Joe X

Joe X
Contributor since: 2013
As a follow-up to the cost of capital discussion for mortgage REITs, ARI just raised its quarterly dividend from $0.44 to $0.46, or 4.5%. If you add this growth rate to the previous 10%-ish kind of yield, that's probably not a bad estimate of the total cost of capital for a commercial mortgage REIT.
Brad - thanks for the update on STWD.
I think it can be a mistake though to invest in these things based on a particular dividend yield. The dividend yield is rarely equal to the cost of capital, so when dividend growth levels out (as it seems to have this year at STWD), the earnings yield has to rise to make up the difference.
ARI's numbers are another way to look at cost of capital and total return expectations. ARI yields about 10%, and the stock price has held in lately because there was a 10% dividend increase for 2015 and potentially (TBD) another increase for next year. So the market is telling you that the total return expectation for these things is not in the upper single digits, but really into the teens. No, I don't think ARI's cost of equity capital is necessarily 20% (sum of a 10% yield plus this year's 10% growth rate), but it's also not 10%.
The other issue facing STWD is growing complexity as it transitions to become more of an equity-focused REIT. As you have pointed out many times, the established business model for an equity REIT is a single property type funded by an investment-grade rated balance sheet. The jury is still out on whether the diversified model can work, and investors will probably expect some extra return (cost of capital) in the meantime.
In summary, investors need to focus on total-return prospects, not just today's dividend yield. In fact, pretend there isn't a dividend and you need to fill in the blanks for the following equation: Earnings Yield + Growth Rate = Cost of Capital. If you can get reasonably close to figuring out these three numbers you'll be well ahead.
Joe X
Thanks for the interesting comparison between Apple and BofA. However, I would think the total cost being imposed on the larger banks is much more than their credit spreads, as they pay a disproportionate amount of premiums to the FDIC. They also pay a disproportionate amount of regulatory and compliance costs. Certainly GE's decision to liquidate its finance portfolio is evidence that these costs have now become too burdensome to justify, even for medium-sized players like GE.
Joe X
UStar - ARI raised $193 million of common equity in 1Q, and even though it came closer to the end of the quarter the de-leveraging effect probably cost them something along the way. I would expect leverage to start creeping up again in 2Q/3Q, which should help generate some incremental earnings. It's not unreasonable to assume that by the end of the year ARI has grown into the current $1.76 annual dividend.
Second, it is management's practice to remove stock compensation expense when reporting ARI's adjusted EPS, which obviously has the effect of boosting earnings. In my view this is an aggressive reporting practice, as it implies that the shares have no cost or value. But if the accountants tell you quite specifically that the GAAP cost of these shares in 1Q'15 was $1.117 million, shouldn't you believe them? When fully deducted as an ongoing expense, real earnings are otherwise lower than reported and the payout ratio higher. That said, it's probably the balance sheet and use of leverage that will ultimately determine dividend coverage for 2015.
Hope this is helpful.
Joe X
Preferred stock is very much at risk when a REIT gets bought out. Here's some things to think about...
1) Preferred stock has no financial covenants, so there is no mechanism to force a par redemption of the preferred if the REIT is taken private. Some public management teams take the high road and offer a par redemption at closing, but it's not a requirement.
2) Preferred coupons in the 6-7% range are going to look like very attractive mezzanine capital to the new buyer. But these cheap coupons were probably reflective of an investment-grade profile at issuance. In the scenario where a company is taken private and levered up, the new clearing rate is going to be more like 8-9%. So the preferreds are going to drop in price - a lot.
3) In an even worst case scenario, the new buyer just turns off the pfd. dividends for awhile to save on cash. Preferreds generally let you pass on up to 6 dividends before the preferreds get to elect two directors to the board. But you could pass on 5 dividends without much in the way of consequence, essentially creating an interest-free loan.
4) Investors need to ask themselves what's the endgame for their REIT preferreds and make sure they're comfortable with the risk. Practically everything has traded back up to par from the 2009 lows, and/or been refinanced at generationally low coupons, so now is the time to think about next steps and swapping into something safer without too much of a yield hit. Is it really worth hanging out in Cedar Realty Trust Series B Pfds. (CDR+B) at a 7.1% current yield when you can swap into Regency Centers at 6.0% (REG+G) with an increased margin of safety? Now is the time to think about it.
