Originally Published October 13th, 2016.
By Ben Reynolds
REITs are required by law to pay out 90% or more of their earnings as dividends. This makes it difficult to pay rising dividends every year. There's very little margin for error because the payout ratio is so high.
If earnings fall (and every business has setbacks eventually), then there's a good chance dividends will fall as well for a REIT.
That's why you wouldn't expect there to be any REITs in the Dividend Aristocrats Index…
The Dividend Aristocrats Index is composed of only businesses with 25+ consecutive years of Dividend Increases.
Amazingly, one REIT qualifies to be a Dividend Aristocrat: HCP.
In addition to a long dividend history, HCP also has a high current dividend yield of 6.4%; the highest of any Dividend Aristocrat.
The stock outperformed the market for much of the last decade, before struggling in the last few years. Performance versus the S&P 500 (including dividends in both cases) is shown below.
This article explores the investment prospects and operations of HCP in detail.
HCP is more stable than most REITs because it operates in the health care industry. The company operates in three primary segments:
In addition, the company operates a Hospital segment, which generates around 6% of portfolio income. The image below gives a breakdown of tenants and total portfolio income from each primary segment.
Click to enlargeSource: June 2016 NAREIT Presentation, slide 6
The image above shows HCP's income by segment after its proposed spin-off. The company is spinning off its ManorCare assets into a new business. ManorCare operates in the post-acute and senior care real estate industry.
ManorCare makes up around 20% of HCP's income currently. The details and rationale for this spin-off are discussed in greater detail in the growth section of this article. In total, HCP operates a portfolio of more than 1,000 properties in the United States and the British Isles.
HCP has grown dividends at 3.2% a year from 2006 through 2015. Funds from operations (hereafter abbreviated as FFO) per share grew at 5.3% a year over the same time period. Investors should not expect rapid growth from HCP. The company pays out the majority of its earnings as dividends. This leaves less to reinvest for growth.
HCP grows by investing capital it raises from both debt and equity markets. From 2006 to 2015, total share count grew by 9.9% a year. Long-term debt grew at 6.9% a year over the same time period.
The company has favorable long-term macroeconomic growth drivers…
The aging 'Baby Boomer' generation means rising health care costs - and more senior housing facilities. This bodes well for HCP. Rising health care costs, in general, are good for HCP's clients. This in turn provides growth for HCP as its clients need more hospitals and buildings.
But not everything is positive at HCP…
The company's ManorCare assets are performing poorly. Changes in payer mix from Medicare to Managed Care plans have reduced both billing rates and number of patients to post-acute/skilled nursing facilities. This has caused ManorCare to struggle.
ManorCare barely covered its fixed costs in HCP's most recent quarter. The company's fixed charge coverage ratio was 1.03 in the quarter.
HCP's management has responded by isolating the problem - and removing it. ManorCare will be spun-off to shareholders of record as of October 24th. Shareholders will receive one stock of Quality Care Properties (the name of the ManorCare spin-off) for every five shares of HCP stock.
The new business will be structured as a REIT… But it is unlikely the spin-off will be able to pay (or at least maintain) a dividend once it is spun-off.
The question for HCP shareholders: Is the dividend safe?
The short answer is, yes. The company generated $0.74 of adjusted FFO per share in its most recent quarter. HCP pays dividends of $0.575 per share. The dividend is still well covered by FFO.
Competitive Advantage & Recession Performance
While HCP's ManorCare division has struggled, there's no doubt the company, as a whole, has a strong and durable competitive advantage. The evidence is its 31 consecutive years of dividend increases.
HCP's competitive advantage comes from its size. The company's large size (it has a $16.9 billion market cap) allows it to diversify its health care properties. Smaller REITs are less diversified, and more subject to risks from individual deals.
HCP also protects itself by entering into beneficial contracts with tenants. The company locks customers into contracts that specify rent increases throughout the life of the contract. This helps HCP to grow (slowly) over time.
The Great Recession was a difficult time for the real estate industry in general. Despite this, HCP performed well during this difficult period. The company's focus on the more stable health care industry is largely responsible for its better performance. When recessions hit, health care still takes priority. This allows HCP's tenants to keep paying regardless of the overall economic climate.
HCP's FFO per share through the Great Recession and recovery is shown below to show how little the company was affected by the recession.
2007 FFO per share of $2.14 (high at the time)
2008 FFO per share of $2.25 (new high)
2009 FFO per share of $2.14 (recession low)
2010 FFO per share of $2.18 (beginning of recovery)
2011 FFO per share of $2.37 (new high)
Valuation & Expected Total Returns
HCP's dividend yield compared to its largest Health Care REIT competitors' yields is shown below:
HCP has a dividend yield of 6.4%
Welltower (NYSE:HCN) has a dividend yield of 5.0%
Ventas (NYSE:VTR) has a dividend yield of 4.4%
The ManorCare debacle has increased HCP's yield. At one point, the stock's dividend yield reached over 8%. It has since come down, but is still well above that of its peers. The higher the yield, the better the valuation for REITs. Since REITs are required to pay out the bulk of their income, dividend yield is a good comparative metric in this case.
HCP appears undervalued at current prices relative to its peers. If interest rates rise, the company's share price will likely decrease. Still, it does appear to be trading at a discount to peers. Investors should, on average, expect positive gains from valuation multiple changes from HCP.
I expect HCP to continue growing its dividend payments at between 3% and 4% a year over the next several years (with a brief pause in growth this year and next year due to ManorCare). This growth combined with the company's 6.4% yield gives investors expected total returns of 9.4% to 10.4% a year, before valuation multiple changes.
HCP is a high-quality REIT. The company will move past the current ManorCare situation - the spin-off will happen this month.
HCP appears undervalued compared to its peers. The company offers investors solid total returns at current prices. Reasonably safe dividend yields of 6%+ that are expected to grow are difficult to find in today's market. There are certainly advantages to investing in stocks expected to grow dividends.
There are no other Dividend Aristocrats with yields even close to that of HCP's. The company stands out in this regard.
With that said, the company does not rank particularly well using The 8 Rules of Dividend Investing due to its high payout ratio, mediocre growth rate, and the volatility of its stock price.
While it may not rank well on these metrics, HCP still makes an intriguing choice for investors looking for yield in today's low rate environment - for investors who can withstand its higher-than-average stock price volatility and expected sluggish growth in the short term.