We use our in-house construction management expertise to evaluate local market conditions, construction costs and other factors to seek appropriate risk adjusted returns. During 2004, we completed and placed into service approximately $70 million of medical office buildings. As of December 31, 2004, we have an interest in two properties under development, one of which is held by HCP MOP.
Mortgage Loans
We have investments in mortgage loans secured by properties that are owned and operated by 10 health care providers. At December 31, 2004, the carrying amount of these mortgage loans totaled $140.7 million. Initial interest rates on mortgage loans outstanding at December 31, 2004 range from 9% to 13% per annum.
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Customer Concentration
The following table provides information about the major operators of our properties for the year ended December 31, 2004 (dollars in thousands):
Operators
Percentage
of Revenue
Tenet Healthcare Corporation (NYSE:THC)
American Retirement Corporation (NYSE:ARC)
Emeritus Corporation (AMEX:ESC)
HealthSouth Corporation (OTC:HLSH.PK)
Kindred Healthcare, Inc. (NASDAQ:KIND)
All of our properties associated with the aforementioned tenants are under triple net leases. These companies are subject to the informational filing requirements of the Securities Exchange Act of 1934, as amended, and are required to file periodic reports with the Securities and Exchange Commission. Financial and other information relating to these operators may be obtained from their public reports.
According to public disclosures by Tenet and HealthSouth, each is experiencing significant legal, financial, and regulatory difficulties. We cannot predict with certainty the impact, if any, of the outcome of these uncertainties on their financial statements. The failure or inability of these operators to pay their obligations could materially reduce our revenues, net income and cash flows, which could in turn reduce the amount of cash available for the payment of dividends, cause our stock price to decline and cause us to incur impairment charges or a loss on the sale of the properties.
One of our hospitals located in Tarzana, California is operated by Tenet and is affected by State of California Senate Bill 1953, which requires certain seismic safety building standards for acute care hospital facilities. See “Government Regulation — California Senate Bill 1953” for more information.
Joint Ventures
Consolidated Joint Ventures
At December 31, 2004, we held ownership interests in 21 limited liability companies and partnerships that together own 82 properties and one mortgage, as follows:
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Taxation of HCP
We believe that we have operated in such a manner as to qualify for taxation as a REIT under Sections 856 to 860 of the Internal Revenue Code of 1986, as amended (the “Code”), commencing with our taxable year ended December 31, 1985, and we intend to continue to operate in such a manner. No assurance can be given that we have operated or will be able to continue to operate in a manner so as to qualify or to remain so qualified. This summary is qualified in its entirety by the applicable Code provisions, rules and regulations promulgated thereunder, and administrative and judicial interpretations thereof.
If we qualify for taxation as a REIT, we will generally not be required to pay federal corporate income taxes on the portion of our net income that is currently distributed to stockholders. This treatment substantially eliminates the “double taxation” (i.e., at the corporate and stockholder levels) that generally results from investment in a corporation. However, we will be required to pay federal income tax under certain circumstances.
The Code defines a REIT as a corporation, trust or association (i) which is managed by one or more trustees or directors; (ii) the beneficial ownership of which is evidenced by transferable shares, or by transferable certificates of beneficial interest; (iii) which would be taxable, but for Sections 856 through 860 of the Code, as a domestic corporation; (iv) which is neither a financial institution nor an insurance company subject to certain provisions of the Code; (v) the beneficial ownership of which is held by 100 or more persons; (vi) during the last half of each taxable year not more than 50% in value of the outstanding stock of which is owned, actually or constructively, by five or fewer individuals; and (vii) which meets certain other tests, described below, regarding the amount of its distributions and the nature of its income and assets. The Code provides that conditions (i) to (iv), inclusive, must be met during the entire taxable year and that condition (v) must be met during at least 335 days of a taxable year of 12 months, or during a proportionate part of a taxable year of less than 12 months.
There presently are two gross income requirements. First, at least 75% of our gross income (excluding gross income from “prohibited transactions” as defined below) for each taxable year must be derived directly or indirectly from investments relating to real property or mortgages on real property or from certain types of temporary investment income. Second, at least 95% of our gross income (excluding gross income from prohibited transactions) for each taxable year must be derived from income that qualifies under the 75% test and all other dividends, interest and gain from the sale or other disposition of stock or securities. A
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“prohibited transaction” is a sale or other disposition of property (other than foreclosure property) held for sale to customers in the ordinary course of business.
At the close of each quarter of our taxable year, we must also satisfy four tests relating to the nature of our assets. First, at least 75% of the value of our total assets must be represented by real estate assets, certain stock or debt instruments purchased with the proceeds of a stock offering or long term public debt offering by us (but only for the one year period after such offering), cash, cash items and government securities. Second, not more than 25% of our total assets may be represented by securities other than those in the 75% asset class. Third, of the investments included in the 25% asset class, the value of any one issuer’s securities owned by us may not exceed 5% of the value of our total assets and we may not own more than 10% of the vote or value of the securities of a non-REIT corporation, other than certain debt securities and interests in taxable REIT subsidiaries, as defined below. Fourth, not more than 20% of the value of our total assets may be represented by securities of one or more taxable REIT subsidiaries.
We own interests in various partnerships and limited liability companies. In the case of a REIT that is a partner in a partnership or a member of a limited liability company that is treated as a partnership under the Code, Treasury Regulations provide that for purposes of the REIT income and asset tests, the REIT will be deemed to own its proportionate share of the assets of the partnership or limited liability company and will be deemed to be entitled to the income of the partnership or limited liability company attributable to such share. The ownership of an interest in a partnership or limited liability company by a REIT may involve special tax risks, including the challenge by the Internal Revenue Service (the “Service”) of the allocations of income and expense items of the partnership or limited liability company, which would affect the computation of taxable income of the REIT, and the status of the partnership or limited liability company as a partnership (as opposed to an association taxable as a corporation) for federal income tax purposes.
We also own interests in a number of subsidiaries which are intended to be treated as qualified REIT subsidiaries (each a “QRS”). The Code provides that such subsidiaries will be ignored for federal income tax purposes and all assets, liabilities and items of income, deduction and credit of such subsidiaries will be treated as our assets, liabilities and items. If any partnership, limited liability company, or subsidiary in which we own an interest were treated as a regular corporation (and not as a partnership, QRS or taxable REIT subsidiary, as the case may be) for federal income tax purposes, we would likely fail to satisfy the REIT asset tests described above and would therefore fail to qualify as a REIT, unless certain relief provisions apply. We believe that each of the partnerships, limited liability companies, and subsidiaries (other than taxable REIT subsidiaries) in which we own an interest will be treated for tax purposes as a partnership, or disregarded entity (in the case of a 100% owned partnership or limited liability company) or QRS, as applicable, although no assurance can be given that the Service will not successfully challenge the status of any such organization.
As of December 31, 2004, we owned interests in two subsidiaries which are intended to be treated as taxable REIT subsidiaries (each a “TRS”). A REIT may own any percentage of the voting stock and value of the securities of a corporation which jointly elects with the REIT to be a TRS, provided certain requirements are met. A TRS generally may engage in any business, including the provision of customary or noncustomary services to tenants of its parent REIT and of others, except a TRS may not manage or operate a hotel or health care facility. A TRS is treated as a regular corporation and is subject to federal income tax and applicable state income and franchise taxes at regular corporate rates. In addition, a 100% tax may be imposed on a REIT if its rental, service or other agreements with its TRS, or the TRS’s agreements with the REIT’s tenants, are not on arm’s-length terms.
In order to qualify as a REIT, we are required to distribute dividends (other than capital gain dividends) to our stockholders in an amount at least equal to (A) the sum of (i) 90% of our “real estate investment trust taxable income” (computed without regard to the dividends paid deduction and our net capital gain) and (ii) 90% of the net income, if any (after tax), from foreclosure property, minus (B) the sum of certain items of
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non-cash income. Such distributions must be paid in the taxable year to which they relate, or in the following taxable year if declared before we timely file our tax return for such year, if paid on or before the first regular dividend payment date after such declaration and if we so elect and specify the dollar amount in our tax return. To the extent that we do not distribute all of our net long-term capital gain or distribute at least 90%, but less than 100%, of our “real estate investment trust taxable income”, as adjusted, we will be required to pay tax thereon at regular corporate tax rates. Furthermore, if we should fail to distribute during each calendar year at least the sum of (i) 85% of our ordinary income for such year, (ii) 95% of our capital gain income for such year, and (iii) any undistributed taxable income from prior periods, we would be required to pay a 4% excise tax on the excess of such required distributions over the amounts actually distributed.
If we fail to qualify for taxation as a REIT in any taxable year, and certain relief provisions do not apply, we will be required to pay tax (including any applicable alternative minimum tax) on our taxable income at regular corporate rates. Distributions to stockholders in any year in which we fail to qualify will not be deductible by us nor will they be required to be made. Unless entitled to relief under specific statutory provisions, we will also be disqualified from taxation as a REIT for the four taxable years following the year during which qualification was lost. It is not possible to state whether in all circumstances we would be entitled to the statutory relief. Failure to qualify for even one year could substantially reduce distributions to stockholders and could result in our incurring substantial indebtedness (to the extent borrowings are feasible) or liquidating substantial investments in order to pay the resulting taxes.
We and our stockholders may be required to pay state or local tax in various state or local jurisdictions, including those in which we or they transact business or reside. The state and local tax treatment of us and our stockholders may not conform to the federal income tax consequences discussed above.
Government Regulation
The health care industry is heavily regulated by federal, state and local laws. This government regulation of the health care industry affects us because:
These laws and regulations are subject to frequent and substantial changes resulting from legislation, adoption of rules and regulations, and administrative and judicial interpretations of existing law. These changes may have a dramatic effect on the definition of permissible or impermissible activities, the relative costs associated with doing business and the amount of reimbursement by both government and other third-party payors. These changes may be applied retroactively. The ultimate timing or effect of these changes cannot be predicted. The failure of any tenant or borrower to comply with such laws, regulations and requirements could affect its ability to operate its facility or facilities and could adversely affect such tenant’s or borrower’s ability to make debt or lease payments to us.
Fraud and Abuse Laws. There are various federal and state laws prohibiting fraud and abusive business practices by health care providers who participate in, receive payments from or are in a position to make referrals in connection with a government-sponsored health care program, including, but not limited to the Medicare and Medicaid programs. These include:
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Each of these laws include criminal and/or civil penalties for violations that range from punitive sanctions, damage assessments, penalties, imprisonment, denial of Medicare and Medicaid payments, and/or exclusion from the Medicare and Medicaid programs. Imposition of any of these types of penalties on our tenants or borrowers could result in a material adverse effect on their operations, which could adversely affect our business. Additionally, certain laws, such as the False Claims Act, allow for individuals to bring qui tam (or whistleblower) actions on behalf of the government for violations of fraud and abuse laws. Some Medicare fiscal intermediaries (private companies that contract with Centers for Medicare & Medicaid Services (“CMS”) to administer the Medicare program) have also increased scrutiny of cost reports filed by skilled nursing providers.
Environmental Matters. A wide variety of federal, state and local environmental and occupational health and safety laws and regulations affect health care facility operations. Under various federal, state and local environmental laws, ordinances and regulations, an owner of real property or a secured lender (such as us) may be liable for the costs of removal or remediation of hazardous or toxic substances at, under or disposed of in connection with such property, as well as other potential costs relating to hazardous or toxic substances (including government fines and damages for injuries to persons and adjacent property). The cost of any required remediation, removal, fines or personal or property damages and the owner’s or secured lender’s liability therefore could exceed the value of the property, and/or the assets of the owner or secured lender. In addition, the presence of such substances, or the failure to properly dispose of or remediate such substances, may adversely affect the owner’s ability to sell or rent such property or to borrow using such property as collateral which, in turn, would reduce our revenue. Although the mortgage loans that we provide and leases covering our properties require the borrower and the tenant to indemnify us for certain environmental liabilities, the scope of such obligations may be limited and we cannot assure that any such borrower or tenant would be able to fulfill its indemnification obligations.
The Medicare and Medicaid Programs. Sources of revenue for tenants and mortgagors may include the federal Medicare program, state Medicaid programs, private insurance carriers, health care service plans and health maintenance organizations, among others. Efforts to reduce costs by these payors will likely continue, which may result in reduced or slower growth in reimbursement for certain services provided by some of our operators. For example, President Bush’s fiscal year 2006 budget includes a proposed reduction in Medicare spending of approximately $1.5 billion, including specific reductions in reimbursement to skilled nursing facilities. It is uncertain to what extent President Bush’s budgetary proposals will be enacted into law. In addition, the failure of any of our operators to comply with various laws and regulations could jeopardize their certification and ability to continue to participate in the Medicare and Medicaid programs.
State Medicaid Programs. Medicaid programs differ from state to state but they are all subject to federally-imposed requirements. At least 50% of the funds available under these programs are provided by the federal government under a matching program. Medicaid programs generally pay for acute and rehabilitative care based on reasonable costs at fixed rates; skilled nursing facilities are generally reimbursed using fixed daily rates. Medicaid payments are generally below retail rates for tenant-operated facilities. Increasingly, states have introduced managed care contracting techniques in the administration of Medicaid programs. Such mechanisms could have the impact of reducing utilization of and reimbursement to facilities.
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Other third party payors in various states and areas base payments on costs, retail rates or, increasingly, negotiated rates. Negotiated rates can include discounts from normal charges, fixed daily rates and prepaid capitated rates.
Entrance Fee Communities. Certain of the facilities mortgaged to or owned by us are operated as entrance fee communities. Generally, an entrance fee is an upfront fee or consideration paid by a resident, a portion of which may be refundable, in exchange for some form of long-term benefit. Some of the entrance fee communities are subject to significant state regulatory oversight, including, for example, oversight of each facility’s financial condition, establishment and monitoring of reserve requirements and other financial restrictions, the right of residents to cancel their contracts within a specified period of time, lien rights in favor of the residents, restrictions on change of ownership and similar matters. Such oversight and the rights of residents within these entrance fee communities may have an effect on the revenue or operations of the operators of such facilities and therefore may adversely impact us.
Health Care Facilities. The health care facilities in our portfolio, including hospitals, skilled nursing facilities, assisted living facilities, and physician group practice clinics, are subject to extensive federal, state and local licensure, certification and inspection laws and regulations. Failure to comply with any of these laws could result in loss of accreditation, denial of reimbursement, imposition of fines, suspension or decertification from federal and state health care programs, loss of license or closure of the facility. Such actions may have an effect on the revenue of the operators of properties owned by or mortgaged to us and therefore adversely impact us.
