Wednesday, August 7, 2013

Stock Thoughts: Healthcare REITs

In my search for attractively valued investment opportunities, my attention has been drawn to real estate investment trusts (REITs). I have been interested in diversifying my portfolio and gaining exposure to real estate by investing in REITs, especially those that consistently grow their dividends. However, as a value-oriented dividend growth investor, I would prefer not to pay the premium valuations that the highest quality REITs often command. Fortunately, over the past two months there has been a strong sell-off among REITs, mainly due to fears of rising interest rates when the Federal Reserve tapers its quantitative easing. As a result of the sell-off, many REITs are now trading at attractive valuations, motivating me to look more closely at what is available.

I decided to focus my research on healthcare REITs; that is, companies that own healthcare-related properties such as skilled nursing facilities, senior housing, medical office buildings, and hospitals. A major reason for this decision is that many of these specialties, such as skilled nursing and senior housing, are likely to benefit from the aging population in the U.S. The figure below (taken from an HCP presentation) shows the projected U.S. population growth of individuals 65 years or older until 2050. This strong demographic trend bodes well for healthcare REITs.

Among the 12 healthcare REITs listed by NAREIT, 5 are on the Dividend Champions, Contenders, and Challengers list for having at least 5 consecutive years of dividend growth. These REITs are HCP (HCP), Health Care REIT (HCN), National Health Investors (NHI), Omega Healthcare Investors (OHI), and Universal Health Realty Income Trust (UHT). In the remainder of this post I will compare some quantitative data from these REITs.

Properties: The table below shows the percentages of properties in different categories owned by each REIT.

HCP seems to be the most diversified; HCN, NHI, and UHT are somewhat less diversified, each having at least 50% of their properties in a single category; OHI is the least diversified, being focused almost entirely on skilled nursing.

Dividends: The table below indicates the current dividend yield, the 5-year historic yield (from Morningstar), the payout ratio (based on funds from operations, FFO), the dividend growth streak in years, and the 5-year dividend growth rate (DGR).

All 5 stocks have yields near or above 5%, which is great. However, in each case the current yield is below the historic yield. Even though REITs are required to pay out a high proportion of their net income, it is worthwhile considering their payout ratios. HCP and OHI both have payout ratios below 80%, which provides more of a buffer against an operational decline compared with the others.

HCP and UHT are both Dividend Champions, having increased their dividends for more than 25 consecutive years. In my research I discovered that HCN froze its dividend from mid-2000 to early 2004, NHI cut and then briefly suspended its dividend in 2000 and 2001, and OHI suspended its dividend from 2001 to late 2003. Even though NHI and OHI have re-established decent dividend growth streaks, those past suspensions are worth keeping in mind. Regarding DGRs, OHI has done very well in recent years; HCN and NHI have been decent; HCP and UHT have been weak.

Balance sheets: The table below provides some information about debt and credit (taken from NAREIT) and Value Line safety ratings if available.

NHI has the best debt ratios, whereas HCP has the best credit rating. Long-term debt has increased over the past few years in all cases (not shown in the table), likely due to unusually low interest rates.

Valuations: The table below indicates the current price of each stock (as of August 7, 2013), the P/FFO ratio (which is more appropriate to use for valuing REITs than the P/E ratio), the current and historic P/B values, Morningstar stars and fair value estimates if available, and Dividend Discount Model (DDM) fair value estimates. The DDM estimates used the 5-year DGR and a discount rate equal to the current yield plus the 5-year DGR. The margin of safety (MoS) reflects the percent discount of the current price from the DDM fair value estimate.

Based on P/FFO, one might consider OHI to be moderately undervalued; HCP and UHT to be slightly undervalued to fairly valued; HCN and NHI to be fairly valued to slightly overvalued. Based on P/B, OHI actually appears overvalued (as does NHI), whereas the others seem to be fairly valued. The DDM calculations give a small margin of safety to each stock; given that none of the margins are greater than 10%, it would be conservative to judge all 5 stocks as fairly valued by that measure. Interestingly, if one uses Morningstar's fair value estimate, HCP is undervalued by at least 20%.

