REIT Rankings: Healthcare
In our REIT Rankings series, we analyze each of residential and commercial real estate sectors. We rank companies 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
Within the Hoya Capital Healthcare REIT Index, we track 11 of the largest healthcare REITs, which account for roughly $100 billion in market value: Alexandria Real Estate Equities (ARE), Welltower Inc. (WELL), Ventas Inc. (VTR), HCP Inc. (HCP), Omega Healthcare Investors (OHI), Healthcare Trust of America (HTA), Medical Properties Trust (MPW), Sabra Health Care REIT (SBRA), Healthcare Realty Trust (HR), National Health Investors (NHI), and Physicians Realty Trust (DOC).
Healthcare REITs comprise roughly 12-14% of the REIT Indexes (VNQ and IYR) and own approximately one-tenth of the total $2 trillion worth of healthcare-related real estate assets in the United States. Healthcare REITs are classic yield REITs paying a high dividend yield and are used by many investors as effective "bond proxies." More than other REIT sectors, healthcare REITs assume significant policy risk, particularly in the skilled nursing and hospital sub-sectors.
These REITs tend to hold assets under a long-term, triple-net lease structure, though these REITs have taken on increasingly more operating responsibilities over the past decade. This is largely a function of REIT regulations that limit the ability of these companies to operate healthcare facilities in-house. For that reason, a unique feature of healthcare REITs is the critical importance and reliance on third-party operators, many of which have struggled to remain profitable in recent years amid rising costs and lower reimbursement rates. There is hope on the horizon, however. After years of relative stagnation, the long-awaited demographic boom is finally in sight for healthcare REITs. The 80+ population will see substantial growth over the next two decades.
There are five distinct sub-sectors within the healthcare REIT category: senior housing, medical office building, skilled nursing, hospitals, and life sciences/research facilities. Each of these sub-sectors 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.
Healthcare REITs tend to focus on a single property type, but the "big three" REITs (HCP, VTR, WELL) hold a fairly diversified portfolio across the healthcare spectrum. Relative to the total value of US healthcare real estate assets, REITs are overweight in the senior housing and skilled nursing sub-sectors, equal-weight in the medical office and life science sub-sectors, and underweight in the hospital sub-sector. Below, we outline the property focus of the 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.
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.
Recent Fundamental Performance
Healthcare REITs fundamentals have lagged the broader REIT average for nearly the entire recovery, not entirely unexpected considering the defensive and recession-resistant nature of the sector. This underperformance, however, has been exacerbated by the aforementioned secular headwinds on the public-pay REITs and oversupply issues in the private-pay REITs. The underperformance gap has widened since 2015, but there's hope that 2018 may have been the bottom for this half-decade long struggle. Per the NAREIT T-Tracker, same-store NOI ticked up to 1.5% in the third quarter from 1.3% in 2Q18.
While demand has been predictably steady for most sub-sectors, relentless supply growth over the past several years (almost entirely within the senior housing and MOB 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. As a percent of inventory, housing starts per year in the senior housing sector will likely average 3-4% per year from 2015 through 2020, significantly outpacing demand growth during this time. The pipeline remains near record highs at $2 billion, but it appears that further expansion is unlikely, illustrated by the green line (TTM rate of growth) in the chart below. Investors are hoping to see signs of receding supply growth in 2019.
Healthcare REITs have offset some of the underlying property-level weakness by accretive external growth, but this growth has become harder to come by in recent years, as the cost of capital advantage has diminished. On a trailing-twelve month basis, healthcare REITs were net sellers of assets for the first time on record in 3Q18. These REITs have historically utilized their cost of capital advantage over private market competitors to accretively expand the size and scale of the business and drive FFO growth. This prudent capital allocation has been responsible for much of the sector's outperformance. The relatively flat performance of the healthcare REIT sector over the past two years, coinciding with generally rising private market valuations, erased much of this cost of capital advantage, making acquisition-fueled growth more difficult.
The post-recession period has seen a continuous wave of consolidation within the healthcare REIT space. Recent M&A activity has focused on the vertical integration of healthcare operators, recognizing the critical importance of having healthy tenants amid broader operator struggles. Capital recycling activity in recent quarters has been well-received by healthcare REIT investors. Even as net acquisition activity has decreased in recent quarters, total transactions remain healthy at roughly $13 billion over the last twelve months, illustrated by the red line in the chart above. We expect healthcare REITs to be net neutral or slightly positive on the acquisition front as the sector enters 2019 with a modest NAV premium.
Deeper Dive: Senior Housing
Third-quarter results were generally better than expected in the senior housing sub-sector, and full-year guidance was mostly untouched from last quarter. While senior housing operating fundamentals continue to weaken, there are signs that the rate of deterioration is slowing, and investors are hopeful that an upward inflection may be finally on the horizon. RIDEA same-store NOI growth remains weak at -2.9% YoY and occupancy declined by another 70 basis points from 3Q17, while triple-net fundamentals remained steady in the quarter. Senior housing REITs have been among the strongest performers over the last quarter and look to end 2018 with an average total return near 10%.
