Should You Invest With A Property-Type Bias?

Includes: HCN, HCP, HR, OHI
by: Factoids


This article for the retail investing audience explains current Health Care REIT valuations.

Valuations are viewed through the prism of required rates of return.

This article ends with a quick discussion on whether now is the time to be buying Health Care REITs.

Let's start with some data so that you will know my coverage universe for this article:

Health Care Update for Q1-14

Yields are calculated on Q1-14 dividends. Health Care REIT (NYSE:HCN) has announced a February increase in the dividend to $0.795/share - Omega Health (NYSE:OHI) an increase to $0.49/share - Sabra Health Care (NASDAQ:SBRA) an increase to $0.36 - Medical Properties Trust (NYSE:MPW) increased to $0.21/share. The Dividend/FFO ratio uses the 2014 FFO projection. Aviv REIT (NYSE:AVIV) started trading on 3-21-13 and Physicians Realty Trust (NYSE:DOC) on 7-19-13. The sector average LTM (last twelve month) dividend change omits AVIV and DOC from that calculation. Ventas Inc. (NYSE:VTR) has atypically had two dividend increases in the LTM. National Health Investors Inc. (NYSE:NHI) has already announced an increase to $0.77 in its Q2-14 dividend.

Share Price 2014 FFO Estimate Div/ Percent Change LTM
Company_name_and_ticker 1-01 03-14 1-01 03-14 Yield FFO Price Pr+Div 14 FFO Target Div

Aviv REIT (AVIV) 23.70 24.97 1.85 1.82 5.77 79.12 5.36 6.88 -1.62 0.38 0.00
Physicians Realty (DOC) 12.24 13.15 0.98 0.95 6.84 94.74 7.43 9.27 -3.06 0.82 0.00
Health Care REIT (HCN) 53.57 58.93 4.00 4.02 5.40 79.10 10.01 11.49 0.50 -4.17 3.92
Health Care Prop (NYSE:HCP) 36.32 37.16 3.06 3.02 5.87 72.19 2.31 3.81 -1.31 -5.45 3.81
Health Care Realty (NYSE:HR) 21.31 23.93 1.41 1.45 5.01 82.76 12.29 13.70 2.84 -3.81 0.00
Health Care Trust (NYSE:HTA) 9.84 11.63 0.69 0.72 4.94 79.86 18.19 19.65 4.35 0.00 0.00
LTC Property (NYSE:LTC) 35.39 37.93 2.65 2.63 5.38 77.57 7.18 8.14 -0.75 0.00 9.68
Med Prop Trust (MPW) 12.22 12.70 1.12 1.12 6.61 75.00 3.93 5.65 0.00 -0.68 5.00
Nat'l Health Inv (NHI) 56.10 61.01 4.13 4.08 4.82 72.06 8.75 10.06 -1.21 0.79 9.70
Omega Health (OHI) 29.80 32.94 2.73 2.74 5.95 71.53 10.54 12.18 0.37 -4.62 8.89
Sabra Health Care (SBRA) 26.14 27.53 2.20 2.27 5.23 63.44 5.32 6.69 3.18 3.30 5.88
Senior Housing (NYSE:SNH) 22.23 22.54 1.74 1.76 6.92 88.64 1.39 3.15 1.15 -2.95 0.00
Universal Health (NYSE:UHT) 40.06 42.39 2.80 2.83 5.90 88.34 5.82 5.82 1.07 0.00 0.81
Ventas (VTR) 57.28 60.76 4.36 4.36 4.77 66.51 6.08 6.08 0.00 -5.87 8.21

Average 5.67 77.92 7.47 8.76 0.39 -1.59 4.66

Health Care Price/FFO Ratios 03-14

The analyst projected FFO stats for UTH that I find at Yahoo Finance look bad to me. Those projections are not in line with what UHT is reporting. This date uses a 2014 FFO projection that is a run rate based on current trends. HTA IPOed in June of 2012. "Normalized FFO" stats for the pre-IPO years came from its 2011 10-K. When AVIV and DOC were added to the sector on 11-19-13, the sector average 2013 price/FFO ratio rose from 14.94 to 15.79. The DOC FFO projection fell 50%, distorting the 2013 sector ratio. 2012 FFO growth was 10.77% and 2013 growth was 7.65% before the addition of the newbies. AVIV and DOC do not distort the 2014 and 2015 sector average ratios.