California Senate Bill 1953. Our hospital located in Tarzana, California is affected by State of California Senate Bill 1953 (SB 1953), which requires certain seismic safety building standards for acute care hospital facilities. This hospital is operated by Tenet under a lease expiring in February 2009. We and Tenet are currently reviewing the SB 1953 compliance of this hospital, multiple plans of action to cause such compliance, the estimated time for completing the same, and the cost of performing necessary remediation of the property. We cannot currently estimate the remediation costs that will need to be incurred prior to 2013 in order to make the facility SB 1953-compliant through 2030, and the final allocation of any remediation costs between us and Tenet. Rent on the hospital in 2004 and 2003 was $10.6 million and $10.8 million, respectively, and our carrying amount is $78.4 million at December 31, 2004.
Nurse Staffing Ratios. On January 1, 2004, a California law became effective mandating specific minimum nurse staffing ratios for acute care hospitals. As a result of this requirement, hospital labor costs will be materially increased. Facilities may also be forced to limit patient admissions due to an inability to hire the necessary number of nurses to meet the required ratio, which affects net operating revenue. It is unclear the extent to which compliance with these nurse staffing ratios in California may adversely affect hospital operators in California.
Current Developments
The health care industry continues to face various challenges, including increased government and private payor pressure on health care providers to control costs, the migration of patients from acute care facilities into extended care and home care settings, and the vertical and horizontal consolidation of health care providers.
Changes in the law, new interpretations of existing laws, and changes in payment methodologies may have a dramatic effect on the definition of permissible or impermissible activities, the relative costs associated with doing business and the amount of reimbursement furnished by both government and other third-party payors. These changes may be applied retroactively under certain circumstances. The ultimate timing or effect of legislative efforts cannot be predicted and may impact us in different ways.
In December of 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”) was signed into law. The Act established an 18-month moratorium on the “whole hospital
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exception” to the Stark law, whereby physicians have been permitted to refer patients for Designated Health Services to hospitals in which they have an ownership interest. The moratorium removes specialty hospitals from the “whole hospital exception” from December 8, 2003 through June 7, 2005. Specialty hospitals include hospitals primarily or exclusively engaged in the care and treatment of cardiac conditions or orthopedic conditions, or hospitals that perform certain surgical procedures. Specialty hospitals in operation or under development as of November 18, 2003 are grandfathered under the moratorium. The Act requires that MedPAC, an independent federal body established to advise Congress on issues affecting the Medicare program, and HHS conduct studies on the costs of service, utilization, quality of care and financial impact of specialty hospitals and their physician owners relative to community hospitals, particularly nonprofits. On January 14, 2005 MedPAC announced that it would recommend that Congress extend the Stark specialty hospital moratorium for an additional 18 months to address concerns about the effects of physician investments in specialty hospitals. MedPAC’s recommendations were based upon its findings that when compared with community hospitals, physician owned specialty hospitals tend to concentrate on certain more profitable Diagnostic Related Groups (“DRGs”) and on patients with relatively low severity within those DRGs, and tend to treat lower percentages of Medicare patients. Congress is not obligated to follow MedPAC’s recommendations. Congress may take legislative action implementing MedPAC’s recommendations or wait for the HHS report on specialty hospital quality, which could lead to further restrictions on hospital ownership by physicians.
In addition to the reforms enacted and considered by Congress from time to time, state legislatures periodically consider various health care reform proposals. Congress and state legislatures can be expected to continue to review and assess alternative health care delivery systems, new regulatory enforcement initiatives, and new payment methodologies.
We believe that government and private efforts to contain or reduce health care costs will continue. These trends are likely to lead to reduced or slower growth in reimbursement for certain services provided by some of our tenants and mortgagors. We believe the vast nature of the health care industry, the financial strength and operating flexibility of our operators, and the diversity of our portfolio will mitigate the impact of any such diminution in reimbursements. However, we cannot predict what legislation will be adopted, and no assurance can be given the health care reforms will not have a material adverse effect on our financial condition or results of operations.
Employees
At December 31, 2004, the Company had 74 full-time employees and one part-time employee, none of whom are subject to a collective bargaining agreement.
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Legal Entities
We conduct our business through various legal entities, including the following at December 31, 2004:
100% Owned
AHP of Nevada, Inc.
AHP of Washington, Inc.
ARC Richmond Place Real Estate Holdings, LLC
Aurora HCP, LLC
Birmingham HCP, LLC
Emeritus Realty III, LLC
Emeritus Realty V, LLC
ESC-La Casa Grande, LLC
Health Care Investors III
HCP 1101 Madison MOB, LLC
HCP 600 Broadway MOB, LLC
HCP Arnold MOB, LLC
HCP Ballard MOB, LLC
HCP Medical Office Buildings I, LLC
HCP Medical Office Buildings II, LLC
HCP MOP Member, LLC
HCP NE Retail MOB, LLC
HCP TRS, Inc.
HCPI Knightdale, Inc.
HCPI Mortgage Corp.
HCPI Trust
HCP Virginia, Inc.
Jackson HCP, LLC
McKinney HCP GP, LLC
McKinney HCP, L.P.
Meadowdome, LLC
Medcap HCPI Development, LLC
Medical Office Buildings of Colorado II, LLC
Medical Office Buildings of Nevada-Southern Hills, LLC
Medical Office Buildings of Reston, LLC
Mission Springs AL, LLC
Overland Park AL, LLC
Tampa HCP, LLC
Texas HCP G.P., Inc.
Texas HCP Holding, L.P.
Texas HCP Medical G.P., Inc.
Texas HCP Medical Office Buildings, L.P.
Texas HCP, Inc.
ARC Holland Real Estate Holdings, LLC
ARC LaBarc Real Estate Holdings LLC
ARC Sun City Real Estate Holdings, LLC
Fayetteville Health Associates Limited Partnership
Ft. Worth-Cal Associates, LLC
HCPI/Colorado Springs Ltd. Partnership
HCPI/Idaho Falls LLC
HCPI/Indiana, LLC
HCPI/Kansas Limited Partnership
HCPI/Little Rock Limited Partnership
HCPI/San Antonio Limited Partnership
HCPI/Sorrento, LLC
HCPI/Tennessee, LLC
Medical Office Buildingsof California LLC
Medical Office Buildingsof Utah LLC
Westminster HCP, LLC
HCPI/Utah, LLC
Davis North I, LLC
HCPI/Utah II, LLC
HCPI/Stansbury, LLC
HCPI/Wesley, LLC
Health Care Property Partners
Louisiana-Two Associates, LLC
Perris-Cal Associates, LLC
Statesboro Associates, LLC
Vista-Cal Associates, LLC
Wichita Health Associates Limited Partnership
Arborwood Living Center, LLC
ARC Brandywine Real Estate Holdings, LLC
ARC Lake Seminole Square Real Estate Holdings, LLC
Edgewood Assisted Living Center, LLC
Greenleaf Living Centers, LLC
HCP Medical Office Portfolio, LLC
Seminole Shores Living Center, LLC
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RISK FACTORS
You should carefully consider the risks described below as well as the risks described in “Competition”, “Government Regulation”, and “Taxation of HCP” and elsewhere in this report, which risks are incorporated by reference into this section, before making an investment decision in our company. The risks and uncertainties described herein are not the only ones facing us and there may be additional risks that we do not presently know of or that we currently consider not likely to have a significant impact. All of these risks could adversely affect our business, financial condition, results of operations and cash flows.
Risks Related to Our Operators
If our tenants and mortgagors are unable to operate our properties in a manner sufficient to generate income, they may be unable to make rent and loan payments to us.
The health care industry is highly competitive and we expect that it may become more competitive in the future. Our tenants and mortgagors are subject to competition from other health care providers that provide similar health care services, including from newly constructed facilities. The profitability of health care facilities depends upon several factors, including the number of physicians using the health care facilities or referring patients there, competitive systems of health care delivery and the size and composition of the population in the surrounding area. Private, federal and state payment programs, including a reduction in reimbursement by any of them, and the effect of other laws and regulations may also have a significant influence on the revenues and income of the properties. If our tenants and mortgagors are not competitive with other health care providers and are unable to generate income, they may be unable to make rent and loan payments to us.
The bankruptcy, insolvency or financial deterioration of our facility operators could significantly delay our ability to collect unpaid rents or require us to find new operators.
Our financial position and our ability to make distributions to our stockholders may be adversely affected by financial difficulties experienced by any of our major operators, including bankruptcy, insolvency or a general downturn in the business, or in the event any of our major operators do not renew or extend their relationship with us as their lease terms expire.
We are exposed to the risk that our operators may not be able to meet their obligations, which may result in their bankruptcy or insolvency. Although our leases and loans provide us the right to terminate an investment, evict an operator, demand immediate repayment and other remedies, the bankruptcy laws afford certain rights to a party that has filed for bankruptcy or reorganization. An operator in bankruptcy may be able to restrict our ability to collect unpaid rents or interest during the bankruptcy proceeding.
Tenet Healthcare Corporation accounts for a significant percentage of our revenues and is currently experiencing significant legal, financial and regulatory difficulties.
During 2004, Tenet Healthcare Corporation accounted for approximately 12% of our revenues. According to public disclosures, Tenet is experiencing significant legal, financial and regulatory difficulties. We cannot predict with certainty the impact, if any, of the outcome of these uncertainties on our consolidated financial statements. The failure or inability of Tenet to pay its obligations could materially reduce our revenue, net income and cash flows and could have a material adverse effect on the value of our common stock.
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Our operators are faced with increased litigation and rising insurance costs that may affect their ability to pay their lease or mortgage payments.
In some states, advocacy groups have been created to monitor the quality of care at health care facilities, and these groups have brought litigation against operators. Also, in several instances, private litigation by patients has succeeded in winning very large damage awards for alleged abuses. The effect of this litigation and potential litigation has been to materially increase the costs of monitoring and reporting quality of care compliance incurred by our tenants. In addition, the cost of liability and medical malpractice insurance has increased and may continue to increase so long as the present litigation environment affecting the operations of health care facilities continues. Continued cost increases could cause our tenants to be unable to pay their lease or mortgage payments, potentially decreasing our revenue and increasing our collection and litigation costs. Moreover, to the extent we are required to take back the affected facilities, our revenue from those facilities could be reduced or eliminated for an extended period of time.
Risks Related to Real Estate Investment and Our Structure
We rely on external sources of capital to fund future capital needs, and if our access to such capital is difficult or on commercially unreasonable terms, we may not be able to meet maturing commitments or make future investments necessary to grow our business.
In order to qualify as a REIT under the Internal Revenue Code, among other things, we are required to distribute to our stockholders at least 90% of our REIT taxable income each year, and we will be subject to tax to the extent we distribute less than 100% of our REIT taxable income to our stockholders each year. Because of these distribution requirements, we may not be able to fund all future capital needs, including capital needs in connection with acquisitions, from cash retained from operations. As a result, we rely on external sources of capital. If we are unable to obtain needed capital at all or only on unfavorable terms from these sources, we might not be able to make the investments needed to grow our business, or to meet our obligations and commitments as they mature, which could negatively affect the ratings of our debt and even, in extreme circumstances, affect our ability to continue operations. Our access to capital depends upon a number of factors over which we have little or no control, including general market conditions, interest rates, the market’s perception of our growth potential, our current and potential future earnings, and our cash distributions and the market price of the shares of our capital stock.
If we are unable to purchase suitable health care facilities at a favorable cost, we will be unable to continue to grow through acquisitions.
The acquisition and financing of health care facilities at favorable costs is highly competitive. If we cannot identify and purchase a sufficient quantity of health care facilities at favorable prices, or if we are unable to finance such acquisitions on commercially favorable terms, our business will suffer.
Unforeseen costs associated with the acquisition of new properties could reduce our profitability.
Our business strategy contemplates future acquisitions. The acquisitions we make may not prove to be successful. We might encounter unanticipated difficulties and expenditures relating to any acquired properties, including contingent liabilities. We might never realize the anticipated benefits of an acquisition, which could adversely affect our profitability.
Since real estate investments are illiquid, we may not be able to sell properties when we desire.
Real estate investments generally cannot be sold quickly. We may not be able to vary our portfolio promptly in response to vacancies or economic conditions. This inability to respond to changes in the performance of our investments could adversely affect our ability to service debt and make distributions to our stockholders. In addition, there are limitations under the federal income tax laws applicable to REITs that may limit our ability to recognize the full economic benefit from a sale of our assets.
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Transfers of health care facilities generally require regulatory approvals and alternative uses of health care facilities are limited.
Because transfers of health care facilities may be subject to regulatory approvals not required for transfers of other types of commercial operations and other types of real estate, there may be delays in transferring operations of our facilities to successor tenants or we may be prohibited from transferring operations to a successor tenant. In addition, many of our properties are health care facilities that may not be easily adapted to non-health care related uses. If we are unable to transfer properties at times opportune to us, our revenue and operations may suffer.
Some potential losses may not be covered by insurance.
We generally require our tenants and mortgagors to secure and maintain comprehensive liability and property insurance that covers us, as well as the tenants or mortgagors, on most of our properties. Some types of losses, however, either may be uninsurable or too expensive to insure against. Should an uninsured loss or a loss in excess of insured limits occur, we could lose all or a portion of the capital we have invested in a property, as well as the anticipated future revenue from the property. In such an event, we might nevertheless remain obligated for any mortgage debt or other financial obligations related to the property. We cannot assure you that material losses in excess of insurance proceeds will not occur in the future.
Loss of our tax status as a REIT would have significant adverse consequences to us.
We believe we currently operate and have operated commencing with our taxable year ended December 31, 1985, in a manner that allows us to qualify as a REIT for federal income tax purposes under the Internal Revenue Code, as amended.
Qualification as a REIT involves the application of highly technical and complex Internal Revenue Code provisions for which there are only limited judicial and administrative interpretations. The determination of various factual matters and circumstances not entirely within our control may affect our ability to qualify as a REIT. For example, in order to qualify as a REIT, at least 95% of our gross income in any year must be derived from qualifying sources, and we must satisfy a number of requirements regarding the composition of our assets. Also, we must make distributions to stockholders aggregating annually at least 90% of our REIT taxable income, excluding capital gains. In addition, new legislation, regulations, administrative interpretations or court decisions may adversely affect our investors or our ability to qualify as a REIT for tax purposes. Although we believe that we have been organized and have operated in such manner, we can give no assurance that we have qualified or will continue to qualify as a REIT for tax purposes.
If we lose our REIT status, we will face serious tax consequences that will substantially reduce the funds available to make payments of principal and interest on the debt securities we issue and to make distributions to our stockholders. If we fail to qualify as a REIT:
In addition, if we fail to qualify as a REIT, we would not be required to make distributions to stockholders.
