When we last discussed the healthcare REIT sector in our May 2014 Outlook, the sector was riding high. Citi had it consistently trading at a large premium to its net asset value (or NAV) since early 2009. Our recommendation that investors avoid the sector was a bold call, but it has been a key driver of our outperformance. From May 1, 2014, to March 30, 2018, the Chilton REIT Composite outperformed the Bloomberg REIT Healthcare Index (Bloomberg: BBREHLTH) and the MSCI US REIT Index (Bloomberg: RMS G) by 3,700 bps and 1,550 bps, respectively.
In 2018, we performed another deep-dive into healthcare real estate, meeting with 20 REITs and key tenants, touring multiple properties, and looking for opportunities in the beleaguered space. What we found was not inspiring.
REITs that focus on higher-risk properties, such as senior housing, skilled nursing facilities (SNFs), and hospitals are trading at some of the lowest multiples in the REIT universe. However, fundamentals for these REITs continue to deteriorate, significantly reducing the predictability of future dividend growth.
We believe dividend growth will be the highest for REITs that specialize in (a) research-oriented healthcare properties and (b) trophy medical office buildings (or MOBs) located on the campuses of large, healthy hospital systems. However, such REITs remain fully priced after accounting for slow growth at most large hospital systems, uncertainty regarding public healthcare policy, and healthcare REITs’ sensitivity to rising interest rates. Therefore, we remain significantly underweight healthcare real estate.
According to data from NCREIF and CoStar, the combined value of all US commercial real estate was about $17 trillion at the end of 2017, of which $1.55 trillion (9%) is healthcare-oriented. Publicly-traded REITs own $172 billion, or 11% of the total. Figure 1 provides an overview of the healthcare real estate sub-sectors and the combined holdings of the healthcare REITs. Property types in which REITs are much more invested than the total market are outlined in green, while large REIT underweights versus the market are outlined in red.
The three most important takeaways of this chart are that REITs (i) own a small percentage of inpatient hospitals (7% vs. 37%), (ii) own a disproportionately large percentage of senior housing (40% vs. 24%), research-oriented facilities (14% vs. 6%), and SNFs (13% vs. 7%), and (iii) are approximately ‘market weight’ everywhere else.
In previous outlooks, we have written that REIT investors need to primarily focus on the location of a REIT’s properties, its balance sheet, and the track record of its management team. For healthcare REITs, these remain important but can be trumped by three other unique factors: operator/affiliated system risk, regulatory risk, and heightened interest rate risk.
Healthcare REITs have to be excellent underwriters of the companies that operate or manage their properties and the healthcare systems to which they are affiliated. Operators are most important in the segment of senior housing where the REIT participates in the operator's profits (also called ‘RIDEA’), but landlords are dependent upon the operator’s health in all healthcare real estate. This contrasts with the ‘location, location, location’ mantra applicable to traditional property types.
Another unique aspect of the sector is the ability to ‘affiliate’ with a healthcare system, a diversified group of medical providers under common or joint ownership (e.g., a hospital system). A property is affiliated with such a system when it is located on or adjacent to system-owned land, or significantly leased to the system.
From our company meetings, we learned that today’s senior living residents and skilled nursing patients are largely deciding between properties on the basis of cost, operator reputation, amenities, and metro area. They are less interested in the specific neighborhood or the property owner. Therefore, a ‘good’ operator can pay for referrals from a large health system, gain market share via online marketing, and keep residents from moving to newer or less expensive properties. However, a cash-strapped operator can struggle to cover the rent at even the newest, best-located properties.
MOB/outpatient care REITs also have to carefully underwrite their operators and affiliated systems. Much like department stores that historically drove traffic to malls, healthy inpatient hospitals refer their less-critical patients to outpatient facilities. However, if a hospital system anchor decides to downsize for any reason, the MOB could suffer negative re-leasing spreads or occupancy loss.
Finally, underwriting operator health is also important for REITs that invest in inpatient hospitals directly, such as Ventas (VTR) and Medical Properties Trust (MPW). There are not many REITs that could find a new system to take over an inpatient hospital if the current system were to leave.
There are two types of healthcare markets: those that require a certificate of need (or CON) and those that do not. A CON is a letter from a regulator that authorizes a developer to build a new healthcare facility or convert an existing asset into one. Figure 2 shows that 36 states and two US territories still have CON programs, even though the federal law requiring them was repealed in 1987. Excess supply is one of the most common reasons a regulator would decide to not grant a CON.
The rationale is that, because healthcare operators have high fixed costs, the only way for them to remain solvent during periods of low occupancy is to make drastic cuts in variable costs (i.e., healthcare quality). For elderly residents or sick patients that cannot move to another property, this can be a life or death issue.
Healthcare real estate owners and operators are partial to the CON system because it props up the rents and occupancies of existing facilities, as it creates a large barrier to entry in a market that has historically had few. REITs with significant exposure to non-CON markets, particularly those without other barriers to entry (e.g., Dallas or Houston) have historically had much lower and occasionally negative rent growth.
The healthcare REIT sector is the most vulnerable to rising interest rates due to their long-term leases and small re-leasing spreads. Long leases are beneficial in times of stress, however, as healthcare REITs rarely have a large amount of leases rolling at once. This, combined with a high dividend yield and dividend/AFFO payout ratio (averaging 5.5% and 83% over the past five years per Citi), causes them to trade more like fixed income than any other REIT. As a result, their correlation with the 10Y UST yield is higher than any other REIT sector, and their relative performance versus the S&P 500 as interest rates rise is worse than any other REIT sector.