FFO / Share % FFO Growth Price/FFO 14 FFO Range
Co. 2010 2011 2012 2013 2014 2015 12-13 13-14 14-15 2013 2014 2015 High Low Range

AVIV 0.00 0.00 0.00 1.26 1.82 2.00 na 44.44 9.89 19.82 13.72 12.48 190 152 20.88%
DOC 0.00 0.00 0.00 0.26 0.95 1.17 na 265.38 23.16 50.58 13.84 11.24 106 83 24.21%
HCN 3.13 3.41 3.51 3.36 4.02 4.23 -4.27 19.64 5.22 17.54 14.66 13.93 410 397 3.23%
HCP 2.19 2.69 2.76 3.01 3.02 3.14 9.06 0.33 3.97 12.35 12.30 11.83 310 296 4.64%
HR 1.29 1.15 1.31 1.32 1.45 1.56 0.76 9.85 7.59 18.13 16.50 15.34 148 139 6.21%
HTA 0.38 0.51 0.61 0.64 0.72 0.77 4.92 12.50 6.94 18.17 16.15 15.10 75 70 6.94%
LTC 1.88 2.15 2.26 2.37 2.63 2.83 4.87 10.97 7.60 16.00 14.42 13.40 269 258 4.18%
MPW 0.66 0.71 0.90 0.96 1.12 1.19 6.67 16.67 6.25 13.23 11.34 10.67 114 109 4.46%
NHI 2.76 2.88 3.18 3.55 4.08 4.28 11.64 14.93 4.90 17.19 14.95 14.25 414 402 2.94%
OHI 1.61 1.89 2.19 2.53 2.74 2.80 15.53 8.30 2.19 13.02 12.02 11.76 279 270 3.28%
SBRA 0.00 1.31 1.41 1.84 2.27 2.41 30.50 23.37 6.17 14.96 12.13 11.42 241 219 9.69%
SNH 1.70 1.73 1.75 1.69 1.76 1.84 -3.43 4.14 4.55 13.34 12.81 12.25 181 154 15.34%
UHT 2.61 2.57 2.84 2.77 2.83 2.89 -2.46 2.17 2.12 15.30 14.98 14.67 283 283 0.00%
VTR 2.85 3.37 3.80 4.14 4.36 4.58 8.95 5.31 5.05 14.68 13.94 13.27 445 420 5.73%

Average 6.89 31.29 6.83 18.16 13.84 12.97

Historical Price/FFO ratios for the sector:

Mar 2007: 15.23 June: 13.19 Sept: 14.18 Dec: 14.55
Mar 2008: 14.17 June: 13.27 Sept: 15.95 Dec: 12.38
Mar 2009: 9.42 June: 10.84 Sept: 12.61 Dec: 13.90
Mar 2010: 12.61 June: 14.10 Sept: 15.45 Dec: 15.41
Mar 2011: 15.07 June: 14.62 Sept: 12.91 Dec: 14.95
Mar 2012: 14.21 June: 15.25 Sept: 15.05 Dec: 15.82
Mar 2013: 17.18 June: 15.84 Sept: 15.21 Dec: 16.67

I see the valuation of equity income stocks as being explained by their "yield plus distribution CAGR" (or projected compound annual growth rate) with significant adjustments for risk. My CAGR assignments are done by gathering data on earnings growth, the dividend to earnings ratio, dividend growth inertia, and dividend CAGR projections from a number of different sources. My required rate of return (or "RRR") assignments are a quantification of the risk attribute using historical earnings projection accuracy, the spreads in the current year earnings projections, the company's credit ratings and debt metrics. I can determine if a stock is a buy by doing the "yield + CAGR - RRR" calculation. That system fails to work with Health Care REITs when RRRs are set using traditional inputs. The "yield + CAGR - RRR" system only explains Health Care REIT valuations when their RRRs are determined by the property types they hold. This article takes you through those steps and provides data to justify that conclusion.