Before 2007, these senior housing assets were primarily leased to triple-net tenants under long-term leases whereby the REITs assumed a little operational risk. The REIT Reform Act in 2007 allowed them 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. NIC data shows that senior housing construction as a percent of inventory has moderated throughout 2018 from 6.0% in 1Q18 from 6.7% to 3Q18. Occupancy continues to dip, but rent growth appears to have stabilized in the mid-to-high 2% range. Net absorption has been negative for 12 consecutive quarters. With new starts still averaging 3.4% of existing inventory, there is no clear end in sight for supply growth yet. Demand, however, will start to improve as the long-awaited demographic boom begins to be realized.
Deeper Dive: Skilled Nursing and Hospitals
For the skilled nursing sub-sector, operator struggles were the theme of 2017, highlighted by solvency issues at many of the top SNF tenants, but 2018 has seen more stable operator performance and a divergence in performance between Omega Healthcare Investors and Sabra Health Care REIT. Rent coverage was fairly stable, as EBITDARM remains at or above 1.7 for both REITs. Omega and Medical Properties Tryst both delivered a very solid year, while Sabra lagged its peers. The sector will deliver an average total return near 20% in 2018.
Per NIC data, national SNF rent growth averaged 2.4%, steady from last quarter following a steady linear downtrend since 2016, when rent growth was averaging nearly 4.5%. Occupancy ticked down to 85.9% in 3Q18 from 86.2% last quarter. Unlike the senior housing sub-sector, supply growth is largely a non-factor in the SNF space, as annual inventory growth continues to be in net-negative territory. Cap rates have expanded slightly over the last couple quarters, to 10.3% from 10.2% last quarter. Omega and Sabra continue to sell underperforming assets and look to opportunistically buy stronger assets at attractive valuations from distressed private market sellers.
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. 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 continue to 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.
Deeper Dive: Medical Office and Life Science
The Medical Office Building and Lab Space/Life Sciences sub-sectors were the only places to hide within the healthcare sector in 2017, but have been the laggards of 2018. Thought to be immune from the policy-related risks of the other sub-sectors, the supply/demand dynamics remain moderately favorable. SS-NOI remained steady with last quarter at 3.6%, with occupancy roughly flat. The sector will end 2018 with an average total return of roughly -10%, dragged down by Alexandria Real Estate Equities and Healthcare Trust of America.
Recent Stock Performance
Pressured by rising interest rates and persistently weak fundamentals, healthcare REITs have underperformed the broader real estate index in four of the past five years. Despite recent underperformance, Healthcare REITs have been one of the best-performing sectors of the Modern REIT Era (1994-Present), outperforming the broader index by roughly 1% per year during that time. Along with a strong track record of prudent capital allocation, the low capex profile inherent with the triple-net lease model has been responsible for much of the long-term outperformance.
The healthcare REIT sector has rallied back to life over the past six months after being left for dead in early 2018 amid the post-tax-reform surge in the 10-year yield. Since March, yields have broadly stabilized and fundamentals appear to have bottomed across most sub-sectors, helping to lift the sector more than 20% since its YTD low. 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.
Valuation of Healthcare REITs
Compared to other REIT sectors, Healthcare REITs appear cheap based on FCF (aka AFFO, FAD, CAD) metrics. The sector now trades at a 0-5% premium to Net Asset Value, a reversal from the NAV discount experienced earlier in 2018, but still commanding far lower premiums than those experienced for much of the post-recession period. This modest NAV premium should provide these REITs with a moderately favorable cost of capital as they reposition their portfolio and seek acquisition opportunities from the increasing number of distressed private market sellers, particularly in the public-pay space.
Dividend Yield and Payout Ratio
Based on dividend yield, healthcare REITs rank near the top, paying out an average yield of 5.3%. Healthcare REITs pay out roughly 90% of their available cash flow.
Investors who are 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 for the MOB or diversified healthcare REITs.
Interest Rate and Equity Market Sensitivity
Healthcare REITs are among the 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 long-term growth prospects than the REIT average.
All healthcare names besides the Lab Space-focused Alexandria Real Estate Equities are highly sensitive to interest rates, and VTR and HTA are two of the most sensitive names across all REIT sectors. Notably, the acute care REITs exhibit lower sensitivity to yields and more sensitivity to the equity markets than other healthcare REITs.
Bottom Line: Hope for 2019
Healthcare REIT fundamentals remain weak, but 2018 appears to have been the bottom of a half-decade long stretch of deteriorating operating performance. Supply growth is peaking as demand begins to accelerate. After years of stagnant demand growth, this demographic boom could not come soon enough. The healthcare real estate industry has been ailing from oversupply and underwhelming demand.
The recent pullback in interest rates has lifted Healthcare REIT valuations over the past quarter. The sector looks to end 2018 with a healthy 6-8% total return. 3Q18 earnings were generally in line with expectations, as senior housing was the standout. Investors are hoping to see signs of an upward inflection in fundamentals by mid-2019. Skilled Nursing and Hospital REITs remain troubled by operator struggles and policy uncertainty, issues unlikely to abate in 2019. Medical Office and Research-focused REITs are the safe havens of the sector.
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Disclosure: I am/we are long VNQ, 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.