As a result of all these factors, our failure to qualify as a REIT also could impair our ability to expand our business and raise capital, and could adversely affect the value of our common stock.
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We are organized to invest in income-producing health care related facilities. In evaluating potential investments, we consider such factors as:
The following summarizes our direct property investments and interests held through joint ventures and mortgage loans (square feet and dollars in thousands).
Facility Location
Owned Properties:
Hospitals:
California
Florida
Georgia
Idaho
Kansas
Louisiana
Other (10 States)
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Skilled Nursing Facilities:
Colorado
Indiana
Maryland
North Carolina
Ohio
Tennessee
Texas
Virginia
Other (20 States)
Assisted LivingFacilities and CCRCs:
Arizona
Michigan
New Jersey
South Carolina
Washington
Other (18 States)
Medical Office Buildings:
Minnesota
Nevada
Other (9 States)
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Other Health Care Facilities:
Connecticut
Massachusetts
Rhode Island
Utah
Wisconsin
Total Owned Properties
Unconsolidated Joint Ventures:
HCP MOP
Other
Total Portfolio
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The following is summarized unaudited information for HCP MOP:
Alaska
Kentucky
West Virginia
On March 12, 2004, James G. Reynolds, our former Executive Vice President and Chief Financial Officer, filed a lawsuit against us and Kenneth B. Roath, the Company’s Chairman, and James F. Flaherty III, our Chief Executive Officer and a director. As previously reported, the Company settled this lawsuit on August 24, 2004. The settlement included a payment of $2.9 million to Mr. Reynolds of which our insurance carrier reimbursed us approximately $1.3 million.
During 2004 and at December 31, 2004, we were not a party to any other material legal proceedings.
None.
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Our common stock is listed on the New York Stock Exchange. Set forth below for the fiscal quarters indicated are the reported high and low closing prices of our common stock on the New York Stock Exchange.
First Quarter
Second Quarter
Third Quarter
Fourth Quarter
As of February 28, 2005, there were approximately 5,568 stockholders of record and approximately 124,539 beneficial stockholders of our common stock.
It has been our policy to declare quarterly dividends to the common stock shareholders so as to comply with applicable provisions of the Internal Revenue Code governing REITs. The cash dividends per share paid on common stock are set forth below:
HCPI/Indiana. On December 4, 1998, we completed the acquisition of a managing member interest in HCPI/Indiana, LLC, a Delaware limited liability company (“HCPI/Indiana”), in exchange for a cash contribution of approximately $31.6 million. In connection with this acquisition, three individuals affiliated with Bremmer & Wiley, Inc. contributed a portfolio of seven medical office buildings to HCPI/Indiana with an aggregate equity value (net of assumed debt) of approximately $2.8 million. In exchange for this capital contribution, the contributing individuals received 89,452 non-managing member units of HCPI/Indiana.
The Amended and Restated Limited Liability Company Agreement of HCPI/Indiana, LLC provides that only we are authorized to act on behalf of HCPI/Indiana and that we have responsibility for the management of its business.
Each non-managing member unit of HCPI/Indiana is exchangeable for an amount of cash approximating the then-current market value of two shares of our common stock or, at our option, two shares of our common stock (subject to certain adjustments, such as stock splits and reclassifications). HCPI/Indiana relied on the exemption provided by Section 4(2) of the Securities Act of 1933, as amended, in connection with the issuance and sale of the non-managing member units. We have registered 178,904 shares of our common stock for issuance from time to time in exchange for units.
HCPI/Utah. On January 25, 1999, we completed the acquisition of a managing member interest in HCPI/Utah, LLC, a Delaware limited liability company (“HCPI/Utah”), in exchange for a cash contribution of approximately $18.9 million. In connection with this acquisition, several entities affiliated with The Boyer Company, L.C. (“Boyer”) contributed a portfolio of 14 medical office buildings (including two ground leaseholds associated therewith) to HCPI/Utah with an aggregate equity value (net of assumed debt) of approximately $18.9 million. In exchange for this capital contribution, the contributing entities received
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593,247 non-managing member units of HCPI/Utah. At the initial closing, HCPI/Utah was also granted the right to acquire additional medical office buildings. Four additional buildings have been contributed to HCPI/Utah and the contributing entities received 133,134 non-managing member units of HCPI/Utah. An additional 56,488 non-managing member units were received by the contributing entities as a result of earn-out agreements on certain of the buildings.
The Amended and Restated Limited Liability Company Agreement of HCPI/Utah provides that only we are authorized to act on behalf of HCPI/Utah and that we have responsibility for the management of its business.
Each non-managing member unit of HCPI/Utah is exchangeable for an amount of cash approximating the then-current market value of two shares of our common stock or, at our option, two shares of our common stock (subject to certain adjustments, such as stock splits and reclassifications). HCPI/Utah relied on the exemption provided by Section 4(2) of the Securities Act of 1933, as amended, in connection with the issuance and sale of the non-managing member units. We have registered 1,506,546 shares of our common stock for issuance from time to time in exchange for units.
HCPI/Utah II. On August 17, 2001, we completed the acquisition of a managing member interest in HCPI/Utah II, LLC, a Delaware limited liability company (“HCPI/Utah II”), in exchange for a cash contribution of approximately $32.8 million. In connection with the acquisition, several entities affiliated with Boyer contributed a portfolio of four medical office buildings, six health care laboratory and biotech research facilities (seven buildings are owned through ground leasehold interests) and undeveloped land with an aggregate equity value (net of assumed debt) of approximately $25.7 million to HCPI/Utah II. In exchange for this capital contribution, the contributing entities received 738,923 non-managing member units of HCPI/Utah II. At the initial closing, HCPI/Utah II was also granted the right to acquire eight additional medical office buildings. Subsequent contributions have resulted in the acquisition of six additional buildings. In connection with the contribution of these six additional buildings, the contributing entities received 184,169 non-managing member units since the initial closing. An additional 93,276 non-managing member units were received by the contributing entities as a result of earn-out agreements on certain buildings.
The Amended and Restated Limited Liability Company Agreement of HCPI/Utah II provides that only we are authorized to act on behalf of HCPI/Utah II and that we have responsibility for the management of its business.
Each non-managing member unit of HCPI/Utah II is exchangeable for an amount of cash approximating the then-current market value of two shares of our common stock or, at our option, two shares of our common stock (subject to certain adjustments, such as stock splits and reclassifications). HCPI/Utah II relied on the exemption provided by Section 4(2) of the Securities Act of 1933, as amended, in connection with the issuance and sale of the non-managing member units. We have registered 2,032,736 shares of our common stock for issuance from time to time in exchange for units.
HCPI/Tennessee. On October 2, 2003, we completed the acquisition of a managing member interest in HCPI/Tennessee, LLC, a Delaware limited liability company (“HCPI/Tennessee”), in exchange for the contribution of property interests with an aggregate equity value of approximately $7.0 million and $169,000 in cash. In connection with the formation of the LLC, MedCap Properties, LLC (“MedCap”) contributed certain property interests to HCPI/Tennessee with an aggregate equity value of approximately $48.2 million. In exchange for this capital contribution, MedCap received 1,064,539 non-managing member units of HCPI/Tennessee. MedCap distributed its non-managing member units in HCPI/Tennessee to the owners of MedCap, including Charles A. Elcan, who is now an Executive Vice President of HCP.
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The Amended and Restated Limited Liability Company Agreement of HCPI/Tennessee provides that only we are authorized to act on behalf of HCPI/Tennessee and that we have responsibility for the management of its business.
Each non-managing member unit of HCPI/Tennessee is exchangeable for an amount of cash approximating the then-current market value of two shares of our common stock or, at our option, two shares of our common stock (subject to certain adjustments, such as stock splits and reclassifications). HCPI/Tennessee relied on the exemption provided by Section 4(2) of the Securities Act of 1933, as amended, in connection with the issuance and sale of the non-managing member units. We have registered 2,129,078 shares of our common stock for issuance from time to time in exchange for units.
Set forth below is our selected financial data as of and for each of the years in the five year period ended December 31, 2004.
Income statement data:
Total revenue
Income from continuing operations
Net income applicable to common shares
Income from continuing operations applicable to common shares:
Basic earnings per common share
Diluted earnings per common share
Net income applicable to common shares:
Balance sheet data:
Total assets
Debt obligations(1)
Stockholders’ equity
Other data:
Dividends paid
Dividends paid per common share
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Cautionary Language Regarding Forward Looking Statements
Statements in this Annual Report that are not historical factual statements are “forward looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. The statements include, among other things, statements regarding the intent, belief or expectations of Health Care Property Investors, Inc. and its officers and can be identified by the use of terminology such as “may,” “will,” “expect,” “believe,” “intend,” “plan,” “estimate,” “should” and other comparable terms or the negative thereof. In addition, we, through our senior management, from time to time make forward looking oral and written public statements concerning our expected future operations and other developments. Readers are cautioned that, while forward looking statements reflect our good faith belief and best judgment based upon current information, they are not guarantees of future performance and are subject to known and unknown risks and uncertainties. Actual results may differ materially from the expectations contained in the forward looking statements as a result of various factors. In addition to the factors set forth under “Risk Factors” in this Annual Report, readers should consider the following:
We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
Executive Summary
We are a real estate investment trust (“REIT”) that invests in health care related properties located throughout the United States. We develop, acquire and manage health care real estate, and provide mortgage financing to health care providers. We invest directly, often structuring sale-leaseback transactions, and through joint ventures. At December 31, 2004, our real estate portfolio, including those held through joint ventures and mortgage loans, consisted of interests in 527 facilities located in 43 states.
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The current operating environment presents many business challenges including (i) the prospect of rising interest rates, (ii) unprecedented state and federal budget deficits that are likely to dampen government reimbursement to the Medicare and Medicaid programs in the years to come, and (iii) a healthcare system in the United States that is projected to increase from 15.3% of gross domestic product (“GDP”) to 17.7% of GDP by 2012, according to the Centers for Medicare and Medicaid Services. Furthermore, health care real estate valuations are at unprecedented high levels driven, in part, by the emergence of new well-capitalized entrants into the health care real estate marketplace.
Our business strategy is based on three principles: (i) opportunistic investing, (ii) portfolio diversification, and (iii) conservative financing. We actively redeploy capital from investments with lower return potential into assets with higher return potential, and recycle capital from shorter term to longer term investments. We make investments where the expected risk-adjusted return exceeds our cost of capital and strive to leverage our operator and other business relationships.
Our strategy contemplates acquiring and developing properties on favorable terms. We attempt to structure transactions that are tax-advantaged and mitigate risks in our underwriting process. Generally, we prefer larger, more complex “negotiated” transactions that leverage our management team’s experience and infrastructure. During 2004, we made gross investments of $538 million, including $70 million of MOB development properties placed into service mid-year. These investments had an average first year yield on cost of just over 9% and allowed us to recycle $100 million of capital with two operators — ARC and Emeritus — from shorter term loans into long term leases. Our 2004 net investments of $438 million were allocated among the following healthcare sectors: (i) 23% assisted living facilities and CCRCs, (ii) 19% skilled nursing facilities, (iii) 49% MOBs, and (iv) 9% life sciences properties.
We follow a disciplined approach to enhancing the value of our existing portfolio, including the ongoing evaluation of properties for potential disposition that no longer fit our strategy. We sold 32 properties during 2004 for $170 million and had 12 properties with a carrying amount of $13.0 million as held for sale at year-end.
We primarily generate revenue by leasing health care related properties under long-term operating leases. Most of our rents are received under triple net leases; however, MOB rents are typically structured as gross or modified gross leases. Accordingly, for MOBs we incur certain property operating expenses, such as real estate taxes, repairs and maintenance, property management fees, utilities and insurance. Our growth depends, in part, on our ability to (i) increase rental income by increasing occupancy levels and rental rates, (ii) maximize tenant recoveries, and (iii) control operating and other expenses. Our operations are impacted by property specific, market specific, general economic and other conditions.
Access to external capital on favorable terms is critical to the success of our strategy. We attempt to match the long-term duration of our leases with long-term fixed rate financing. At December 31, 2004, 23% of our consolidated debt is at variable interest rates. We intend to maintain an investment grade rating on our fixed income securities and manage various capital ratios and amounts within appropriate parameters. Our senior debt is rated BBB+ by both Standard & Poor’s and Fitch Ratings and Baa2 by Moody’s Investors Service.
Capital market access impacts our cost of capital and our ability to refinance existing indebtedness as it matures, as well as to fund future acquisitions and development through the issuance of additional securities. Our ability to access capital on favorable terms is dependent on various factors, including general market conditions, interest rates, credit ratings on our securities, perception of our potential future earnings and cash distributions, and the market price of our capital stock.
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Critical Accounting Policies
The preparation of financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”), requires management to use judgment in the application of accounting policies, including making estimates and assumptions. We base estimates on our experience and on various other assumptions believed to be reasonable under the circumstances. These judgments affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. If our judgment or interpretation of the facts and circumstances relating to various transactions or other matters had been different, it is possible that different accounting would have been applied resulting in a different presentation of our financial statements. From time to time, we re-evaluate our estimates and assumptions. In the event estimates or assumptions prove to be different from actual results, adjustments are made in subsequent periods to reflect more current estimates and assumptions about matters that are inherently uncertain.
Revenue Recognition
Rental income from tenants is our principal source of revenue and is recognized in accordance with GAAP, including Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 104, Revenue Recognition (“SAB 104”). For leases with minimum scheduled rent increases, we recognize income on a straight-line basis over the lease term when collectibility is reasonably assured. Recognizing rental income on a straight-line basis for leases results in recognized revenue exceeding amounts contractually due from the tenant. Such cumulative excess amounts are included in other assets in our consolidated balance sheets. In the event we determine that collectibility of amounts for straight-line rents is not reasonably assured, we limit future recognition to amounts contractually owed and, where appropriate, we establish an allowance for estimated losses.
We monitor the liquidity and creditworthiness of our tenants and borrowers on an ongoing basis. Our evaluation considers industry and economic conditions, property performance, security deposits and guarantees, and other matters. We establish provisions and maintain an allowance for estimated losses resulting from the possible inability of our tenants and borrowers to make payments sufficient to recover recognized assets. For straight-line rent amounts, our assessment is based on income recoverable over the term of the lease. Our ability to assess the collectibility potential of amounts to be received from tenants and borrowers directly affects our reported financial position and results of operations.
Real Estate
Real estate, consisting of land, buildings, and improvements, is recorded at cost. We allocate the cost of the acquisition to the acquired tangible and identified intangible assets and liabilities, primarily lease related
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intangibles, based on their estimated fair values in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 141, Business Combinations.
