The recent blockbuster deal between Merrill Gardens and Health Care REIT underscores the growth potential in seniors housing and signals an upswing in transaction activity, say industry experts. The companies are forming an $817 million partnership that will own and operate 38 seniors housing communities with about 4,300 units.

The partnership is the first one of its type in the seniors housing industry structured under the REIT Investment Diversification and Empowerment Act of 2007, or RIDEA. It allows healthcare REITs to receive rents as a landlord and participate in operating profits as a tenant.

After management fees, Health Care REIT expects annual average net operating income growth of about 5% compared with 2.5% annual rent increases under triple-net lease structures.

The deal comes just as the seniors housing industry appears poised to rebound. With the economy slowly recovering, occupancies at seniors housing properties are expected to improve over the next 24 months, say experts. Meanwhile, the population of the elderly continues to swell.

What’s more, few new seniors housing projects are being built. New projects now under way equal about 1.1% of the existing inventory. New construction peaked in the first quarter of 2008 when it comprised 4.2% of existing inventory, according to the National Investment Center for the Seniors Housing & Care Industry (NIC).

“There will be pricing power with high-end buildings in great locations,” says George Chapman, chief executive at Toledo, Ohio-based Health Care REIT.

The new partnership will consist of 25 buildings now owned by Merrill Gardens. Another 13 buildings owned by Health Care REIT and currently managed by Merrill Gardens also are included. Health Care REIT will own 80% of the partnership, and Merrill Gardens 20%.

Merrill Gardens will manage all the properties in the partnership. Merrill Gardens currently has two properties in development, one in San Diego, and another in Kirkland, Wash. The company manages eight buildings for other owners.

Health Care REIT will pay $209 million cash for its share in the Merrill Gardens buildings and assume debt of $249 million with an average interest rate of 5%. The transaction is expected to close September 1.

Publicly traded Health Care REIT owns 625 properties. The company’s stock closed Aug. 17 at $45.39, a 14.1% increase from a year ago.

Merrill Gardens is based in Seattle and privately held. It is owned by the Merrill family, well known for its development of the lumber industry in the Northwest.

Golden opportunity

Many of the properties in the partnership are located in affluent markets in the western U.S. where it is difficult to develop because land is expensive and zoning approvals are hard to win. “These communities have great locations, mostly in California and Washington,” says Chapman at Health Care REIT.

The communities feature independent, assisted and/or memory care units. About 99% of all building revenue is from private-pay residents.

The average occupancy rate at Merrill Gardens buildings is approximately 92%, says Bill Pettit, president and chief operating officer at Merrill Gardens. Assisted living occupancy stands at about 88% industry-wide, according to NIC.

Merrill Gardens plans to boost the occupancy rate across its portfolio to 97% over the next 12 to 18 months. “We expect good top-line revenue growth,” says Pettit. Rents at Merrill Gardens buildings average about $3,500 a month, and will rise this year about 3% to 5%.

For Merrill Gardens, the new partnership provides access to capital at a time when funding for new projects is scarce and expensive. “We wanted an institutional investor as a partner to grow the company,” says Pettit.

Over the next three years, Merrill Gardens expects to develop nine communities valued at $300 million. The joint venture has the option to purchase the buildings. “We see opportunities for more projects with Merrill Gardens and our capital,” says Chapman at Health Care REIT.

Like many real estate trusts during the downturn, Health Care REIT has been beefing up it balance sheet by building cash reserves. The company is expected to be an acquirer of properties in the year ahead. Health Care REIT recently purchased a $143 million portfolio from a seniors housing operator, though company executives did not reveal the name of the operator.

Two years ago, Health Care REIT was poised to create a RIDEA partnership with Sunrise Senior Living, but that deal fell apart. “We have been looking for the right partner to do this kind of transaction,” says Chapman. “We have the chance for a greater- than-normal upside with this structure.”

Health Care REIT and Merrill Gardens have a long relationship. Merrill Gardens has managed retirement buildings owned by Health Care REIT, and the two companies have purchased properties together before.

Looking ahead, more seniors housing deals with similar RIDEA structures will emerge, but only for independent and assisted living properties, says Rob Mains, research analyst at investment firm Morgan Keegan in Saratoga Springs, N.Y.

The profit potential is in private-pay housing, not nursing homes that depend on government reimbursements, emphasizes Mains. “It has to be the right kind of REIT with a good operating partner.”