Health Care REITs Cash Flow Analysis

by: Bruce Miller


Health Care REITs are popular with Income Investors.

Health Care REITs have provided long and reliable income.

Health Care REITs are providing attractive yields.

Are these dividends sustainable?

The Health Care REITs HCP, Inc. (NYSE:HCP), Welltower (HCN), Ventas (NYSE:VTR) (formerly NHP), National Holdings Corp. (NYSE:NHI) and LTC Properties (NYSE:LTC) have been staples of my income portfolio since 1998-2000, and they have not disappointed. Over this period, the dividends I've collected on each have been over twice what I paid for the stocks and the weighted dividend growth rate has averaged just under 4%/yr ... and this through the great recession! For an income investor, it just doesn't get much better.

My purpose in mentioning this is not to brag of my income investing acumen, but to reinforce the old adage that involves babies and drunks ... I was just plain lucky. In 1998 I didn't know which end of the income investing stick pointed up. All I knew was this funny sounding REIT-thing was paying greater than a 10% dividend, which was more than I was then able to get with my succession of maturing CDs ... and that seemed pretty cool. But the interest was sparked and through the formal study of a CFP course, reading as much as I could get my hands on and generally being a nuisance to a couple of CFA friends, I know a great deal more today than I did then.

In my recent article on Income Investing And Understanding The Statement of Cash Flows, I note that for a dividend to be sustainable, management must be both willing AND able to pay it. The single best measure of the ABILITY to pay it comes from the statement of cash flows (SCF). So with HC REIT yields as high as they've been for several years, it might be a good time to do some cash flow analysis to try and determine how sustainable today's high yields are.

Per NAREIT's web site, there are 16 exchange traded HC REITs. I've excluded those with less than a five-year dividend history, leaving 10 HC REITs. All data I obtained from the company's income statement or SCF comes from the Morningstar web page. All calculations are mine. I have double-checked them, but there are so many calculations in the tables below that it is entirely possible there are boo-boos. If anything looks wrong, please feel free to speak up.

The following is a listing of these 10 HC REITs, trading symbols and current yields (as of Jan 9, 2016).

I have arranged the analysis into dividend history and 5 CF measures, as follow:

1. Dividend History

This chart shows the one-, three- and five-year dividend growth rates. Note that some HC REITs have high but inconsistent growth rates while others, such as HCP and HCN show a steady growth rate while others offer growth rates that are zero or below inflation. The problem with high growth rates is they are at a greater risk of becoming moderate or even low growth rates. But high growth often commands a premium (lower current yield) over moderate growth, so one of the exercises I do with high growth/lower yield stocks is to cut the dividend growth rate by 50% to see what longer term effect it will have on portfolio income growth. But as we will see later, an attractive dividend history is a good starting point, but it must be used along with other measures of dividend sustainability. Remember, a company must show both a WILLINGNESS through a long growing dividend, and the ABILITY to pay a dividend. Lets look now at ABILITY as measured by the companies cash flows.

2. Dividend to Cash Flow From Operations (CFFO) Ratio

Sustainable dividends are paid from CFFO. It is certainly possible to pay them from the sale of assets, borrowed dollars, corporate savings or even from the proceeds of issuing stock. But with very few exceptions, none of these are sustainable. So it certainly makes sense to measure how much of a company's operational cash net of operational expenses is available to pay the dividend.

This chart shows the preceding 10 quarters of high, low and trailing twelve month dividend/CFFO POR. To smooth out the spikes due to short term quarterly cash events, I've added four consecutive quarterly dividends and divide it by the same 4 quarters of CFFO. I then roll this up to the next quarter and repeat. Clearly, a company paying less of their operational cash in dividends will leave more cash to be used towards investments, debt reduction, stock buy-backs or corporate savings. But a high POR by itself is not necessarily indicative of higher costs of capital and a slower growing dividend as HCN has shown, although such a stock is certainly at risk for slower dividend growth. At an average of 87% over the TTMs, clearly, HC REITs have high operational cash payout ratios.

A variation of this metric is to track how much of a company's CFFO, after dividends, is available to pay for new investments. The higher this percent, the lower will be the cost of financing new investing activities and, generally, the more cash available to pay the dividend.

This metric is calculated by subtracting the most recent 10 quarters of cash dividends paid from the same 10 quarters of total CFFO. This remaining operational cash is then divided by total investing expense (CFFI) over the same 10 quarters. The higher the percentage, the lower will be the cost of capital to the company.

