3. Real Estate and Lending Activities

Acquisitions

2014 Activity

On March 31, 2014, we acquired a general acute care hospital and an adjacent parcel of land for an aggregate purchase price of $115 million from a joint venture of LHP Hospital Group, Inc. and Hackensack University Medical Center Mountainside. The facility was simultaneously leased back to the seller under a lease with a 15-year initial term with a 3-year extension option, followed by a further 12-year extension option at fair market value. The lease provides for consumer price-indexed annual rent increases, subject to a specified floor and ceiling. The lease includes a customary right of first refusal with respect to a subsequent proposed sale of the facility.

2013 Activity

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”).

As part of these acquisitions, we acquired the following assets:


	2014		2013
Assets Acquired
Land	$	8,515	$	—
Building		99,602		—
Intangible lease assets — subject to amortization (weighted average useful life 15 years)		6,883		—
Net investments in direct financing leases		—		75,000

Total assets acquired	$	115,000	$	75,000

The purchase price allocation attributable to the facility acquired in the 2014 first quarter along with the facilities acquired from IASIS and RHM in the 2013 third and fourth quarters is preliminary as we are waiting on additional information to perform our final analysis. When all relevant information is obtained, and if changes to our provisional purchase price allocations are needed, we will retrospectively adjust to reflect the 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.

Development Activities

During the first six months of 2014, we completed construction and began recording rental income on the following facilities:

•

Northern Utah Rehabilitation Hospital – This $19 million inpatient rehabilitation facility located in South Ogden, Utah is leased to Ernest pursuant to the 2012 master lease.

•

First Choice ER (a subsidiary of Adeptus Health) – We completed 8 acute care facilities for this tenant during 2014 totaling approximately $29.5 million, including Nacogdoches, Alvin, Brodie, Firestone, Frisco, Briar Forest, North Gate and Cedar Hill. These facilities are leased pursuant to the master lease entered into in 2013.

During the first six months of 2014, we began construction on two additional facilities pursuant to the master funding and development agreement with First Choice ER.

In regards to our Twelve Oaks facility, approximately 55% of this facility is being occupied, pursuant to a 15 year lease.

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

Property

Location

Property Type

Operator

Commitment

Costs Incurred
as of
June 30,
2014

Estimated
Completion
Date

Oakleaf Surgical Hospital

Altoona, WI

Acute Care Hospital

National Surgical
Hospitals

33,500

28,669

3Q 2014

First Choice ER - Allen

Allen, TX

Acute Care Hospital

Adeptus Health

6,187

3,365

3Q 2014

First Choice ER - Broomfield

Broomfield, CO

Acute Care Hospital

Adeptus Health

5,238

2,515

3Q 2014

First Choice ER - Spring

Spring, TX

Acute Care Hospital

Adeptus Health

5,804

2,676

3Q 2014

First Choice ER - Fountain

Fountain, CO

Acute Care Hospital

Adeptus Health

6,194

3,380

3Q 2014

First Choice ER - Missouri City (Sienna)

Houston, TX

Acute Care Hospital

Adeptus Health

5,394

3,565

3Q 2014

First Choice ER - Pearland

Pearland, TX

Acute Care Hospital

Adeptus Health

5,691

2,331

4Q 2014

First Choice ER - Thornton

Thornton, CO

Acute Care Hospital

Adeptus Health

6,029

2,652

4Q 2014

First Choice ER - Missouri City (Dulles)

Houston, TX

Acute Care Hospital

Adeptus Health

5,693

2,516

4Q 2014

First Choice ER - Commerce City

Denver, CO

Acute Care Hospital

Adeptus Health

5,371

707

4Q 2014

85,101

52,376

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.

Leasing Operations

All of our leases are accounted for as operating leases except for the master lease of 13 Ernest facilities and five Prime facilities which are accounted for as direct financing leases (“DFLs”). The components of our net investment in DFLs consisted of the following (dollars in thousands):


	As of June 30, 2014			As of December 31, 2013
Minimum lease payments receivable	$	1,626,490		$	1,647,567
Estimated residual values		211,888			211,863
Less: Unearned income		(1,404,067	)		(1,428,406	)

Net investment in direct financing leases	$	434,311		$	431,024

Monroe Facility

As of June 30, 2014 and December 31, 2013, our net investment (exclusive of the related real estate) in Monroe was as follows:


	As of June 30, 2014			As of December 31, 2013
Loans	$	32,943		$	31,341
Less: Loan impairment reserve		(32,943	)		(12,000	)

Loans, net		—			19,341
Interest, rent and other receivables		—			20,972

Net investment	$	—		$	40,313

The current operator of our Monroe facility has not made all payments required by the real estate lease agreement and working capital loan agreement, and we have deemed these assets to be impaired. During 2010, we recorded a $12 million impairment charge on the working capital loan and fully reserved for unbilled straight-line rent receivables as well. Since 2010, we have not recognized any interest income on the Monroe loan and have not recorded any unbilled rent revenue. In addition, we stopped recording billed rental revenue on April 1, 2013.

