Unfairly punished this year, health care REITs rebounding
For any investor looking at the performance of their health care REIT stocks this year, one would think that earnings and cash flow had dropped, dividends had been cut or major tenants had announced financial difficulties or even a bankruptcy or two. But no, none of this has happened, and contrary to investor opinion, health care REITs are in a good position to take advantage of the changed credit market conditions.
So why did health care REITs take the plunge this year, and are they still undervalued? The answer to the first question is a lot easier than the second one. One common explanation at the time was that investors were reacting to rising interest rates in the first six months of this year. REIT stocks are interest-rate sensitive and usually move in an inverse relationship with interest rates, but interest rates rose by just 50 basis points in the first half of the year and then receded after June. That hardly seemed to merit the punishment meted out by investors.
Second, health care REITs have had a tremendous run this decade, as have most of the other REIT sectors. Real estate in general has been hot for several years (just look at seniors housing), and then REITs got in the cross-hairs of private equity firms, and takeover premiums started to push share prices up even further. Meanwhile, real estate mutual funds that invest in REITs received a record $11.2 billion of new funds to invest in 2006, and while we don’t know what portion of that went into health care REITs, that amount of demand for real estate-oriented stocks had to have a positive impact. So it would be easy to say that health care REITs, other REITs and real estate in general basically peaked in early 2007 and, with investor queasiness beginning with the residential real estate market, the sentiment just changed.
But aren’t health care REITs different? With triple net leases, strong lease coverage ratios and higher dividend yields, one would think that investors might like health care REITs in general, and as a defensive stock if the economy is beginning to wobble, because they are somewhat recession-resistant. And within the health care REIT sector, there are significant differences among the various companies. Investors, however, don’t seem to see it that way, as five of the health care REITs reached a 52-week high on the same day (February 8, 2007), including the three largest by market cap, and two others peaked the prior day. Six months later, nine of the health care REITs hit 52-week lows within a two-week period (July 26-August 9). So despite different dividend yields and payout ratios, tenant concentrations and property types, they move remarkably in tandem with each other. Unfortunately, they moved mostly lower this year.
So the plunge since February has to do with a combination of perceived interest rate risk, a topping out of the real estate market in general, cashing in after above-market returns in 2006 when the median health care REIT total return was 36.9%, perhaps a belief that the seniors housing and care industry itself was topping out (but we are really giving investors too much credit on this one) and, perhaps, a little bit of ignorance. Unfortunately, there are still a number of investors who look at the sector as health care and not real estate, and penalize health care REITs from a valuation perspective.
The final blow came in July with the subprime mortgage market mess, when any lender/investor needing to tap the credit markets to grow and acquire assets was hammered by investors seeking safety. Take the case of CapitalSource (NYSE: CSE), which while not a health care REIT is a significant player in the seniors housing market. CSE’s shares plunged 40% in July based on concerns about the cost and availability of capital for it to grow, resulting in a current dividend yield over 13%. If you are looking for yield and believe the capital markets will settle down, that is an incredible yield to lock in. We believe with health care REITs in general that it has been a bit of a case of throwing the baby out with the bath water.
As to the second question of whether health care REITs are undervalued, the easy answer is that they were all significantly undervalued by the end of July, if not before. The fact that they are all up by a range of 10% to almost 40% from those lows in just one month certainly indicates that the market overreacted to the credit crisis and its impact on health care REITs. But that seems to be a pattern with investors and health care REITs this year. Without being a wise guy, the time to invest would have been on August 1 (don’t you love hindsight?), but no one really knew how many other shoes were going to drop in the credit crisis.
The two largest health care REITs are Health Care Property Investors (NYSE: HCP), which actually just changed its name to HCP, and Ventas (NYSE: VTR). On a market cap basis, combined they represent nearly 50% of the total health care REIT universe and tend to be quite competitive with each other, to say the least. And although there are many differences between the two companies, including style, the similarities are extraordinary.
Although Ventas has been best known for being the primary landlord for Kindred Healthcare (NYSE: KND), in terms of dollar value of investments Kindred has dropped to third in VTR’s portfolio. The top two are Sunrise Senior Living (NYSE: SRZ) and Brookdale Senior Living (NYSE: BKD), with $1.96 billion and $1.39 billion in assets, respectively. And wouldn’t you know it, the top two companies for HCP are also Sunrise with $2.2 billion in investments and Brookdale with $662 million. Both REITs also have sizable investments in Capital Senior Living (NYSE: CSU) and Summerville Senior Living. These four companies represent about 65% of VTR’s investments and 41% of HCP’s.
One major difference, however, is that HCP receives rental income from its 103 Sunrise assets, while VTR receives all of the income (after paying a management fee) from its 78 Sunrise properties, so it has the potential to make a higher return if performance exceeds expectations (or lower returns if the operations were to tank). In other words, unlike the traditional REIT structure with a fixed rental stream, VTR owns the real estate and the business with a variable income stream. This all becomes interesting to watch because the outcome of the sale of Sunrise Senior Living, currently in process, may be influenced by either HCP or VTR, since both REITs have such a huge stake in seeing the company’s assets perform well. While we have a pretty good sense that HCP’s senior management would like to purchase Sunrise, possibly using its existing Sunrise assets as a financing vehicle, the timing may not be right after just closing on the $2.9 billion Slough Estates deal (primarily science and pharma lab and office space in California). Whatever happens, any buyer, including HCP, will be eying SRZ’s development pipeline as the goose that can lay a lot of golden eggs. Why do you think Fortress Investment Group (NYSE: FIG) paid such a high price for Holiday Retirement earlier this year?
Despite the credit crunch, both VTR and HCP have ample credit facilities for acquisitions without tapping the public markets, although according to Morgan Keegan HCP has the largest untapped borrowing capacity in place. Both companies will also benefit from what we believe to be a more conservative acquisition market for the rest of this year and into 2008, with higher cap rates and less competition from private equity firms. HCP and VTR both hit their 52-week highs on February 8, while VTR hit its low two weeks after HCP did this summer. Despite that lag, VTR has rebounded by 44% from its low on August 9, while HCP is up just 21% from its low in July. The reason why this is important is that HCP probably has more near-term upside in its share price, although we believe both will perform well once investors realize the baby, in fact, has been thrown out with the bath water.
We like HCP’s 5.9% current dividend yield, compared with 5.0% with Ventas, but we believe management at Ventas is more conservative than at HCP, which is a plus in this market. We have never had the problem with the Kindred portfolio that some (especially ratings agencies) have had, and with the new rents and the high lease coverage ratios, we still believe it gives balance to VTR. We also have some reservations about the Slough Estates acquisition and how it will perform relative to HCP’s more traditional assets. California real estate is usually looked upon favorably, but we have heard very mixed opinions about the portfolio. Both companies will have plenty of acquisition opportunities, and perhaps more than the last few years if the credit markets don’t improve soon. So if you looked at health care REIT values in the middle of the summer credit market crisis and invested, you have made out quite well. It is not, however, too late to take the plunge if you have a long-term horizon.
Unfairly punished this year, health care REITs rebounding