3. Real Estate and Lending Activities

Acquisitions

2012 Activity

On February 29, 2012, we made loans to and acquired assets from Ernest for a combined purchase price and investment of $396.5 million, consisting of $200 million to purchase real estate assets, a first mortgage loan of $100 million, an acquisition loan for $93.2 million and a capital contribution of $3.3 million (“Ernest Transaction”).

Real Estate Acquisition and Mortgage Loan Financing

Pursuant to a definitive real property asset purchase agreement (the “Purchase Agreement”), we acquired from Ernest and certain of its subsidiaries (i) a portfolio of five rehabilitation facilities (including a ground lease interest relating to a community-based acute rehabilitation facility in Wyoming), (ii) seven long-term acute care facilities located in seven states and (iii) undeveloped land in Provo, Utah (collectively, the “Acquired Facilities”) for an aggregate purchase price of $200 million, subject to certain adjustments. The Acquired Facilities are leased to subsidiaries of Ernest pursuant to a master lease agreement. The master lease agreement has a 20-year term with three five-year extension options and provides for an initial rental rate of 9%, with consumer price-indexed increases, limited to a 2% floor and 5% ceiling annually thereafter. In addition, we made Ernest a $100 million loan secured by a first mortgage interest in four subsidiaries of Ernest, which has terms similar to the leasing terms described above.

Acquisition Loan and Equity Contribution

Through an affiliate of one of our TRSs, we made investments of approximately $96.5 million in Ernest Health Holdings, LLC (“Ernest Holdings”), which is the owner of Ernest. These investments, which are structured as a $93.2 million loan and a $3.3 million equity contribution generally provide that we will receive a preferential return of 15% of the loan amount and approximately 79% of the remaining earnings of Ernest. Ernest is required to pay us a minimum of 6% and 7% of the loan amount in years one and two, respectively, and 10% thereafter, although there are provisions in the loan agreement that are expected to result in full payment of the 15% preference when funds are sufficient. Any of the 15% in excess of the minimum that is not paid may be accrued and paid upon the occurrence of a capital or liquidity event and is payable at maturity. The loan may be prepaid without penalty at any time.

Financing of Ernest Transaction

To finance the Ernest Transaction, we completed equity and senior unsecured notes offerings in February 2012. See Notes 4 and 5 for more information on these financing activities.

2011 Activity

On January 4, 2011, we acquired the real estate of the 19-bed, 4-year old Gilbert Hospital in a suburb of Phoenix, Arizona area for $17.1 million. Gilbert Hospital is operated by affiliates of Visionary Health, LLC. We acquired this asset subject to an existing lease that expires in May 2022.

On January 31, 2011, we acquired for $23.5 million the real estate of the 60-bed Atrium Medical Center at Corinth in the Dallas area, a long-term acute care hospital that was completed in 2009 and is subject to a lease that expires in June 2024. In addition, through one of our affiliates, we invested $1.3 million to acquire approximately 19% of a joint venture arrangement with an affiliate of Vibra Healthcare, LLC (“Vibra”) that will manage and has acquired a 51% interest in the operations of the facility. We also made a $5.2 million working capital loan to the joint venture. The former operators of the hospital, comprised primarily of local physicians, retained ownership of 49% of the operating entity.

On February 4, 2011, we purchased for $58 million the real estate of Bayonne Medical Center, a 6-story, 278-bed acute care hospital in the New Jersey area of metropolitan New York, and leased the facility to the operator under a 15-year lease, with six 5-year extension options. The operator is an affiliate of a private hospital operating company that acquired the hospital in 2008.

On February 9, 2011, we acquired the real estate of the 306-bed Alvarado Hospital in San Diego, California for $70 million from Prime Healthcare Services, Inc. (“Prime”). Prime is the operator of the facility.

On February 14, 2011, we completed the acquisition of the Northland LTACH Hospital located in Kansas City, a 35-bed hospital that opened in April 2008 and has a lease that expires in 2028. This hospital is currently being operated by Kindred Healthcare Inc. The purchase price of this hospital was $19.5 million, which included the assumption of a mortgage loan.

