The early tremors of the long-awaited demographic-driven demand boom are finally beginning to appear for the sputtering healthcare REIT sector. The 2020s look promising after a disappointing decade.
The 'Aging Boomer' investment thesis has been no secret to developers. The healthcare real estate industry - especially senior housing REITs – continues to deal with significant oversupply issues.
Senior housing REITs suffered a setback with disappointing 3Q19 earnings, but 2019 still appears to have been the bottom of a half-decade-long stretch of deteriorating rent growth and occupancy levels.
Skilled Nursing and Hospital REITs remain troubled by operator struggles and policy uncertainty, issues unlikely to abate in 2020. The demographic tailwinds won't come until the 2030s for these sub-sectors.
Fears of a "retirement crisis" are overblown due in large part to rising home values over the past decade. Americans - mostly Boomers - have built up $10 trillion in additional home equity over the last decade.
REIT Rankings: Healthcare
In our REIT Rankings series, we introduce and update readers to each of the residential and commercial real estate sectors. We focus on sector-level fundamentals, analyzing supply and demand conditions and macroeconomic factors driving underlying performance. We update these reports quarterly with a breakdown and analysis of the most recent earnings results.
Healthcare Real Estate Sector Overview
Within the Hoya Capital Healthcare REIT Index, we track all 18 healthcare REITs, which account for roughly $150 billion in market value. One of the higher-yielding and more defensive REIT sectors, healthcare REITs comprise roughly 12% of the broad-based commercial Real Estate ETF (VNQ) and are well-positioned to capture the demographic-driven tailwinds of the aging US population. Investors looking to invest in the sector through a pure-play ETF can do so through the Janus Henderson Long Term Care ETF (OLD), which also includes exposure to healthcare operators outside the US.
For healthcare REITs, the long-awaited demographic-driven demand boom from the aging Baby Boomers - a historically large generation generally defined as those born between 1945 and 1965 - is finally on the horizon. Following the relatively small "Silent Generation," Baby Boomers are a healthier and wealthier cohort, expected to live longer lives and consume healthcare at a rate that significantly exceeds their prior generational peers. After years of relative stagnation in the critical 80+ population cohort for healthcare real estate, the long-awaited demographic boom is finally in sight as this age segment will nearly double over the next 30 years and grow at an estimated 4% per year through 2040.
There are five sub-sectors within the healthcare REIT category, and each of these sub-sectors has distinct risk/return characteristics and each is currently in different stages of the real estate supply/demand cycle: Senior Housing, Skilled Nursing, Hospital, Medical Office, and Research/Lab. The senior housing sub-sector can be further split into two categories based on lease structure: triple-net leased properties and RIDEA or SHOP (senior housing operating properties). Under the SHOP model, REITs assume more operating responsibilities, assuming more upside potential and downside risk.
Policy-risk is an especially important factor for the skilled nursing and hospital sub-sectors, which derive a significant portion of their revenue mix from public and private health insurance reimbursements. These "public pay" REITs have been pressured in recent years by policy changes that have targeted higher-cost facilities and attempted to push patients into lower-cost settings. However, supply growth has been far more muted in these sub-sectors, unlike in the private-pay senior housing sub-sectors where supply growth remains a continuous headwind that has pressured occupancy and rent growth.
Healthcare REITs tend to focus on a single property type and are led by the "Big Three" healthcare REITs - Ventas (VTR), Welltower (WELL), and Healthpeak (PEAK), which recently changed their name and ticker symbol from HCP, Inc. (HCP). These "Big 3" REITs hold a fairly diversified portfolio across the healthcare spectrum, although these firms have divested most of their public-pay assets in recent years to focus more exclusively on the senior housing sub-sector. Other players in the senior housing space include New Senior (SNR), and National Health (NHI) and Diversified Healthcare (DHC), which also recently changed their name and ticker symbol from Senior Housing Properties (SNH).
On the public-pay side, the skilled nursing sub-sector includes Omega Healthcare (OHI), Sabra Health Care (SBRA), CareTrust (CTRE), and LTC Properties (LTC) while there is a single hospital-focused REIT, Medical Properties (MPW). Operator struggles - including bankruptcies and lease restructurings - have plagued these public-pay REITs over the last half-decade, but saw some much-needed stabilization. Finally, in the medical office and research/lab space sub-sectors, there are half-a-dozen MOB-focused REITs including Healthcare Realty (HR), Healthcare Trust (HTA), Universal Health (UHT), Physicians Realty (DOC), Community Healthcare (CHCT), and Global Medical REIT (GMRE). Alexandria Realty (ARE), meanwhile, is the lone REIT focused exclusively on research and lab space. While not expected to be as directly impacted by the demographic tailwinds as the other sub-sectors, the medical office and research lab/space segments were the most consistent performers last decade.