Joe X
The OP does not seem to be aware that IG-rated corporate bonds issued by REITs incorporate some very restrictive financial covenants. In a buyout situation, these covenants force the issuer to redeem the bonds (at preferential pricing) before all the new secured leverage is piled on.
So, in fact, REIT buyouts have never been problematic for existing corporate bondholders. What has been problematic is the use of excessive secured leverage to effect the buyout, but that's another matter.
Joe X
Not surprisingly, ARCP's bank lenders are getting a little restless and seem to have required ARCP to eliminate the common dividend in return for another extension on the financial statements. ARCP also said that when the dividend was reinstated, it would be at a rate consistent with peers.
ARCP is in the midst of a fairly serious operational, financial and portfolio restructuring. The end result will probably be a stronger company with a stronger balance sheet, but all of these changes are going to be dilutive to FFO. The company also said that it has retained Korn Ferry to search for a new executive team. That's good news, but anyone coming on board is going to want to start with a clean slate. That means less leverage and less goodwill.
The winner in today's announcement might be the ARCP preferreds. Ultimately there is going to be improved preferred dividend coverage and probably less leverage above you. That said, fallout from the common dividend news could cause some volatility across the board.
Joe X.
Today's announcement regarding Board and executive changes is good news over the long term, but places increasing doubt on ARCP's maintaining the current common dividend.
My read is that the independent directors have a very firm grasp on ARCP's need for a complete restructuring of the company's governance and business profile. Morgan Stanley has already been hired to advise on Cole, and the Board has now moved very decisively to make a complete change of the C-suite, Chairman, and ties to Schorsch-related entities. ARCP shareholders, and potential ARCP shareholders, should feel comfortable that these structural issues are now going to get fixed.
I'm not sure I agree that the removal of David Kay and Lisa Beeson implies that there are additional financial statement problems waiting to be be disclosed. The Board would certainly have used this opportunity to update investors if that was the case. I think the Board understands that ARCP is in need of a very broad makeover (get ready for a name change down the road), and that replacing Kay and Beeson simply had to be part of the process. Given ARCP's profile as one of the largest net-lease REITs, it probably shouldn't be too hard to find experienced managers to fill these roles. Realty Income better be locking in their top managers because you know they'll be getting calls...
Today's management announcement is just the first step for ARCP. The company must also deal with the complexity of Cole, and that means selling it or spinning it off. Net-lease REITs are first and foremost specialty finance companies, and can only survive they have a lower cost of capital than their tenants. Business complexity and variability work against this, so that implies that Cole needs to exit the picture sooner rather than later. Don't know if Morgan Stanley's mandate stops at Cole, whether there are additional sub-portfolios that are going to get shopped, or whether it's simply prep the company for sale. Since you only want to clean house once, now's the time to put everything on the table.
The last step is cleaning up the balance sheet. Too much goodwill and more leverage than you'd like to see. This is not rocket science - the goal should be to resemble Realty Income or National Retail Properties in as short a time frame as possible.
To sum up, the Board took a very decisive first step in ARCP's overall restructuring. There's more to come and ARCP's continuation as an independent public company is perhaps less certain. In my view, all of this increases the probability that the common dividend is going to be lowered.
Joe X
As noted above, ARCP has effectively cancelled the sale of Cole Capital and will instead receive a breakup payment of $60 million from the former buyer, RCS Capital. This is the strongest indicator yet that the value of Cole Capital has diminished over the last several weeks. In fact, the value has diminished so much that a knowledgeable buyer is willing to pay $60 million just to walk away.
In my view, today’s announcement reinforces the risk of potential impairment charges to the $2.3 billion of goodwill on ARCP’s balance sheet. Of this amount, $548 million (as of 6/30) is related to Cole Capital’s business value and is specifically attributed to “growth from new income streams and the ability to offer new products.” While Cole at one point may have been a growth story, today’s breakup fee suggests otherwise, and heightens the risk that the auditors will be taking a hard look at these goodwill balances for the next set of financial statements.
Joe X
Guys, thanks again for all the comments on ARCP. Here's another risk to the sustainability of the common dividend...
One of the most negative things about ARCP is the $2.2 billion of goodwill created in the 1Q'14 acquisition of Cole. According to the 6/30 10-Q, approximately $1.7 billion of goodwill is attributed to such items as a lower cost of capital, critical mass, and an enhanced access to capital. Another $548 million of goodwill is attributed to Cole Capital for its "growth from new income streams and the ability to offer new products."