Summary: Of the healthcare REITs briefly surveyed here, there are two that I consider to be more attractive investment opportunities than the others: HCP and OHI. Regarding HCP, I like its long dividend growth track record, low payout ratio, relatively high credit rating, fair valuation, and good property diversification; however, I dislike its weak dividend growth rate. It is considered a "blue chip" REIT partly because it is "arguably the best-diversified landlord in healthcare" (according to Josh Peters of Morningstar). Regarding OHI, I like its high current yield, relatively high dividend growth rate, low payout ratio, and fair to undervaluation; however, I dislike its lower credit rating, past dividend suspension, and lack of property diversification. It is considered a "pure play" REIT because of its focus on skilled nursing facilities, offering more risk but possibly more reward than others. Brad Thomas, a REIT industry expert who writes for Seeking Alpha, has favorable opinions on both names and wrote a recent article on OHI.

Thus, if I were to invest in a healthcare REIT, then I would likely choose either HCP or OHI. I have also been looking at non-healthcare REITs. Two of the more popular names among dividend growth investors are Realty Income (O) and Digital Realty Trust (DLR). I consider O to be a well-run blue chip REIT with a solid dividend growth record, but I desire a better valuation. I consider DLR to be undervalued despite strong recent growth, but it has a higher risk/reward ratio than other REITs due to its technology emphasis. I will continue examining these and other names as I explore the REIT space. Note that if I decide to invest in a REIT, then it will likely be in my Roth IRA because REIT dividends would be taxed as ordinary income in my taxable account.

14 comments:

  1. Fantastic summary with lots of information. I'm printing this for future reference. I was interested in O and decided to wait because even after a 20% drop in share price, I concluded it was fairly valued and the small dividend increases don't justify the current price for a longterm investment (Longterm Return = Initial Yield + Dividend Growth Rate).

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    1. ADY: Thanks for the feedback. I have a similar view of O, although I would be okay with starting a position under $40.

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  2. REITs have performed magnificently for me over the last 7 years, right through the meltdown, the recovery and into the heady over-valuation this year.
    choose best of breed, plan to hold forever; real estate may briefly go out of style, but it will never permanently lose its value. I'm happy to accept 5% yields year in and year out, occasionally rebalance a bit. easy-peasy

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    1. Anonymous: Thanks for your comment -- I'm glad REITs have served you well!

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  3. Thanks for the rundown and pointing out that REITs are good candidates for a ROTH account (that's where all of mine are). Within REITs, I'm a huge fan of the healthcare segment. That's where I put most of my money, but have since stopped because I don't want to over allocate.

    I think there will be strong demand for healthcare properties in the coming years which should lead to high occupancy rates and a lot of room for growth. My favorite company off your list is NHI, but I like them all except UHT. I'm a fan of NHI mainly because their debt is low, although it appears other investors like the company too seeing as how the valuation is pretty rich. NHI tends to do special dividends at years end, perhaps instead of committing to heavy quarterly payout that might be hard to maintain over time. I wish more companies would follow suit and pay out excess cash as a special dividend. It's a nice feature that I've only seen with a handful of companies.

    My largest REIT holding is LTC from the healthcare segment, however I was able to acquire shares a few years back at very favorable valuations. The dividend growth is sort of erratic with that company, but I think they'll do an increase within the next 6 months or so (they are conservative and tend not to let dividends get ahead of cash flow).

    However I'm up to 4 REITs and am close to the 10% allocation I want in real estate. Probably will not purchase anything else in this sector unless prices continue to decline!

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    1. CI: Thanks for your thoughts on the healthcare REITs. I agree that a Roth IRA is the best place to hold them. I haven't decided how much weight I eventually want REITs to have in my portfolio, but your 10% allocation sounds reasonable. My goal would be to own 3-5 REITs that are involved in different specialties.

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  4. Great post. I've been looking at DLR, O, and OHI and the numbers I've put together mirror yours. I am thinking of O and OHI to diversify a little bit, as I have no REITs in my Roth (although hold both VNQ and VNQI in my IRA). I like O for safety, but the recent dip in DLR makes for a compelling entry point.

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    1. BidAsk: Thanks for your comment. Outside of healthcare, I have looked at DLR and O. I still need to do more research, but I think I'd like to own O at some point.

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  5. I read a comment in another article about holding REITs in a Roth IRA and getting hit with tax on some kind of depreciation that was taken during the time you own the REIT, especially if it is held over a long period of time. I am considering suggesting my son buy a healthcare REIT in his Roth and now worry if it is wise. Would love an answer to this question that can be understood by someone who is not a tax accountant.

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    1. Anonymous: To the best of my knowledge, there are no taxes applicable to REITs held in a Roth IRA. I am not aware of any depreciation-related effects, either. Sometimes part of the dividends paid by REITs represents a return of capital, but given that no taxes are paid on what happens in a Roth IRA or on withdrawals from the account, it should have no tax consequences.

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