Assessing Health Care REIT Valuations Part 2

Includes: HCN, HCP, VTR
by: Factoids


What are equity Required Rates of Return?

Why are Required Rates of Return needed to understand valuations?

Part one of this article covered the following points:

1. What is FAD (Funds Available for Distribution)?

2. A brief intro to the significance of FAD retention

3. Why FAD is important - the dividend/FAD ratio predicts dividend growth and FAD growth predicts dividend growth. You need FAD numbers to refine your dividend CAGRs (Compound Annual Growth Rate) projections.

4. Setting CAGRs - historical numbers and ratios

5. Setting CAGRs - briefly looking at all the inputs

In this, the second part of the article, I will cover the following:

6. What is a RRR (Required Rates of Return) - and why "cap rates" are REIT RRRs.

7. Putting it all together with "yield + CAGR - RRR."

8. Confirming valuations assessments with analyst ratings.

9. Confirming valuation assessments with the trends in share price appreciation.

In the first part of this article, I covered why Funds Available for Distribution is the earnings metric needed to set projections for forward dividend growth. This article uses the theory that all equity income stocks sell at a reasonably equal yield plus dividend CAGR minus any adjustments needed for differences in risk. This article begins with the assessments done for risk.

What are RRRs - and why "cap rates" are REIT RRRs.

This investor was late to the party in understanding the importance of RRRs (Required Rates of Return). Like all boomers - I blame others for my faults. I blame the market and its talking heads along with Pavlov. I did not start investing in individual stocks until after the crash at the beginning of the millennium. And from 2001 through 2007 - all you needed to know was that the total return projections on income equities was roughly equal to the "yield + dividend CAGR." As I refined by CAGR projections - I purchased stocks with the highest "yield + CAGRs" - and was rewarded for it. That reward created a Pavlovian reaction. I became a RRR agnostic. I believed I did not need to get nuanced about risk. There was some risk in everything - and there was no need to nitpick about what I believed were small differences. Then along came the credit crisis.

I experienced some dividend cuts - and some dividend eliminations - in the stocks I held. But all stocks did not fall equally. I began to search for reasons why. It took a bat to the head that was the credit crisis before I began to see risk. And I saw it everywhere! There were varying risks in varying amounts of leverage. There were varying risks in different business models - models that can vary within the same sector. There were varying risks in different asset types - asset types that can vary within the same sector.

After years of tracking the change in the current year earnings projection as a tool to explain why one stock was up and another was down - I had years and years of "earnings projection accuracy" numbers. When you put together a long series of years of earnings projection accuracy - I found that projection disappointments were not random. I first thought that some companies "over promised and under delivered." I thought that because the talking heads discussed stuff like that. But the pattern in the numbers said something different.

There was a high correlation between my newfangled "earnings projection accuracy" metric and credit ratings. Credit ratings also correlated with key credit metrics like debt to market cap and interest coverage ratios. Credit metrics correlated with the cost of debt. This was beginning to make sense. Companies that had higher forward earnings visibility should be those with the better credit ratings. I also saw a correlation between "earnings projection accuracy" numbers and price to earnings valuations. And that made sense. A company with an earnings projection that I can believe in should have a higher price/earnings metric that a company with an earnings projection I could not believe in. Companies with higher historical projection accuracy were the companies with the more believable earnings projections. I also tracked the spreads between the high and low earnings projection. There is a high correlation between projections with low spreads and companies with higher accuracy. I love that logical coincidence. Or to paraphrase the A Team's "Hannibal" Smith, I love it when a valuation assessment system comes together with secondary supporting metrics.

This new "yield + CAGR - RRR" valuation models works for banks, BDCs (Business Development Companies), consumer staples, dividend paying industrials, MLPs (energy Master Limited Partnerships) and dividend paying tech. I am new to investing in Health Care / Pharma - but it looks like this system works there, too. It works for all the sectors I invest - except for one: REITs.