While it's bad enough to create the goodwill in the first place, it's going to get even more interesting when the auditors need to test these values for impairment. Hard to tell whether the 9/30 balance sheet will take a hit since the accounting issues surfaced after that date. But the 12/31 balance sheet is going to get a real scrubbing, and it's hard to see these values holding up.
I know some will say writeoffs of non-cash items have no impact. But bond covenants and bank covenants usually work off of book values, and because goodwill represents 25% of shareholders' equity it could be a material item. In particular, goodwill writeoffs will raise leverage ratios at a time when ARCP's credit metrics are under the most scrutiny.
If book equity gets reduced through writedowns, ARCP may need to sell assets to reduce leverage - and that's where the current $1 dividend could take a hit. Net-lease dividends are a function of asset yield, interest rates on debt, and leverage. The obvious risk here is that if assets have to be sold to reduce bank debt, there's simply that much less cash flow available to drive the dividend. And just because the company punted and paid $0.08333 for December doesn't mean they're committed to paying $1 in 2015.
It takes a lot of moxie to put $2.2 billion of goodwill on a REIT balance sheet, so take a good look, might not be there much longer.
Joe X
Mark - thanks for pointing out the yield on the ARCP preferred stock. Looking at recent prices (WSJ preferred stock table for 11/25), the ARCP 6.7% preferred closed at $21.76 while Realty Income's 6.625% preferred closed at $26.70. That's nearly a $5/share gap on almost identical dividend payments.
While it's going to be awhile before ARCP has navigated through the mess it's created, there seems to be an opportunity here for the ARCP preferreds to close the gap on benchmark Realty Income. Even if ARCP were to make up $2 of the $5 discount over the next 12 months, that would give you a 16.9% one-year return.
Key risks are going to be a common dividend cut, which might temporarily unnerve the ARCP preferred too, and the timing of resolving the issues with Cole, the relationship with Nick Schorsch, and cleaning up shareholder lawsuits. But the risk profile could look a lot better by the end of 2015 than it does now. In the meantime, you're getting paid to wait.
Joe X
I would be careful about placing too much reliance on the rating agencies for credit predictions, particularly in real estate. All three (Fitch, Moody's, S&P) were spectacularly wrong when it came to analyzing residential real estate in the form of RMBS and CDO's. Their ratings for commercial mortgage-back securities (CMBS) were also faulty during the peak volume years of 2005-2007. About the only place they were actually on the conservative side was the REIT sector, which has seen only one default over the last 25 years (General Growth) and no losses.
Brad - thanks for bringing United Development Funding (UDF) to everyone's attention. However, I'm going to agree with more than a few of the guys above that UDF has a ton of intrinsic risk that is not nearly offset by an 8% dividend.
At the bottom of the housing cycle, there is nothing more worthless than undeveloped or partially developed residential lots. While it's true that there is equity below UDF's loans, that equity will quickly vaporize when the cycle turns, and borrowers will not be able to stand up to their commitments. If you want an example of how this might play out in a public REIT format, look no further than iStar Financial, which is still trading 70% below it 2007 peak and hasn't been able to reinstate a dividend. Going into the downturn, iStar prided itself on itself on its custom-tailored financing solutions to smart borrowers. The company then spent years fighting these same borrowers through foreclosure, and STAR is now the successor owner to a lot of commercial and residential land deals. Sure that's a good thing when the cycle turns up, but STAR's pre-crisis investors were almost completely wiped out.
If I were looking to take residential development risk, I would look to the established public homebuilder stocks such as Lennar or Pulte, where at least I get the upside of fat development profits on the upside of the cycle to compensate me for the intrinsic land risk. I would also take a hint from these same battle-scarred public homebuilders, who generally try to keep the land risk off their balance sheets.
The good news I suppose is that we're still in the early innings of the housing cycle, and if you follow basic residential housing stats you find that the uptrends can easily go on for 10-20 years before the inevitable downturn. So it's entirely possible that UDF could have a nice run here. But with such a small balance sheet and concentrated loan portfolio, UDF's price would need to drop a lot more in order to make the value proposition more attractive. I would also keep in mind that an 8.20% dividend yield cannot be UDF's total cost of equity. So if UDF can't lever up (difficult given the collateral) or widen lending spreads (maybe more likely to shrink), then it's hard to see how the dividend is going to grow much. In this scenario, the stock price will then sink to where the dividend yield equals the cost of capital, likely double digits.
