By Chad Tracy
Since the Federal Reserve's recent announcements regarding the "tapering" of its quantitative easing programs, the real estate investment trust (REIT) market has been in a tailspin.
The Dow Jones Equity REIT Index has fallen sharply since the middle of May, as investors began to sell on fear that the REIT market -- where profits are often tied closely to interest rates -- is in for hard days ahead.
But investors should keep in mind that not all REITs are created equal.
While some mortgage REITs such as Annaly Capital (NYSE: NLY) or American Capital Agency (NYSE: AGNC) depend on the difference between short-term rates and the price they can get for holding long-term debt (the yield curve), others make money by buying and leasing physical property.
This second type of REIT tends to be more stable, as the leasing of physical assets is much less volatile than the market for complex financial instruments.
So while the REIT market as a whole has declined in the wake of the Fed's recent announcements, REITs that invest in physical property have in some cases suffered price drops that are based on mostly on fear and have little to do with the value of the underlying business.
The company I'm going to tell you about today makes money by investing in health care real estate. Regular SteetAuthority readers are probably already familiar with the idea that the growing demand for health care due to the aging baby boomer generation represents a stellar investment opportunity.
Elliot Gue, the expert behind Top 10 Stocks (and a recent guest on CNBC) recently recommended another health care REIT in his May issue. While I can't reveal the name of his pick out of fairness to his subscribers, I think it's worth reprinting some of the demographic data he mentioned concerning health care REITs in general:
The U.S. Census Bureau estimates that the population of Americans older than 65 will increase by 37% (3.2% annually) during the next decade and that the number of U.S. residents over 75 years of age will surge by 46% (3.8% annually) in the subsequent decade.
These favorable demographic trends should fuel demand for space in independent-living facilities, followed by assisted-living and skilled-nursing facilities that offer increasing levels of care. While per-capita health care spending for Americans between 65 and 75 years old is elevated relative to younger population segments, this metric soars by roughly 70% after the age of 75. The aging U.S. population should fuel consumption of health care products and services.
Meanwhile, baby boomers' investment strategies are poised to continue evolving from a focus on accruing assets to turning accumulated savings into a dependable, lifelong income stream -- a potential boon for shares of health care REITs and other dividend-paying defensive stocks.
After reviewing a number of options in this sector, one in particular caught my eye. This company boasts a "fortress" balance sheet, a long history of rising dividends, and one of the best management teams in the business.
HCP Inc. (NYSE: HCP) acquires and manages health care real estate and provides financing to health care providers.
The company currently yields nearly 5% and has raised its dividend every year for the past decade. There is no reason to suspect the future will be any different, as HCP holds little debt and has been increasing its free cash flow by leaps and bounds.
From 2010 to 2011, the company nearly doubled free cash flow, from $276 million in 2010 to $526 million in 2011. In 2012, free cash flow was up to $840 million, an increase of 63%.
The company's debt-to-equity ratio is 0.8, slightly lower than the industry average of 0.9. Yet even after a recent $1.7 billion acquisition, the company still has plenty of cash left over to pay (and keep growing) dividends.
One of the key reasons for HCP's success has been its focus on triple-net leases. Under this structure, tenants are responsible for paying all property operating expenses. These include real estate taxes, utilities and the cost of property upkeep. In addition, the company has built-in protection from inflation, due to rent payments that generally keep pace with or exceed the inflation rate.
In its recent $1.7 billion deal, HCP added 129 properties to its senior housing community portfolio. These properties offer initial lease terms of 14 to 16 years, with the option to extend leases at higher rents for up to 30 to 35 years.
Long-term, steady-income generating deals like these are HCP's specialty. Disciplined acquisition, along with a consistent ability to create shareholder value, makes HCP's management team hard to beat.
Since CEO Jay Flaherty took the helm in 2002, HCP has returned an average of 16% a year to shareholders through dividends and capital gains. That compares with an annual average gain of 6% in the S&P 500 in that time.
Best of all, after the recent market pullback, shares have been selling at a discount. HCP shares dropped 23% between May 21 and June 20.
Yet after poring over the latest company transcripts and financial statements, I haven't been able to find any red flags that would justify such a steep decline. Nor could I find sufficient evidence to support the idea that, relative to its peers, HCP was simply an overvalued stock that was due for a correction.
HCP is thriving and should continue to do so for years to come. Owning and renting properties in the health care sector is one of the safest and most stable business models in the REIT universe.
When quality companies like HCP experience irrational price drops, it's a good time for savvy investors to shop for bargains.
Risks to Consider: Changes in governmental health care regulation are always a potential concern in the health care sector. Should programs such as Medicare and Medicaid undergo significant revisions, it could have a negative impact on tenants' ability to pay rent or to afford rent increases.
HCP is a great investment at today's prices for long-term, dividend-oriented investors.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.