3. Real Estate and Lending Activities

Acquisitions

2013 Activity

On September 26, 2013, we acquired three general acute care hospitals from affiliates of IASIS Healthcare LLC (“IASIS”) for a combined purchase price of $283.3 million (including a commitment to provide approximately $2.0 million for improvements to a fourth hospital that we already own). Each of the facilities will be leased back to IASIS under leases with initial 15-year terms plus two renewal options of five years each, and consumer price-indexed rent increases limited to a 2.5% ceiling annually. The lessees will also have a right of first refusal option with respect to subsequent proposed sales of the facilities. All of our leases with affiliates of IASIS will be cross-defaulted with each other. In addition to the IASIS acquisitions transactions, we have amended our lease with IASIS for the Pioneer Valley Hospital in West Valley City, Utah, which extended the lease to 2028 from 2019 and adjusted the rent.

On July 18, 2013, we acquired the real estate of Esplanade Rehab Hospital in Corpus Christi, Texas (now operating as Corpus Christi Rehabilitation Hospital) for $15.8 million (including a $0.5 million commitment to acquire adjacent land and leased the facility to an affiliate of Ernest Health Inc. (“Ernest”) under the master lease agreement entered into with Ernest in 2012 that initially provided for a 20-year term with three five-year extension options, plus consumer price-indexed rent increases, limited to a 2% floor and 5% ceiling annually.

On June 11, 2013, we acquired the real estate of two acute care hospitals in Kansas from affiliates of Prime Healthcare Services, Inc. (“Prime”) for a combined purchase price of $75 million and leased the facilities to the operator under a master lease agreement. The master lease is for 10 years and contains two renewal options of five years each, and the rent increases annually based on the greater of the consumer price-index or 2%. This lease is accounted for as a direct financing lease (“DFL”).

2012 Activity

On September 19, 2012, we acquired the real estate of the 380 bed St. Mary’s Regional Medical Center, an acute care hospital in Reno, Nevada for $80 million and the real estate of the 140 bed Roxborough Memorial Hospital in Pennsylvania for $30 million. The acquired facilities are leased to Prime pursuant to a master lease agreement.

On July 3, 2012, we funded a $100 million mortgage loan secured by the real property of Centinela Hospital Medical Center. Centinela is a 369 bed acute care facility that is operated by Prime. This mortgage loan is cross-defaulted with other mortgage loans to Prime and the master lease agreements.

On February 29, 2012, we made loans to and acquired assets from Ernest for a combined purchase price and investment of $396.5 million (“Ernest Transaction”).

Real Estate Acquisition and Mortgage Loan Financing

Pursuant to a definitive real property asset 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 provided 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, which is the owner of Ernest. These investments are structured as a $93.2 million acquisition loan and a $3.3 million equity contribution.

The interest rate on the acquisition loan is 15%. 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.

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


	2013		2012
Land	$	16,220	$	—
Building		265,030		—
Net investments in direct financing leases		85,000		310,000
Mortgage loans		—		200,000
Other loans		5,250		93,200
Equity investments		—		3,300


Total	$	371,500	$	606,500

From the respective acquisition dates, the properties and mortgage loans acquired in 2013 contributed $2.9 million and $3.3 million of revenue and income (excluding related acquisition expenses), respectively, for the three and nine month periods ended September 30, 2013, respectively. In addition, we incurred $1.6 million and $1.6 million of acquisition related costs on the 2013 acquisitions for the three and nine months ended September 30, 2013.

The purchase price allocation attributable to the IASIS facilities is preliminary as we are waiting on additional information to perform our final analysis. When all relevant information is obtained, resulting in 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.

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, as if each acquisition in 2013 and 2012 were consummated on the same terms at the beginning of 2012 and 2011, respectively. Supplemental pro forma earnings were adjusted to exclude acquisition-related costs on consummated deals incurred in the three and nine months ended September 30, 2012 ($ amounts in thousands, except per share/unit data).


	For the Three Months Ended September 30,				For the Nine Months Ended September 30,
	2013		2012		2013		2012
Total revenues	$	65,518	$	63,695	$	196,708	$	188,339
Net income		29,366		37,091		89,570		92,620
Net income per share/unit — diluted	$	0.18	$	0.25	$	0.55	$	0.63

Development Activities

On June 11, 2013, we entered into a master funding and development agreement with First Choice ER, LLC (“First Choice”) to develop up to 25 freestanding emergency room facilities for a maximum aggregate funding of $100 million. During the third quarter of 2013, we began construction on two of these emergency room facilities in Dallas, Texas and Austin, Texas for a total development price of $5.2 million and $5.5 million, respectively. One of the facilities is expected to be completed in the fourth quarter of 2013, while the other in the first quarter of 2014. We have funded $4.3 million through the end of the 2013 third quarter.