Joe X

User 5842391 - congratulations on getting the timing right if you indeed jumped into the net-lease sector toward the end of 2013. However, the gain you are sitting on should make you more cautious, not less. Let's address your points in order...
1) If rates are at 11-month lows, the risk to companies with long-duration flat cash flows is greatest, not lowest.
2) The liability side of the balance sheet (leverage) is a secondary issue. It's the asset side that's the problem. Properties under 20-year lease with generally reasonable extension options pose a risk in a rising rate environment. While you may eventually grow your way out of the problem, the typical 1.5% annual lease escalation is not sufficient to offset sudden jumps in market rates.
3) While it's true that FFO yields might be higher than bonds, this ignores two really key items. First, FFO yields are not the right metric. Many health care REITs, especially the large-cap ones like HCP, HCN and VTR, own properties that require ongoing capital expenditures. Second, "FFO" is often the subject of dubious adjustments to make it look better. Omega Healthcare, in particular, likes to add back tenant credit losses, financing costs, and management stock compensation expense. All of these items combine to lower the yield premium to bonds and should not be ignored.
Finally, net-lease REITs such as the health care names have much longer duration than the bond market. The weighted average maturity for the entire US bond market (AGG) is 6.9 years. In contrast, the net-lease REITs are usually sitting on something like 10-11 year average remaining primary lease terms, but that doesn't include extension options that can tack on 5-10 years after that.
Let me also add my thanks to the Chilton REIT Team for providing a timely and thoughtful article on investing in the health care REITs.
Rgds, Joe X
If you like nursing home risk, OHI is the stock for you. However, there is no free lunch, and in the event of any future cutbacks to Medicare reimbursement - or just nominal increases - that can place pressure on OHI's tenant base. The economics of this business are basically the same for all of OHI's operators, so if one goes under the others are likely to feel the pinch.
This is a bullish analysis of OHI, but leaves out some important questions. Such as, if demographics are so great, why is industry occupancy flat at best? OHI's own occupancy was last reported at 83.8%, which illustrates that the great demographic wave still hasn't moved the needle. Another health care REIT, HCP, has been seeing cash flow coverage decrease in their SNF portfolio (run by Manor Care), to the point where investors are becoming concerned. Investors should also ask themselves what steps the government will take to control costs if and when demand does increase due to demographics. In summary, that rosy future for nursing home operators might still be a long way off.

OHI is not just another health care REIT. Diversified companies like HCP, HCN and VTR have a much lower risk profile. I agree that OHI's management is experienced and does a good job running the company within this sector. And there's nothing on the near-term horizon that looks particularly threatening. Just be aware that OHI's higher going-in cap rates and higher dividend yield are there for a reason.
Joe X
Jerry - from the data you presented I don't know why you see the pricing of DLR's preferreds as irrational. They are each trading with a current yield of 7.7% to 7.8%, which makes sense as they are each pari passu with respect to payment priority.
I suppose you could say that the varying lengths of call protection (i.e. between 3 and 5 years) should perhaps be reflected in differences in current yield. But the potential for refinancing any of these preferreds is very low - rates have moved higher, seem likely to go higher still - and DLR's preferred issues are here to stay for a long time. It would take a very extraordinary environment again - incredibly low rates, recovery in real estate markets - to produce the kind of market demand where DLR would have the chance to reissue preferreds with lower coupons. This window in time has shut.
I do agree that if DLR is ever liquidated along the way or purchased by an AAA conglomerate, then the Series G preferreds might be the ones to own. But absent that kind of scenario, all of DLR's preferred stock should (and apparently does) trade within a very tight band. Hope this is helpful.
Joe X.
Jon - you're correct that the last sentence was a little on the murky side. What I was trying to express so badly is that net-lease REITs (such as HCP) with their long-duration cash flows are fairly sensitive to changes in the rate environment. When long-term rates started to move in the early summer, the entire REIT sector sold off pretty badly, especially REITs with longer term leases. So rather than spending a lot of time at the moment trying to choose between HCP, HCN, VTR, etc., investors might be better off thinking about whether they want to be in the net-lease sector in the first place, and if so at what level of concentration in their portfolio. Hope that's helpful.
Joe X.
