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Net Investment in Direct Financing Leases | 9 Months Ended
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Sep. 30, 2015
Net Investment in Direct Financing Leases |
Net Investment in Direct Financing Leases | NOTE 6. Net Investment in Direct Financing Leases Net investment in direct financing leases (“DFLs”) consisted of the following (dollars in thousands):
|  | September 30, |  | December 31, |
|  | 2015 |  | 2014 |
Minimum lease payments receivable |  | $ | 26,517,705 |  | $ | 24,182,525 |
Estimated residual values |  |  | 3,905,685 |  |  | 4,126,426 |
Less unearned income |  |  | (23,532,360) |  |  | (21,028,617) |
Net investment in direct financing leases |  | $ | 6,891,030 |  | $ | 7,280,334 |
Properties subject to direct financing leases |  |  | 362 |  |  | 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 lease agreement (the “Master Lease”) with a subsidiary (“Lessee”) of HCRMC. During the first quarter of 2015, the Company and HCRMC agreed to market for sale the real estate and operations associated with 50 non-strategic facilities that are under the Master Lease. HCRMC will receive an annual rent reduction under the Master Lease based on 7.75% of the net sales proceeds received by HCP. The first facility sale closed on July 31, 2015. The remaining facility sales are expected to occur during the fourth quarter of 2015 and the first quarter of 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 from the Lessee equal to an aggregate amount of $525 million, which was allocated into two tranches: (i) a Tranche A Deferred Rent Obligation of $275 million and (ii) a Tranche B Deferred Rent Obligation of $250 million. Until the entire Tranche A Deferred Rent Obligation 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 Deferred Rent Obligation is paid in full, the outstanding principal balance of the Tranche B Deferred Rent Obligation 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 Deferred Rent Obligation is due and payable on the earlier of (i) certain capital or liquidity events of HCRMC, including an IPO 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 Deferred Rent Obligation 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 will be used to reduce the Tranche A Deferred Rent Obligation as the purchases are consummated. The closing of the purchases of these facilities will be subject to certain customary conditions and approvals. Subsequent to September 30, 2015, HCRMC and HCP completed three of the nine facility purchases for $87 million in October 2015. The purchases of the remaining six facilities are expected to occur by the end of the first quarter of 2016. If the closing with respect to any of these facilities has not occurred by April 1, 2016, the obligation to purchase any unsold facilities will terminate. Following the purchase of a facility, the Lessee will lease such facility from the Company pursuant to the Master Lease. The nine facilities will contribute an aggregate of $19 million of annual rent (subject to escalation) under the Master Lease. In March 2015, the Company recorded a net impairment charge of $478 million related to its DFL investments with HCRMC. 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 HCRMC Lease Amendment discounted at the original DFL investments’ effective lease rate. There is no related allowance for credit losses recorded within the carrying value of the HCRMC DFL investments. See Notes 8 and 15 for additional discussion of the Company’s equity interest in HCRMC and related September 2015 impairment charge. See Note 8 for additional discussion of the U.S. Department of Justice action related to HCRMC. Direct Financing Lease Internal Ratings The following table summarizes the Company’s internal ratings for DFLs at September 30, 2015 (dollars in thousands):
|  | Carrying |  | Percentage of |  | Internal Ratings |
Segment |  | Amount |  | DFL Portfolio |  | Performing DFLs |  | Watch List DFLs |  | Workout DFLs |
Senior housing |  | $ | 1,574,246 |  | 23 |  | $ | 1,207,550 |  | $ | 366,696 |  | $ | — |
Post-acute/skilled nursing |  |  | 5,192,893 |  | 75 |  |  | 5,192,893 |  |  | — |  |  | — |
Hospital |  |  | 123,891 |  | 2 |  |  | 123,891 |  |  | — |  |  | — |
|  | $ | 6,891,030 |  | 100 |  | $ | 6,524,334 |  | $ | 366,696 |  | $ | — |
As a result of HCRMC related events, the Company reassessed the collectability of all contractual rent payments under the amended Master Lease. The Company has concluded that the collection of the amended rent payments is reasonably assured and has assigned an internal rating of “Performing” to its HCRMC DFL investments. Beginning September 30, 2013, the Company placed a 14-property senior housing DFL (the “DFL Portfolio”) on non-accrual status. The Company determined that the collection of all rental payments was and continues to be no longer reasonably assured; therefore, rental revenue from the DFL Portfolio is recognized on a cash basis. The Company re-assessed the DFL Portfolio for impairment on September 30, 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 three months ended September 30, 2015 and 2014, the Company recognized DFL income of $3 million and $5 million, respectively, and received cash payments of $5 million and $6 million, respectively, from the DFL Portfolio. During the nine months ended September 30, 2015 and 2014, the Company recognized DFL income of $12 million and $15 million, respectively, and received cash payments of $16 million and $18 million, respectively, from the DFL Portfolio. The carrying value of the DFL Portfolio was $367 million and $370 million at September 30, 2015 and December 31, 2014, respectively.

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- Definition The entire disclosure for lessor's leasing arrangements, which includes direct financing, sales type and leveraged leases. Disclosure may include the effect on the balance sheet and the income statement resulting from a change in lease classification for leases that at inception would have been classified differently had guidance been in effect at the inception of the original lease. + References Reference 1: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Accounting Standards Codification -Topic 840 -SubTopic 30 -Section 50 -Paragraph 4 -URI http://asc.fasb.org/extlink&oid=25496975&loc=d3e45377-112738 Reference 2: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Accounting Standards Codification -Topic 840 -SubTopic 10 -Section 50 -Paragraph 4 -URI http://asc.fasb.org/extlink&oid=6452767&loc=d3e37045-112695 Reference 3: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Accounting Standards Codification -Topic 840 -SubTopic 10 -Section 55 -Paragraph 47 -URI http://asc.fasb.org/extlink&oid=6584217&loc=d3e38847-112698 + Details
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