On May 20, 2013, we entered into an agreement to finance the development of and lease an inpatient rehabilitation facility in South Ogden, Utah for $19.2 million, which will be leased to Ernest under the 2012 master lease. The facility is expected to be completed in the 2014 third quarter. We have funded $7.4 million through the end of the 2013 third quarter.

On March 4, 2013, we entered into an agreement to finance the development of and lease an inpatient rehabilitation facility in Post Falls, Idaho for $14.4 million, which will be leased to Ernest under the 2012 master lease. The facility is expected to be completed in the fourth quarter of 2013. We have funded $10.4 million through the end of the 2013 third quarter.

In regards to our Twelve Oaks facility, approximately 55% of this facility became occupied as of January 23, 2013, pursuant to a 15 year lease.

On December 20, 2012, we entered into an agreement to finance the development of and lease an acute care facility in Altoona, Wisconsin for $33.5 million, which will be leased to an affiliate of National Surgical Hospitals. The facility is expected to be completed in the fourth quarter of 2014. We have funded $11.1 million through the end of the 2013 third quarter.

On October 1, 2012, we agreed to fund the construction of an inpatient rehabilitation hospital in Spartanburg, South Carolina that will be operated by Ernest. The facility opened in the third quarter of 2013, and the cost of the land and building for this facility approximates $15 million. The initial lease term for this property is approximately 20 years.

On June 13, 2012, we entered into an agreement with Ernest to fund the development of and lease a 40-bed rehabilitation hospital in Lafayette, Indiana. The facility opened in the first quarter of 2013, and the cost of the land and building for this facility approximates $15 million. The initial lease term for this property is approximately 20 years.

On May 4, 2012, we agreed to develop and lease a 26-bed facility next to our current facility in Victoria, Texas. Total development cost of the new facility is estimated to be $9.4 million, and it is expected to be completed in fourth quarter of 2013. We have funded $8.4 million through the end of the 2013 third quarter.

On October 14, 2011, we entered into agreements with a joint venture of Emerus Holding, Inc. and Vanguard Health System, a subsidiary of Baptist Health System, to acquire, provide for development funding and lease three emergency care focused acute care hospitals for $30.0 million in the suburban markets of San Antonio, Texas. The three facilities are subject to a master lease structure with an initial term of 15 years and three five-year extension options. Rent escalates annually based on consumer priced indexed increases and to be not less than one percent or greater than three percent. One of these properties was completed in the fourth quarter of 2012 with the remaining two being completed in the first quarter of 2013.

See table below for a status update on our current development projects (in thousands):

Property

Location

Property Type

Operator

Original
Commitment

Costs
Incurred as
of September 30,
2013

Estimated
Completion
Date

Victoria Rehabilitation Hospital

Victoria, TX

Long-term Acute

Care Hospital

Post Acute Medical

9,400

8,391

4^th Qtr 2013

First Choice ER — Brodie

Austin, TX

General Acute
Care Hospital

First Choice

5,470

1,509

1^st Qtr 2014

First Choice ER — Little Elm

Dallas, TX

General Acute
Care Hospital

First Choice

5,200

2,792

4^th Qtr 2013

Rehabilitation Hospital of the Northwest

Post Falls, ID

Rehabilitation

Hospital

Ernest Health, Inc.

14,387

10,389

4^th Qtr 2013

Oakleaf Surgical Hospital

Altoona, WI

General Acute

Care Hospital

National Surgical

Hospitals

33,500

11,146

3^rd Qtr 2014

Northern Utah Rehabilitation Hospital

South Ogden, UT

Rehabilitation

Hospital

Ernest Health, Inc.

19,153

7,406

3^rd Qtr 2014

First Choice Emergency Rooms

Various

General Acute

Care Hospital

First Choice

89,330

—

Various

176,440

41,633

Disposals

In April 2013, we sold two long-term acute care hospitals, Summit Hospital of Southeast Arizona and Summit Hospital of Southeast Texas, for total proceeds of $18.5 million, resulting in a gain of $2.1 million.

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.

On August 21, 2012, we sold our Denham Springs facility for $5.2 million, resulting in a gain of $0.3 million.

On September 28, 2012, we sold our Thornton facility for $17.4 million, resulting in a gain of $8.4 million.