We assess fair value based on estimated cash flow projections that utilize appropriate discount and/or capitalization rates, as well as available market information. Estimates of future cash flows are based on a number of factors including historical operating results, known and anticipated trends, and market and economic conditions. The fair value of the tangible assets of an acquired property considers the value of the property as if it were vacant.
We record acquired “above and below” market leases at their fair value, using a discount rate which reflects the risks associated with the leases acquired, equal to the difference between (i) the contractual amounts to be paid pursuant to each in-place lease and (ii) management’s estimate of fair market lease rates for each corresponding in-place lease, measured over a period equal to the remaining term of the lease for above-market leases and the initial term plus the term of any below-market fixed-rate renewal options for below-market leases. Other intangible assets acquired include amounts for in-place lease values that are based on our evaluation of the specific characteristics of each tenant’s lease. Factors to be considered include estimates of carrying costs during hypothetical expected lease-up periods, market conditions, and costs to execute similar leases. In estimating carrying costs, we include real estate taxes, insurance and other operating expenses and estimates of lost rentals at market rates during the expected lease-up periods, depending on local market conditions. In estimating costs to execute similar leases, we consider leasing commissions, legal and other related costs.
Real estate assets are periodically reviewed for potential impairment by comparing the carrying amount to the expected undiscounted future cash flows to be generated from the assets. If the sum of the expected future net undiscounted cash flows is less than the carrying amount of the property, we will recognize an impairment loss by adjusting the asset’s carrying amount to its estimated fair value. Fair value for properties to be held and used is based on the present value of the future cash flows expected to be generated from the asset. Properties held for sale are recorded at the lower of carrying amount or fair value less costs to dispose. Our ability to accurately predict future cash flows impacts the determination of fair value, which may significantly impact our reported results of operations.
Consolidation and Investments in Joint Ventures
Our consolidated financial statements include the accounts of Health Care Property Investors, Inc., its wholly owned subsidiaries and its controlled, through voting rights or other means, joint ventures. We adopted Interpretation No. 46R, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research bulletin No. 51” (“FIN 46”) effective January 1, 2004 for variable interest entities created before February 1, 2003, and effective January 1, 2003 for variable interest entities created after January 31, 2003. FIN 46 provides guidance on the identification of entities for which control is achieved through means other than voting rights (“variable interest entities” or “VIEs”) and the determination of which business enterprise is the primary beneficiary of the VIE. Application of FIN 46 requires complex judgments and estimates. Our ability to correctly assess our influence or control over an entity affects our reported financial condition and results of operations. A variable interest entity is broadly defined as an entity where either (i) the equity investors as a group, if any, do not have a controlling financial interest or (ii) the equity investment at risk is insufficient to finance that entity’s activities without additional financial support. We consolidate investments in VIEs when we determine that we are the primary beneficiary of the VIE. The adoption of FIN 46 resulted in the consolidation of five joint ventures effective January 1, 2004, that were previously accounted for under the equity method. The consolidation of these joint ventures did not have a significant effect on our consolidated financial statements or results of operations.
Investments in entities in which we do not consolidate but over which we have the ability to exercise significant influence over operating and financial policies are reported under the equity method. Generally, under the equity method of accounting, our share of the investee’s earnings or loss is included in our operating results.
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Results of Operations
Year Ended December 31, 2004 as Compared to Year Ended December 31, 2003
Rental income. Triple net rental income increased 17% to $280.1 million primarily due to acquisitions completed in 2004. We also recognized $5.7 million of rental income during the fourth quarter of 2004 resulting from a change in estimate related to the collectibility of straight-line rental income from ARC. The consolidation of five joint ventures upon the adoption of FIN 46 effective January 2004 increased reported triple net rental income by approximately $2.8 million.
Medical office building rental income increased 28% to $108.6 million in 2004. The increase is primarily related to 13 properties purchased from MedCap in October 2003, including four development properties we placed in service in mid-2004, and other MOB acquisition activities.
Equity income. Equity income from unconsolidated joint ventures reflects a full year of operations from HCP MOP in 2004 versus three months in 2003. This was offset by higher HCP MOP interest expense following HCP MOP obtaining $288 million of non-recourse mortgage debt in early 2004. During 2004 and 2003, we recognized $1.5 million and $1.7 million of equity income from HCP MOP, respectively. At December 31, 2004, 100 properties were held by unconsolidated joint ventures, including HCP MOP, compared to 115 properties at December 31, 2003.
Interest and other income. Interest and other income for 2004 was $37.9 million representing a decline of 22%. The change reflects the net effects of (i) $4.6 million of revenue from the recognition of ARC related interest income upon the repayment during 2004 to us by ARC of $83 million of debt and accrued interest thereon, and (ii) a reduced level of loans receivable following the aforementioned repayment from ARC and a $17 million repayment from Emeritus. During 2004 and 2003, we also recognized management and other fees from HCP MOP of $3.1 million and $2.5 million, respectively. Other income in 2003 includes a $3.4 million tax related accrual reversal related to our 1999 acquisition of American Health Properties.
Interest expense. Interest expense increased slightly over 2003. The increase was due to the net effects of (i) the assumption of $81 million of mortgage debt in conjunction with the ARC and Emeritus transactions in July 2004, (ii) the retirement of $31 million of mortgage debt in the first quarter of 2004 in connection with the sale of $127 million of MOB and other health care properties, and (iii) other changes in average borrowings levels. Interest expense in 2004 also included $0.8 million of previously unamortized deferred financing costs that were written off in connection with the refinancing of our revolving credit agreement.
Operating costs and expenses. Operating costs were $43.3 million during 2004 representing an increase of 33%. Operating costs are predominately related to MOB properties that are leased under gross or modified gross lease agreements where we share certain costs with tenants. Additionally, we contract with third party property managers on most of our MOB properties. Accordingly, the number of properties in our MOB portfolio directly impacts operating costs. The increases were primarily attributable to the acquisition of 13 properties from MedCap in October 2003, including four development properties we placed in service in mid-2004. In the fourth quarter of 2004, we increased our allowance for loan losses by $1.6 million on certain unsecured loans. The provision resulted from one operator who defaulted on the payment of two of four unsecured notes upon their maturity and our recent credit assessment of another operator.
General and administrative expenses. General and administrative expenses were $36.0 million in 2004 compared to $24.4 million in 2003, primarily reflecting higher employee compensation costs. Also contributing to the increase was $0.7 million in expenses associated with the move of our corporate offices to Long Beach, CA, $1.5 million in income tax expense on income from certain assets held in a TRS, and a charge of $1.6 million related to the settlement of a lawsuit filed against us by our former Executive Vice President and Chief Financial Officer. Additionally, during 2004 we implemented a new information
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technology system to enhance our reporting and asset management activities and expended considerable resources towards compliance with recent regulatory requirements, principally the Sarbanes-Oxley Act of 2002.
Depreciation and amortization. Real estate depreciation and amortization increased primarily due to the acquisition and construction of properties aggregating approximately $538 million during 2004 and $239 million during 2003.
Impairments. Impairment losses on real estate were $17.1 million in 2004 and $14.0 million in 2003. Included in continuing operations were impairments of $3.2 million and $2.1 million for 2004 and 2003, respectively, which relate to two and one properties, respectively.
Discontinued operations. Income from discontinued operations for 2004 and 2003 were $11.2 million and $12.6 million, respectively. The decrease is due to a decline in operating income from discontinued operations of $8.4 million to $4.0 million for 2004 partially offset by a net gain on real estate dispositions and impairments of $7.2 million in 2004 compared to a net gain on real estate dispositions and impairments of $0.2 million in 2003.
Year Ended December 31, 2003 as Compared to Year Ended December 31, 2002
Rental income. Triple net related income increased 6% to $240.2 million during 2003, primarily attributable to acquisitions. MOB rental income for 2003 increased 17% primarily due to acquisition and development activity.
Equity income. Equity income from unconsolidated joint ventures was $2.9 million for 2003 compared to $0.9 million in 2002 reflecting our investment in HCP MOP in October 2003. During 2003, we recognized $1.7 million of equity income from HCP MOP. At December 31, 2003, 115 properties were held by unconsolidated joint ventures, including HCP MOP, compared to 19 properties at December 31, 2002.
Interest and other income. Interest and other income increased primarily due to the September 2002 loan to ARC, as well as a partial prepayment of that loan in September 2003. Other income in 2003 includes a $3.4 million tax related accrual reversal related to our 1999 acquisition of American Health Properties.
Interest expense. Interest expense was higher in 2003 due to the issuance of $200 million principal amount of 6% long term debt in February 2003 and $250 million principal amount of 6.45% long term debt in June 2002.
Operating cost and expenses. Operating costs were $32.5 million for 2003 representing an increase of 28%. The increase was primarily attributable to the acquisition of 13 properties from MedCap in October 2003.
General and administrative. General and administrative expenses increased 31% to $24.4 million for 2003. Higher general and administrative expenses were caused by costs related to vacant properties, an increase in troubled operators, duplicate asset management functions resulting from the acquisition and transition of MedCap, and higher employee compensation costs.
Depreciation and amortization. Real estate depreciation and amortization increased 8% to $73.3 million as a result of the acquisition of properties totaling approximately $239 million during 2003 and $233 million in 2002.
Impairments. Impairment losses included in continuing operations were $2.1 million and zero for the 2003 and 2002, respectively. Impairment losses included in continuing operations during 2003 relate to one property.
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Preferred stock redemptions. Preferred stock redemption charges were $18.6 million in 2003 and relate to the repurchase of outstanding preferred stock at an amount in excess of the carrying amount.
Discontinued operations. The increase in income from discontinued operations for 2003 is due to a net gain on real estate dispositions and impairments of $0.2 million compared to a net loss on real estate dispositions and impairments of $10.3 million in 2002, partially offset by a decline in operating income from discontinued operations of $5.0 million to $12.4 million for 2003 from $17.4 million in 2002. Discontinued operations include impairment charges of $11.9 million and $11.0 million for 2003 and 2002, respectively.
Liquidity and Capital Resources
Our principal liquidity needs are to (i) fund normal operating expenses, (ii) meet debt service requirements, (iii) fund capital expenditures including tenant improvements and leasing costs, (iv) fund acquisition and development activities, and (v) make minimum distributions required to maintain our REIT qualification under the Internal Revenue Code, as amended.
We believe these needs will be satisfied using cash flows generated by operations and provided by financing activities. We intend to repay maturing debt with proceeds from future debt and/or equity offerings and anticipate making future investments dependent on the availability of cost-effective sources of capital. We use the public debt and equity markets as our principal source of financing. As of December 31, 2004, our senior debt is rated BBB+ by both Standard & Poor’s Ratings Group and Fitch Ratings and Baa2 by Moody’s Investors Service.
Net cash provided by operating activities was $272.5 million and $263.6 million for 2004 and 2003, respectively. Cash flow from operations reflects increased revenues offset by higher costs and expenses, and changes in receivables, payables, accruals, and deferred revenue. Our cash flows from operations are dependent upon the occupancy level of multi-tenant buildings, rental rates on leases, our tenants’ performance on their lease obligations, the level of operating expenses, and other factors. See Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Results of Operations.
Net cash used in investing activities was $82.0 million during 2004 and principally reflects the net effect of: (i) $127.6 million received from the sale of seven medical office buildings and 10 other health care related facilities in the first quarter, (ii) $340.9 million principally used to fund acquisitions, (iii) $92.0 million received from HCP MOP upon the completion of $288 million of non-recourse mortgage financing, and (iv) $25.6 million in principal repayments received on loans. The ARC and Emeritus transactions retired approximately $100 million of aggregate loans owed to us simultaneously with the related property acquisitions. Accordingly, this portion of these transactions has been considered a non-cash activity. See Note 12 to the Consolidated Financial Statements. During 2004 and 2003, we used $3.4 million and $6.5 million to fund lease commissions and tenant and capital improvements, respectively.
Net cash used in financing activities was $187.8 million for 2004 and includes: (i) the repayment of approximately $92.0 million of senior notes, (ii) payment of common and preferred dividends aggregating $243.3 million, and (iii) repayments on mortgage debt of $69.4 million, including $56.6 million of debt we assumed in connection with the Emeritus transaction. These uses were partially offset by proceeds of $42.6 million from common stock issuances, $87.0 million from senior note issuances, and $102.1 million from net proceeds on our line of credit. In order to qualify as a REIT for federal income tax purposes, we must distribute at least 90% of our taxable income to our shareholders. Accordingly, we intend to continue to make regular quarterly distributions to holders of our common and preferred stock.
At December 31, 2004, we held approximately $16.9 million in deposits and $27.6 million in irrevocable letters of credit from commercial banks securing tenants’ lease obligations and borrowers’ loan obligations. We may draw upon the letters of credit or depository accounts if there are defaults under the related leases or loans. Amounts available under letters of credit could change based upon facility operating conditions and other factors and such changes may be material.
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Debt
At December 31, 2004, we have the following outstanding debt:
Revolving line of credit. Borrowings under the line of credit were $300 million at December 31, 2004 with a weighted average interest rate of 3.14%. On October 26, 2004, we closed a new $500 million three-year unsecured revolving credit facility. The facility accrues interest, based on our current credit ratings, at 65 basis points over LIBOR with a 15 basis point facility fee. In addition, a competitive bid option, whereby the lenders participating in the credit facility bid on the interest to be charged which may result in a reduced interest rate, is available for up to 50% of borrowings. The credit facility also contains an “accordion” feature allowing borrowings to be increased by $100 million in certain conditions.
The new credit agreement contains certain financial restrictions and requirements customary in transactions of this type. The more significant covenants, using terms defined in the agreements, limit (i) Consolidated Total Indebtedness to Consolidated Total Asset Value to 60%, (ii) Secured Debt to Consolidated Total Asset Value to 30% and (iii) Unsecured Debt to Consolidated Unencumbered Asset Value to 60%. We must also maintain (i) a Fixed Charge Coverage ratio, as defined, of 1.75 times and (ii) a formula-determined Minimum Tangible Net Worth. As of December 31, 2004 we were in compliance with each of these restrictions and requirements.
Mortgage debt. At December 31, 2004, we had $139.4 million in mortgage debt secured by 28 health care facilities with a carrying amount of $268.4 million. Interest rates on the mortgage notes ranged from 1.07% to 9.32% with a weighted average rate of 7.86% at December 31, 2004.
The instruments encumbering the properties restrict title transfer of the respective properties subject to the terms of the mortgage, prohibit additional liens, require payment of real estate taxes, maintenance of the properties in good condition, maintenance of insurance on the properties and include a requirement to obtain lender consent to enter into material tenant leases.