As part of these acquisitions, we purchased and invested in the following assets: (dollar amounts in thousands)


	2012		2011
Assets Acquired
Land	$	—	$	16,151
Building		—		157,834
Intangible lease assets — subject to amortization (weighted average useful life of 13.3 years in 2011)		—		14,093
Net investments in direct financing leases		200,000		—
Mortgage loans		100,000		—
Other loans		93,200		5,233
Equity investments		3,300		1,268

Total assets acquired	$	396,500	$	194,579
Total liabilities assumed		—		(14,592	)

Net assets acquired	$	396,500	$	179,987

From the acquisition date, the Ernest Transaction contributed $11.1 million and $15.0 million of revenue and income (excluding related acquisition expenses) for the three and six month periods ended June 30, 2012, respectively. In addition, we incurred $0.3 million and $3.7 million of acquisition related costs on the Ernest Transaction for the three and six months ended June 30, 2012.

The purchase price allocation attributable to the Ernest Transaction is preliminary as we are waiting on additional information to perform our final analysis. When all relevant information is obtained, resulting changes, if any, to our provisional purchase price allocation will be retrospectively adjusted to reflect new information obtained about the facts and circumstances that existed as of the respective acquisition date that, if known, would have affected the measurement of the amounts recognized as of that date.

From the respective acquisition dates, the five hospitals acquired in 2011 contributed $5.3 million and $8.5 million of revenue and $3.4 million and $5.4 million of income (excluding related acquisition expenses) for the three and six months ended June 30, 2011, respectively. In addition, we incurred $0.6 million and $2.7 million of acquisition related costs for the three and six months ended June 30, 2011, of which $0.1 million and $1.7 million, respectively, related to acquisitions consummated as of June 30, 2011.

The results of operations for each of the properties acquired are included in our consolidated results from the effective date of each acquisition. The following table sets forth certain unaudited pro forma consolidated financial data for 2012 and 2011, as if each acquisition in 2012 and 2011 were consummated on the same terms at the beginning of 2011 and 2010, respectively. Supplemental pro forma earnings were adjusted to exclude acquisition-related costs on consummated deals incurred in the three and six months ended June 30, 2012 and 2011 (dollar amounts in thousands except per share/unit data).


	For the Three Months Ended June 30,				For the Six Months Ended June 30,
	2012		2011		2012		2011
Total revenues	$	51,070	$	48,671	$	101,287	$	98,250
Net income		19,672		10,825		39,401		32,133
Net income per share/unit — diluted	$	0.14	$	0.08	$	0.29	$	0.23

Development Activities

On June 13, 2012, we entered into an agreement with Ernest to develop and lease a 40-bed rehabilitation hospital in Lafayette, Indiana. Total development cost is estimated to be $16.6 million and the facility is expected to be completed in early 2013. We have funded $2.4 million through the second quarter of 2012.

On May 4, 2012, we amended the current lease on our Victoria, Texas facility with Post Acute Medical to extend the current lease term into 2028, and we agreed to develop and lease a 26-bed facility next to the current facility. Total development cost of the new facility is estimated to be $9.4 million and it is expected to be completed in June 2013.

On March 1, 2012, we received a certificate of occupancy for our recently constructed Florence acute care facility near Phoenix, Arizona. With this, we started recognizing rent on this facility in March 2012. During the construction period, we accrued and deferred rent based on the cost paid during the construction period. In March 2012, we began recognizing a portion of the accrued construction period rent along with interest on the unpaid amount. This accrued construction period rent will be recognized in our income statement and paid over the 25 year lease term. Land and building costs associated with this property approximates $30 million.

In addition to the new development projects, our other three development projects, which will be leased to Emerus Holding, Inc., are expected to be completed in the 2012 fourth quarter. Estimated total development cost for these three facilities is $30 million. We have funded $11.7 million through the second quarter of 2012. In regard to our River Oaks facility, re-development efforts continue and we currently expect this facility to be completed in the first quarter of 2013.

