My primary goal as a dividend growth investor is to build a sustainable and rising stream of dividend income that will eventually enable me to be financially independent. I plan to achieve this goal by regularly investing new capital in attractively valued dividend growth stocks and reinvesting the dividends received from those stocks. The combination of new capital investment, dividend reinvestment, and dividend growth over many years will facilitate the growth of my dividend income stream. To read about my dividend growth investing progress thus far, please see my latest quarterly review.
In my ongoing search for attractively valued dividend growth stocks, my attention has been drawn recently to real estate investment trusts [REITs]. Until now, my portfolio had zero exposure to real estate, partly because the highest-quality REITs often command premium valuations. However, there has been a strong sell-off among REITs since late May, mainly due to concerns about how rising interest rates will affect their operations when the Federal Reserve tapers its quantitative easing program. Due to the sell-off, several REITs have become fairly valued or undervalued, motivating me to look more closely at them.
I focused my search on healthcare REITs because I have been wanting to increase my portfolio's exposure to healthcare and this REIT category is likely to benefit from a favorable demographic trend. The figure below shows the projected population growth of individuals aged 65 years or older in the U.S. until 2050. As individuals get older, their healthcare needs often become greater, and this strong demographic trend bodes well for healthcare REITs.
Five of the 12 healthcare REITs listed by NAREIT appear on David Fish's Dividend Champions, Contenders, and Challengers list because they each have at least 5 consecutive years of dividend growth. These REITs are HCP, Inc. (NYSE:HCP), Health Care REIT (NYSE:HCN), National Health Investors (NYSE:NHI), Omega Healthcare Investors (NYSE:OHI), and Universal Health Realty Income Trust (NYSE:UHT). After a comparative analysis, I decided that HCP was one of the more attractive investment opportunities.
HCP: A Diversified Healthcare REIT
HCP is a real estate company that invests primarily in healthcare-related properties. It was organized in 1985 when it was spun off from National Medical Enterprises (now Tenet Healthcare). The company acquires, develops, leases, manages, and disposes of healthcare real estate in the context of a "5 x 5" business model:
Source: HCP 2013 Annual Meeting Presentation
This business model gives HCP flexibility regarding the healthcare segments and products for its investments. As a result of this flexibility, the company has built a portfolio that is diversified by healthcare segment, geography, and operators/tenants, as indicated in the table below. Josh Peters of Morningstar referred to HCP as "arguably the best-diversified landlord in healthcare."
Data source: HCP website
Data source: Morningstar
HCP consistently increased its revenue over the past several years at a 18.9% compounded annual growth rate [CAGR]. However, as is the case with many REITs, much of the revenue growth coincided with the issuance of more shares. On a per-share basis, revenue growth was a much more modest 3.8%.
Funds From Operations and Dividends
Data source: Value Line
Instead of earnings, it is more appropriate to evaluate REITs on the basis of their funds from operations [FFO]. HCP increased its FFO at a 5.9% CAGR, which is satisfactory. HCP increased its dividend at a 2.4% CAGR, which is relatively weak but roughly in-line with inflation. The current dividend yield for HCP is around 5%. Notably, HCP is one of the only REITs that qualifies as a Dividend Champion, having increased its dividend for 28 consecutive years. It is also a member of the S&P 500 Dividend Aristocrats. This kind of steady and reliable dividend growth is a desirable feature for an investor such as myself.
Sometimes there is a question as to whether a company's long-term dividend growth is primarily driven by earnings growth (or FFO growth for REITs) or an expansion of the payout ratio. For example, a company with flat earnings can maintain a dividend growth streak if it simply pays out more of its earnings year after year. In the case of HCP, it is clear from the previous figure that dividend growth has been supported by FFO growth. Moreover, the figure below shows that the payout ratio has actually decreased while the dividend increased:
Data source: Value Line
Thus, management has become more conservative in recent years, which is perhaps a prudent action because a lower payout ratio enables the company to maintain or continue increasing its dividend even in the context of sluggish FFO growth in the future.
HCP has a BBB+ credit rating, which is the highest among healthcare REITs. Its debt/capitalization ratio is 45% and its interest coverage is 2.8x. Value Line gives the company a safety rating of 3.
As noted earlier, it is more appropriate to use FFO than earnings when evaluating REITs. For this reason, one should ignore the P/E ratio and look at the P/FFO ratio, which is about 14.2 for HCP. The figure below shows that this value falls in the middle of the range of average annual P/FFO ratios, which suggests HCP is fairly valued on a historical basis.
Data source: Value Line
The judgment of fair valuation is further supported by a P/B ratio of 1.8, which is near the 5-year historical average of 1.7. Moreover, using a Dividend Discount Model with a dividend growth rate [DGR] equal to the 5-year CAGR of 2.4% and a discount rate equal to the current yield plus the 5-year DGR, one gets a fair value estimate of around $43, which is near the current price of about $42. Interestingly, Morningstar gives HCP a much higher fair value estimate of $55, implying that the stock is undervalued by at least 20%. However, I think a more conservative judgment is that HCP is fairly valued at $42 per share.
I am comfortable with paying fair value for a high-quality, "blue chip" REIT such as HCP, which is why I started a position in the stock at $41.80 per share on August 8, 2013. I bought the shares in my Roth IRA because REIT dividends would be taxed as ordinary income in my taxable account. By holding HCP in my Roth IRA I avoid taxes altogether. This purchase finally gives my portfolio some exposure to real estate and helps boost my portfolio's overall yield. I view HCP as a high-yield/low-growth holding that is unlikely to be a home-run stock, but very likely to continue hitting singles year after year.