Senior unsecured notes. At December 31, 2004 we had $1.0 billion in aggregate principal amount of senior unsecured notes outstanding. Interest rates on the notes ranged from 3.39% to 7.875% with a weighted average rate of 6.55% at December 31, 2004.
Senior unsecured notes include $200 million principal amount of 6.875% Mandatory Par Put Remarketed Securities (“MOPPRS”) due June 8, 2015. The MOPPRS contain an option (the “MOPPRS Option”) exercisable by the Remarketing Dealer, an investment bank affiliate, which derives its value from the yield on ten-year U.S. Treasury rates relative to a fixed strike rate of 5.565%. Generally, the value of the option to the Remarketing Dealer increases as ten-year Treasury rates decline and the option’s value to the Remarketing Dealer decreases as ten-year Treasury rates rise. The ten year U.S. Treasury rate at December 31, 2004 was 4.24%. The value of this option to the Remarketing Dealer approximated $20 million at December 31, 2004. Conversely, such amount represents a potential unrecognized loss to us.
On June 8, 2005, if the ten-year Treasury rate is less than 5.565%, we expect that the Remarketing Dealer will exercise the MOPPRS Option, redeem the securities from the holders at par plus accrued interest, and reissue the senior notes as ten-year notes at a premium based on a fixed coupon interest rate set at our applicable credit spread plus 5.565%. However, if the ten-year Treasury rate is above 5.565%, we expect that the Remarketing Dealer will redeem the outstanding senior notes and we will be required to repurchase the outstanding MOPPRS at par plus accrued interest.
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Debt Maturities
The following table summarizes our stated debt maturities and scheduled principal repayments at December 31, 2004 (in thousands):
Equity
At December 31, 2004, we have outstanding 4,000,000 shares of 7.25% Series E cumulative redeemable preferred stock, 7,820,000 shares of 7.10% Series F cumulative redeemable preferred stock, and 133.7 million shares of common stock.
During 2004, we issued approximately 853,000 shares of our common stock under our Dividend Reinvestment and Stock Purchase Plan at an average price per share of $25.37 for an aggregate amount of $21.7 million. We also received $21.1 million in proceeds from stock option exercises. At December 31, 2004, stockholders’ equity totaled $1.4 billion and our equity securities had a market value of $4.1 billion.
As of December 31, 2004, there were a total of 2.5 million non-managing member units outstanding in four limited liability companies of which we are the managing member: HCPI/Tennessee, LLC; HCPI/Utah, LLC; HCPI/Utah II, LLC; and HCPI/Indiana, LLC. The non-managing member units are exchangeable for an amount of cash approximating the then-current market value of two shares of our common stock or, at our option, two shares of our common stock (subject to certain adjustments, such as stock splits and reclassifications). During the year ended December 31, 2004, we issued 20,287 non-managing member units.
As of December 31, 2004, we had $1.5 billion available for future issuances of debt and equity securities under a shelf registration statement filed with the SEC. These securities may be issued from time to time in the future based on our needs and the then-existing market conditions.
Off-Balance Sheet Arrangements
We own interests in certain unconsolidated joint ventures, including HCP MOP, as described under Note 6 to the Consolidated Financial Statements. Except in limited circumstances, our risk of loss is limited to our investment carrying amount and any outstanding loans receivable.
See Liquidity and Capital Resources — Debt for a discussion of the MOPPRS Option related to our senior unsecured notes.
We have no other material off balance sheet arrangements that we expect to materially effect our liquidity and capital resources except these described under “Contractual Obligations”.
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Contractual Obligations
Following are our material contractual payment obligations and commitments at December 31, 2004 (in thousands):
Unsecured senior notes and mortgage debt
Revolving line of credit
Acquisition and construction commitments
Operating leases
Interest expense
Inflation
Our leases often provide for either fixed increases in base rents or indexed escalators, based on the Consumer Price Index or other measures, and/or additional rent based on increases in our tenant’s facility revenue. Substantially all of our MOB leases require the tenant to pay a share of property operating costs such as real estate taxes, insurance, utilities, etc. We believe that inflationary increases in expenses will be offset, in part, by the tenant expense reimbursements and contractual rent increases described above.
New Accounting Pronouncements
See Note 2 to the Consolidated Financial Statements for the impact of new accounting standards.
At December 31, 2004, we are exposed to market risks related to fluctuations in interest rates on $11.9 million of variable rate mortgage notes payable, $300.1 million of variable rate bank debt and $25 million of variable senior notes. Of our consolidated debt of $1.5 billion at year end 2004, approximately 23% is at variable interest rates with the balance at fixed interest rates.
Fluctuation in the interest rate environment will not affect our future earnings and cash flows on our fixed rate debt until that debt must be replaced or refinanced. However, interest rate changes will affect the fair value of our fixed rate instruments. Conversely, changes in interest rates on variable rate debt would change our future earnings and cash flows, but not affect the fair value of those instruments. Assuming a one percentage point increase in the interest rate related to the variable-rate debt including the mortgage notes payable, the bank line of credit and senior notes, and assuming no change in the outstanding balance as of December 31, 2004, interest expense for 2004 would increase by approximately $3.4 million, or $0.03 per common share on a diluted basis.
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The principal amount and the average interest rates for our mortgage loans receivable and debt categorized by maturity dates is presented in the table below. The fair value estimates for the mortgage loans receivable are based on the estimates of management and on rates currently prevailing for comparable loans. The fair market value estimates for debt securities are based on discounting future cash flows utilizing current rates offered to us for debt of the same type and remaining maturity.
Loans Receivable:
Secured loans receivable
Weighted average interest rate
Liabilities:
Variable rate debt:
Bank notes payable
Senior notes payable
Mortgage notes payable
Fixed rate debt:
See Liquidity and Capital Resources — Debt for a discussion of the MOPPRS Option related to our senior notes.
See Index to Consolidated Financial Statements.
We have had no disagreements with our independent registered public accounting firm on accounting and financial disclosure.
Disclosure Controls and Procedures. We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
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Also, we have investments in certain unconsolidated entities. Our disclosure controls and procedures with respect to such entities are substantially more limited than those we maintain with respect to our consolidated subsidiaries.
As required by Rule 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer, Chief Financial Officer, and Chief Accounting Officer of the effectiveness of the design and operation of our disclosure controls and procedures as of December 31, 2004. Based on the foregoing, our Chief Executive Officer, Chief Financial Officer and Chief Accounting Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level.
Changes in Internal Control Over Financial Reporting. We devoted significant time and resources during 2004 to initiatives intended to improve our internal control over financial reporting. We undertook these actions in response to (i) management’s and the Audit Committee’s directives to strengthen internal controls as a result of our growth and increased complexity, and (ii) changes in laws and regulations affecting public companies, including requirements to comply with Section 404 of the Sarbanes Oxley Act of 2002 for the year ended December 31, 2004. As part of these initiatives, we established an internal audit function, implemented a new information system with significant changes in related processes and procedures, and enhanced our accounting and finance staff. Additionally, in connection with our Section 404 compliance effort, we addressed certain internal control deficiencies by, among other things, formalizing and communicating certain policies and procedures, redesigning and integrating systems and processes, strengthening information technology general and application controls, and improving authorization and monitoring controls. All significant initiatives are conducted under the Audit Committee’s and senior management’s oversight.
Management’s Annual Report on Internal Control over Financial Reporting. Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Securities Exchange Act of 1934 Rule 13a-15(f) and 15d-15(f). Under the supervision and with the participation of our management, including our Chief Executive Officer, Chief Financial Officer and Chief Accounting Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control — Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2004.
Our assessment of the effectiveness of our internal control over financial reporting as of December 31, 2004, has been attested to by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report which is included herein.
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders of Health Care Property Investors, Inc.
We have audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting, that Health Care Property Investors, Inc. maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Health Care Property Investors, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Health Care Property Investors, Inc. maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Health Care Property Investors, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Health Care Property Investors, Inc. as of December 31, 2004 and 2003, and the related consolidated statements of income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2004 and the related schedule, and our report dated March 9, 2005 expressed an unqualified opinion thereon.
/s/ ERNST & YOUNG LLP
Irvine, California
March 9, 2005
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Our executive officers were as follows on February 20, 2005:
Name
Position
Kenneth B. Roath
Chairman
James F. Flaherty III
President and Chief Executive Officer
Charles A. Elcan
Executive Vice President — Medical Office Properties
Paul F. Gallagher
Executive Vice President — Portfolio Strategy
Edward J. Henning
Senior Vice President — General Counsel and Corporate Secretary
Stephen R. Maulbetsch
Senior Vice President — Acquisitions and Dispositions
Talya Nevo-Hacohen
Senior Vice President — Strategic Development and Treasurer
Mark A. Wallace
Senior Vice President and Chief Financial Officer
We hereby incorporate by reference the information appearing under the captions “Board of Directors and Executive Officers,” “Code of Business Conduct,” “Board of Directors and Executive Officers — Committees of the Board” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Registrant’s definitive proxy statement relating to its Annual Meeting of Stockholders to be held on May 12, 2005.
The Company has filed, as exhibits to this Annual Report on Form 10-K for the year ended December 31, 2004, the certifications of its Chief Executive Officer and Chief Financial Officer required pursuant to Section 302 of the Sarbanes-Oxley Act of 2004.
On June 3, 2004, the Company submitted to the New York Stock Exchange the Annual CEO Certification required pursuant to Section 303A.12(a) of the New York Stock Exchange Listed Company Manual.
We hereby incorporate by reference the information under the caption “Executive Compensation” in the Registrant’s definitive proxy statement relating to its Annual Meeting of Stockholders to be held on May 12, 2005.
We hereby incorporate by reference the information under the captions “Principal Stockholders” and “Board of Directors and Executive Officers” in the Registrant’s definitive proxy statement relating to its Annual Meeting of Stockholders to be held on May 12, 2005.
We hereby incorporate by reference the information under the captions “Certain Transactions” and “Compensation Committee Interlocks and Insider Participation” in the Registrant’s definitive proxy statement relating to its Annual Meeting of Stockholders to be held on May 12, 2005.
We hereby incorporate by reference under the caption “Audit and Non-Audit Fees” in the Registrant’s definitive proxy statement relating to its Annual Meeting of Shareholders to be held on May 12, 2005.
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Consolidated Balance Sheets — December 31, 2004 and 2003
Consolidated Statements of Income — for the years ended December 31, 2004, 2003 and 2002
Consolidated Statements of Stockholders’ Equity — for the years ended December 31, 2004, 2003 and 2002
Consolidated Statements of Cash Flows — for the years ended December 31, 2004, 2003 and 2002
Notes to Consolidated Financial Statements
Schedule III: Real Estate and Accumulated Depreciation
Note: All other schedules have been omitted because the required information is presented in the financial statements and the related notes or because the schedules are not applicable.
Current Report on Form 8-K, filed with the Securities and Exchange Commission on January 28, 2005, pursuant to which the Company filed an amendment to its Amended and Restated 2000 Stock Incentive Plan and approved various stock agreements and amended an employment agreement for one of its senior officers.
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43
44
45
46
47
For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into registrant’s Registration Statement on Form S-8 Nos. 33-28483 and 333-90353 filed May 11, 1989 and November 5, 1999, respectively, Form S-8 Nos. 333-54786 and 333-54784 each filed February 1, 2001, and Form S-8 No. 333-108838 filed September 16, 2003.
Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy expressed in the Securities Act of 1933 and will be governed by the final adjudication of such issue.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: March 14, 2005
(Registrant)
James F. Flaherty III,
(Principal Executive Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signature
Title
Date
/S/ KENNETH B. ROATH
/s/ JAMES F. FLAHERTY III
/s/ MARK A. WALLACE
/s/ GEORGE P. DOYLE
George P. Doyle
/s/ MARY A. CIRILLO
Mary A. Cirillo
/s/ ROBERT R. FANNING, JR.
Robert R. Fanning, Jr.
/s/ DAVID B. HENRY
David B. Henry
/s/ MICHAEL D. MCKEE
Michael D. McKee
/s/ HAROLD M. MESSMER, JR.
Harold M. Messmer, Jr.
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/s/ PETER L. RHEIN
Peter L. Rhein
/s/ RICHARD M. ROSENBERG
Richard M. Rosenberg
/s/ JOSEPH P. SULLIVAN
Joseph P. Sullivan
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INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Stockholders’ Equity
Consolidated Statements of Cash Flows
Schedule II has been intentionally omitted as the required information is presented in the Notes to Consolidated Financial Statements.
F-1
We have audited the accompanying consolidated balance sheets of Health Care Property Investors, Inc. as of December 31, 2004 and 2003, and the related consolidated statements of income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Health Care Property Investors, Inc. at December 31, 2004 and 2003, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Health Care Property Investors, Inc.’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control — Integrated Framework issued by the Committee of the Sponsoring Organizations of the Treadway Commission and our report dated March 9, 2005 expressed an unqualified opinion thereon.
F-2
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
Real estate:
Buildings and improvements
Developments in process
Land
Less accumulated depreciation
Net real estate
Loans receivable, net:
Joint venture partners
Others
Investments in and advances to unconsolidated joint ventures
Accounts receivable, net of allowance of $834 and $1,580, respectively
Cash and cash equivalents
Other assets, net
Bank line of credit
Senior unsecured notes
Mortgage debt
Accounts payable and accrued liabilities
Deferred revenue
Total liabilities
Minority interests
Stockholders’ equity:
Preferred stock, $1.00 par value: 50,000,000 shares authorized; 11,820,000 shares issued and outstanding, liquidation preference of $25 per share
Common stock, $1.00 par value: 400,000,000 shares authorized; 133,658,318 and 131,039,800 shares issues and outstanding, respectively
Additional paid-in capital
Cumulative net income
Cumulative dividends
Other equity
Total stockholders’ equity
Total liabilities and stockholders’ equity
See accompanying Notes to Consolidated Financial Statements.