Disposals

On June 15, 2012, we sold the HealthSouth Rehabilitation Hospital of Fayetteville in Fayetteville, Arkansas for $16 million, resulting in a loss of $1.4 million. Due to this sale, the operating results of this facility for the current and all prior periods have been included in discontinued operations, and we have reclassified the related real estate to Real Estate Held for Sale. In connection with this sale, HealthSouth Corporation agreed to extend the lease on our Wichita, Kansas property, which is now set to end in March 2022.

Leasing Operations

Denham Springs facility

For the six months ended June 30, 2012, there have been no significant developments to our Denham Springs facility or its operator. We have not recorded any rental revenue or reversed previously established reserves during the first or second quarters. At June 30, 2012, we continue to believe, based on existing collateral and the current real estate market, that the $0.7 million loan and the $4.1 million of real estate are fully recoverable; however, no assurances can be made that future reserves will not be needed.

Ernest

We are accounting for the master lease of 12 facilities to Ernest as a DFL. The components of our net investment in DFL consisted of the following (dollars in thousands):


	As of June 30, 2012
Minimum lease payments receivable	$	896,900
Estimated residual values		200,000
Less unearned income		(895,744	)

Net investment in direct financing leases	$	201,156

Monroe facility

As of June 30, 2012, we have advanced $29.9 million to the operator/lessee of Monroe Hospital in Bloomington, Indiana pursuant to a working capital loan agreement, including additional advances of $1.3 million during the second quarter of 2012. In addition, as of June 30, 2012, we have $18.0 million of rent, interest and other charges owed to us by the operator, of which $5.6 million of interest receivables are significantly more than 90 days past due. Because the operator has not made all payments required by the working capital loan agreement and the related real estate lease agreement, we consider the loan to be impaired. During 2010, we recorded a $12 million impairment charge on the working capital loan and recorded a valuation allowance for unbilled straight-line rent in the amount of $2.5 million. We have not recognized any interest income on the Monroe loan since it was considered impaired and have not recorded any unbilled rent since 2010.

At June 30, 2012, our net investment (exclusive of the related real estate) of $35.9 million is our maximum exposure to Monroe and the amount is deemed collectible/recoverable. In making this determination, we considered our first priority secured interest in approximately (i) $5 million in hospital patient receivables, (ii) cash balances of approximately $1 million, (iii) our assessment of the realizable value of our other collateral and (iv) continued improvement in operational revenue statistics compared to previous years. However, no assurances can be made that we will not have additional charges for further impairment of our working capital loan in the future.

Loans

On March 1, 2012, pursuant to our convertible note agreement, we converted $1.7 million of our $5.0 million convertible note into a 9.9% equity interest in the operator of our Hoboken University Medical Center facility. At June 30, 2012, $3.3 million remains outstanding on the convertible note, and we retain the option, through November 2014, to convert this remainder into a 15.1% of equity interest in the operator.

Concentrations of Credit Risk

For the three and six months ended June 30, 2012, revenue from affiliates of Ernest (including rent and interest from mortgage and acquisition loans) accounted for 11.2% and 16.0%, respectively, of total revenue. However, from an investment concentration perspective, Ernest represented 19.4% of our total assets at June 30, 2012.

For the three months ended June 30, 2012 and 2011, revenue from affiliates of Prime (including rent and interest from mortgage loans) accounted for 22.1% and 31.7%, respectively, of total revenue. For the six months ended June 30, 2012 and 2011, revenue from affiliates of Prime (including rent and interest from mortgage loans) accounted for 24.1% and 31.0%, respectively, of total revenue. However, from an investment concentration perspective, Prime represented 20.1% and 25.6% of our total assets at June 30, 2012 and 2011, respectively.

On an individual property basis, we had no investment of any single property greater than 5% of our total assets as of June 30, 2012.

From a geographic perspective, all of our properties are located in the United States with 24.0% of our total assets at June 30, 2012 located in Texas.