I invest in the four main REIT sectors (apartments, health care, office and retail) - with just under 10% of my portfolio allocated to this sector. One third of my REIT investments are in the Health Care sub-sector - so I am relatively over weighted in that sector. Only consumer staples and energy partnerships have a higher weighting in my portfolio. This retired individual is a "GARY" (or growth at a reasonable yield) investor with a focus on dividend security. I like Health Care REITs because you can find instances of superior dividend growth in this sub-sector. I like Health Care REITs because there were only two (HR and MPW) out of ten existing REITs that had a dividend cut during the credit crisis of 2008 - 2010. The occurrence of cuts happened with more intensity in other REIT sub-sectors. I like the picture that demographics give the sector. As the population rises for old folks, the use of health care properties should logically rise. I like REITs because they provide my portfolio with need diversification. REITs often zig when the overall market zags. Finally, I like REITs because their forward earnings tend to be very visible. REIT earnings projection accuracy strongly tends to be higher than in most other equity income sectors.

How I met my RRRs

Those of you who have read my stat updates on my Seeking Alpha InstaBlog know that I track earnings projection changes since the beginning of the year as one of the metrics that explain the differences in share price appreciation during the year. Stocks with growing earnings projections within a given year (I am not referring to year over year growth) strongly tend to outperform stocks with flat projections. Stocks with flat projection strongly tend to outperform stocks with falling projections. That is true in sector after sector. That is true year after year. Combine earnings projection changes with intra-year target price changes and intra-year changes in dividend CAGR projections, and you have enough data to explain most of the differences in share price appreciation in a given sector.

One day during the credit crisis of 2008 - 2009, I went looking for an explanation of why some stocks in a given sector were falling harder and faster than others. I could see some explanation in the changes in earnings projections. But a casual look at earnings projection changes left me with the impression that projection changes almost happen at random. But was that really the case? I wondered what would happen if I took all the data of projection changes that happened in prior years, and presented that historical data in one spreadsheet. Would earnings projection disappointments be random events where all stocks in a sector had an equal chance of disappointments? Or would there be some stocks with superior records of lacking major earnings disappointments? The data I have gathered over the last decade supports the latter hypothesis. And it also turns out that in most sectors there is strong correlation between earnings projection accuracy and a company's credit rating. That is logical. A company with more visible earnings should also be one that is more likely to pay its debts. It was turning out that companies with superior credit ratings tended to fall the least within a given sector. There was also a correlation between inferior credit ratings and interruptions in dividend growth.

I may be a slow learner. I know that there are a lot of books on investing that I have failed to read. I know I have heard the term "required rate of return" many times before. It was a subject covered in my finance text book back in college. But I never really appreciated the concept until I viewed it through the prism of earnings projection accuracy. It makes sense that a dollar's worth of income from company A should be worth more than a dollar's work of income from company B - if there was relatively more certainty in company A's earnings projection. Add uncertain to a company's earnings, and the P/E (or price to earnings) ratio should logically need to be lower because each projected dollar's worth of earnings is worth less. Subtract uncertain to a company's earnings, and the P/E ratio should logically be higher. High P/Es would tend to result in a lower dividend rate. Lower P/Es would tend to result in a higher dividend rate.

Add uncertain to a company's earnings, and the required rate of return (or yield plus dividend CAGR projection) should logically need to be higher. And while it is true that some sectors have companies that generally have better projection accuracy than others, there is also a lot of variability in projection accuracy within a sector. And if that is true, then required rates of return should also vary within a given sector. That also should not come as a surprise. Don't credit ratings vary within a given sector?

There is one more correlation that the data revealed. The companies with higher earnings projection accuracy also strongly tended to be the ones with a lower current year spread (the distance between the high and low numbers) in their earnings projections. This is not consistently the case. There is also a correlation between earnings growth and spreads in projections. Add a lot of growth to projected earnings, and the analysts will disagree on the degree of the growth - or the timing of that growth. Still, companies with the same degree of earnings per share growth will tend to differ in the spreads of their earnings projections in a way that correlates with their historical earnings projection accuracy.

Earnings projection accuracy for Health Care REITs

In the spreadsheet below, I provide data on earnings projection accuracy from 2006 up to changes in the 2014 projection. I cover a lot of information in the header to that spreadsheet. Please do not skim or skip that information.