While I do not heavily lean on FFO projection accuracy for setting my REIT RRRs - you probably want to see that data. Here it is:

FFO estimates projection accuracy by Year

This spreadsheet shows how my historical FFO accuracy ratings 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
company Chng Chng Chng Chng Chng Begin End Chng Begin End Chng Begin End Chng Begin Cur Chng Rate Sprd

Health Care REIT, Inc. (NYSE:HCN) -3% 2% 2% -11% -2% 3.30 3.41 3% 3.77 3.51 -7% 3.91 3.36 -14% 4.00 4.07 2% 3.50 5%
Health Care Properties (NYSE:HCP) -5% 0% -2% -7% 0% 2.55 2.69 5% 2.80 2.76 -1% 2.97 3.01 1% 3.06 3.03 -1% 1.50 4%
Healthcare Realty Trust Incorporated (NYSE:HR) -14% -36% 2% 6% -7% 1.37 1.15 -16% 1.30 1.31 1% 1.39 1.32 -5% 1.41 1.46 4% 4.00 3%
Healthcare Trust of America, Inc. (NYSE:HTA)           0.51 0.51 0% 0.60 0.61 2% 0.66 0.64 -3% 0.69 0.73 6% 1.50 8%
LTC Properties Inc. (NYSE:LTC) 1% -2% -4% -4% -6% 2.06 2.15 4% 2.29 2.26 -1% 2.43 2.37 -2% 2.65 2.60 -2% 1.50 4%
Medical Properties Trust Inc. (NYSE:MPW)       0% 0% 0.71 0.71 0% 0.90 0.90 0% 1.07 0.96 -10% 1.12 1.10 -2% 3.00 15%
National Health Investors (NYSE:NHI)       0% 2% 2.88 2.88 0% 3.00 3.18 6% 3.39 3.55 5% 4.13 4.20 2% 1.20 7%
Omega Healthcare Investors Inc. (NYSE:OHI) 16% 11% -9% -5% -6% 1.85 1.89 2% 1.94 2.19 13% 2.24 2.53 13% 2.73 2.77 1% 2.00 6%
Sabra Health Care REIT, Inc. (NASDAQ:SBRA)           1.31 1.31 0% 1.41 1.41 0% 1.72 1.84 7% 2.20 2.27 3% 2.00 31%
Senior Housing Properties Trust (NYSE: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 7%
Universal Health Realty Income Trust (NYSE: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%
Ventas, Inc. (NYSE:VTR) 3% -3% -3% -6% 5% 3.10 3.37 9% 3.67 3.80 4% 3.99 4.14 4% 4.36 4.38 0% 1.50 4%

Average                                 2.35 7.80
Click to enlarge

You would need to see the data from several other sectors before you appreciate the major difference between this set and other sets. But I can save you some effort. The number of earnings disappointments here are much smaller than average. And when disappointments happen here - the size of the disappointments tend to be significantly smaller. You should not be surprised that REITs have relatively high earnings visibility. That attribute results in Health Care REITs being relatively lower risk investments. If "all income equities sell at a logical yield plus CAGR with significant adjustments for risk," then REITs should logically sell at lower "yield + CAGRs." I will show the "yield + CAGR" stats in an upcoming spreadsheet. And their "yield + CAGRs" are smaller than average. Whether you are aware of it or not - you (the current and future REIT investor) are paying a price for REITs being relatively low risk in their lower returns.

Before we move on - spend a minute with that data. As noted before, 2008 and 2009 contained several unpleasant surprises. I heavily weight the track record since 2010 in setting my accuracy ratings - but I do not ignore the older data. In this sector, a 5% unpleasant surprise is a significantly sized surprise - and merits an accuracy demotion. Having that low of a threshold for demotion is atypical. Health Care Properties, Healthcare Trust of America, LTC Properties, National Health Investors and Ventas have great FFO projection accuracy records. Health Care REIT, Healthcare Realty Trust, Medical Properties Trust, Senior Housing Properties Trust and Universal Health Realty Income Trust do not. This information influences my purchase behavior. I like FFO projections I can believe in.

