Ventas: Get Blue Chip Quality Without Paying For It

The buy thesis

Ventas Inc. (NYSE:VTR) is a healthcare REIT of supreme quality and it is usually priced as such. However, the recent sell-off provides an opportunity to obtain said quality at a bargain. Fundamentally, Ventas is still thriving with growing earnings, dividends and guidance, yet it has dropped 30% since May 21st and underperformed the S&P by 38% over the past year.

We believe the current market pricing is consequent to temporary conditions and that substantial capital appreciation will occur upon the cessation of said conditions.

Origin of opportunity

There seem to be 3 temporary conditions driving VTR's underperformance.

1. REIT related selling through ETFs
2. Tax loss selling
3. Misguided fears of rising interest rates

ETF outflows:

With a market cap of nearly $17B, Ventas is among the largest REITs and is consequently a major holding in most REIT ETFs. Since May 21st, when the REIT sell-off began, many REIT ETFs have experienced substantial outflows. As an example, we can look at the iShares US Real Estate ETF (IYR). As of November 27th, Ventas was a major holding at 2.86%.

Since May 21st, IYR has experienced net outflows of $933mm.

Given the 2.86% weight on VTR, this translates to net forced selling of $26.7mm worth of Ventas. Other examples include iShares Cohen and Steers REIT ETF (ICF) and Vanguard REIT ETF (VNQ) which experienced outflows of $427mm and $119mm respectively. The overall forced selling impact to Ventas is shown in the table below.

ETF	Net outflow since 5/21	% holdings of VTR	Net forced selling of VTR
IYR	$933mm	2.86%	$26.7mm
ICF	$427mm	6.07%	$25.9mm
VNQ	$119mm	3.67%	$4.4mm
Totals	$1.479B	n/a	$57mm

Click to enlarge

While this may seem small relative to VTR's overall trading volume over that period, bear in mind that these are only 3 of the many REIT ETFs with Ventas as a major holding. The overall impact may have been far more substantial.

The forced selling from ETFs was exacerbated by the subsequent tax-loss selling. With the S&P returning almost 30% YTD, many investors are looking to wash taxable gains with a loss. We believe Ventas has served this role.

The third downward pressure on VTR's market price was misguided selling based on (potentially) rising interest rates.

Given the fixed income structure of long-term triple net healthcare leases, one would expect spreads to tighten as revenues remain constant and interest rates rise. This seems to bode poorly for VTR's earnings and is, in our opinion, partially responsible for the selloff. This view, however, is not correct as we will demonstrate in the following section

Catalyst #1: Cessation of temporary adverse market pricing conditions

Neither the ETF based selling nor the tax-loss selling has anything to do with VTR's fundamentals. Each was a situational event that is unsustainable. ETFs cannot have net outflows perpetually and tax-loss selling will end at or before the end of the 2013. Upon cessation of these events, the excess supply of VTR common stock will be removed and demand for the stock will be unchanged. Basic economics tells us that a net decrease in supply coupled with no change in demand will result in higher market pricing.

The third selling pressure (rising interest rate fears) could also subside as the market realizes VTR's resilience to rising interest rates. As mentioned above, the idea behind the fear is that higher rates will compress leasing spreads through raising the weighted average cost of capital, but digging a little deeper suggests this is not the case. A majority of VTR's debt is fixed rate and long term, so it will not become more expensive in the near term and renewal is a distant concern.

Debbie Cafaro seems to be very aware that the low rate environment cannot last forever and took advantage of the situation by issuing over $5B in Senior Notes with a weighted average cost of only 3.5%

Data from SNL Financial

In addition to obtaining cheap financing, she made sure to sustain VTR's competitive advantage by locking these rates in for the long term. In fact, VTR has no debt maturities until 2015 with the majority lasting until 2019 or later.

Further, we should note that most of the near term maturities are the variable rate debt.

Data from SNL Financial

The near term expiry of the floating rate debt along with the extended length of the low rate fixed rate debt substantially mitigates VTR's risk in a potentially rising rate environment.

In summary, all three of the current forces applying negative pressure to VTR's market pricing are either soon to be removed or fundamentally unfounded. We believe this will cause substantial capital appreciation in the near term.

In addition to the removal of negative catalysts, VTR has some powerful positive catalysts coming into play.

Catalyst#2: Continued earnings growth through an active acquisition and development pipeline

On October 25th VTR reported superb 3Q results including an 8% YoY increase to normalized FFO. This was driven by 6.2% same store NOI growth along with a slew of accretive acquisitions.

Ventas plans to continue this growth through an acquisition and development strategy announced at the REITWORLD 2013 conference.

In addition to the potentially $350mm of 7-12% cap-rate developments shown above, VTR projects access to $1-2B potential acquisitions each month. Given the history of high cap-rate acquisitions among healthcare REITs and the favorable supply/demand balance, it seems reasonable to project a similar 7-12% cap rate for its acquisition pipeline.

In terms of financing such growth, VTR has around $1B of liquidity from the aforementioned senior notes and remaining capacity on its credit facilities.

Catalyst#3: Dividend growth

Ventas has a long history of dividend growth. Between the anticipated FFO growth and its conservative payout ratio of only ~65%, expect dividends to continue their current trajectory.

Between strong fundamentals and a discounted market price, we believe VTR is poised to outperform, but how much potential does it have?

Magnitude of opportunity

Among healthcare REITs there has traditionally been a quality premium. Specifically, investors have traded the blue chip companies like Ventas at substantially higher multiples than the smaller and less proven REITs like Omega Healthcare (OHI) and Medical Properties Trust (MPW). Through most of the year, VTR traded at an FFO multiple approximately 4 higher than MPW and 6 higher than OHI. (see chart below)

Data from SNL Financial

This premium was justified by the quality gap. Ventas has superior capital structure and size which grants access to far cheaper capital and consequently better leasing spreads. It also has premium properties which maintain largely private-pay revenue streams from the relatively wealthier demographics they service.

The quality gap has not disappeared, but the premium has.

At the currently depressed market price of $56.83, VTR trades at only 13.2X 2014 FactSet projected FFO and 12.5X 2015 FactSet projected FFO. What was once the market leader is now among the cheapest in the sector.

While it would be ambitious to project a return to its former 20X FFO multiple, we believe 16X 2014 FFO is a plausible and fair value for VTR. This would provide a small and justifiable quality premium over its peers. Such a multiple would result in capital appreciation of around 25%. While we are quite bullish on Ventas, we must also mention the risks of investment.

Risks and concerns

Domestic healthcare issues: While demographic trends are favorable and VTR is well diversified within the healthcare sector, regulatory or reimbursement problems affecting the industry may interfere with the ability of tenants to pay rent.

Slowing of the acquisition pipeline: Presently, it seems that the demand for financing coming from healthcare providers outweighs the supply, but that could change in either of 2 ways:

1. Healthcare providers anticipate an unfavorable environment and slow the growth which was the impetus for obtaining financing.
2. New suppliers of financing enter the field. We have already seen a couple of new healthcare REITs go public this past year and the relatively low barrier to entry suggests more could arrive. In my opinion, VTR is somewhat resistant to this second concern as its lower cost of capital provides competitive advantage.

The bottom line

Ventas is substantially undervalued in the current environment consequent to unsustainable factors. The cessation of these negative forces along with strong growth potential should propel Ventas into a run of outperformance.

Disclosure: 2nd Market Capital and its affiliated accounts are long VTR, MPW and OHI. I am personally long VTR and OHI. This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer.

Disclosure: I am long VTR, OHI, MPW. 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.