FFO estimates projection accuracy by Year

This spreadsheet shows how my historical FFO accuracy ratings (the data under the Acc rate column) are assessed. Low numbers are the better ratings. REITs that have had no earnings disappointments greater than a negative 5% over the last five years are assigned a 1 rating. One 5% disappointment adds half a point to the rating. One 10% disappointment adds a full point to a rating. For the REITs that I have followed less than 5 years, the best rating is a 1.5. The beginning projection is one that I gathered at the start of that year. The ending number is the actual normalized FFO/share for that year. The FFO spread is the high FFO projection minus the low projection, with that result divided by the average projection. High spread numbers also add points to my accuracy ratings - something that is currently done for SBRA and SNH. My historical accuracy rating assessments are used to assign a required rate of return for each REIT. HTA, MPW, NHI and SBRA were not added to my coverage universe until 2013. The appearance of high earnings accuracy for this group is due to my failure to gather beginning of the year projections in years prior to 2013.

2006 2007 2008 2009 2010 2011 2012 2013 2014 Acc FFO
comp Chng Chng Chng Chng Chng Begin End Chng Begin End Chng Begin End Chng Begin Cur Chng Rate Sprd

HCN -3% 2% 2% -11% -2% 3.30 3.41 3% 3.77 3.51 -7% 3.91 3.36 -14% 4.00 4.02 0% 3.50 3%
HCP -5% 0% -2% -7% 0% 2.55 2.69 5% 2.80 2.76 -1% 2.97 3.01 1% 3.06 3.02 -1% 1.50 5%
HR -14% -36% 2% 6% -7% 1.37 1.15 -16% 1.30 1.31 1% 1.39 1.32 -5% 1.41 1.45 3% 4.00 6%
HTA 0.51 0.51 0% 0.60 0.61 2% 0.66 0.64 -3% 0.69 0.72 4% 1.50 7%
LTC 1% -2% -4% -4% -6% 2.06 2.15 4% 2.29 2.26 -1% 2.43 2.37 -2% 2.65 2.63 -1% 1.50 4%
MPW 0% 0% 0.71 0.71 0% 0.90 0.90 0% 1.07 0.96 -10% 1.12 1.12 0% 3.00 4%
NHI 0% 0% 2.88 2.88 0% 3.00 3.18 6% 3.39 3.55 5% 4.13 4.08 -1% 1.20 3%
OHI 16% 11% -9% -5% -6% 1.85 1.89 2% 1.94 2.19 13% 2.24 2.53 13% 2.73 2.74 0% 2.00 3%
SBRA 1.31 1.31 0% 1.41 1.41 0% 1.72 1.84 7% 2.20 2.27 3% 2.00 10%
SNH -1% -3% -3% -6% -2% 1.78 1.73 -3% 1.86 1.75 -6% 1.84 1.69 -8% 1.74 1.76 1% 3.00 15%
UHT -6% -2% -3% 11% -7% 2.60 2.57 -1% 2.57 2.84 11% 3.01 2.77 -8% 2.80 2.83 1% 3.50 0%
VTR 3% -3% -3% -6% 5% 3.10 3.37 9% 3.67 3.80 4% 3.99 4.14 4% 4.36 4.36 0% 1.50 6%

Average 2.35 5.56

This sector has good earnings projection accuracy. I have to nitpick to find variances in the quality of the earnings projections. To see an example of bad projection accuracy - see Get skeptical about this MLP claim where I provide the data on energy master limited partnerships or MLPs.

Assessing RRRs

I will start with comparing the traditional RRR metrics way of assessing RRRs compared to the "property type" way of assessing RRRs. I will use Health Care REIT and Health Care Properties for my examples. HCN has a much worse than sector average earnings projection accuracy history. There were more than 10% earnings disappointments in both 2009 and 2013. There was more than a 5% disappointment in 2012. Normally - this is a big red flag that adds to the required rate of return. Compared to HCP, HCN has the slightly inferior credit rating. There is a high correlation between my accuracy ratings and S&P bond or credit ratings. A metric based system would provide HCP with the superior or lower RRR. On the other hand, when one uses the property type weightings (which I detail in a spreadsheet after my next series of comparisons) to assess RRRs, HCN had a higher weighting in senior housing and MOBs (the good assets) and lower weightings in Skilled Nursing and Debt (the bad assets). An RRR based on property type would provide HCN with the superior or lower RRR.

Over the last six years, dividend growth for the two has been very close to the same - while HCP has been superior the past two years. The dividend to FAD ratios is nearly equal. HCP has the superior dividend to FFO ratio. HCN has had 8.03% FAD growth per year over the last three years. HCP has had 5.75% FAD growth over the last three years. The consensus analyst next five year FFO growth projections are 6.2% for HCN and 3.5% for HCP. The last time I checked, the brokerage analysts to which I have access are split as to which will have the superior dividend growth over the next five years. The numbers provide no clear winner. I am currently assessing a five year forward dividend CAGR of 4.1% for both.