Still a relatively fragmented industry, Healthcare REITs own approximately one-tenth of the total $2 trillion worth of healthcare-related real estate assets in the United States. 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. Healthcare REITs have historically been a defensively-oriented sector that generally pays high dividend yields, averaging 4.6%, well above the REIT sector average of 3.5%. We'll discuss the dividend yields of all 18 REITs towards the bottom of this report.
Due in part to high dividend yields, healthcare REITs are among the more interest-rate-sensitive real estate sectors and tend to perform best in lower-rate 'Goldilocks' macroeconomic environments. 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. Healthcare REITs have historically leased properties to tenants under a long-term, triple-net lease structure, though these REITs have taken on increasingly more operating responsibilities over the past decade following the REIT Investment Diversification and Empowerment Act (RIDEA) which allowed REITs to participate in property-level economics.
Within the senior housing sector, CBRE estimates that there are roughly 3 million professionally-managed senior housing or skilled nursing units in the US, representing roughly 2% of the total US housing stock. The 'Aging Boomer' investment thesis has been no secret to developers as senior housing has been one of the few housing segments seeing ample speculative supply growth in preparation for aging boomers, defying the broader "housing shortage" theme of limited supply in the entry-level and mass-market housing segments. As we often point out in our research, by nearly every metric, the US housing markets remain significantly undersupplied at the national-level, which has been the driving force behind the above-trend home price appreciation and rent growth over the last decade.
Ironically, we argue that no cohort has benefited more for the broader housing shortage than the aging boomers, who have enjoyed substantial home price appreciation over the last decade due in large part to this lack of supply growth in the post-crisis period. Americans - mostly Boomers who have the highest homeownership rate in America at nearly 80% - have built up $10 trillion in additional home equity over the last decade. For that reason, we believe that the fears of a "retirement crisis" are overblown and that these accrued savings will be a key source of future spending power for healthcare services - including potential senior housing - among the roughly 10% of Americans that choose to live in purpose-built senior housing.
Healthcare REIT Stock Performance
Healthcare REITs entered the 2010s as the single-best performing real estate sector of the prior decade, delivering total returns that more than doubled the REIT average from 2000-2009, driven by a continuous wave of accretive acquisitions that were fueled by the sector's favorable cost and access to capital. The 2010s were a comparatively disappointing decade for healthcare REITs as the sector delivered compound total returns averaging 10.1% per year, 250 basis points shy of the 12.6% average compound total returns delivered by the FTSE Nareit All Equity REITs Index.
Following three straight years of underperformance, however, healthcare REITs have shown signs of renewed life over the last two years, ahead of the impending demographic boom that is expected to fuel healthy demand growth throughout the 2020s. After delivering strong outperformance in 2018, healthcare REITs delivered total returns of 21% in 2019 on a market-capitalization-weighted basis, but that performance was weighed down by comparatively weak performance from the "Big 3" REITs, particularly Ventas which delivered a disappointing earnings set-back in the most recent quarter. Using a simple average, healthcare REITs jumped more than 40% in 2019, one of the only REIT sectors that saw small-caps outperform large-caps last year.
It was a good time to be a small-cap healthcare REIT in 2019, as the four smallest REITs in the sector all surged at least 50% on the year, led by 90% jumps from Universal Health Realty and New Senior Investment Trust. At the sub-sector level, medical office and research/lab focused REITs led the way, averaging 43% returns in 2019, followed by senior housing REITs at 31% and skilled nursing REITs at 29%. Healthcare REITs - particularly the senior-housing-focused REITs - have stumbled since the beginning of 3Q19 earnings season, however, for reasons that we'll analyze in detail below.
Healthcare REIT Fundamental Performance
Outside of surprisingly disappointing results in the senior housing operating segments from Ventas and Healthpeak that we'll discuss in more detail below, 3Q19 earnings season generally continued a trend of stabilization across the healthcare REIT sector as the worst of the oversupply pressures appears to have waned. According to recently-released NIC data for the fourth quarter, 2019 will be the first year since 2015 to have seen a sequential uptick in average occupancy for senior housing and the first year since 2005 to see an uptick for skilled nursing. While wage pressures continue to pressure margins and rent growth remains uninspiring at inflation-matching levels, we think there's clear evidence that 2019 saw a bottoming in sector fundamentals. In 3Q19, same-store NOI growth rose to the strongest TTM growth rate in two years at 1.66% following three years of deteriorating performance.
