As the financial calamity of 2008 unfolded, REIT shares have fallen along side the broader market, pushing dividend yields to highs not seen for several years. The industry is now rife with fears stemming from the beleaguered commercial real estate market. For many REITs caught with overleveraged balance sheets, the perfect storm of impending debt maturity and the frozen credit market will not bode well.
However, with crisis comes opportunity. As rationality returns to the markets and investors once again look to fundamentals, REITs with the most robust balance sheets will emerge in an even stronger position.
One such sector that I believe will thrive over the long run is health care REITs. In this article, I will explore Health Care REIT (HCN), a company which I believe is poised to outperform in what is likely to be a slow and arduous recovery.
Health Care REIT leases real estate to the operators of medical facilities that cater to the elderly. I believe that this company’s relatively non-cyclical business will appeal to investors, particularly those seeking the support of a reliable dividend. Key strengths include:
High quality cash flows supported by a strong core business. Healthcare is a generally secular industry and thus is less susceptible to economic downturns. I believe that the geriatrics specialty would have even more stable business trends given that nearly all elderly individuals are covered by some form of Medicare. Despite some recent pressure on tenant occupancy in the entrance fee based CRCC developments, the shortfall appears to be inconsequential.
Favorable demographic trends should prove beneficial. Regardless of the economic climate over the next several years, Health Care REIT stands to benefit from an aging US population. As the bolus of baby boomers develops growing medical needs, the facilities owned by Health Care REIT are perfectly aligned to capitalize on this trend.
A steady dividend supported by a strong balance sheet and cash flow. Unlike many other REITs that made the blunder of egregiously using leverage and off-balance sheet joint ventures, Health Care REIT has used leverage conservatively and does not hold a stake in any joint ventures. There is little reason to believe the company will have any difficulty fulfilling its debt obligations. The company’s dividend is well supported by cash flow, in line with historical levels.
Health Care REIT is set to outshine its competitors. When liquidity returns to the debt and real estate markets, I believe this company will be in an advantageous strategic position. Its solid financial footing should enable it to continue working on new developments going forward while many of its rivals are constrained by the capital markets.
A prolonged period of economic turmoil can still weigh on results. Although Health Care REIT has held together pretty well so far, the adverse effects of the economy on its tenants could eventually hurt the bottom line. For example, an operator of medical office buildings could go bankrupt if its consumers are unable to pay. Thus far, management seems to have had success in monitoring and replacing the most at-risk operators.
The success of entrance fee based communities is somewhat levered to the housing market. The independent living/CCRC developments may fall short of occupancy expectations if the economy worsens enough to make it difficult for seniors to foot the large entrance fees. In other cases, seniors may hesitate moving into independent living/CCRCs if they are bogged down with financial obligations at a prior residence. Management has noted some sluggishness in the entrance fee based communities, which they attribute to the housing crisis. Since these communities are an integral aspect of Health Care REIT’s new developments, occupancy rates should be monitored closely.
Reimbursement risk from Medicare and Medicaid threaten certain revenue streams. Obama's administration is on a crusade to curb rising healthcare costs, and reimbursement is one lever the government can pull. The impacts could be felt through lackluster annual Medicare market basket adjustments, or outright payment cuts to some services. Of Health Care REIT’s 2008 results:
- 30% of skilled nursing facilities revenue was from Medicare
- 43% within specialty care facilities revenue was from Medicare
- 51% with skilled nursing facilities revenue was from Medicaid
- 19% at specialty care facilities revenue was from Medicaid
The full fury of government intervention was experienced by the industry with the Balanced Budget Act of 1997. The bill radically changed reimbursement schedules, and inadvertently resulted in severe financial stress for skilled nursing facilities. Many nursing homes went bankrupt. The only good outcome of this program was a critical learning experience for government officials as to the impacts of such cavalier cost cutting measures.
Sector rotation can broadly hurt the stock prices of REITs. During times of strong economic growth, buy side investors tend to favor high growth stocks. If the economy begins to move forward with great momentum, such a rotation in investment habits could occur and money could roll away from the stable, but low growth REITs.