Ricky - thanks for the comment. Regarding the negative $1.1 billion, you need to add back the $1.9 billion of non-cash depreciation charges (I'm looking at the Sept. 30 balance sheet) that HCP has taken on its real estate properties. When you do, you find that cash earnings have covered the dividends. Under GAAP accounting, non-cash depreciation charges tend to mask the true dividend capacity of real estate companies, which is why most REIT analysts focus on FFO/share rather than EPS as an earnings metric. Hope that's helpful.
Joe X.
Geez, this is what happens when you get old and your Varilux prescription doesn't correct as well as it used to. Per the most recent proxy filed on 4/5/13, it's Debra A. Cafaro.
Joe X
Apologies for the spelling error - Debra F. Cafaro is indeed correct as noted by the OP.
Thanks for the in-depth review of Health Care REIT (HCN) versus Ventas (VTR). I would be cautious however in extrapolating VTR's historical outperformance into the future. Here's why...
Ventas was formed in 1998 when the former Vencor spun off its real estate into a separate public company. Owing to cuts in Medicare reimbursement and charges of over-billing, Vencor filed for bankruptcy in September 1999. This had a severe impact on Ventas of course, which forced the real estate company to eliminate its dividend and enter into restructuring talks with its own lenders.
This is where Deborah Cafaro enters the picture. Cafaro was a former real estate attorney who was just coming off a successful CEO assignment at an apartment REIT (company was fixed and sold). The challenge for this new CEO at Ventas was to re-negotiate the leases with Vencor, deal with the bank group, and try to keep Ventas out of bankruptcy. To everyone's credit, all of this was accomplished. However, what needs to be remembered is that when the leases were restructured with Vencor (now Kindred), they were struck at below-market rates in order to give Kindred some breathing room and make it into a more viable tenant. In return for the below-market rates, the lease pools (there were four of them) were also structured with resets that would allow Ventas to recapture some of the upside in these properties over time.
All of this background helps explain why VTR has had such strong dividend growth versus HCN and HCP (see the first graph in this article). This graph captures the recovery phase of the Kindred leases, but neglects to include the early part of the story when REIT investors would have incurred severe losses of income due to the dividend elimination. HCN and HCP were also dealing with tenant-related issues at the time, but managed to keep their quarterly dividends intact. Ventas also paid more for its debt in the early years, but has seen its cost of debt capital (a key earnings driver) improve as its ratings have reached parity with HCN and HCP.
A lot of the upside in the Kindred leases has now washed through Ventas' income statement, and Kindred has now been reduced from a 99% portfolio concentration to 12% of NOI according to the latest supplemental. It's certainly been a great ride for investors, but some of that is just the reversal of a really bad ride for a few years. Today, VTR is one of the three large-cap health care REITs with a nicely diversified portfolio and a low cost of capital. Growth rates going forward are going to look nothing like the past, because leases are now at market rates and the high rate of balance sheet growth is unlikely to persist. If you take a look at the graph again, VTR's more recent growth rate, while positive, is much closer to its peers (HCN, HCP).
In conclusion, VTR (today) is a well-managed and nicely diversified health care REIT with a low cost of capital. But so is HCN for that matter, and as you point out HCN has a much newer portfolio that is positioned very nicely to appeal to upscale boomers as they move through their senior years. While you would have been much better off owning VTR in 2002 when it was just emerging from a painful restructuring, it doesn't seem like there's a major case for outperformance looking forward.
Guys - thanks for all the comments. It's been a couple weeks now since HCP's CEO change announcement on October 3rd, which is more than enough time for investors, traders and sell-side analysts to have digested the news. Here's the results:
1) HCP closed at $41.77 on October 2nd, which was the night before the CEO announcement. The stock closed yesterday at $42.84, which is a 2.6% increase.
2) Over this same time frame, the S&P 500 moved from $1,693.87 to $1,733.15, which is a 2.3% increase.
3) If you had "dumped" your HCP at the $39.05 low (closing price on Friday, October 4), that was a full 6.5% below the pre-announcement price. The S&P was down only 0.2% during those two days, so trading HCP for the index just after the news would have lost you a full 6 points, which is equal to a year's worth of dividends for any of the health care REIT stocks. If you dumped HCP at the lows and just sat in cash while trying to figure it all out (a common reaction too), you'd have given up a 9.7% gain through yesterday's close.
4) This illustrates the danger of trading on seemingly negative headlines, which crop up with every stock. Again, for those investors who have determined that an allocation to the health care REIT sector is appropriate for their risk tolerance and portfolio, we continue to believe that the best strategy is simply to hold a basket of the large-cap health care REITs (HCP, HCN, VTR), and try to ride out the inevitable headlines that come with holding any individual stock over a long period of time.
