REIT Rankings: Healthcare
In our REIT Rankings series, we analyze one of the fifteen real estate sectors. We rank REITs within the sectors based on both common and unique valuation metrics, presenting investors with numerous options that fit their own investing style and risk/return objectives. We update these rankings every quarter with new developments for existing readers.
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Healthcare Sector Overview
Healthcare REITs comprise roughly 11% of the REIT Indexes (VNQ and IYR). Within our market value-weighted healthcare index, we track 10 of the largest REITs within the sector, which account for roughly $90 billion in market value: HCP (HCP) Healthcare Realty (HR), Healthcare Trust (HTA), Omega Healthcare (OHI), Ventas (VTR), Welltower (WELL), Physicians Realty Trust (DOC), Medical Properties (MPW), National Health (NHI), and Sabra (SBRA).
There are four distinct subsectors within the Healthcare REIT category: senior housing, medical office building, skilled nursing, and hospitals. Each of these subsectors has separate risk/return characteristics. Skilled nursing and hospital REITs assume the most policy-related risk, followed by senior housing. Medical office building and life science REITs are generally the most predictable and stable. As we'll discuss in more detail shortly, the Affordable Care Act pushed more of the financial risk from payors (insurers and government) onto healthcare providers (doctors, hospitals, healthcare facilities), which has pressured the healthcare real estate sector, particularly at the higher-cost end of the spectrum.
The Bull and Bear Thesis for Healthcare REITs
The 'bull' thesis for healthcare REITs typically centers around the aging population and impending demographic wave of boomers, the long-term outperformance of the sector compared to the REIT average, and the healthy dividend yield. Below we outline the reasons to be bullish on healthcare REITs.
The 'bear' thesis typically focuses on the secular headwinds of the ACA on public-pay REITs, the oversupply issues that encumber the senior housing REITs, and the interest rate-sensitivity of the sector. Below we outline the reasons to be bearish on healthcare REITs.
Recent Stock Performance
Healthcare REITs have been the weakest performing real estate sector over the past year. Weakening fundamentals and rising interest rates have knocked 25% of value off this historically steady sector. In 2017, the sector produced a total return (including dividends) of 0.9%, falling short of the 5% total return for the FTSE Equity REIT index.
Whether it is fundamentally justified or not, the entire REIT sector has traded as a de-facto bond proxy since the passage of tax reform last December. We continue to note that, over the long term, REITs have historically exhibited near-zero correlation with interest rates, but that this correlation tends to spike during periods of heightened interest rate uncertainty. The REIT index has dipped 15% since tax reform passed Congress amid rapidly rising inflation expectations, which has dragged the 10-year yield to three-year highs. As we'll discuss in more detail below, healthcare REITs are the most interest rate-sensitive REIT sector.
The combination of rising rates and weak fundamentals have led to further pain in 2018. The sector is down more than 16% so far in 2018 compared to a 10% dip in the broader average. Interestingly, the troubled skilled nursing sector has been the best-performing sub-sector YTD, followed by hospitals, medical office, and senior housing.
Healthcare REITs delivered mixed earnings results in 4Q17. Of the ten REITs we track, 5 beat FFO/NOI estimates (HCP, HTA, OHI, MPW, NHI), 2 met estimates (VTR, DOC), and 3 missed estimates (WELL, HR, SBRA). Consistent with the trends across the REIT sector, 2018 guidance was notably weaker than expected. Per the NAREIT T-Tracker, same-store NOI ticked up to 2.1% in the quarter from 2.0% in 3Q17. SS-NOI for healthcare REITs has been below the REIT average since 2014, though the gap has closed as the REIT average slowed to 2.6%.
While demand has been predictably steady, relentless supply growth over the past several years (primarily in the senior housing sectors) has weakened fundamentals. The internal development pipeline from REITs themselves illustrates the boom in construction activity that began in 2014 and is expected to continue well into the next decade. Development yields continue to be favorable as private market valuations have remained steady despite the significant selloff in the REIT markets.