Health Care REIT manages a portfolio of properties aimed at providing health care to the elderly. As of June 30, 2009, the company owned 620 properties fairly disbursed geographically among 39 states. Each property belongs to one of five categories:
Independent Living / Continuing Care Retirement Communities (CCRC) are large, multifamily residential developments are designed to meet the changing medical needs of retired individuals as they age. Most are exclusive to people age 55 and up. Many of these developments are designed to be located near recreational venues such as golf courses, which cater to the demographic. But importantly, medical facilities including assisted living and physician office buildings are also nearby or on the campus. The goal is to offer various levels of medical service without requiring the individual to change into an unfamiliar setting as he or she ages.
Some IL/CCRCs generate revenue through monthly rental income, but it is becoming more commonplace for communities to charge a one-time entrance fee. This entrance fee could range from $20,000 to $400,000. However, the majority of fees seem to be above $100,000. Upon the resident’s death or departure from the community, 60%-90% of the entrance fee is usually refunded (to the estate in the event of death). Of Health Care REIT’s properties, 60% of the unit mix is entrance fee based.
Assisted Living facilities bridge the gap between independent living and skilled nursing facilities. These properties are state regulated, rental based housing units that allow the individual to live semi-independently, but with the assistance of trained staff. Services include assistance with bathing, dressing, toileting, eating, and management of medication. Some of these centers are qualified to take care of patients afflicted with Alzheimer’s disease or dementia.
Skilled Nursing facilities, synonymous with nursing homes, provide short term acute care for the elderly. These properties can charge by rental or daily rates, and are staffed by professionals 24 hours.
Specialty Care consists of long term acute care hospitals. These facilities offer a variety of inpatient and outpatient services.
Medical Office Buildings contain clinics, physician offices, laboratories and other outpatient-related facilities. They are often located near hospitals and other medical properties.
Management runs a perpetual process of evaluating the strategic value of its properties. The company routinely divests of assets that no longer have the same long-term appeal in light of senior housing trends. Lately the company has been disposing of its smaller medical office buildings and standalone senior housing properties. Entrance fee based communities seem to have the construction limelight, with 10 of 15 such developments opening recently. New investment is focused on combination facilities and more modern medical office buildings.
I believe Health Care REIT is well positioned to benefit from the large, graying baby boomer population. The Census Bureau, which considers “boomers” to be individuals born in 1946 through 1964, estimated this demographic to be 78.2 million in 2005. According to the Census Bureau’s 2008 statistics, the 65 and over population is anticipated to grow by about 6.6 million, or 16% from 2010 through 2015.
According to current statistics, just 5% of the United States population accounts for 49% of total healthcare costs. Furthermore, about 30% of all healthcare spending involves patients in their last year of life. Given such data, it is not unreasonable to infer that a large elderly population would increase demand for the kinds of facilities owned by Health Care REIT.
Balance Sheet Analysis
Health Care REIT appears to be well capitalized with a solid balance sheet. Management has kept a conservative mix of debt and capital. A debt-to-capital ratio above 0.60 is typically considered onerous. As far as I could tell from the financials, the company appears to be comfortably in line with its covenants.
According to company reports, the only off-balance sheet vehicles are letters of credit. Unlike many other REITs, the company is not hampered by off-balance sheet joint ventures.
Furthermore, the bulk of debt maturities appear to be several years out. Due to management's well-maintained financial discipline, I do not foresee any capital access issues for this company should it decide to roll over any of its near-term maturing debt.
On a final note, the majority of the debt is also unsecured, which frees Health Care REIT’s properties from the burden of encumbrances.
The company in the past has consistently raised its dividend, and there is little reason to believe that it would stall future increases. Dividend coverage appears to have remained stable for the past several years.
Health Care REIT’s Price/FFO multiple appears to trade at the midpoint of its peers. Its historic median multiple appears to be approximately 12.2X, making Monday’s close of 40.78 appear expensive.
Despite its recent price, I still believe that HCN is a strong portfolio holding and could trade at a premium to its historic multiple as investors seek stability in a precarious economy.
Assigning a multiple of 13X to the consensus 2010 estimate would bring HCN to a price of 42.90, a gain of 11.9% including one year of dividends.
However, my suggestion would be to buy aggressively if the stock pulls back into the 30s.
Full Disclosure: At the time of this writing, Winston does not hold a position in HCN.