So why does HCP sell at a yield that is 47 basis points higher than HCN? As I have said, HCP has the superior credit rating and FFO projection accuracy. I can only find justification for this difference in pricing (or yields) based on a valuation assessment that says that HCN owns the better assets and merits a lower required rate of return. And HCN does possess a strong weighting in the favored assets types.

Comparing HCN to HCP is like splitting hairs. Let's do some more comparisons between REITs with significantly different attributes. Next, I will compare Health Care Reality to Omega Healthcare Investors .

OHI has had 8.89% dividend growth over the last twelve months and averaged 10.27% over the last 6 years. HR has had 0.00% dividend growth over the last twelve months and averaged a negative 3.68% change over the last 6 years. Dividend growth over the last ten years has been great for OHI while the dividend has fallen for HR. FAD growth over the last three years has averaged 3.04% for HR and 9.17% for OHI. OHI has the superior (or lower) dividend to FFO ratio - which suggests superior future dividend growth. On the other hand, the 2014 dividend to FAD ratios are close to the same - which suggest nearly equal future dividend growth. The analyst consensus CAGR projections - which are probably based on FAD projections for 2015 and beyond - are superior for HR. OHI has an anemic 3.0% projection while HR has a 4.0% projection.

FFO projection accuracy for OHI is superior and current year FFO projection spreads are smaller for OHI. HR and OHI both have BBB- credit ratings from S&P. The metrics would lightly suggest that OHI deserves the smaller required rate of return.

Given those metrics - OHI appears to be the safer or lower RRR option. As to a CAGR, let's just say it may be close. Thus OHI should sell for a slightly lower yield and higher price/FFO ratio - right? Wrong. The current yield for HR is 5.01% while the yield for OHI is 5.95%. The current price/FFO is 16.50 for HR and 12.02 for OHI. Why is that the case?

The market loves MOBs (Medical Office Buildings). MOB properties sell at significantly lower cap rates. HR has 80% of its portfolio is MOBs. (Data on REIT weightings by property type are just three paragraphs away.) The market hates SNFs (Skilled Nursing Facilities). SNFs strongly tend to sell at high cap rates. OHI has 87% of its portfolio in SNFs.

Surely OHI must be about to have some major mean revision when it comes to dividend growth. But the metrics for 2014 show no sign that such is imminent. Dividend growth was 9.76% in 2012 when the dividend to FAD ratio was 80.37%. Dividend growth was 8.89% in 2013 when the dividend to FAD ratio was 85.33%. OHI has superior FFO projection accuracy - so I am guessing that FAD projection accuracy should also be high. OHI has a 2014 projected 80.00% dividend to FAD ratio using the current dividend. If one projects a 4 cent (or 8.16%) dividend increase to $0.53/share/quarter - the resulting dividend to FAD ratio would be (2.12/2.45) 86.53%. That is in line with OHI's history. There is some mean revision in that near 8% dividend growth projection - but OHI is moving at a slow pace towards that mean revision. And that 2014 calculation is one reason to believe that the analyst forward CAGR projection for OHI is a low-balled projection.

Mean revision would be a good thing for HR. And with a projected 2014 dividend to FAD ratio of 81.08%, the odds are very good that dividend growth is in HR's future. But a low pace of FAD growth over the last three years may signal fairly low forward dividend growth going forward. The consensus analyst five year forward FFO CAGR is 4%. That compares to a projection of 3% for OHI. The dividend to FAD ratios for both is nearly equal. Should HR have a five year forward dividend growth projection that is higher than OHI? I personally am not making that projection. The analysts are. On the other hand, current market valuations suggest a price implied dividend growth rate of 2.99% for HR and 4.55% for OHI.

Let's move on to the "Yield + CAGR" (- RRR) spreadsheet. HR has a "yield + CAGR" of 7.51% while OHI has a metric of 10.95%. That 344 basis point difference can only be explained by a major difference in both the CAGRs (let's say the analysts are right and there is 100 basis points superiority for HR) and the RRRs (which would mean a 244 basis points superiority for HR). That is a difference that the market has already priced in by pricing HR at a higher Price/FFO and lower yield - at a time when HR has few hints of having dividend CAGR equality or superiority.

