NOTE 6. Net Investment in Direct Financing Leases

The components of net investment in DFLs consisted of the following (dollars in thousands):


	December 31,
	2015		2014
Minimum lease payments receivable	$	26,283,392	$	24,182,525
Estimated residual values		3,900,679		4,126,426
Less unearned income		(23,462,022)		(21,028,617)
Net investment in direct financing leases before allowance		6,722,049		7,280,334
Allowance for DFL losses		(817,040)		—
Net investment in direct financing leases	$	5,905,009	$	7,280,334
Properties subject to direct financing leases		348		363

HCR ManorCare, Inc.

The Company acquired 334 post-acute, skilled nursing and assisted living facilities in its 2011 transaction with HCR ManorCare Inc. (“HCRMC”) and entered into a triple-net Master Lease and Security Agreement (the “Master Lease”) with a subsidiary (“Lessee”) of HCRMC.

As part of the Company’s fourth quarter 2015 review process, including its internal rating evaluation, it assessed the collectibility of all contractual rent payments under the HCRMC amended master lease (the “Amended Master Lease”). The Company’s evaluation included, but was not limited to, consideration of: (i) the continued decline in HCRMC’s operating performance and fixed charge coverage ratio during the second half of 2015, with the most significant deterioration occurring during the fourth quarter, (ii) the reduced growth outlook for the post-acute/skilled nursing business and (iii) HCRMC’s 2015 audited financial statements. The Company determined that the timing and amounts owed under the HCRMC DFL investments are no longer reasonably assured and assigned an internal rating of “Watch List” as of December 31, 2015. Further, the Company placed the HCRMC DFL investments on nonaccrual and will utilize the cash method of accounting in accordance with its policy (see Note 2).

As a result of assigning an internal rating of “Watch List” for its HCRMC DFL investments during the quarterly review process, the Company further evaluated the carrying amount of its HCRMC DFL investments. As a result of the significant decline in HCRMC’s fixed charge coverage ratio in the fourth quarter of 2015, combined with a lower growth outlook for the post-acute/skilled nursing business, the Company determined that it is probable that its HCRMC DFL investments are impaired and the amount of the loss can be reasonably estimated. In the fourth quarter of 2015, the Company recorded an allowance for DFL losses (impairment charge) of $817 million, reducing the carrying amount of its HCRMC DFL investments from $6.0 billion to $5.2 billion. See Note 17 for additional discussion of the impairment charge and related valuation assumptions.

In December 2015, the Company reduced the carrying amount of its equity investment in HCRMC to zero, and income will be recognized only if cash distributions are received from HCRMC; as a result, the Company will no longer recharacterize (eliminate) its proportional ownership share of income from DFLs to equity income from unconsolidated joint ventures (see Note 8).

The Company recognized HCRMC DFL income and HCRMC equity income as follows (in thousands):


	Year Ended
	December 31,
	2015		2014		2013
Cash income	$	482,770	$	519,280	$	502,354
DFL accretion, net		90,065		79,349		82,688
Total DFL income from HCRMC	$	572,835	$	598,629	$	585,042
DFL accretion income recharacterized to equity income	$	58,047	$	62,445	$	62,061
Equity loss from HCRMC		(7,324)		(9,270)		(6,460)
Total equity income from HCRMC	$	50,723	$	53,175	$	55,601

During the years ended December 31, 2015, 2014 and 2013, the Company recognized a total of $148 million, $142 million and $145 million of accretion, net, respectively, related to its HCRMC DFL investments.

During the quarter ended March 31, 2015, the Company and HCRMC agreed to market for sale the real estate and operations associated with 50 non-strategic facilities that were under the Master Lease. HCRMC receives an annual rent reduction under the Master Lease based on 7.75% of the net sales proceeds received by HCP. During the year ended December 31, 2015, the Company completed sales of 22 non-strategic HCRMC facilities for $219 million. Subsequent to December 31, 2015, the Company sold an additional 11 facilities, bringing the total facilities sold through February 8, 2016 to 33, with the remaining facility sales expected to close by mid-2016.

On March 29, 2015, certain subsidiaries of the Company entered into an amendment to the Master Lease (the “HCRMC Lease Amendment”) effective April 1, 2015. The HCRMC Lease Amendment reduced initial annual rent by a net $68 million from $541 million to $473 million. Commencing on April 1, 2016, the minimum rent escalation shall be reset to 3.0% for each lease year through the expiration of the initial term of each applicable pool of facilities. Prior to the HCRMC Lease Amendment, rent payments would have increased 3.5% on April 1, 2015 and 2016 and 3.0% thereafter. The initial term was extended five years to an average of 16 years, and the extension options’ aggregate terms remained the same.

