Well, we’re right back to discussing capitalization rates, or cap rates, today.
The topic has turned into an important series I began two weeks ago. Its purpose: to give you another one-up on understanding the properties we scope out here on Seeking Alpha. And knowing your cap rates is, quite simply, an excellent step toward establishing a big-picture view of any real estate investment trust, or REIT.
The series kicked off, then, with a thorough explanation of what cap rates are. If you read it and its follow-up on May 20 – this one specifically about net lease REITs cap rates – you might be getting a bit bored already of hearing cap rates defined.
But out of respect for any newbies, here’s what we’re talking about.
As I explained in the first article on the subject, “The Cap Rate Series: The Answer Is No Longer 9%,” cap rates are “a simplistic yet invaluable tool that can tell me – and you – a lot about how safe or risky a REIT’s forward-thinking potential really is.” More specifically, it’s “the answer you get when you divide a rental property’s net operating income by its all-inclusive, bottom-line purchase price.”
So that would be:
Net Operating Income ÷ Current Market Value of the Asset = Cap Rate
Just a few decades ago, it used to be that the average cap rate across all REIT sectors was always 9%. But that go-to answer just doesn’t fit anymore, hence the reason this series exists. We’re exploring each of the REIT categories to see what number we should be shooting for.
That is to say we’re exploring each of the major REIT categories. There are a lot of them out there these days.
Which might be why the cap rate is no longer always 9%.
Bringing Out the Stethoscope for Healthcare REITs
Today’s exact assignment is to figure out an ideal cap rate for healthcare REITs. That’s our stated goal, and we will reach a workable answer that you can put toward profitable decisions going forward.
Rest assured of that.
But first, we naturally should do at least a cursory examination of what healthcare REITs are and what they do. So I’ll briefly turn to Nareit, a great go-to source for facts and figures about real estate investment trusts.
Healthcare REITs own and manage a variety of healthcare-related real estate and collect rent from tenants. Healthcare REITs’ property types include senior living facilities, hospitals, medical office buildings and skilled nursing facilities.
This grouping includes big businesses such as Welltower Inc (WELL), which is based out of Toledo, Ohio. An S&P 500 company, it rents to senior housing communities, post-acute providers, and other non-hospital health systems across the U.S., Canada, and the United Kingdom.
And, if you go to its website, you’ll immediately see it boasting its delegation of “one of Fortune 2019 World’s Most Admired Companies,” along with the fact that it was “the only healthcare real estate company named to the list this year.”
Good for it! Genuinely.
But that hardly means it’s the only interesting piece of property out there when it comes to healthcare REITs.
There’s also Community Healthcare Trust (CHCT), Ventas, Inc. (VTR), CareTrust REIT (CTRE), National Health Investors (NHI), Global Medical REIT (GMRE), and more than a dozen others. To be precise, as of May 22, 2019, there were a total of 18 publicly listed healthcare REITs found on major U.S. exchanges. Together, they’re worth $105.4 billion.
(None of these stocks should be taken as official recommendations unless specified below.)
That’s big business right there, which is why it’s worth our time to learn more about these establishments.
Overall Sector Strength
The beauty of healthcare REITs is in the necessity of what they offer – room and board for businesses that focus on physical health. There are plenty of products and services that people can and do live without, especially during tougher times.
But healthcare isn’t typically one of them.
That means that, as a sector, healthcare REITs are rather recession-proof. Still, don’t think for a moment that you can simply buy into any old one with any old management and make a mint. It’s not that easy.
Everybody focuses on the baby boom but what about the baby bust?
We know the majority of SNF utilization is between 75 and 87 years old. To get a proxy of the headwind, it’s important to track the average annual birthrate for 75- to 87-year-olds in each calendar year.
Source: Centers for Disease Control and Prevention
The aging of the baby boomers will drive a multi-decade increase in demand, and increasing occupancy will improve financial performance for most healthcare REITs and increase their capacity to pay rent.
Source: Centers for Disease Control and Prevention
You have to do some serious digging into which healthcare REIT does. Where do they operate? How steady or thriving are those particular markets when it comes to population and general economy? How are they expanding, if at all?
And, while you’re at it, you might want to check out their cap rates as well. Investing in the following healthcare property sectors can be attractive, but it’s important to also consider the cost of capital for reach REIT.