From the data, it is apparent that some REITs have lower RRRs than others. Why would a stock like HR with a history of multiple dividend cuts and no recent history of dividend growth sell at a lower yield than OHI or SBRA - which have recently been on a dividend growth spurt? I needed an explanation for that. That kind of thing would not happen in other sectors. And with HR having the worst dividend history in the sector - why would it sell at the highest price to earnings (or price to FFO) metric in the sector?

Here is my explanation - REITs are hybrids. That are part "stock" and part "real estate." But in what proportion? In the spirit of Yogi Bara - who is quoted as saying that "Baseball is 90% mental, the other half is physical" - REITs are 90% real estate and 50% stocks. REITs have RRRs that are almost totally based on the cap rates at which individual properties sell on the real estate market. I am not telling you that because I was logical and smart enough to deduce the answer. I am telling you that because that is the only answer the works. It is the answer that explains the valuation for HR. And you can go to the office REIT sector and find it is the only answer that fits the valuations for - Boston Properties Inc. (NYSE:BXP), SL Green Realty Corp. (NYSE:SLG) and Vornado Realty Trust (NYSE:VNO) - which are all REITs with atypically high price/FFO metrics due to the significantly lower cap rates for high quality NYC real estate.

From my notes on the earnings conference calls for this and past quarters, MOBs are selling at 6% "cash" cap rates, Seniors Housing properties are selling at 7% cap rates, and Skilled Nursing Faculties' cap rates in the low 9s and hospitals in the mid 9s. And it is the difference in caps rates that explains why high MOB REITs have 7.5% RRR assessments, high Senior Housing REITs have 9.2% RRRs, high SNF REITs have 10% RRRs, and the one hospital REIT has an 11.5% RRR. Most REITs have a combination of assets - and that complicates the setting of accurate RRRs. I also let the credit metrics lightly influence my RRRs. Let's look at that property type spreadsheet:

Weightings by Property Type

Company Hospitals Skilled Nursing RIDE-A Sen Hou Assisted Living MOBs Life Science Debt My RRRs
Aviv REIT, Inc. AVIV 3% 84% 0% 10% 0% 0% 3% 10.70
Physicians Realty Trust DOC 13% 21% 0% 0% 66% 0% 0% 9.00
Health Care REIT, Inc. HCN 4% 14% 39% 25% 15% 2% 1% 9.20
Health Care Properties HCP 5% 28% 4% 33% 13% 15% 3% 9.20
Healthcare Realty Trust Incorporated HR 9% 0% 0% 0% 87% 0% 3% 7.60
Healthcare Trust of America, Inc. HTA 5% 0% 0% 4% 90% 0% 1% 7.40
LTC Properties Inc. LTC 0% 50% 0% 40% 0% 0% 10% 9.60
Medical Properties Trust Inc. MPW 86% 0% 0% 0% 1% 0% 13% 11.50
National Health Investors NHI 4% 33% 12% 41% 1% 4% 6% 9.60
Omega Healthcare Investors Inc. OHI 2% 89% 0% 2% 0% 0% 8% 10.50
Sabra Health Care REIT, Inc. SBRA 12% 67% 0% 9% 0% 0% 12% 10.60
Senior Housing Properties Trust SNH 3% 3% 14% 34% 44% 0% 0% 8.70
Universal Health Realty Income Trust UHT 43% 0% 0% 0% 55% 0% 2% 9.50
Ventas, Inc. VTR 7% 3% 27% 47% 16% 0% 2% 9.50
Click to enlarge

Putting it all together with "yield + CAGR - RRR."