Healthcare REITs have historically been an acquisition-fuel sector, similar to net lease REITs. These REITs have utilized their cost of capital advantage over private market competitors to accretively expand the size and scale of the business and drive FFO growth. The sharp selloff in REIT valuations, along with the steady private market valuations, have erased their cost of capital advantage as the NAV premium has flipped to a discount.
As a result of lower share prices, these REITs are having more difficulty funding acquisitions with the same accretive spreads as in the past. After peaking in 2015, the acquisition activity within the sector has tailed off considerably. Healthcare REITs acquired less than $400M in assets in 4Q17, the second-lowest quarter for net acquisitions since 2009. Unless this NAV discount reverses, these REITs will have considerably more difficulty growing FFO over the next several quarters.
Within the senior housing category, note that senior housing fundamentals continue to weaken after several years of relentless supply growth. The "Big 3" healthcare REITs have shifted their portfolio in recent years to focus more exclusively on senior housing assets. Before 2007, these senior housing assets were primarily leased to triple-net tenants under long-term leases whereby these REITs assumed a little operational risk. The REIT Reform Act in 2007 allowed these REITs to take advantage of more operational upside (and downside) through the RIDEA structure.
While RIDEA assets outperform when markets are tight, these assets similarly underperform when fundamentals are weak. We note the continued struggles of the operating assets (RIDEA), which saw same-store NOI dip to just 0.7% in the quarter as occupancy fell nearly 200 bps from last year. RIDEA performance is expected to be worse in 2018 with SS-NOI dipping into negative territory. The triple-net-leased assets, however, continue to perform decently well with SS-NOI growth expected to rise 2.4% in 2018.
NIC data shows that senior housing construction as a percent of inventory remains high at 5.8% and is most acute in the assisted living category, which remains very elevated at over 8% of existing inventory. Net absorption has been negative for nine consecutive quarters.
Skilled Nursing & Hospitals
Amid an otherwise dismal year, skilled nursing REITs actually delivered stronger-than-expected earnings. Rent coverage was fairly stable as EBITDARM remains above 1.7 for both REITs. However, dilutive asset sales and shifting of assets within the same-store pool seems to have inflated these metrics. Asset sales will continue to be a focus for these REITs in 2018 which we think will weigh on FFO metrics in the short term but will create shareholder value over the longer term. Omega sold nearly $200M assets in the quarter and is targeting $300M for 2018. The payor mix continues to be an issue for both SNF REITs.
Despite a decent 4Q17, skilled nursing performed below expectations throughout 2017 as coverage levels generally deteriorated and more operators were added to the list of "at-risk" tenants, a list that includes at least four top 20 tenants, including Genesis, Signature, Orianna, and Preferred Care. The two primary issues continue to be reimbursement methodology and payer mix. In an effort to "bend the cost curve," the transition to a value-based reimbursement system under the Affordable Care Act has resulted in shorter lengths of stay, lower reimbursement rates, and lower occupancy rates.
Relating to reimbursement, the Center for Medicare and Medicaid released a draft of their proposed changes to SNF reimbursement methodology that would likely put continued downward pressure on margins by adopting a more value-based method rather than a fee-for-service method of reimbursement. This would especially hurt the SNF operators that have lower quality ratings. In regards to the payer-mix, SNF operators have been badly hurt by the decline in private-pay and the rise of government pay, particularly Medicaid. Government-pay generally reimburses SNF at 20-30% lower levels and often at levels below the cost of care.
Omega and Sabra are actively trying to contain the damage from struggling operators by offering concessions and rent reductions to these tenants in an effort to keep them solvent. We believe that these REITs are far-better positioned than smaller SNF owners to work out favorable deals with operators that may result in short-term pain but longer-term gain. As we'll discuss below, these REITs see opportunity in the turmoil and are actively recycling capital to acquire assets at favorable valuations.