As you can see (above), the skilled nursing sector has the highest cap rates and the life science and medical office building sectors (or MOBs) have the lowest. Here’s a snapshot of the cap rates over time:
Source: OHI Investor Presentation
Now let’s take a closer look at the weighted average cost of capital (or WACC) for each REIT, starting with their cost of equity:
As you can see, the REITs with the lowest equity cost include Alexandria Real Estate (ARE) with a 4.8% equity cost, Community Healthcare, with a 4.4% equity cost, and Healthcare Realty (HR) with a 4.9% equity cost. The REITs with elevated equity WACCs include Senior Housing Properties (SNH) with a 16.8% equity cost, Sabra Realty (SBRA) with a 9.9% equity cost, and New Senior (SNR) with an 8.0% equity cost.
Now let’s examine the debt costs for the healthcare REITs:
As you can see, the REITs with the lowest debt WACC include Alexandria Real Estate with a 1.7% debt cost, Ventas with a 1.7% debt cost, and LTC Properties (LTC) with a 1.8% debt cost. New Senior has the highest cost of debt (3.6%) because of the company’ higher leverage.
Now let’s examine the combined cost of equity and debt to arrive at the WACCs for each REIT (I highlighted the REITs with WACCs at 5% or below):
Now, keep in mind, the REITs with the lowest cost of capital does not necessarily mean that they are the most profitable. Because the business models vary, as I explained above, there are different risk tolerance profiles for each property sector. So the way to provide an accurate measure of profitability is to assign a cap rate to each REIT, and that is precisely what we did with the chart below:
Keep in mind that many of these REITs are diversified in nature, so they invest in multiple property categories. For example, Ventas invests in senior housing, medical office, life science, and hospitals – thus we assign an average cap rate of 6.8% to arrive at a profitability score of 1.5% (or 150 basis points of profitability).
It’s important to recognize that Ventas could easily increase leverage to “juice up” the profits, but the company opts to maintain strict discipline with its balance sheet.
Alternatively, Senior Housing has dangerous leverage and we have maintained distance from buying shares given the overall lack of discipline. Assume for a minute that all of the REITs enjoyed a Ventas-like balance sheet and that all of the companies acquired properties at a 7% average cap rate (the average for all property sectors):
As you can see, on a leverage neutral-basis (all REITs with 40% debt) and using 7% standard cap rates, the REITs with the best overall WACC include Community Healthcare, Alexandria, Healthcare Realty, Welltower, and HCP (HCP).
The reason that the MOB REITs – Physicians Realty (DOC), Healthcare Trust of America (HTA), and Healthcare Realty – are all generating sub-100-basis-point profit margins (second chart above) is because they are purchasing properties at sub 6% cap rates. However, we like the defensive nature of the business model and the going-in-yield (or cap rates) for the properties increase by an average of 2% to 2.5% per year.
Also, the reason we include the cap rate for Alexandria at 7.4% (versus the 5.0% cap rate referenced above) is that the company develops properties that yield 7.4% at stabilization. This means the company is generating impressive profits, and it is one of the reasons that it has been able to deliver strong earnings and dividend growth over the years.
Finally, I will conclude my cap rate article by referencing my recent article, "Catalysts Are In Place For Omega Healthcare To Fly Like A SWAN". As I explained,
Although we’re not upgrading it to SWAN status just yet, we do believe it deserves an official “Buy.” Given the above-referenced catalysts and likely dividend increase, we believe this SWAN-a-be is an intelligent pick that deserves shelf space. Rest assured that management knows the importance of a dividend increase. And that, my friends, helps me sleep well at night.
As the WACC scorecard illustrates, Omega generates impressive growth (320 basis points) and while the property sector (skilled nursing) is much higher risk (than MOBs or life science properties), investors are being compensated adequately.
Soure: FAST Graphs
Alternatively, Ventas is continuing to deploy capital into more defensive properties and this should allow the company to eventually generate more reliable growth in the future. It’s management's job to utilize its cost of capital advantage to deliver sustainable growth in the form of earnings and dividends.
Our next cap rate article (in the series) is on the industrial sector. Stay tuned.
Author's note: Brad Thomas is a Wall Street writer, and that means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free, and the sole purpose for writing it is to assist with research, while also providing a forum for second-level thinking.
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Disclosure: I am/we are long VTR, CTRE, NHI, GMRE, LTC, DOC, HTA. 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.