Thanks for the update on Fama's work with mutual fund data. It is a strong reminder to only use mutual funds when you have to, and be very mindful of the fees.
I would like to add one comment though regarding Buffett's returns at Berkshire Hathaway (BRK). There is a very unique structural advantage at Berkshire which doesn't seem to get much attention, and that is the practice of only paying management in cash. In conventional compensation structures, middle and senior management is compensated though base salaries, bonuses and oftentimes a significant stock component in the form of grants, options, etc. Over time, this stock compensation has the effect of diluting shareholder returns as the share count climbs each and every year.
Buffet has recognized that management teams will effectively work for less if they are simply paid in cash every year, rather than paid in some combination of cash and shares. While it's theoretically attractive to align management and shareholder interests by requiring management to own shares, it's almost never achieved by requiring management to come out of pocket on their own. Rather, shareholders end up giving away a certain amount of their holdings each year to "incent" management to stay and do what they were probably paid very well to do anyway.
Buffett's desire to control share count is very evident in his current investing style, which focuses on the outright acquisition of businesses (Burlington Northern, Lubrizol, etc.) rather than taking minority investments in public companies. Interestingly, we don't seem to hear reports that there is a mass-exodus of management once a company is acquired by Buffett, or that operating returns somehow become sub-standard.
Fama's work shows that retail investors, on average, are being diluted by mutual fund fees. Buffett has taken this approach one step further and suggested that investors are suffering another level of returns dilution. Perhaps institutional investors will start to examine this issue more closely and realize that core market returns could perhaps be improved without taking on increased business risk or financial leverage. We'll see.
Dragon - thanks for taking the time to comment.
I suppose if you are pinning your investment thesis on a particular CEO, then you have to sell if he gets the boot. The problem with that strategy is it leaves you vulnerable and jumpy to negative events that crop up with every stock. Switching costs are high in these situations because you're invariably selling low (lots of volume out of HCP) and buying high (peers VTR and HCN getting pushed up as newcomers rush in).
To be sure there are some companies - Apple and Berkshire comes to mind - where an iconic CEO really does make a difference. Health care REITs, though, are at the opposite end of that spectrum. Using HCP as an example, the investment portfolio is well diversified by product type and conservatively financed with a high equity component, tenants are locked in under long term net leases, and the end result is predictable cash flows to pay for a growing dividend. It's an extremely stable business model, to the point where the entire staff of HCP could take the week off and tenant rent checks would still be there on Monday morning.
The reason to own HCP was not that Jay Flaherty was the former CEO, or that Lauralee Martin is the new CEO. Rather, you are looking for a large-cap health care REIT with diversified cash flows and an industry-leading cost of capital that allows you to partner with quality tenants. None of that changed last week, and even though Jay is gone the other 150 people at HCP are more than qualified to carry on. Lastly, take a look at the huge and complicated global book of business that Lauralee Martin ran for years at Jones Lang LaSalle - managing 150 professionals in Long Beach is going to seem like a vacation.
Now let's address the question of whether there was adequate disclosure surrounding the announcement. On the conference call, Chairman Mike McKee was clear to point out the change in CEO's was basically a management style issue and not the result of some potential issue with the portfolio. To expect the HCP board, or any board for that matter, to go into chapter and verse on exactly why someone wore out their welcome after a long period of time is naive, and would be inadvisable from a legal standpoint. HCP probably has one of the toughest boards around if you're the CEO - Mike McKee, Lauralee Martin and David Henry are all active CEO's and Roath/Sullivan are each retired CEO's. Flaherty lasted 10 years reporting to this crowd and that in itself couldn't have been easy. In the end, the board simply decided it wanted Martin (62) rather than Flaherty (55) to groom the next layer of talent and that was the end of it.
The most important part of Thursday's CEO announcement was that it was not accompanied by any type of earnings revision, real estate valuation charge, or tenant receivable reserve. If there was ever a time to make an announcement along those lines, Thursday was it. Assuming we're in the all-clear on those issues, the odds favor a continued recovery in HCP's stock price over the next few weeks.
Joe X
I would be careful in your thesis that Martin lacks the requisite experience to lead a large-cap health care REIT.