While demand has been predictably steady and showing early signs of Boomer-led acceleration for most sub-sectors outside of skilled nursing, relentless supply growth over the past several years has continued to pressure same-store NOI growth for the senior housing sector. Inventory growth peaked in 2018 at nearly 3.5%, but pulled back in 2019 to slightly under 3% and the current development pipeline tracked by NIC indicates that we'll indeed see waning supply growth through 2021. We project that in 2020, we'll see roughly supply/demand equilibrium followed by a decade of demand growth outpacing supply growth.
Interestingly, even as the other private-market developers have pulled back, healthcare REITs haven't skipped a beat, as the REIT development pipeline reached a new record high in the last quarter at $4.1 billion. As we've pointed out in other property-sector reports, REITs tend to outperform their private-market peers when sector fundamentals are in the 'Goldilocks' zone: strong enough to drive same-store NOI growth, but not strong enough to prompt a wave of supply growth from the private markets. A few years of challenging fundamentals may have been exactly what the doctor ordered to return to that 'Goldilocks' zone.
Healthcare REITs have offset some of the underlying property-level weakness over the past half-decade through accretive external growth, but this growth was hard to come by last year with a relatively weak cost of equity capital with entire REIT sector trading at a persistent NAV discount. Strong share price performance over the last two years has restored the sector's coveted NAV premium, allowing these REITs to get back to doing what they do best: grow via accretive external acquisitions. Healthcare REITs were net buyers again in 3Q19, adding to a robust quarter of acquisitions in 2Q19. Together, the past two quarters were the strongest six months of net acquisition activity since 2015 as healthcare REITs have now acquired $6.5 billion in assets over the last twelve months, representing nearly 5% of the sector's market value.
Deeper Dive: Senior Housing
Senior housing REITs were on a clear uptrend heading into 3Q19 earnings season, but disappointing results from Ventas and Healthpeak in their senior housing operating segment threw a wrench into the works, at least temporarily. The double-whammy of upward wage pressures and oversupply pressures led to a -5.0% dip in SHOP NOI at Ventas from the same quarter last year, as the company now expects SHOP NOI growth to decline -4.0% to -5.0% versus an expectation of flat to slightly down. Healthpeak saw similarly disappointing results in their SHOP segment, reporting a 6.0% dip in same-store cash NOI.
Results from the other four senior-housing focused REITs, however, were actually pretty decent with Welltower reporting a 2.3% rise in same-store NOI from their SHOP portfolio while just-released 4Q19 data from the NIC data service noted that fundamentals have generally remained stable in the back-half of 2019. NIC reported that occupancy remained steady at 88.0% while rent growth declined slightly to 2.8%. Inventory growth has trended down to 2.7%, the lowest supply growth levels in several years. Pricing was also strong with cap rates declining to 6.3% from 6.8% in the prior quarter.
Deeper Dive: Skilled Nursing and Hospitals
While the outlook has stabilized in the senior housing space over the last year, skilled nursing fundamentals remain murky at best. The skilled nursing and hospital sectors continue to be the targets of policy-makers seeking to reduce aggregate healthcare costs. The demographic-driven demand won't hit this sub-sector, which caters to a much older demographic than senior housing, until closer to 2030. Fundamentals haven't gotten any worse in 2019, at least, which has been enough to power the largest skilled nursing REITs, Omega Healthcare and Sabra Healthcare, to a strong two-year run of performance. Rent coverage and occupancy metrics reported by these REITs were fairly stable in 3Q19.
Per NIC data released last week, national SNF rent growth averaged 2.6% in 4Q19, up slightly from the 2.5% rate last quarter. Occupancy remained steady at 86.5%. Unlike the senior housing sub-sector, supply growth is largely a non-factor in the SNF space. Skilled nursing remains very much out of favor with private market investors and remains a highly speculative play within the REIT space. Cap rates have continued to reset higher over the last couple quarters, to 11.1% from an average of around 10.0% in 2017. Omega and Sabra continue to sell underperforming assets and look to opportunistically buy stronger assets at attractive valuations from distressed private market sellers.