Medical Office & Life Science
The Medical Office Building and Life Science sub-sectors continue to be a bright-spot within the healthcare space. Immune from the policy-related risks of the other sub-sectors, the supply/demand dynamics remain favorable. SS-NOI rose to 3.3% in the quarter with occupancy ticking up 40bps.
These sectors, however, account for less than one-third of healthcare REIT assets. In addition to these three MOB-focused REITs, the "Big 3" also have 20-40% allocations to MOB and Life Science in their portfolios (Welltower: 20%, Ventas: 30%, HCP: 50%). As we'll note below, these higher-quality assets trade at a sizable premium in both the public and private markets.
Valuation of Healthcare REITs
Compared to the twelve other REIT sectors, Healthcare REITs appear cheap based on FCF (aka AFFO, FAD, CAD) metrics. The sector now trades at a 15-20% discount to Net Asset Value, which provides a floor for REIT valuations but also makes external growth more difficult.
At the sector level, we note the deep discount applied to the skilled nursing-focused REITs, Omega Healthcare and Sabra. Healthcare Realty Trust and Healthcare Trust of America, which have a portfolio concentrated in medical office buildings, command the highest premiums within the sector.
In terms of healthcare policy, the worst-case-scenario for SNF appears to be largely priced into the stock valuations, in our view. Omega Healthcare and Sabra are some of the "cheapest" REITs we track based on cash flow metrics. We, therefore, like the SNF space at these valuations, but caution that significant risks remain.
Interest Rate and Equity Market Sensitivity
Healthcare REITs, along with net lease REITs, are two most "bond-like" REIT sectors, meaning that these REITs are heavily influenced by movements in interest rates. Interest rate sensitivity is a result of long lease terms, high dividend yields, and lower growth prospects.
As a sector, healthcare REITs are firmly in the Yield REIT category. All healthcare names we track are highly sensitive to interest rates, and VTR and HTA are two of the most sensitive names across all REIT sectors. Notably, the skilled nursing REITs exhibit lower sensitivity to yields and more sensitivity to the equity markets than other healthcare REITs.
Dividend Yield and Payout Ratio
Based on dividend yield, healthcare REITs rank at the top, paying out an average yield of 6.9%. Healthcare REITs payout roughly 91% of their available cash flow.
Investors looking for income and are willing to take on policy and operational risk should take a look at the skilled nursing REITs Omega and Sabra. Investors seeking more of a safe, predictable income stream would be better suited with the MOB or diversified healthcare REITs.
Healthcare REITs have been the weakest-performing real estate sector over the past year. Weakening fundamentals and rising interest rates have knocked 25% of value off this historically steady sector. In an effort to contain runaway costs, the ACA has taken aim at the higher-cost providers, including skilled nursing and hospital operators. Acute care REITs are struggling amid deteriorating fundamentals.
Meanwhile, private-pay healthcare REITs are facing a different set of challenges. While longer-term demographics remain highly favorable, supply growth continues to outpace demand for senior housing facilities. Broader trends of oversupply and tenant troubles across the healthcare REIT space continued into 4Q17. There are pockets of strength, however, in the medical office and life science subsectors.
While fundamentals will remain challenged for several more years, valuations appear attractive for long-term investors willing to assume the interest rate and policy-related risks. We currently view the skilled nursing REITs, Sabra and Omega, as the most compelling long-term names in the sector for investors willing to assume a high degree of short-term risk. To see where healthcare REITs fit into a diversified REIT portfolio, be sure to check out our other REIT Rankings: Industrial, Single Family Rental, Cell Tower, Apartment, Net Lease, Data Center, Mall, Manufactured Housing, Student Housing, Storage, Hotels, Office, Shopping Centers, and International.
Please add your comments if you have additional insight or opinions. Again, we encourage readers to follow our Seeking Alpha page (click "Follow" at the top) to continue to stay up to date on our REIT rankings, weekly recaps, and analysis on the REIT and broader real estate sector.
Disclosure: I am/we are long VNQ, SPY, OHI, SBRA.
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.
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