Both Deb Cafaro and George Chapman were mid-level real estate attorneys when they made the transition to REIT management at VTR and HCN, respectively. Both have done well and both companies are now part of the S&P 500 along with HCP. Jay Flaherty was coming off a successful career in investment banking when he joined HCP, again without any prior public company management experience. The point being is that, back in the day, the names Cafaro, Chapman and Flaherty were not exactly household words in the halls of NAREIT.
Lauralee Martin, in contrast, is bringing a huge amount of senior real estate experience to the table from her recent role as CEO - Americas for Jones Lang LaSalle. In case you're not familiar, JLL employs over 40,000 people worldwide and the Americas division accounts for about 44% of global revenue. Some of JLL's key business lines include leasing, property and asset management, real estate investment banking, and capital markets. Sound familiar? These are the exact same functions performed by HCP's team of about 150 people in Long Beach.
On almost any measure, the board made a very informed decision to bring Martin in as CEO. She has a track record of success, has managed an organization many times the size of HCP, and has five years of experience on HCP's board and a solid understanding of the company's people, portfolio, and opportunities. In short, she is exactly the kind of seasoned real estate executive that most REITs would kill for.
Just a thought.
In regard to your lengthy and bullish article on OHI this week, I wouldn't be so quick to blithely dismiss Medicare cuts that "only impact short-term stay residents at nursing facilities. Medicare does not pay for long-term care at nursing homes."
Short-term Medicare patients are the most profitable patients that a nursing home has. Medicaid rates for long-term patients are far lower, and result in only break-even margins for the operator. Therefore, changes in Medicare reimbursement are critical for the financial solvency of these facilities. In fact, when the government cut Medicare rates back in the late 1990's, many nursing home operators filed for bankruptcy, and the knock-on impact to OHI with its undiversified nursing home portfolio were quite severe. OHI eliminated its dividend, changed management, and went into a restructuring period that lasted several years. You should ask shareholders from this time period whether they were sleeping well at night.
You might have also pointed out that OHI's price drop last week began after the HCP earnings call on Tuesday, where management noted that its HCR Manor Care nursing home portfolio "continues to face headwinds, notably the softness in admission and patient volumes experienced by the acute care hospital sector. As 90% of HCR's admissions represent discharges from the hospital sector, this dynamic negatively impacted HCR's occupancy during the first half of 2013."
If the largest nursing home operator in the country is feeling these issues, don't you think they might also affect OHI? And if HCP has about 30% of its portfolio in the nursing home space, isn't the issue magnified about 3x for OHI?
Finally, the yield on the 10-year treasury last week began at 2.62% on Monday and closed at 2.63% on Friday, with some minor variations in between. This would hardly be the catalyst for a major change in OHI's stock price, which seemed to be the opening thesis of your article.
Here's a few comments on the apparently weak June 2013 starts/permits numbers for housing.
First, anyone who has worked with this data knows how volatile it can be month-to-month, with said data almost always being revised for accuracy in subsequent months. Sometimes revisions can go back for 1-2 quarters before the numbers actually settle in. A better way to look at the underlying trend is to 1) average the monthly starts/permits data (to remove micro timing noise); and, 2) look at a rolling 3-month average (removes a lot of the revision noise). Also, the combination of single-family data and multifamily data is confusing - pull it apart into the separate components. Once you have smoothed out the series, fast money accounts can then compare the monthly spot data to see if, indeed, there's something really new to trade on.
It is also useful to have some context for the raw data. For the last several years, new single family sales have been constrained by end user demand, not by production capacity. This dynamic has changed quite a bit over the last 6-12 months, and builders are starting to struggle to keep up with demand. Recall that builders (and their subcontractors) went through numerous rounds of layoffs during the downturn and will have to start hiring again to meet up with annual demand that looks like it could breach 1,000,000 units perhaps next year.
One last comment on conclusions from the smoothed single-family starts / permits data. Peaks and troughs are remarkably easy to spot, and, upward and downward trends tend to continue for a very long time. Forget the June headlines numbers, this recovery has room to run.
Geodan - I think you are a little off in your view that BAC sold the 6% preferreds at par in August 2011 and Berkshire Hathaway got the warrants for free. If you take the time to read Footnote 12 in BAC's September 2011 10-Q (page 218), you will find that the fair market value of the preferred was $2.9 billion, and the warrants were booked at $2.1 billion. Even today, with the substantial rally in BAC's credit spreads, the company's preferred issues barely trade at 6%. Had the warrants turned out to be worthless, Berkshire would have been left with a substantial loss on the deal, hardly the risk-free trade you describe. I do agree that Buffet's investment was timely, but BAC preferred stock and options were and are widely available in the market and the basics of the trade could have been replicated in your own portfolio.