The limitations of this metric is it does not consider how much is being spent on new investments. A company must generally invest in new capital to sustain and grow its cash flow over the years ahead. A company who spends little in net investing activities will not be doing this. Also, this metric is not a trend, but a 10 quarter snapshot. But the financially strongest companies such as Johnson & Johnson (NYSE:JNJ), Kimberly-Clark (NYSE:KMB) or Wal-Mart (NYSE:WMT), to name a very few, will pay all investing activities from CFFO after dividends.

3. Interest Expense Sensitivity

Measures of company debt are typically given as debt-to-equity or sometimes debt-to-assets ratios. These are interesting but not very relevant to a company's ability to pay its dividend. What matters is how much cash a company uses to pay the fixed-cost interest expense.

This metric is obtained by adding interest expense back to CFFO and then dividing this sum into the company's interest expense for the TTM. This is not a trend analysis, but a snapshot of the current percent of operational cash that is paid to interest. There are two income risks associated with a high interest expense ratio. First, an increase in interest rates may expose the company to a higher cost of debt when the existing debt matures and must be replaced. Second, interest payments are generally fixed and like our household fixed costs (car payments, mortgage payment) must be paid and cannot be managed away without a bankruptcy filing ... and debt (primarily bond) holders must generally be paid first.

A couple of limitations of this metric. Higher interest is not necessarily a bad thing, if the investments purchased with the borrowed dollars returns more cash to the company than the increased interest expense. And this metric does not measure capitalized interest, which is interest that is added to the cost of new capital that it is financing, such as constructing a new building.

But generally, a higher interest expense ratio correlates with slower dividend growth and puts the company at a greater risk of a dividend cut if their business (revenues) slow.

4. Return on Investments to CFFO

This is the core concern of income investors ... the ABILITY of the company to generate increased operational cash flows with increasing investing activities, as this increasing cash flows will sustain future dividends and dividend growth. The hard part is measuring management's success (or lack thereof) in achieving this.

The method I use is to add together the previous four years of CFFO and subtract from this the sum of the four years just prior. So for VTR I add the CFFO of 2015 + 2014 + 2013 + 2012, and then subtract from this total the sum of CFFOs of 2014 + 2013 + 2012 + 2011. This shows how much the 4 year rolling total of CFFO has increased (decreased). I then divide this growth (decline) by the total of the previous four years of CFFI to provide a measure of the return on investments. I use years rather than quarters as some investments require time to develop and add net growth to cash flows, something a quarterly measure would be too short an interval to detect. I use the previous four years of CFFI as these are the investing activities made over the period CFFO growth is measured and it seems a reasonable period to allow investments to become fully productive. Now, this is an inexact measure, as it does not take into account increasing returns on investments made in prior years nor for investments made in the prior four years that require a longer maturity to become fully productive. But to picture this metric, the above graph shows the highest ROI over the past 10 years and the lowest and the average. The graph also shows the average of all HC REITs.

5. "Managerial Efficiency"

This is a deceptively simply ratio: CFFO/Revenue, where CFFO and Revenue represents the previous four quarter totals, done to smooth out the peaks and troughs of quarterly values.

It is relatively easy to raise revenues with new investments, but it's difficult to convert those 'top-line' revenue dollars into 'bottom-line' CFFO. The ability to generate net operational cash from new investing activities is, generally, the measure of managerial efficiency, as expressed by the CFA study guide. The limitation of this is that some REITs are more expensive to manage than others, depending on property types, age of properties, locations and so forth. Although I haven't explored this, it seems logical that the higher the fixed interest cost, the lower the ratio ... although the decision to carry debt is managerial. But it is interesting that several REITs have 'tight' ratio spreads, suggesting management invests in a certain mix of properties that it manages well.


I am over-exposed to HC REIT income, so am not looking to add more. But were I looking to add to portfolio income would I be looking to HC REITs? You bet! Just from my "eye-balling" of the above dividend histories and CF metrics, VTR, HCP, NHI, OHI and LTC would be good candidates. HCN with high interest expense, high POR, low ROI to CFFO and low managerial efficiency would be iffy, while the others HC REIT CF metrics are sufficiently poor to avoid them.

Disclosure: I am/we are long LTC, HCN, HCP, NHI, 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.