One could substitute Health Care Trust for HR and Sabra Health Care REIT for OHI, and most of the above text would fit for that comparison. I believe I have provided enough examples to show how my valuation comparisons are done. I will poll in the comment section of this article to test if there is an audience that desires more comparisons.

My RRR assignment by property type data

The percent by property type data in the spreadsheet below uses numbers from the end of Q3-13. My RRRs are very lightly adjusted for credit ratings and historical FFO projection accuracy. The two REITs heavy in MOBs have RRRs below 8%. The one REIT heavy in Hospital properties has the highest RRR of 11.5%. The other REITs with RRRs over 10% are those with heavy weightings in Skilled Nursing Facilities. For the Ventas valuation to make any sense at all, it needs a 10.5% RRR. I justify that assessment by saying that REITs that are heavy in RIDEA (the REIT Investment Diversification and Empowerment Act) or operating assets should have a higher RRR assignment. The switch to more operating assets is done to capture more upside potential. So it is logical that it could capture downside potential as well. The result is that earnings should be more volatile. And higher earnings volatility merits a higher RRR. Those REITs that are heavy in Senior Housing assets have RRRs around 9%. REITs that had debt holdings had increases to the assigned RRRs.

Property Type Weightings

Company Hospitals Skilled Nursing Senior Housing MOBs Life Science Debt My RRRs
Aviv REIT AVIV 0% 88% 10% 0% 0% 2% 10.70
Physicians Realty DOC 26% 0% 0% 74% 0% 0% 9.00
Health Care REIT HCN 4% 16% 62% 17% 2% 0% 9.00
Health Care Prop HCP 4% 28% 35% 13% 17% 3% 9.20
Health Care Realty HR 11% 0% 0% 80% 0% 9% 7.80
Health Care Trust HTA 4% 0% 4% 92% 0% 0% 7.50
LTC Property LTC 0% 51% 45% 0% 0% 4% 9.70
Med Prop Trust MPW 81% 0% 0% 1% 0% 18% 11.50
Nat'l Health Inv NHI 5% 42% 45% 1% 0% 7% 9.80
Omega Health OHI 2% 87% 3% 0% 0% 8% 10.50
Sabra Health Care SBRA 7% 78% 15% 0% 0% 0% 10.30
Senior Housing SNH 0% 4% 60% 31% 0% 0% 9.10
Universal Health UHT 43% 0% 0% 55% 0% 2% 9.50
Ventas VTR 3% 15% 61% 19% 0% 2% 10.50

Below is the spreadsheet where I use the RRRs from the above spreadsheet to explain the current valuations:

Yield + CAGR Total Return Expectations

Company Q1-14 My Total Bonds Acc My Total Rtn Consensus Pr Impl Div
Yield CAGR Return Rate Rate RRRs - RRR Ratings CAGR / FAD

Aviv REIT AVIV 5.77% 5.00% 10.77% NR 3.0 10.70 0.07 2.8 4.93 75.39
Physicians Realty DOC 6.84% 3.20% 10.04% NR 3.0 9.00 1.04 1.5 2.16 90.91
Health Care REIT HCN 5.40% 4.10% 9.50% BBB 3.5 9.00 0.50 2.7 3.60 88.83
Health Care Prop HCP 5.87% 4.10% 9.97% BBB+ 1.5 9.20 0.77 2.8 3.33 87.20
Health Care Realty HR 5.01% 2.50% 7.51% BBB- 4.0 7.80 -0.29 3.0 2.79 81.08
Health Care Trust HTA 4.94% 2.50% 7.44% BBB- 1.5 7.50 -0.06 2.4 2.56 95.83
LTC Property LTC 5.38% 4.40% 9.78% NR 1.5 9.70 0.08 2.9 4.32 80.95
Med Prop Trust MPW 6.61% 4.50% 11.11% BB 3.0 11.50 -0.39 3.0 4.89 79.25
Nat'l Health Inv NHI 4.82% 5.00% 9.82% NR 1.2 9.80 0.02 3.1 4.98 84.48
Omega Health OHI 5.95% 5.00% 10.95% BBB- 2.0 10.50 0.45 2.8 4.55 80.00
Sabra Health Care SBRA 5.23% 5.50% 10.73% BB- 2.0 10.30 0.43 1.9 5.07 67.29
Senior Housing SNH 6.92% 1.80% 8.72% BBB- 3.0 9.10 -0.38 3.2 2.18 97.50
Universal Health UHT 5.90% 3.00% 8.90% NR 3.5 9.50 -0.60 3.0 3.60 89.93
Ventas VTR 4.77% 6.20% 10.97% BBB 1.5 10.50 0.47 2.8 5.73 69.88