I do not have a ton of confidence in my REIT RRR assessments because I had not been doing that task for years. On the other hand, I do have a good amount of my confidence in setting my CAGRs. And this is where some simple math comes to my assistance. If my RRR assessments were in error, then my "price implied" CAGRs would not make sense - because RRRs are a key component in that calculation. And while my price implied CAGRs are not perfectly aligned with my CAGRs - that is never the case in any sector. The amount of alignment is similar to that in other sectors I track. As a result of this, I have confidence that my RRR assessments are in alignment with current market valuations.

Confirming valuation assessments with analyst ratings.

In the end - it is the bottom line that matters. My valuation assessments (the "yield + CAGR - RRR" numbers) are mostly in alignment with the analyst ratings.


Yield + CAGR Total Return Expectations

Company Q2-14 My Projected S&P Proj FFO Fixed My Total Consensus Price Div
    Yield CAGR Total Bond Historical Charge RRRs Return Ratings Implied / FAD
        Return Rate Accuracy Coverage   - RRR   CAGR Ratio

Aviv REIT, Inc. AVIV 5.21% 5.00% 10.21% NR 3.0 3.3 10.70 -0.49 2.6 5.49 75.39
Physicians Realty Trust DOC 6.93% 3.20% 10.13% NR 3.0 2.8 9.00 1.13 1.7 2.07 90.91
Health Care REIT, Inc. HCN 4.93% 4.40% 9.33% BBB 3.5 2.8 9.20 0.13 2.6 4.27 88.33
Health Care Properties HCP 5.18% 4.00% 9.18% BBB+ 1.5 3.7 9.20 -0.02 2.7 4.02 87.20
Healthcare Realty Trust Incorporated HR 4.84% 2.50% 7.34% BBB- 4.0 2.7 7.60 -0.26 3.1 2.76 81.63
Healthcare Trust of America, Inc. HTA 4.78% 2.70% 7.48% BBB 1.5 3.5 7.40 0.08 2.4 2.62 92.74
LTC Properties Inc. LTC 5.16% 4.40% 9.56% NR 1.5 6.6 9.60 -0.04 2.8 4.44 81.60
Medical Properties Trust Inc. MPW 6.26% 4.50% 10.76% BB 3.0 0.0 11.50 -0.74 2.9 5.24 79.25
National Health Investors NHI 4.97% 5.40% 10.37% NR 1.2 8.0 9.60 0.77 2.7 4.63 82.80
Omega Healthcare Investors Inc. OHI 5.46% 5.00% 10.46% BBB- 2.0 4.2 10.50 -0.04 3.1 5.04 80.00
Sabra Health Care REIT, Inc. SBRA 5.29% 5.80% 11.09% BB- 2.0 2.9 10.60 0.49 2.0 5.31 71.03
Senior Housing Properties Trust SNH 6.59% 1.80% 8.39% BBB- 3.0 3.8 8.70 -0.31 3.5 2.11 97.50
Universal Health Realty Income Trust UHT 5.78% 2.60% 8.38% NR 3.5 0.0 9.50 -1.12 3.0 3.72 89.93
Ventas, Inc. VTR 4.33% 5.80% 10.13% BBB 1.5 4.6 9.50 0.63 2.7 5.17 68.40
Click to enlarge

I have an emotional need to express that I really like the above spreadsheet. While ratings offer a judgment - there is no "why" in that single numerical assessment. It takes two spreadsheets that I have already displayed to arrive at the almost full story that justifies my CAGR and the RRR. Those numbers need a lot of justification. And it takes the combination of a yield, a CAGR and a RRR to reach a valuation judgment, I strongly believe that the final judgment of a rating - whether in an analyst update (where summary justifications are often too thin) or a Yahoo Finance web page (where justifications are totally lacking) - also deserves a "why."