During the first quarter of 2014, we executed a non-binding letter of intent with a third party with respect to a restructuring of our investment in the form of a new joint venture that would acquire the real estate of our Monroe facility and related assets in exchange for a combination of cash and promissory notes along with the potential of additional cash, if any, to be generated from our share in this new joint venture’s operations. Based on those new developments and the fair value of the loan’s underlying collateral at that time (using Level 2 inputs), we recorded an approximate $20.5 million impairment charge in the 2014 first quarter. Subsequent to the 2014 first quarter, we terminated this non-binding letter of intent.

In July 2014, we entered into an agreement with a third-party to manage the Monroe Hospital. In addition, we entered into a non-binding letter of intent with this same party to lease the facility for initial cash rents of $2.1 million. These agreements contemplate a bankruptcy filing by the existing tenant and do not provide us with any recovery on the past due receivables at June 30, 2014. Based on these new developments and the fair value of our real estate and the underlying collateral of our loan (using Level 2 inputs), we recorded a $26.5 million impairment charge in the 2014 second quarter. This charge effectively reduces our overall investment in Monroe to the fair value of the underlying real estate, or $25 million, which we believe is fully recoverable at June 30, 2014.

Bucks facility

On May 20, 2014, the tenant of our Bucks facility gave notice of their intent to exercise the lease’s purchase option. Pursuant to this purchase option, the tenant acquired the facility on August 6, 2014 for $35 million. At June 30, 2014, we met the criteria to classify this facility as an Asset Held for Sale; thus, we wrote down this facility to fair market value less cost to sell, resulting in a $3.1 million real estate impairment charge. The sale of the Bucks facility is not a strategic shift in our operations, and therefore the results of the Bucks operations have not been reclassified as discontinued operations.

Florence facility

On March 6, 2013, the tenant of our facility in Phoenix, Arizona filed for Chapter 11 bankruptcy; but continues to pay rent. We have a letter of credit for approximately $1.2 million to cover any rent and other monetary payments not made. Although no assurances can be made that we will not have any impairment charges in the future, we believe our real estate investment in Florence of approximately $28 million at June 30, 2014, is fully recoverable.

Gilbert facility

In the first quarter of 2014, the tenant of our facility in Gilbert, Arizona filed for Chapter 11 bankruptcy; we sent notice of termination of the lease prior to the bankruptcy filing. As a result of the lease terminating, we recorded a charge of approximately $1 million to reserve against the straight-line rent receivables. In addition, we accelerated the amortization of the related lease intangible asset resulting in $1.1 million of additional expense in the 2014 first quarter. At June 30, 2014, we have $0.3 million of outstanding receivables, which we believe are collectible. Although no assurances can be made that we will not have any impairment charges or write-offs of receivables in the future, we believe our real estate investment in Gilbert of approximately $14 million at June 30, 2014, is fully recoverable.

Loans

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


	As of June 30, 2014		As of December 31, 2013
Mortgage loans	$	385,100	$	388,756
Acquisition loans		108,772		109,655
Working capital and other loans		28,346		47,983
Convertible loan		3,352		3,352


	$	525,570	$	549,746

The decrease in our working capital and other loans is primarily due to the impairment charge incurred on our Monroe loan during 2014 – see Note 3, Leasing Operations for further discussion.

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, 2014, $3.3 million remains outstanding on the convertible note, and we retain the option, subject to regulatory approvals, to convert this remainder into 15.1% of equity interest in the operator.

Concentrations of Credit Risk

For the three months ended June 30, 2014 and 2013, revenue from affiliates of Prime (including rent and interest from mortgage loans) accounted for 27.9% and 32.5%, respectively, of total revenue. For the six months ended June 30, 2014 and 2013, revenue from affiliates of Prime (including rent and interest from mortgage loans) accounted for 28.5% and 31.9%, respectively, of total revenue. From an investment concentration perspective, Prime represented 22.3% and 24.5% of our total assets at June 30, 2014 and December 31, 2013, respectively.

For the three months ended June 30, 2014 and 2013, revenue from affiliates of Ernest (including rent and interest from mortgage and acquisition loans) accounted for 18.2% and 20.4%, respectively, of total revenue. For the six months ended June 30, 2014 and 2013, revenue from affiliates of Ernest (including rent and interest from mortgage and acquisition loans) accounted for 18.9% and 20.5%, respectively, of total revenue. From an investment concentration perspective, Ernest represented 15.1% and 15.9% of our total assets at June 30, 2014 and December 31, 2013, respectively.

On an individual property basis, we had no investment of any single property greater than 4% of our total assets as of June 30, 2014.

From a geographic perspective, investments located in California represented 17.1% of our total assets at June 30, 2014, down from 18.7% at December 31, 2013. Investments located in Texas represented 21.3% of our total assets at June 30, 2014, down slightly from 22.7% at December 31, 2013. In addition, we further expanded our portfolio into Europe with the RHM portfolio acquisition in 2013, which represents less than 8% of total assets at June 30, 2014.