Average 5.67% 4.06% 9.73% 2.71

A quick summation:

I believe I have provided this audience with the tools to understand current Health Care REIT valuations. And the most valuable players in that tool kit are the perceptions that (1) RRRs play a major role in understanding the different valuations and (2) RRRs are based on the weightings of the property types that the REIT owns. Future dividend growth projections play a role in understanding the valuations. But it is important to know that dividend inertia and forward dividend CAGR projections can frequently be very different numbers. Make the extra effort to get your CAGR projections from a variety of sources.

One last point on this topic

While I have shown evidence that earnings projection accuracy fails to play a role in RRR assignment, it does not mean that I am personally going to ignore the data. I still want the data. I will still track the data. The FFO data that I am using is "normalized" FFO projections and historical "normalized" FFO data. That data already weeds out many one-time events. To me, it is not a big deal to miss a non-normalized FFO number. But missing a normalized projection is a big deal. As shown in the spreadsheets, HCN and Senior Housing Properties both underperformed in FFO based on their beginning of the year projections in 2013. And both under performed the sector based on price appreciation in 2013. The data also shows that Medical Properties Trust also had a FFO disappointment. But MPW had major gains in FAD/share in 2013. MPW also announced its first dividend change since 2008 - a 5% increase. The good news far outweighed the bad. MPW beat the sector average on price appreciation in 2013. While FFO projection accuracy fails to explain RRR assignments, it still can explain relative performance in price appreciation - all other factors being equal.

Should you invest with a property-type bias?

After showing that one needs a property-type bias in understanding REIT valuations, one big question still remains. Should you invest with a strong preference for MOBs (the higher valued assets) and reluctance to own SNFs (the lower valued assets)? For that answer, I would want to have some longer term data - and that is provided below.

Price Changes and Total Returns Since the Beginning of 2012, 2011 and 2010

Dividend growth takes the current dividend minus the Q4-09 dividend divided by the Q4-09 dividend

03-14-14 12-31-11 Change 12-31-10 Change 12-31-09 Change Div Grth
Company Price Price Price Pr+Dist Price Price Pr+Dist Price Price Pr+Dist Since 10

Health Care REIT HCN 58.93 54.53 8.07 20.57 47.64 23.70 44.01 44.32 32.96 60.98 16.91
Health Care Prop HCP 37.16 41.43 -10.31 0.91 36.79 1.01 18.85 30.54 21.68 49.26 18.48
Health Care Realty HR 23.93 18.59 28.73 43.25 21.17 13.04 31.46 21.46 11.51 35.27 -22.08
LTC Property LTC 37.93 30.86 22.91 36.57 28.08 35.08 56.07 26.75 41.79 69.78 30.77
Med Prop Trust MPW 12.70 9.87 28.67 47.01 10.83 17.27 41.37 10.00 27.00 61.10 5.00
Nat'l Health Inv NHI 61.01 43.18 41.29 55.77 45.14 35.16 54.53 36.99 64.94 94.80 33.64
Omega Health OHI 32.94 19.35 70.23 91.11 22.44 46.79 71.70 19.45 69.36 105.14 63.33
Senior Housing SNH 22.54 22.44 0.45 15.95 21.94 2.73 25.39 21.87 3.06 32.42 8.33
Universal Health UHT 42.39 39.00 8.69 23.00 36.53 16.04 37.96 32.03 32.34 64.88 5.04
Ventas VTR 60.76 55.13 10.21 20.99 52.48 15.78 31.48 43.74 38.91 62.64 41.46

20.89 35.42 20.66 41.28 34.36 63.63

This data is on those REITs that were paying a dividend in Q4-09. I see two REITs that stand out as having better total returns over that period: OHI and NHI. OHI is heavily weighted in SNFs, and NHI has a good weighting in SNFs. LTC has done better than average - and it, too, has a good weighting in SNFs. I see three REITs that stand out as having lower total returns over that period: SNH, HR and HCP. And these are three REITs with quality asset mixes. If there is a correlation between asset quality and total returns, then the favored property type has been SNFs.