As consideration for the rent reduction, the Company received a Deferred Rent Obligation (“DRO”) from the Lessee equal to an aggregate amount of $525 million, which was allocated into two tranches: (i) a Tranche A DRO of $275 million and (ii) a Tranche B DRO of $250 million. Until the entire Tranche A DRO is paid in full, the Lessee will make rental payments equal to 6.9% of the outstanding amount (representing $19 million) for the initial lease year (the “Tranche A Current Payment”), increased each year thereafter by 3.0%. Commencing on April 1, 2016, until the Tranche B DRO is paid in full, the outstanding principal balance of the Tranche B DRO will be increased annually by (i) 3.0% initially, (ii) 4.0% commencing on April 1, 2019, (iii) 5.0% commencing on April 1, 2020, and (iv) 6.0% commencing on April 1, 2021 and for the remainder of its term. The DRO is due and payable on the earlier of (i) certain capital or liquidity events of HCRMC, including an initial public offering or sale, or (ii) March 31, 2029, which is not subject to any extensions. The HCRMC Lease Amendment also imposes certain restrictions on the Lessee and HCRMC until the DRO is paid in full, including with respect to the payment of dividends and the transfer of interest in HCRMC.

Additionally, HCRMC agreed to sell, and HCP agreed to purchase, nine post-acute facilities for an aggregate purchase price of $275 million. The proceeds from the nine facilities are to be used to reduce the Tranche A DRO as the purchases are consummated. The closing of the purchases of these facilities are subject to certain customary conditions and approvals. Through December 31, 2015, HCRMC and HCP completed seven of the nine facility purchases for $184 million. The purchases of the remaining two facilities are expected to occur by mid-2016. Following the purchase of a facility, the Lessee leases such facility from the Company pursuant to the Amended Master Lease. The nine facilities will contribute an aggregate of $19 million of annual rent (subject to escalation) under the Amended Master Lease.

In March 2015, the Company recorded an impairment charge of $478 million related to its HCRMC DFL investments. The impairment charge reduced the carrying value of the HCRMC DFL investments from $6.6 billion to $6.1 billion, based on the present value of the future lease payments effective April 1, 2015 under the Amended Master Lease discounted at the original DFL investments’ effective lease rate (see Note 17).

See Note 8 for additional discussion of the Company’s equity interest in HCRMC and the U.S. Department of Justice (“DOJ”) action related to HCRMC.

During the year ended December 31, 2014, the Company received a $13 million payoff from the sale of a HCRMC post-acute/skilled nursing facility that collateralized this DFL.

Direct Financing Lease Internal Ratings

The following table summarizes the Company’s internal ratings for net investment in DFLs at December 31, 2015 (dollars in thousands):


	Carrying		Percentage of	Internal Ratings
Investment Type	Amount		DFL Portfolio	Performing DFLs		Watch List DFLs		Workout DFLs
Senior housing	$	1,788,764	30	$	261,261	$	1,527,503	$	—
Post-acute/skilled nursing		3,992,354	68		—		3,992,354		—
Hospital		123,891	2		123,891		—		—
	$	5,905,009	100	$	385,152	$	5,519,857	$	—

Beginning September 30, 2013, the Company placed a 14 property senior housing DFL (the “DFL Portfolio”) on nonaccrual status and classified the DFL Portfolio on “Watch List” status. The Company determined that the collection of all rental payments was and continues to be no longer reasonably assured; therefore, rental revenue for the DFL Portfolio has been recognized on a cash basis. The Company re-assessed the DFL Portfolio for impairment on December 31, 2015 and determined that the DFL Portfolio was not impaired based on its belief that: (i) it was not probable that it will not collect all of the rental payments under the terms of the lease; and (ii) the fair value of the underlying collateral exceeded the DFL Portfolio’s carrying amount. The fair value of the DFL Portfolio was estimated based on a discounted cash flow model, the inputs to which are considered to be a Level 3 measurement within the fair value hierarchy. Inputs to this valuation model include real estate capitalization rates, industry growth rates and operating margins, some of which influence the Company’s expectation of future cash flows from the DFL Portfolio and, accordingly, the fair value of its investment. During the years ended December 31, 2015, 2014 and 2013, the Company recognized DFL income of $15 million, $19 million and $24 million, respectively, and received cash payments of $20 million, $24 million and $24 million, respectively, from the DFL Portfolio. The carrying value of the DFL Portfolio was $366 million and $370 million at December 31, 2015 and 2014, respectively.

Certain leases contain provisions that allow the tenants to elect to purchase the properties during or at the end of the lease terms for the aggregate initial investment amount plus adjustments, if any, as defined in the lease agreements. Certain leases also permit the Company to require the tenants to purchase the properties at the end of the lease terms.

Future minimum lease payments contractually due under DFLs at December 31, 2015, were as follow (in thousands):


Year	Amount
2016	$	552,985
2017		545,307
2018		559,979
2019		576,206
2020		586,229
Thereafter		23,462,686
	$	26,283,392