F-3
CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data)
Revenues:
Rental income
Equity income from unconsolidated joint ventures
Interest and other income
Costs and expenses:
Interest
Depreciation and amortization
Operating
General and administrative
Impairments
Income before minority interests
Discontinued operations:
Operating income
Gain (loss) on sales of real estate, net of impairments
Net income
Preferred stock dividends
Preferred stock redemption charges
Basic earnings per common share:
Continuing operations
Discontinued operations
Diluted earnings per common share:
Weighted average shares used to calculate earnings per share:
Basic
Diluted
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CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(In thousands)
December 31, 2001
Issuances of common stock, net
Exercise of stock options
Common stock dividends
Amortization of deferred compensation
Change in notes receivable from officers
Other comprehensive loss
December 31, 2002
Issuance of preferred stock, net
Redemption of preferred stock
Changes in notes receivable from officers
Other comprehensive income
December 31, 2003
December 31, 2004
F-5
CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization:
Amortization of deferred compensation and debt costs
Provision for loan losses
Straight-line rents
Distributions of earnings from unconsolidated joint ventures
Net gain on sales of real estate
Changes in:
Accounts receivable
Other assets
Accounts payable, accrued liabilities and deferred revenue
Net cash provided by operating activities
Cash flows from investing activities:
Acquisition and development of real estate
Net proceeds from sales of real estate
Distributions from (investments and advances to) unconsolidated joint ventures
Principal repayments on loans receivable and other, net
Net cash used in investing activities
Cash flows from financing activities:
Borrowings (repayments) under bank line of credit
Repayment of senior unsecured notes
Issuance of senior unsecured notes
Net proceeds from the issuance of preferred stock
Net proceeds from the issuance of common stock and exercise of options
Repayment of mortgage debt
Repurchase of preferred stock
Dividends paid on common and preferred stock
Distributions to minority interests
Other, net
Net cash (used in) provided by financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents, beginning of year
Cash and cash equivalents, end of year
F-6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) Business
Health Care Property Investors, Inc. is a real estate investment trust (“REIT”) that, together with its consolidated entities (collectively, “HCP” or the “Company”), invests directly, or through joint ventures and mortgage loans, in health care related properties located throughout the United States.
(2) Summary of Significant Accounting Policies
Use of Estimates
Management is required to make estimates and assumptions in the preparation of financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”). These estimates and assumptions affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ.
Principles of Consolidation
The consolidated financial statements include the accounts of HCP, its wholly owned subsidiaries and its controlled, through voting rights or other means, joint ventures. All material intercompany transactions and balances have been eliminated in consolidation.
The Company adopted Interpretation No. 46R, Consolidation of Variable Interest Entities, as revised (“FIN 46R”), effective January 1, 2004 for variable interest entities created before February 1, 2003 and effective January 1, 2003 for variable interest entities created after January 31, 2003. FIN 46R provides guidance on the identification of entities for which control is achieved through means other than voting rights (“variable interest entities” or “VIEs”) and the determination of which business enterprise is the primary beneficiary of the VIE. A variable interest entity is broadly defined as an entity where either (i) the equity investors as a group, if any, do not have a controlling financial interest or (ii) the equity investment at risk is insufficient to finance that entity’s activities without additional financial support. The Company consolidates investments in VIEs when it is determined that the Company is the primary beneficiary of the VIE. The adoption of FIN 46R resulted in the consolidation of five joint ventures effective January 1, 2004, that were previously accounted for under the equity method. The consolidation of these joint ventures did not have a significant effect on the Company’s consolidated financial statements or results of operations.
Investments in entities which the Company does not consolidate but for which the Company has the ability to exercise significant influence over operating and financial policies are reported under the equity method. Generally, under the equity method of accounting the Company’s share of the investee’s earnings or loss is included in the Company’s operating results.
Rental income from tenants is recognized in accordance with GAAP, including Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 104, Revenue Recognition (“SAB 104”). For leases with minimum scheduled rent increases, the Company recognizes income on a straight-line basis over the lease term when collectibility is reasonably assured. Recognizing rental income on a straight-line basis for leases results in recognized revenue exceeding amounts contractually due from tenants. Such cumulative excess amounts are included in other assets and were $11.0 million, net of allowances, at December 31, 2004. In the event the Company determines that collectibility of straight-line rents is not reasonably assured, the Company limits future recognition to amounts contractually owed, and, where appropriate, the Company establishes an allowance for estimated losses.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
Certain leases provide for additional rents, based upon a percentage of the facility’s revenue in excess of specified base periods or other thresholds. Such revenue is deferred until the related thresholds are achieved.
The Company monitors the liquidity and creditworthiness of its tenants and borrowers on an ongoing basis. The evaluation considers industry and economic conditions, property performance, security deposits and guarantees, and other matters. The Company establishes provisions and maintains an allowance for estimated losses resulting from the possible inability of its tenants and borrowers to make payments sufficient to recover recognized assets. For straight-line rent amounts, the Company’s assessment is based on income recoverable over the term of the lease. At December 31, 2004 and 2003, respectively, the Company had an allowance of $15.8 million and $11.2 million, included in other assets, as a result of the Company’s determination that collectibility is not reasonably assured for certain straight-line rent amounts. The fourth quarter of 2004 includes income of $5.7 million resulting from the Company’s change in estimate relating to the collectibility of straight-line rents due from affiliates of American Retirement Corporation.
Loans Receivable
Loans receivable are classified as held-to-maturity because the Company has the positive intent and ability to hold the securities to maturity. Held-to-maturity securities are stated at amortized cost. The Company recognizes interest income on loans, including the amortization of discounts and premiums, using the effective interest method.
Real estate, consisting of land, buildings, and improvements, is recorded at cost. The Company allocates acquisition costs to the acquired tangible and identified intangible assets and liabilities, primarily lease intangibles, based on their estimated fair values in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 141, Business Combinations.
The Company assesses fair value based on estimated cash flow projections that utilize appropriate discount and/or capitalization rates, as well as available market information. Estimates of future cash flows are based on a number of factors including historical operating results, known and anticipated trends, and market and economic conditions. The fair value of the tangible assets of an acquired property considers the value of the property as if it were vacant.
The Company records acquired “above and below” market leases at their fair value using a discount rate which reflects the risks associated with the leases acquired, equal to the difference between (i) the contractual amounts to be paid pursuant to each in-place lease and (ii) management’s estimate of fair market lease rates for each corresponding in-place lease, measured over a period equal to the remaining term of the lease for above-market leases and the initial term plus the term for any below-market fixed rate renewal options for below-market leases. Other intangible assets acquired include amounts for in-place lease values that are based on the Company’s evaluation of the specific characteristics of each tenant’s lease. Factors to be considered include estimates of carrying costs during hypothetical expected lease-up periods, market conditions, and costs to execute similar leases. In estimating carrying costs, the Company includes real estate taxes, insurance and other operating expenses and estimates of lost rentals at market rates during the expected lease-up periods, depending on local market conditions. In estimating costs to execute similar leases, the Company considers leasing commissions, legal and other related costs.
Real estate assets are periodically reviewed for potential impairment by comparing the carrying amount to the expected undiscounted future cash flows to be generated from the assets. If the sum of the expected
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future net undiscounted cash flows is less than the carrying amount of the property, the Company will recognize an impairment loss by adjusting the asset’s carrying amount to its estimated fair value. Fair value for properties to be held and used is based on the present value of the future cash flows expected to be generated from the asset. Properties held for sale are recorded at the lower of carrying amount or fair value less costs to dispose.
Developments in process are carried at cost which includes pre-construction costs essential to development of the property, construction costs, capitalized interest, and other costs directly related to the property. Capitalization of interest ceases when the property is ready for service which generally is near the date that a certificate of occupancy is obtained. Expenditures for tenant improvements and leasing commissions are capitalized and amortized over the terms of the respective leases. Repairs and maintenance are expensed as incurred.
The Company computes depreciation on properties using the straight-line method over the assets’ estimated useful life. Depreciation is discontinued when a property is identified as held for sale. Building and improvements are depreciated over useful lives ranging up to 45 years. Above and below market rent intangibles are amortized to revenue over the remaining noncancellable lease terms. Other in-place lease intangibles are amortized to expense over the remaining lease term and expected bargain renewal periods. At December 31, 2004, lease intangibles were $19.9 million and are included in other assets.
Income Taxes
The Company has elected and believes it operates so as to qualify as a “REIT” under Sections 856 to 860 of the Internal Revenue Code of 1986, as amended (the “Code”). Under the Code, the Company generally is not subject to federal income tax on its taxable income distributed to stockholders if certain distribution, income, asset, and shareholder tests are met. A REIT must distribute to stockholders at least 90% of its annual taxable income. At December 31, 2004 and 2003, the tax basis of the Company’s net assets is less than the reported amounts by $288 million and $287 million, respectively.
Certain activities the Company undertakes must be conducted by entities which elect to be treated as taxable REIT subsidiaries (“TRSs”). TRSs are subject to both federal and state income taxes. For the year ended December 31, 2004, income tax expense related to the Company’s TRSs approximated $1.5 million and is included in general and administrative expenses. The Company’s income tax expense in 2003 and 2002 was insignificant.
Discontinued Operations
Certain long lived assets are classified as discontinued operations in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Long-lived assets to be disposed of are reported at the lower of their carrying amount or their fair value less cost to sell. Further, depreciation of these assets ceases at the time the assets are classified as discontinued operations. Discontinued operations are defined in SFAS No. 144 as a component of an entity that has either been disposed of or is deemed as held for sale if both the operations and cash flows of the component have been or will be eliminated from ongoing operations as a result of the disposal transaction and the entity will not have any significant continuing involvement in the operations of the component after the disposal transaction.
The Company periodically sells assets based on market conditions and the exercise of purchase options by tenants. The operating results of properties meeting the criteria established in SFAS No. 144 are reported
F-9
as discontinued operations in the Company’s consolidated statement of income. Discontinued operations in 2004 include 44 properties with revenues of $8.8 million. The Company had 69 and 80 properties classified as discontinued operations for the years ended December 31, 2003 and 2002, with revenue of $30.7 million and $37.0 million, respectively. During 2004, 2003, and 2002, 32, 25 and 11 properties were sold, respectively, with net gains on real estate dispositions of $21.1 million, $12.1 million and $0.7 million, respectively. While SFAS No. 144 provides that the assets and liabilities of discontinued operations be presented separately in the balance sheet, such amounts are immaterial for the Company. Accordingly, such reclassification has not been made. At December 31, 2004, the carrying amount of assets held for sale was $13.0 million and is included in real estate.
Stock-Based Compensation
On January 1, 2002, the Company adopted the fair value method of accounting for stock-based compensation in accordance with SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), as amended by SFAS No. 148, Accounting for Stock-Based Compensation — Transaction and Disclosure(“SFAS 148”). The fair value provisions of SFAS 123 were adopted prospectively with the fair value of all new stock option grants recognized as compensation expense beginning January 1, 2002. Since only new grants are accounted for under the fair value method, stock-based compensation expense is less than that which would have been recognized if the fair value method had been applied to all awards. Compensation expense for awards with graded vesting is generally recognized ratably over the vesting period.
The following table reflects net income and earnings per share, adjusted as if the fair value based method had been applied to all outstanding stock awards in each period (in thousands, except per share amounts):
Net income, as reported
Add: Stock-based compensation expense included in reported net income
Deduct: Stock-based employee compensation expense determined under the fair value based method
Pro forma net income
Earnings per share:
Basic — as reported
Basic — pro forma
Diluted — as reported
Diluted — pro forma
Cash and Cash Equivalents
Cash and cash equivalents represent short term investments with original maturities of three months or less when purchased. Cash and cash equivalents at December 31, 2004 and 2003 include $3.6 million and $0.9 million that are restricted and not immediately accessible.
F-10
Segment Reporting
The Company principally operates in one segment — the ownership of health care related assets. The Company has determined that it operates in a single segment for financial reporting purposes based on, among others things, its present internal reporting and decision making.
Stock Split
As of March 2, 2004, each shareholder received one additional share of common stock for each share they own resulting from a 2-for-1 stock split declared by the Company on January 22, 2004. The stock split has been reflected in all periods presented.
Minority Interests and Mandatorily Redeemable Financial Instruments
As of December 31, 2004, there were 2.5 million non-managing member units outstanding in four limited liability companies of which the Company is the managing member: HCPI/Tennessee, LLC; HCPI/Utah, LLC; HCPI/Utah II, LLC; and HCPI Indiana, LLC. The Company consolidates these entities since it exercises control. Each non-managing member unit is redeemable for cash or, at the Company’s option, two shares of common stock. During 2003, the Company issued 1.1 million non-managing member units of HCPI/Tennessee, LLC as part of the MedCap acquisition. See Note 4.
SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, requires, among other things, that mandatorily redeemable financial instruments be classified as a liability and recorded at settlement value. Consolidated joint ventures with a limited-life are considered mandatorily redeemable. Implementation of the provisions of SFAS 150 that require the valuation and establishment of a liability for limited-life entities was subsequently deferred. As of December 31, 2004, the Company has eleven limited life entities that have a settlement value of the minority interests of approximately $4.7 million, which is approximately $2.8 million more than the carrying amount.
Preferred Stock Redemptions
The Company recognizes the excess of the redemption value of cumulative redeemable preferred stock redeemed over their carrying amount as a charge to income in accordance with Financial Accounting Standards Board (“FASB”) — Emerging Issues Task Force (“EITF”) Topic D-42, The Effect on the Calculation of Earnings per Share for the Redemption or Induced Conversion of Preferred Stock. In July 2003, the Securities and Exchange Commission (“SEC”) staff issued a clarification of the SEC’s position on the application of FASB EITF Topic D-42. The SEC staff’s position, as clarified, is that in applying Topic D-42, the carrying value of preferred shares that are redeemed should be reduced by the amount of original issuance costs, regardless of where in stockholders’ equity those costs are reflected. See Note 10.
SFAS No. 123R, Share-Based Payments, which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation was issued in December 2004. Generally, the approach in SFAS 123R is similar to that in SFAS 123. However, SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. SFAS 123R must be adopted no later than July 1, 2005. The Company believes the adoption of SFAS 123R will not have a significant impact on its consolidated financial statements since it previously adopted the fair value method under SFAS 123.
F-11
Reclassifications
Certain reclassifications have been made for comparative financial statement presentation.
(3) Future Minimum Rents
Future minimum lease payments to be received, excluding operating expense reimbursements, from tenants under non-cancelable operating leases as of December 31, 2004, are as follows (in thousands):
(4) Acquisitions and Development
In December 2004, the Company acquired three medical office buildings (MOBs), a 42% condominium interest in a fourth MOB and one retail/garage building for $111 million from Swedish Medical Center in Seattle, Washington.
In July 2004, the Company acquired eleven assisted living facilities from Emeritus Corporation for $84 million, including $56 million of assumed debt, through a sale-leaseback transaction. The leases have initial terms of 15 years and two ten-year renewal options. The first year lease rate is approximately 9.25% with Consumer Price Index (“CPI”) based escalators not exceeding 3% annually. Emeritus used $17 million of the proceeds to repay existing debt owed to the Company. The $56 million of assumed debt was subsequently repaid by the Company in late 2004.