I agree that BAC's approval for $5 billion of stock repurchases and $5.5 billion to retire preferred is good news. But it's really even better than that. The Fed process is also a referendum on the soundness of BAC's mortgage repurchase reserves and litigation reserves. You would think that the Fed would be paying very close attention to these issues at any bank, but particularly BAC given that they are front and center on these two issues. Clearly the Fed feels that BAC's reserves are sufficient to cover the known issues, or that future modest reserving would not eliminate earnings or eat into the capital base. That's the way I read it anyway and hats off to management on a very successful outcome with the Fed.
Bruce - keep in mind that REITs have hefty recurring capital expenditure needs just like other businesses. Yes the depreciation "shield" allows them to retain some cash flow, but over time much of that ends up getting spent on roofs, parking lots, HVAC systems, common areas, periodic cosmetic upgrades, etc., that keep the properties competitive. You can find a summary of these expenditures in the REITs' supplemental data packages that are published each quarter. When you do the math, you find that there's not a lot of free cash flow.
Here's a little bit different take on the question of dividends, and specifically REIT dividends.
At times, too much emphasis is placed on dividends as the end-all in investing, especially these days. Not the least of which is that capital gains rates are generally lower than ordinary rates, at least for most of us. So why the obsession with stock dividends?
The answer has to do with agency risk. Simply put, for every dollar distributed via a dividend, there's one less dollar for management to potentially mis-allocate either into a dying business, or into an area where they have little expertise. This is one reason why Berkshire Hathaway has such a good track record - operating management is kept on a short leash and major capital decisions are made by Warren Buffett. High dividends also shorten the duration of your investment and reduce the risk of selling into a weaker market at the end.
REITs work the same way as Berkshire Hathaway. Because of the high dividend distribution requirements, management has to come back to the capital markets if they want to grow the portfolio. And you'd better have both a good operating and capital investment track record if you want to raise fresh equity.
BAC is a really good example of where management was not kept on a short capital leash. LEH of course is another. You'd be hard pressed to find too many investment debacles in REIT-land, as companies generally stick to their knitting (single-sector REITs are the norm) and development risk is held to modest levels.
The question over capital allocation is exactly the issue going on with Apple (APPL) and the seemingly endless discussion over what the company should do with its cash hoard. Investors have shouldered a lot of business risk through many product cycles, and the payoff is sitting in offshore investment accounts and diluting your IRR. Thankfully for REIT investors, there's never much discussion of what to do with excess cash because there isn't any.
So clear out all the cash and make management run the leanest, most efficient operating business you ever saw. That wasn't the intent of the 90% REIT distribution rule, but it's sure been a nice result.
In my view, Citi's early disclosure of its capital plan was prudent given the difference between what it asked for ($1.2 billion stock repurchase) and higher market expectations. That's the conservative way of doing it. Had expectations built up unnecessarily, then Citi might have been criticized for not speaking out earlier. They made the right choice.
C was up 10.9% last week and 1.9% today (Monday, March 11), so your thesis that Citi somehow "blew it" by not asking for more is hard to accept. While an increase in the dividend would have been nice as well, the downside risk of not having a plan accepted by the Fed, for the second year, would have been severe.
And what would be the impact if, say, Citi's quarterly dividend was raised from $0.01 to a nickel or even a dime? Forty cents a year is not even 1% of the current stock price. In short, your return in Citi over the next few years has almost nothing to do with dividend policy. Investors are not playing in C for nickels and dimes. There is huge upside in C given the drag from Citi Holdings, expense management, uptick in capital markets activity, steeper yield curve in NIM expansion, etc. The upside over the next few years could be substantial, and will primarily be driven by earnings, not capital distribution.
And there's plenty of things banks can do with the retained cash that's accretive. For one, repurchase of expensive holding company debt improves the balance sheet, reduces funding risk, and helps the NIM. You can never be too well capitalized, and even though banks are well out of the danger zone in terms of funding risk and liquidity, they will hopefully continue to chip away at their debt footprint.
So don't worry about the dividend increases, they will come and help sustain the story in the out years when the business is closer to normal.