Leasing Operations

On July 3, 2012, we entered into master lease agreements with certain subsidiaries of Prime, which replaced the then current leases with the same tenants covering the same properties. The master leases are for 10 years and contain two renewal options of five years each. The initial lease rate is generally consistent with the blended average rate of the prior lease agreements. However, the annual escalators, which in the prior leases were limited, have been increased 100% of consumer price index increases, along with a minimum floor. The master leases include repurchase options substantially similar to those in the prior leases, including provisions establishing minimum repurchase prices equal to our total investment.

All of our leases are accounted for as operating leases except for the master lease of 13 Ernest facilities and four other facilities which are accounted for as DFLs. The components of our net investment in DFL consisted of the following (dollars in thousands):


	As of September 30, 2013			As of December 31, 2012
Minimum lease payments receivable	$	1,566,155		$	1,277,923
Estimated residual values		211,283			201,283
Less: Unearned income		(1,373,926	)		(1,164,794	)


Net investment in direct financing leases	$	403,512		$	314,412

Monroe facility

As of September 30, 2013, we have advanced $29.9 million to the operator/lessee of Monroe Hospital in Bloomington, Indiana, pursuant to a working capital loan agreement and also have $21.0 million of rent, interest and other charges owed to us by the operator, of which $6.0 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, have not recorded any unbilled (straight-line) rent since 2010, and stopped recording current rent on April 1, 2013 until we begin receiving cash payments.

At September 30, 2013, our net investment (exclusive of the related real estate) of approximately $39 million is our maximum exposure to Monroe and the amount is presently deemed collectible/recoverable. In making this determination, we considered our first priority secured interest in (i) approximately $4 million in hospital patient receivables, (ii) cash balances of $0.1 million, (iii) our assessment of the realizable value of our other collateral and (iv) projected EBITDA of the hospital operations that we have modeled under various scenarios for sensitivity purposes. Although we believe our net investment in Monroe at September 30, 2013, is recoverable, no assurances can be made that we will not have additional impairment charges on our working capital loan or other receivables in the future.

Florence facility

On March 1, 2012, we received a certificate of occupancy for our approximate $30 million Florence acute care facility constructed near Phoenix, Arizona. With this, we started collecting and recognizing rent on this facility in March 2012. On March 6, 2013, the tenant of this facility filed for Chapter 11 bankruptcy. Florence is current on rent, and at September 30, 2013, we had less than $0.5 million of receivables outstanding. In addition, we have a letter of credit for approximately $1.2 million to cover any rent and other monetary payments not paid in the future. Although no assurances can be made that we will not have any impairment charges in the future, we believe our investment in Florence at September 30, 2013, is fully recoverable.

Loans

The following is a summary of our loans (in thousands):


	As of September 30, 2013		As of December 31, 2012
Mortgage loans	$	368,650	$	368,650
Acquisition loans		103,516		98,433
Working capital and other loans		54,377		57,458
Convertible loan		3,352		3,352


	$	529,895	$	527,893

Our mortgage loans cover 9 of our properties with three operators.

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 September 30, 2013, $3.3 million remains outstanding on the convertible note, and we retain the option, through November 2014, to convert this remainder into 15.1% of equity interest in the operator.

Concentrations of Credit Risk

For the three months ended September 30, 2013 and 2012, revenue from affiliates of Ernest (including rent and interest from mortgage and acquisition loans) accounted for 20.7% and 21.1%, respectively, of total revenue. For the nine months ended September 30, 2013 and 2012, revenue from affiliates of Ernest (including rent and interest from mortgage and acquisition loans) accounted for 20.5% and 18.4%, respectively, of total revenue. From an investment concentration perspective, Ernest represented 17.4% and 18.2% of our total assets at September 30, 2013 and December 31, 2012, respectively.

For the three months ended September 30, 2013 and 2012, revenue from affiliates of Prime (including rent and interest from mortgage loans) accounted for 33.7% and 28.7%, respectively, of total revenue. For the nine months ended September 30, 2013 and 2012, revenue from affiliates of Prime (including rent and interest from mortgage loans) accounted for 32.4% and 26.0%, respectively, of total revenue. From an investment concentration perspective, Prime represented 26.7% and 27.9% of our total assets at September 30, 2013 and December 31, 2012, respectively.

On an individual property basis, we had no investment of any single property greater than 5% of our total assets as of September 30, 2013.

From a geographic perspective, all of our properties are currently located in the United States with 24.5% and 20.4% of our total assets at September 30, 2013, located in Texas and California, respectively.