In July 2004, the Company acquired substantially all of American Retirement Corporation’s (“ARC”) interest in three continuing care retirement communities (“CCRCs”) and one assisted living facility for $113 million. The transaction was structured as a sale-leaseback with an initial lease term of ten years and three ten-year renewal options. The first year lease rate is 9% with additional rents contingent on facility revenue exceeding certain thresholds. ARC used a portion of the proceeds to repay its existing $83 million loan and interest thereon, to the Company. Additionally, the Company provided ARC with a new $5.7 million mortgage loan accruing interest at 9% per annum.
In June 2004, the Company acquired an MOB located in Las Vegas, Nevada, for $22 million.
In April and June 2004, the Company acquired nine skilled nursing facilities for $63 million in related transactions. The nine facilities have an initial lease term of five years and three five-year renewal options. The first year lease rate is approximately 9.3% with annual rent escalators of 2%.
In January 2004, the Company acquired a heath care laboratory and biotech research facility located in San Diego, California for a purchase price of approximately $40 million.
F-12
A summary of 2004 acquisitions is as follows (in thousands):
Acquisition
ARC
Emeritus
Swedish
In October 2003, the Company acquired from MedCap Properties, LLC (“MedCap”) five MOBs for cash of $28 million. Four of these properties were under construction at the acquisition date. Additionally, eight MOBs were contributed to the HCPI/Tennessee, LLC by MedCap in exchange for 1.1 million non-managing member operating partnership units. The units were distributed to the owners of MedCap, including owners that were subsequently elected as senior officers of the Company. The units are exchangeable for cash or, at the Company’s option, convertible into common stock on a one unit for two share basis. The units were valued at $45.26 per unit based on the quoted market value of the Company’s common stock at the time of the transaction. MedCap was not affiliated with the Company prior to October 2003. As a result, the senior officers acquired approximately 0.7 million non-managing member units of HCPI/Tennessee representing an ownership interest therein of approximatelysixty percent. The Company is the sole holder of managing member units and exercises voting control of HCPI/Tennessee.
The Company agreed to complete development of the four MOBs and pay a contingent purchase price, or earn-out, to the former members of MedCap, including the senior officers. Development of these properties was completed and the MOBs were placed into service in mid-2004. The purchase price is based on stabilized net operating income of the properties, as defined, during a specified period. As of December 31, 2004, no contingent purchase price amounts had been paid or accrued.
The HCPI/Tennessee LLC agreement also provides for a “make whole” payment to the non-managing members upon the sale of properties acquired in the MedCap transactions and other events. Such payment is generally equal to taxes the non-managing members incur as a result of certain specified events. During 2004, HCPI/Tennessee sold one MOB and the Company paid $0.2 million to senior officers under these agreements.
(5) Tenant Concentration
Tenet Healthcare Corporation (NYSE: THC) and American Retirement Corporation (NYSE: ARC) each accounted for 12% of the Company’s revenue in 2004. The carrying amount of the Company’s real estate assets leased to Tenet and ARC was $352.8 million and $383.5 million at December 31, 2004, respectively.
These companies are publicly traded and are subject to the informational filing requirements of the Securities and Exchange Act of 1934, as amended. Accordingly each is required to file periodic reports on Form 10-K and Form 10-Q with the SEC. Certain operators of our properties are experiencing financial, legal and regulatory difficulties. The loss of one of these operators or a combination of smaller operators could have a material impact on our results of operations or financial position.
F-13
(6) Investments in and Advances to Joint Ventures
HCP Medical Office Portfolio, LLC (“HCP MOP”) is a joint venture formed in June 2003 between the Company and an affiliate of General Electric Company (“GE”). HCP MOP is engaged in the acquisition, development and operation of MOB properties. The Company has a 33% ownership interest therein and is the managing member. Activities of the joint venture requiring equity capital are generally funded on a transactional basis by the members in proportion to their ownership interest. Cash distributions are made to the members in proportion to their ownership interest until GE’s cumulative return, as defined, exceeds specified thresholds. Thereafter, the Company’s economic interest increases.
The Company uses the equity method of accounting for its investment in HCP MOP because it exercises significant influence through voting rights and its position as managing member. However, the Company does not consolidate HCP MOP since it does not control, through voting rights or other means, the joint venture as GE has significant decision making rights and has the majority of the economic interest.
Summarized unaudited condensed financial information of HCP MOP follows:
Real estate, at cost
Mortgage loans and notes payable
Other liabilities
GE’s capital
HCP’s capital
Total liabilities and members’ capital
10/31/03
to
12/31/03
Rental and other income
HCP’s equity income
Fees earned by HCP
Distributions received
HCP MOP acquired 100 properties from MedCap in October 2003 for cash of $460 million and the assumption of $26 million of mortgage debt that accrues interest at 7%. In connection therewith, the Company contributed $143 million to HCP MOP. In January 2004, HCP MOP completed $288 million of
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non-recourse mortgage financings, including $254 million at a weighted average fixed interest rate of 5.57% with the balance based on LIBOR plus 1.75%. The Company received $92 million of distributions from HCP MOP in connection with this financing during early 2004.
The Company has not guaranteed any indebtedness or other obligations of HCP MOP. Generally, the Company may only be required to provide additional funding to HCP MOP under limited circumstances as specified in the related agreements. At December 31, 2004, investments and advances to unconsolidated joint ventures includes outstanding advances to HCP MOP of $6.4 million.
Other Unconsolidated Joint Ventures
The following entities are owned by the Company with minority interests and are accounted for on the equity method at December 31, 2004 (dollars in thousands):
Entity
Greenleaf Living Center, LLC
Summarized unaudited condensed combined financial information for the other unconsolidated joint ventures follows:
Real estate, net
Notes payable
Accounts payable
Entrance fee liabilities and deferred life estate obligations
Other partners’ capital
Total liabilities and partners’ capital
F-15
As of December 31, 2004, the Company has guaranteed approximately $7.2 million of a total of $15.4 million of notes payable for four of these joint ventures.
(7) Loans Receivable
Loan loss allowance
Secured loans to joint venture partners represent amounts due from affiliates of ARC. During 2004, ARC repaid its secured loans and interest thereon, and the Company recognized $4.6 million of additional interest income. The interest income recognized resulted from the reversal of a previously established allowance of $4.6 million that was based on, among other things, the Company’s analysis of the loan to asset value underlying the investment.
In the fourth quarter of 2004, the Company recorded a charge of $1.6 million to increase its loan loss allowance as a result of one borrower who defaulted upon maturity of two notes and a recent credit assessment of another borrower.
At December 31, 2004, minimum future principal payments to be received on secured loans receivable are $16.4 million in 2005, $62.3 million in 2006, $12.9 million in 2007, $2.3 million in 2008, $7.1 million in 2009, and $39.7 million thereafter.
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Following is a summary of secured loans receivable at December 31, 2004:
FinalPaymentDue
Payment Terms
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(8) Debt
Senior Unsecured Notes
Following is a summary of senior unsecured notes outstanding at December 31, 2004 (dollars in thousands):
Year Issued
Rate
1998
1995
1996
1997
2002
2003
MOPPRS option
Net discounts
Senior notes include $200 million principal amount of 6.875% Mandatory Par Put Remarketed Securities (“MOPPRS”) due June 8, 2015. The MOPPRs contain an option (the “MOPPRS Option”) exercisable by the Remarketing Dealer, an investment bank affiliate, which derives its value from the yield on ten-year U.S. Treasury securities relative to a fixed strike rate of 5.565%. Generally, the value of the option to the Remarketing Dealer increases as U.S. Treasury rates decline and the option’s value to the Remarketing Dealer decreases as U.S. Treasury rates rise. The ten-year U.S. Treasury rate was 4.24% at December 31, 2004. The value of this option to the Remarketing Dealer approximated $20 million at December 31, 2004. Conversely, such amount represents a potential unrecognized loss to the Company.
On June 8, 2005, if the ten-year Treasury rate is less than 5.565%, the Company expects that the Remarketing Dealer will exercise the MOPPRS Option, redeem the securities from the holders at par plus accrued interest, and reissue the Senior notes as ten-year notes at a premium based on a fixed coupon interest rate set at our applicable credit spread plus 5.565%. However, if the ten-year Treasury rate is above 5.565%, the Company expects that the Remarketing Dealer will redeem the outstanding Senior notes and the Company will be required to repurchase the outstanding MOPPRS at par plus accrued interest.
In June 2004, the Company issued $25 million in aggregate principal amount of 6.00% fixed rate senior notes due 2014 and $25 million in aggregate principal amount of variable-rate senior notes due 2014. In July 2004, the Company issued $37 million in aggregate principal amount of 6.00% senior notes due 2014. In February 2003, the Company issued $200 million in aggregate principal amount of 6.00% senior notes due 2015.
The weighted average interest rate on the senior unsecured notes at December 31, 2004 and 2003, respectively, was 6.6% and 6.9%. Discounts, premiums and the MOPPRS Option are amortized to interest expense over the term of the related debt.
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The MOPPRS and other senior unsecured notes contain certain covenants including limitations on debt and other terms customary in transactions of this type.
Mortgage Debt
At December 31, 2004, the Company had $139.4 million in mortgage debt secured by 28 health care facilities with a carrying amount of $268.4 million. Interest rates on the mortgage notes ranged from 1.07% to 9.32%. At December 31, 2004 and 2003, the weighted-average interest rate on mortgage notes payable was 7.86% and 7.95%, respectively.
The instruments encumbering the properties restrict title transfer of the respective properties subject to the terms of the mortgage, prohibit additional liens, restrict prepayment, require payment of real estate taxes, maintenance of the properties in good condition, maintenance of insurance on the properties and include a requirement to obtain lender consent to enter into material tenant leases.
Bank Line of Credit
In October 2004, the Company closed a new $500 million three-year unsecured revolving credit facility. Interest accrues at LIBOR plus 65 basis points, based on the Company’s current credit ratings, with a 15 basis point facility fee. The new credit agreement contains certain financial restrictions and requirements customary in transactions of this type. The more significant covenants, using terms defined in the agreements, limit (i) Consolidated Total Indebtedness to Total Asset Value to 60%, (ii) Secured Debt to Total Asset Value to 30%, and (iii) Unsecured Debt to Consolidated Unencumbered Asset Value to 60%. The agreement also requires that the Company maintain (i) a Fixed Charge Coverage Ratio, as defined, of 1.75 times and (ii) a formula-determined Minimum Tangible Net Worth. As of December 31, 2004, the Company was in compliance with each of these restrictions and requirements. The weighted average interest rates on outstanding line of credit borrowings at December 31, 2004 and 2003 were 3.14% and 2.06% respectively.
Debt maturities at December 31, 2004 are as follows (in thousands):
Senior
Notes
Bank
Line of
Credit
(9) Commitments and Contingencies
The Company, from time to time, is party to legal proceedings, lawsuits and other claims in the ordinary course of our business. These claims, even if not meritorious, could force us to spend significant financial resources. Except as described below, the Company is not aware of any legal proceedings or claims that it believes will have, individually or taken together, a material adverse effect on its business, prospects, financial condition or results of operations.
F-19
On March 12, 2004, James G. Reynolds, the Company’s former Executive Vice President and Chief Financial Officer, filed a lawsuit against the Company and Kenneth B. Roath, the Company’s Chairman, and James F. Flaherty III, the Company’s Chief Executive Officer and a director. The Company settled this lawsuit on August 24, 2004. The settlement included a payment of $2.9 million to Mr. Reynolds of which the Company’s insurance carrier reimbursed the Company approximately $1.3 million.
One of the Company’s properties located in Tarzana, California is affected by State of California Senate Bill 1953 (SB 1953), which requires certain seismic safety building standards for acute care hospital facilities. This hospital is operated by Tenet under a lease expiring in February 2009. The Company and Tenet are currently reviewing the SB 1953 compliance of this hospital, multiple plans of action to cause such compliance, the estimated time for completing the same, and the cost of performing necessary remediation of the property. We cannot currently estimate the remediation costs that will need to be incurred prior to 2013 in order to make the facility SB 1953-compliant through 2030, and the final allocation of any remediation costs between the Company and Tenet. Rent on the hospital in 2004 and 2003 was $10.6 million and $10.8 million, respectively, and the carrying amount was $78.4 million at December 31, 2004.
Certain residents of two of the Company’s CCRCs have entered into a master trust agreement with the operator of the facilities whereby amounts paid upfront by such residents were deposited into a trust account. These funds were then made available to the CCRC operator in the form of a non-interest bearing loan to provide permanent financing for the related communities. The operator of the CCRC is the borrower under these arrangements; however, two of the Company’s properties are collateral under the master trust agreements. As of December 31, 2004, the remaining obligation under the master trust agreements for these two properties is $12.2 million. The Company’s property is released as collateral as the master trust liabilities are extinguished.
Leases with certain tenants contain purchase options whereby the tenant may elect to acquire the underlying real estate. Future minimum lease payments to be received from leases subject to purchase options are summarized as follows (dollars in thousands):
F-20
Rental expense attributable to continuing operations for the years ended December 31, 2004, 2003 and 2002 was approximately $1.3 million, $0.6 million and $0.5 million, respectively. These rental expense amounts include ground rent and other leases. Future minimum lease obligations under noncancelable ground leases as of December 31, 2004 were as follows (in thousands):
(10) Stockholders’ Equity
Dividends on the Company’s common stock are characterized for federal income tax purposes as ordinary income, capital gains, non-taxable return of capital or a combination thereof. Following are our annual common stock dividends per share:
Ordinary income
Return of capital
During 2004 and 2003, the Company issued 0.9 million and 6.2 million shares of common stock under its Dividend Reinvestment and Stock Purchase Plan (DRIP), respectively. The Company issued 1.4 million and 2.6 million shares upon exercise of stock options during 2004 and 2003, respectively. During 2003, the Company also issued 2.8 million shares of common stock at a net offering price of $20.75 per share, generating net proceeds of $58.1 million.
In January 2005, the Company announced that its Board declared a quarterly cash dividend of $0.42 per share. The common stock cash dividend was paid on February 18, 2005 to stockholders of record as of the close of business on February 7, 2005.
Preferred Stock
The Series E and Series F preferred stock have no stated maturity, are not subject to any sinking fund or mandatory redemption and are not convertible into any other securities of the Company. Dividends are payable quarterly in arrears. The following summarizes cumulative redeemable preferred stock outstanding at December 31, 2004:
Series
Callable at
Par on or After
Series E
Series F
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Dividends on preferred stock are characterized as ordinary income for federal income tax purposes and are summarized in the following annual distribution table:
Series A
Series B
Series C
On September 15, 2003, the Company issued 4,000,000 shares of 7.25% Series E Cumulative Redeemable Preferred Stock at $25 per share, generating gross proceeds of $100 million.