From what we have written so far, it should not come as a surprise that Chilton does not own any healthcare REITs, making it the Composite’s largest underweight versus the RMZ. However, there are several parts of the sector that we do favor, particularly on a relative basis. Valuations of these companies are currently out of our comfort zone, but we have owned them in the past and would be interested in them at lower price points, even in a rising rate environment.
Our favorite type of healthcare real estate is high-quality research and development-oriented campuses. Currently, there is only one REIT that specializes in this category, Alexandria Real Estate Equities (ARE). But, the third largest healthcare REIT, HCP (HCP), is also significantly overweight research-oriented real estate (26% exposure). Portfolio information for the largest healthcare REITs is included in Figure 3.
High-quality medical research campuses are office/flex properties where tenants pay a 20-50% premium over traditional office/flex space in order to cluster with other cutting-edge firms, often on or near the campus of a top-tier research university. Studies have shown that putting diverse research firms together pays for itself many times over via higher researcher productivity, recruiting advantages, and better access to graduate students and university professors. Tenants are often high credit, they do not require much up-front tenant improvements, and landlords rarely have trouble re-leasing spaces.
REITs in this space have historically traded at much higher AFFO multiples than other healthcare REITs, but, today, these premiums are higher than they have ever been. According to Citi, on March 30, ARE traded at 21x forward AFFO, 9x and 5x higher than other healthcare REITs and the REIT universe, respectively. Since 2002, ARE’s P/AFFO has on average been only 6x and 2x higher than healthcare and the REIT universe, respectively.
Our second favorite type is high-quality MOB/outpatient care centers. Inpatient facilities such as acute-care hospitals typically handle the most dangerous, critical, and expensive procedures. They require patients to stay overnight, are almost always located on a hospital campus, and leverage the skillsets of many kinds of doctors. Outpatient facilities, by contrast, offer equally high levels of care for non-life threatening procedures that do not require an overnight stay. They also are benefiting from a long-term shift to outpatient care. American Hospital Association survey data shows that, between 1994 and 2014, the total number of inpatient days fell by more than 10%, while outpatient visits increased by 80%. Most experts expect this to continue into the future, albeit at a slightly slower pace. For example, healthcare researcher Sg2 projects 15% growth in outpatient visits over the next decade, which compares to a 2% decline in inpatient days. High-quality MOBs also are much more reliant on private insurance and Affordable Care Act (ACA) insurance than they are on Medicare and Medicaid, which means their tenants have less regulatory risk.
Within the MOB space, the best properties are not necessarily those in toniest of submarkets or those that charge the highest rents, although these are good signs. The best MOBs are the critical facilities located on the primary campuses of growing and reputable hospital systems. Ideally, they have strong tenants signed on for long leases with rent escalators, and they own the land on which they are built. However, it is more important that assets are located on-campus and deemed critical assets by a vibrant hospital system, as people will drive farther for such properties than they will for almost any other sector. Notably, the rent coverage for the average MOB tenant is >9.0x, which compares to 1.3x for SNF tenants and 1.1x for senior housing operators.
There are three MOB-focused REITs: Healthcare Trust of America (HTA), Healthcare Realty Trust (HR), and Physicians Realty Trust (DOC). HR has the highest percentage of truly on-campus facilities, the strongest stable of affiliated hospitals and most supportive demographics. However, all three should benefit from the secular shift toward outpatient facilities.
We advise investors to avoid two categories of healthcare real estate: (1) properties with large exposure to Medicare/Medicaid, and (2) properties with minimal barriers to new supply.
The first group, often referred to as public-pay healthcare REITs, includes inpatient hospitals and skilled nursing facilities. The former is suffering from the long-term shift toward outpatient care that has been occurring since the early 1990s. REIT management teams believe we are still early in this process, with two telling us that the US may still have 30-50% more inpatient acute care hospital beds than we need.
SNFs have particularly high operator risk and high tenant concentration. Operators of these assets typically face low margins, frequent lawsuits, high employee turnover, heavy government oversight, and an arguably unfair share of public pressure to lower the cost of healthcare. While SNF REITs often benefit from regulation that restricts new supply, they are paid almost entirely via reimbursements from Medicare and Medicaid. Reimbursement rates for these programs are much lower than they are for private-pay insurance.
Figure 3 includes three of the five REITs with the most exposure to SNFs. These companies trade at 7-10x forward AFFO as of March 30, 2018, versus the healthcare REIT and REIT universe averages of 13x and 16x, respectively. SNFs have some of the lowest long-term rent growth of any type of REIT, and their public-pay reimbursements are most vulnerable when both Congress and the Executive branch are controlled by Republicans.
Our second least favorite group of healthcare real estate is low-barrier/commodity senior housing. These properties tend to do well when the national senior housing market has higher demand than supply. However, due to their poor locations, they have extremely volatile cash flows and little downside protection when new construction is plentiful, thus creating a poor risk/reward scenario. Figure 3 shows that the companies with the highest exposure to senior housing are WELL, VTR, SNH, and HCP. Notably, WELL, VTR, and HCP, called the Big Three Healthcare REITs, own 53% of all healthcare REIT asset value.
While there will always be a need for a physical place to go for health-related issues, there are unique investment characteristics of healthcare real estate that must be considered. As explained above, we do not find any healthcare REITs that adequately price in the risks associated with high supply, tenant concentration risk, rising interest rates, or regulatory risk. As a result, we are still waiting for the appropriate time and price to add a healthcare REIT to the Chilton REIT Composite.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.