Healthcare REIT Valuations & Dividends
Healthcare REITs continue to trade at discounted valuations relative to other REIT sectors based on consensus Free Cash Flow (aka AFFO, FAD, CAD) metrics. Powered by the iREIT Terminal, we see that the sector now trades at a 10-20% premium to Net Asset Value, a reversal from the NAV discount experienced earlier in 2018, again giving the sector the ammunition to fund accretive acquisition opportunities, which had been relatively few and far between over the past since 2016.
Dividend yields of the individual names in the healthcare REIT sector range from a low of 2.4% (Universal Health Realty) to a high of 8.4% (Sabra Healthcare). Investors seeking a safe, predictable income stream should focus on the MOB, lab/research, and upper-tier senior housing healthcare REITs such as the Big 3 (Welltower, Ventas, and HCP), Healthcare Trust, Healthcare Realty, Physicians Realty, or Alexandria. Investors who are looking willing to take on significant speculative policy and operational risk can take a look at the primarily public-pay REITs such as Omega, Medical Properties, and Sabra.
Bull & Bear Case for Healthcare REITs
One of the few things that investors seem to agree upon is the impending explosive growth in healthcare spending, which totaled $3.5 trillion in 2018 and is expected to grow more than 5% per year in the next decade. There is a debate, however, on how aging Boomers will actually be able to pay for these health services, but we point out that the fears of a "retirement crisis" are overblown due in large part to rising home values over the past decade as Americans - mostly Boomers - have built up $10 trillion in additional home equity over the last decade which can be tapped over the next decade to pay for healthcare services. The early tremors of the long-awaited demographic-driven demand boom are finally beginning to appear for the sputtering healthcare REIT sector and the 2020s look promising after a disappointing decade. Below, we outline five reasons that investors are bullish on healthcare REITs.
However, to reiterate, the healthcare real estate industry continues to deal with significant supply growth issues, particularly in the private-pay senior housing segments. Skilled Nursing and Hospital REITs, meanwhile, remain troubled by operator struggles and policy uncertainty, issues unlikely to abate in 2020. Additionally, many of the key assumptions underlying the bullish thesis are certainly up for debate, specifically the willingness and age at which seniors actually move out of their own homes into purpose-built senior housing. The age at which seniors move from their own homes into purpose-built senior housing has been increasing over the last few years, driven by both affordability and improvements in medical and communications technology. The availability and relative affordability of in-home health care will also have significant impacts on senior housing demand. Below we outline the five reasons that investors are bearish on the healthcare REIT sector.
Our Conclusions: 'Retirement Crisis' Fears Overblown
We're believers in the demographic-driven demand story for senior housing and have been noting since our earlier research pieces on this platform that this is more of a "mid-2020s story" than a "mid-2010s story." Well, here we are in the 2020s. Earlier in the decade, there were legitimate concerns about Boomers' ability to pay for premium senior housing units. As discussed, we believe that the financial health of the Boomer generation is now stronger than most presume, driven by the strong post-recession recovery in home values and positive outlook for future home price appreciation. Amid the broader "Renter Nation" trend of lower homeownership rates, the 65+ age cohort actually owns homes at a higher rate than in 1995 at just shy of 80%.
The question now is whether supply growth will cool to the point that senior housing REITs will actually be able to enjoy the full effects of the demographic-driven demand. We believe that this past half-decade of weak fundamentals was necessary to flush out some of the private market developers and excess capital flowing into the sector, which weakened these REITs' competitive advantage. As we discussed in last week's report, The REIT Paradox: Cheap REITs Stay Cheap, among other advantages of the REIT structure (liquidity, scalability, reliable dividends, ability to diversify, and good corporate governance), access to the public equity markets to fuel accretive acquisitions has been the defining competitive advantage for REITs, explaining much of the consistent outperformance over the last 25 years.
We're indeed seeing evidence that non-REITs are pulling back from development of senior housing assets, but will need to see that continue into the early 2020s. Ventas' and Healthpeak's disappointing senior housing earnings threw a curveball into our positive outlook, but at this point, it appears that these weak 3Q19 results may have been Ventas and Healthpeak-specific operational issues given the otherwise steady data from other REITs and from the NIC data service. Fourth-quarter earnings results, which begin in just two weeks, will be especially critical and we believe that the sector is well-positioned for upside surprises, kicking off a decade that we believe will be far stronger than the last.
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Disclosure: I am/we are long WELL, PEAK, VTR, OHI. 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.
Additional disclosure: Hoya Capital Real Estate advises an ETF. In addition to the long positions listed below, Hoya Capital is long all components in the Hoya Capital Housing 100 Index. Real Estate and Housing Index definitions and holdings are available at HoyaCapital.com.
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