On December 3, 2003, the Company issued 7,820,000 shares of 7.10% Series F Cumulative Redeemable Preferred Stock at $25 per share, raising gross proceeds of $195.5 million.
On May 2, 2003, the Company redeemed all of the outstanding 8.6% Series C preferred stock. The amount paid to redeem the preferred stock was approximately $99.4 million plus accrued dividends. The redemption amount in excess of the carrying amount of the Series C preferred stock resulted in a preferred stock redemption charge of $11.8 million.
On September 10, 2003, the Company redeemed all of the outstanding 7.875% Series A preferred stock. The amount paid to redeem the Series A preferred stock was approximately $60 million plus accrued dividends. The redemption amount in excess of the carrying amount of the Series A preferred stock resulted in a preferred stock redemption charge of $2.2 million.
On October 1, 2003, the Company redeemed all of the 8.7% Series B preferred stock. The amount paid to redeem the Series B preferred stock was approximately $133.6 million plus accrued dividends. The redemption amount in excess of the carrying amount of the Series B preferred stock resulted in a preferred stock redemption charge of $4.6 million.
Comprehensive Income and Other Equity
Unamortized balance of deferred compensation
Notes receivable from officers and directors for purchase of common stock
Accumulated other comprehensive loss
Total other equity
Other comprehensive loss is a reduction of net income in calculating comprehensive income. Comprehensive income for the years ended December 31, 2004 and 2003 was $167.2 million and $159.6 million, respectively.
F-22
(11) Impairments
During 2004, 16 properties were determined to be impaired in connection with an assessment of the underlying undiscounted cash flows or as a result of being classified as held for sale and being recorded at the lower of the carrying amount or fair market value less costs to sell. As a result, impairment charges of $17.1 million reduced the carrying amount of the properties to their estimated fair values. During 2003 and 2002, 15 and 12 properties respectively, were deemed impaired resulting in impairment charges of $14.0 million and $11.0 million, respectively. Impairment charges principally arose as a result of reduced anticipated holding periods and planned near-term dispositions.
Impairment charges are summarized as follows:
(12) Supplemental Cash Flow and Rental Income Information
Supplemental Cash Flow Information
Interest paid, net of capitalized interest and other
Taxes paid
Capitalized interest
Mortgages assumed on acquired properties
Mortgages included with real estate dispositions
Loans receivable settled in connection with real estate acquisitions
Non-managing member units issued in connections with acquisitions
Accrued dividends
Restricted stock issued, net of cancellations
Conversion of non-managing member units into common stock
Rental Income Information
Triple net properties
MOB and other
F-23
(13) Earnings Per Common Share
The Company computes earnings per share in accordance with SFAS No. 128, Earnings Per Share. Basic earnings per common share is computed by dividing net income applicable to common shares by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per common share is calculated including the effect of dilutive securities. Approximately 1 million options to purchase shares of common stock that had an exercise price in excess of the average market price of the common stock during 2004, 2003 and 2002 were not included because they are not dilutive. Additionally, 5.1 million shares issuable upon conversion of 2.5 million non-managing member units in 2004, 5.4 million shares issuable upon conversion of 2.7 million non-managing member units in 2003 and 3.1 million shares issuable upon the conversion of 1.6 million non-managing member units in 2002 were not included since they are anti-dilutive.
Dilutive options and unvested restricted stock
(14) Disclosures About Fair Value of Financial Instruments
The carrying amount of cash and cash equivalents, receivables, payables, and accrued liabilities are reasonable estimates of fair value because of the short maturities of these instruments. Fair values for secured loans receivable, senior unsecured notes and mortgage debt are estimates based on rates currently prevailing for similar instruments of similar maturities. The fair value of the MOPPRS Option was determined through estimates provided by investment banks affiliates:
Senior unsecured notes and mortgage debt
(15) Compensation Plans
Stock Based Compensation
The Company’s 2000 Stock Incentive Plan (the “Incentive Plan”) provides for the granting of stock based compensation, including stock options, restricted stock, and performance restricted stock units. The maximum number of shares issuable over the term of the Incentive Plan is 11.4 million shares with approximately 6.7 million shares available for future awards at December 31, 2004.
F-24
Stock Options
Stock options are generally granted with an exercise price equal to the fair market value of the underlying stock on the date of grant. Stock options generally vest ratably over a five-year period. Vesting of certain options may accelerate upon retirement, a change in control of the Company, as defined, and other events. A summary of the option activity is presented in the following table (in thousands, except per share amounts):
Number of
Shares
OptionsExercisable
Balance at January 1, 2002
Granted/sold
Exercised
Forfeited
Balance at December 31, 2002
Balance at December 31, 2003
Balance at December 31, 2004
A summary of stock options outstanding at December 31, 2004, is presented in the following table (in thousands, except per share and life data).
F-25
The weighted average fair value per share at the dates of grant for options awarded during 2004, 2003 and 2002 was $1.79, $0.91 and $1.61, respectively. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model. The assumptions underlying the determination of such fair values for options granted are summarized as follows:
Dividend yield
Expected life — years
Risk-free interest rate
Expected stock price volatility
Restricted Stock and Performance Restricted Stock Units
Under the Incentive Plan, restricted stock and performance restricted stock units generally vest over a 3-5 year period. The vesting of certain restricted shares and units may accelerate upon retirement, a change in control of the Company, as defined, and other events. When vested, each performance restricted stock unit is convertible into one share of common stock. The restricted stock and performance restricted stock units are valued on the grant date based on the market price of a common share on that date. Generally, the Company recognizes the fair value of the awards over the applicable vesting period as compensation expense. At December 31, 2004, there were 568,000 unvested shares of restricted stock and 204,000 performance restricted stock units outstanding, with no units then convertible into common stock. The following table summarizes awards for restricted stock and performance restricted stock units (in thousands):
Performance restricted stock units
Restricted stock
Employee Benefit Plan
The Company maintains a 401(k) and profit sharing plan that allows for eligible participants to defer compensation, subject to certain limitations imposed by the Code. The Company provides a matching contribution of up to 4% of each participant’s eligible compensation. During 2004, 2003 and 2002, the Company’s matching contributions have been approximately $0.2 million in each year.
(16) Transactions with Related Parties
Mr. Fanning, a director of the Company, on January 1, 2004, had remaining balances on loans from the Company of $107,938 with an interest rate of 5.55% due on April 8, 2004 and $127,690 with an interest rate of 3.85% due on April 9, 2005. Mr. Fanning paid both loans in full on April 5, 2004. The loans were made for the purpose of purchasing shares upon option exercise and such loans were secured by the common stock of the Company. The authority of the Company to maintain such loans was “grandfathered” under the Exchange Act, as amended by Section 402 of the Sarbanes-Oxley Act of 2002.
Mr. Flaherty, Chief Executive Officer, President and director of the Company, is a director of Quest Diagnostics Incorporated (“Quest”). During 2004, Quest made payments of approximately $0.6 million to
F-26
the Company or its affiliates for the lease of medical office space at 16 locations. The leases for 15 of those locations were entered into by the predecessor landlord prior to the Company’s ownership of the particular medical office building with 11 of those leases entered into before Mr. Flaherty became an employee and director of the Company and a director of Quest. The lease for the remaining location was entered into by the Company before Mr. Flaherty became an employee and director of the Company and a director of Quest.
Mr. McKee, a director of the Company, is Vice Chairman and Chief Operating Officer of The Irvine Company. During each of 2004, 2003 and 2002, the Company made payments of approximately $0.5 million to The Irvine Company for the lease of office space.
Mr. Messmer, a director of the Company, is Chairman and Chief Executive Officer of Robert Half International Inc. During 2004, 2003 and 2002, the Company made payments of approximately $1.1 million, $50,000 and $15,000, respectively, to Robert Half International Inc. and certain of its subsidiaries for services including placement of temporary and permanent employees and Sarbanes-Oxley compliance consultation.
Mr. Rhein, a director of the Company, is a director of Cohen & Steers, Inc. Cohen & Steers Capital Management, Inc., a wholly owned subsidiary of Cohen & Steers, Inc., is an investment adviser registered under Section 203 of the Investment Advisers Act of 1940 and as of December 31, 2004, owned 7.3% of our common stock.
Mr. Sullivan, a director of the Company, is a director of each of SCCI Healthcare Services Corporation and Covenant Care, Inc. During 2004, 2003 and 2002, SCCI Healthcare Services Corporation made payments of approximately $1.0 million, $1.3 million and $1.2 million, respectively, to the Company for a lease and a loan, which loan was paid in full in July 2004, related to two of its hospital properties, and Covenant Care, Inc. made payments of approximately $7.9 million, $7.6 million and $7.5 million, respectively, to the Company for the lease of certain of its nursing home properties. The agreements that required payment to the Company from SCCI Healthcare Services Corporation and Covenant Care, Inc. were entered into prior to Mr. Sullivan being elected a director of the Company.
Notwithstanding these matters, the Board of Directors of the Company has determined, in accordance with the categorical standards adopted by the Board, that each of Messrs. Fanning, McKee, Messmer, Rhein and Sullivan is independent within the meaning of the rules of the New York Stock Exchange.
F-27
(17) Selected Quarterly Financial Data (Unaudited)
Gain (loss) from real estate dispositions, net of impairments
Results of operations for properties sold or to be sold have been classified as discontinued operations for all periods presented.
F-28
Gross Amount at Which Carried
at Close of Period 12/31/04
City
Slidell
Los Gatos
San Antonio
Overland Park
Peoria
Little Rock
Colorado Springs
Plaquemine
Ft. Lauderdale
Webster
Tucson
Bennetsville
Cheraw
Cleveland
Fayetteville
Wichita
West Valley City
Victorville
Morgantown
Amarillo
Irvine
Tarzana
Palm Beach Garden
Roswell
Poplar Bluff
Hickory
Idaho Falls
Total hospitals
Skilled nursing
Fort Collins
Claremont
Salem
Walla Walla
Las Vegas
Omro
Livermore
Fairhaven
Westborough
F-29
Schedule III: Real Estate and Accumulated Depreciation — (Continued)
Morrison
Walnut Cove
Chelmsford
Highland
Hilliard
Canton
Orlando
Mobile
Vincennes
Newark
Bellflower
El Monte
Lomita
Downey
Glendora
Hayward
Maryville
Bolivar
Blountville
Camden
Huntingdon
Jefferson City
Loudon
Memphis
Ripley
West Point
Upland
Whitehouse
Marion
Denver
Marysville
Yuba City
Mayfield
Mc Bain
Deckerville
Edmond
Hutchinson
Moore
F-30
Delaware
Lake City
Lexington Park
Cambridge
Elkton
Green Bay
Sturgeon Bay
Milwaukee
Orange Park
Port St. Lucie
Cedar Rapids
Salina
Piggott
Dumas
Frankston
Pittsburg
Live Oak
Winter Haven
Lake Worth
Jeffersonville
Ferdinand
Lowell
Milford
Petersburg
Lenoir
Woodfin
King
Knightdale
Yorktown
Chesterton
Arden
Vista
Ponca City
Seminole
Shawnee
Statesboro
Fort Worth
Ogden
Rexburg
F-31
Franklin
Stillwater
Perris
Bad Axe
Texas City
Hillsdale
Indianapolis
Greenfield
Anderson
Fort Wayne
Kokomo
Lebanon
Angola
Huntington
Fairborn
Georgetown
Port Clinton
Springfield
Toledo
Versailles
Douglas
Safford
Lakewood
Issaquah
New Albany
Spencer
Jasper
Kingsport
Huntsville
F-32
Lawrence County
Richmond
Tell City
Albany
Augusta
Bedford
Taylorsville
Galveston
Port Arthur
Logansport
Pilot Point
Ligonier
Seymour
Fishersville
Floyd
Newport News
Roanoke
Staunton
Williamsburg
Woodstock
Cynthiana
Independence
Windsor
Carthage
Michigan City
Total skilled nursing
Assisted living & CCRCs
Voorhees
Everett
Phoenix
Renton
Dover
Allentown
Latrobe
F-33
Painted Post
Gun Barrel
Sherman
Spartanburg
Easley
Hendersonville
Columbus
Pinellas Park
Victoria
Mesquite
Lubbock
Conroe
Beaumont
El Paso
San Marcos
Vineland
Glassboro
Albuquerque
Temple
Houston
Birmingham
Lake Charles
Lafayette
Alexandria
Tampa
Woodbridge
Murietta
Lodi
Ontario
Fairfield
Voorhees Township
Ocala
Westminster
Zephyr Hills
Casselberry
F-34
Lancaster
Rock Hill
Sumter
Evansville
Jackson
Boise
Odessa
Sugar Land
The Woodlands
Palm Desert
Sterling Heights
Cincinnati
Port Richey
Auburn
Biloxi
Jacksonville
Delray Beach
Mission
Friendswood
Austin
Altamonte Springs
Clearwater
Mesa
Boynton Beach
Saco
Cape Elizabeth
Sun City Center
F-35
Holland
Lexington
Bozeman
Englewood
Escondido
Lewiston
New Port Richey
Puyallup
Stockton
Total assisted living & CCRCs
Pampa
Lufkin
Longview
Bountiful
San Diego
Poway
Minneapolis
Brownsburg
Zionsville
F-36
Castle Dale
Centerville
Elko
Grantsville
Washington Terrace
Salt Lake City
Orem
Springville
Glen Burnie
Providence
Layton
Harrison
Roseburg
Murfreesboro
St Louis/Shrewsbury
Atlantis
Valencia
West Hills
Plano
F-37
Oro Valley
Kaysville
Stansbury
Thornton
Chandler
Hermitage
San Jose
McKinney
Lone Tree
Reston
Seattle
Total medical office building
Knoxville
Sunnyvale
Clarksville
Sacramento
Greendale
Elm Grove
F-38
Bristol
East Providence
Newington
Warwick
West Springfield
Enfield
Total other
Total continuing operations properties
Discontinued operations properties
Modesto
Mountain Home
Texarkana
Star City
Seaside
Milledgeville
Oklahoma City
Okemah
San Angelo
Total discontinued operations properties
Corporate and other assets
F-39
Schedule III total
Less: Lease-up intangibles included in other assets
Amount included under real estate on Consolidated Balance Sheet
Balances at beginning of year
Acquisition of real state, development and improvements
Disposition of real estate
Balances associated with changes in reporting presentation
Balances at end of year
Accumulated depreciation:
Depreciation expense
F-40