One thing that surprises me in this data - the performance of VTR. VTR - which has the reputation as being the superior Health Care REIT - has actually been close to sector average in share price appreciation and slightly below sector average in total return - while at the same time having better dividend growth. Why? I can see two reasons: (1) VTR started this time period with a yield that was well below sector average (4.96 compared to the sector average of 6.13%) and a price/FFO ratio that was well above sector average (16.57 compared to the sector average 13.90). Is there a lesson in the VTR story since 2010? I would say there is. The lesson is to buy good at a reasonable price. And how do you know anything is at a reasonable price? My answer is for you to do the yield plus CAGR minus RRR calculation. (2) The second reason VTR has been "just average" over that time period - its dramatic shift towards RIDEA properties has raised its RRR and hurts its relative valuations. There is still the hope that VTR will capture an upside in FFO growth that will offset the RRR change. But at this time, the RIDEA shift has been nothing but bad news for VTR shareholders.

Here is how I would handle the "property type" bias question. Use the data to explain valuations. Don't use the data to project future returns. Use the data to asset in your diversification. For example - a portfolio of only HR and HTA lacks diversification because both are MOB heavy. And a portfolio of only OHI and SBRA lacks diversification because both are SNF heavy.

Is now the time to buy or add to your REITs?

REITs are up in 2014 mainly due to interest rates being down - and due to it being (so far) a "risk off" year. But long term, almost everyone expects interest rates to rise. Historically, a good time to buy or add to your Health Care REITs is when sector average yields are around 6.5% or higher. Currently, the Health Care sector average yield is 5.67%. Here is the long term data on yields:

Historical Price/FFO ratios for the sector:

The good news is that employing such data to make timing decisions works well. The bad news is that such a system will - in almost all instances - tell you the same thing in sector after sector. Based on historical yields, it is a sub-optimal time to add to energy MLPs, consumer stable stocks, regional banks, even Business Development Companies.

I do not try to employ a portfolio strategy that requires me to be smarter than I am. As a result, I personally do not try to time the market. I stay diversified, having portions of my portfolio that will do well in a higher interest rate environment. I give a high priority to buying investments with growing distributions. Historically, that market stats will tell you that "dividend growth" has been a winning formula. The market stats provide me with the consistent impression that yield is like a bird in the hand - while growth is like the two birds in a bush. Growth sells at a discount due to the fact that growth can dissipate without sufficient warning. I am hyper-diversified in dividend growth due to the dissipation risk. I track earnings projection accuracy and other risk metrics - and that tracking leads me to buying "safer" growth.

I gather the data on projections for distribution growth from a variety of sources like Value Line, Yahoo Finance (which has CAGR projections that look like earnings CAGRs and not dividend CAGRs), David Fish's CCC list, and reports from multiple brokerages. While it is a sub-optimal time to buy a REIT due to interest rate concerns, it is a terrible time to buy a low growth "anything". I invest with the perception that is rarely a bad time to buy a good stock. I have occasionally demonstrated the ability to find those rare times.

What would I be buying now?

I would use my "total return minus required rate of return" formula as my guide - if I were starting a health care REIT portfolio today. One should also note that there is strong agreement between the "total return minus RRR" calculation and the consensus analyst ratings. I would buy Physicians Realty Trust due to its relatively high yield to get some MOB exposure (but DOC is new and evolving - so this is a relatively risky REIT), VTR for senior living exposure (but VTR also carries extra risk due to its growth spurt in operating properties), and OHI for Skilled Nursing exposure. There is some risk that you would be buying OHI just before its dividend growth rate starts to fall. If the yield difference was 30 basis points less between SBRA and OHI, I would buy SBRA due to its superior dividend/FAD ratio. I should also note that HCN and HCP are selling at price implied yields that are below their CAGR projections - which mean they are selling at decent discounts. The data tells me it is important to buy good valuations - and HCP appears to currently be the best value in the sector. I would want to keep my allocation to the sector relatively low. As already stated, this 60 year old investor is 10% weighted in REITs. I believe that is an age appropriate allocation. I expect to add weight to that allocation as I age. I am not in need of the extra income generation that REITs provide due to my high allocation to MLPs.

I will be posting a few polling questions in the comments section of this article. Please do not post a text response to any of those polling questions until the poll section is over.

Disclosure: I am long LTC, OHI, VTR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.