For example - why is my rating on MPW a negative (and thus worse than average) when it has a "yield + CAGR" that is above average? Because it has assets that warrant a high RRR; it has a credit rating that is worse than average; it has an earnings projection accuracy rating that is worse than average; and it fails to mention its fixed charge coverage ratio or SSNOI growth in its earnings release or quarterly supplement. Why is my rating for UHT negative? More or less, it is the same reason as MPW. Why is my rating for VTR positive? Its "yield + CAGR" is higher than average; its credit rating is above average; its fixed charge coverage ratio is above average; its historical FFO projection accuracy is above average; its dividend/FAD ratio suggests much stronger than average dividend growth. A rating is nice. A "why" is better. There is no way to double check a rating. But you have enough information to double check a "why" inclusive assessment. If a stock under performs its rating that comes without justification (or when a stock with good ratings has a price performance that is bad), what do you check to determine the reason? Offer justification along with an assessment, and you have something to check.

After providing evidence that my valuations are in alignment with the analysts, I suspect some of you will be thinking that I have provided evidence that my valuation assessments are equally as bad as those of the analysts. After all, it is not the case that the best rated stocks always outperform.

This may come as news to you - but the best rated stocks are not supposed to always outperform. Analyst ratings are a risk adjusted valuation assessment. Sometimes, high risk outperforms low risk. The risk factor alone explains why there are times when lower rated stocks outperform. And the risk factor also explains why they outperform with such inconsistency (grin).

Confirming valuation assessments with the trends in share price appreciation.

Which REITs have outperformed year to date? It's the MOB and RIDEA REITs. Why? You can find the long answer in my prior article "Explaining Year-To-Date Health Care REIT Returns."

The short answer - MOB REITs are up in 2014 because it is a "risk off year." Ten-year treasuries are up. The S&P 500 is flat. The Russell 2000 is down. MOBs are the low risk Health Care properties. You can tell that from their cap rates and from the quality of their customers. HTA has investment grade rated tenants paying 41% of their annualized base rent. HR has investment grade rated tenants leasing 78.9% of its total square feet. None of the other fellow Health Care REITs disclose these qualitative metrics. RIDEA (or operating - or non-triple-net) property REITs are up because their SSNOI growth is up compared to other Health Care REITs.

This has been a very long article - and I still have not told you which REITs to buy and which to avoid. That is going to have to wait for one more article. There is still a lot that I have not covered. But I have covered enough data that I can end with this potential tale of caution.

Earlier in this article, I noted that the FAD metrics are screaming that VTR is a bargain. I guessed that there must be bad news that is out there hiding. I wanted to end with something a little controversial - and my best guess at to the hidden bad news for VTR is speculative and controversial. Just in case I failed to provide something to talk about with all the data provided above - I am throwing in this one last bit for a piece of insurance that the readers will have content that merits a few comments.

VTR is buying high quality operating Senior Housing facilities and paying for that quality with low cap rates. That would be an OK thing if the market was rewarding VTR with an equally low required rate of return. I believe I have shown convincing evidence that MOB REITs have significantly lower required rates of return which is mostly likely due to the low cap rates for MOB properties. VTR - and HCN - are paying cap rates for their new Senior Housing operating properties that are just as low as the MOBs. But their valuations are not reflecting that with lower RRRs for HCN and VTR.

It is my perception that the required rates of return for VTR actually rose in 2013 as the market assessed a higher risk to VTR due to operating properties instead of triple-netting them. This imbalance between the valuations at which VTR is buying properties and the stock market is assessing their valuation after purchase is something that cannot continue with a happy ending. Think of this process as being like a mortgage REIT or BDC loading up on US treasuries and failing to have the market reward it with relatively lower yields. VTR and HCN are doing an asset allocation shift that is like such a shift in mortgage REITs and BDCs. For the shift to be good news for the stock holders, the market needs to react with a change in the valuations for these stocks.

VTR could be purchased by private equity, where they could split up the properties and harvest this valuation disconnect. And private equity could do this task with significantly higher leverage. My fear of a buyout is only speculation. I would not even call that speculation "probable." But the "valuation disconnect" is very real. It is a problem. And logically - it is one weird problem. Basically I am saying that VTR has a problem because it is undervalued. Normally, being undervalued is a good thing. That may not be the case in this instance.

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.