14 Oct Healthcare REITs: Out Of Rehab
REIT Rankings: Healthcare
In our REIT Rankings series, we analyze each of the commercial and residential real estate sectors. We analyze 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 this report every quarter with new developments.
Healthcare Real Estate Sector Overview
Within the Hoya Capital Healthcare REIT Index, we track the 17 largest healthcare REITs, which account for roughly $150 billion in market value: Welltower (WELL), Ventas (VTR), HCP Inc. (HCP), Alexandria (ARE), Omega Healthcare (OHI), Medical Properties Trust (MPW), Healthcare Trust of America (HTA), Healthcare Realty (HR), Sabra Healthcare (SBRA), National Health Investors (NHI), Physicians Realty (DOC), CareTrust (CTRE), Senior Housing Properties (SNH), LTC Properties (LTC), Universal Health Realty (UHT), Community Healthcare (CHCT), and New Senior Investment Trust (SNR).
Healthcare REITs comprise roughly 15% of the broad-based Real Estate ETFs (VNQ and IYR). Investors looking to invest in the sector through a relatively 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.
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.
There are five sub-sectors within the healthcare REIT category, and each of these sub-sectors has distinct risk/return characteristics: 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, which tend to be more sensitive to underlying industry fundamentals.
Policy-risk is an 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.
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. The Big Three have diversified away from the relatively troubled skilled nursing and hospital sub-sector in recent years, focusing instead on the private-pay senior housing, medical office, and research/lab sectors. 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.
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. While just a tiny slice of the total housing market, senior housing has been one of the few housing segments seeing ample speculative supply growth in preparation for aging boomers. 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.
Healthcare REITs have historically been a defensively-oriented sector that generally pay a high dividend yield and are used by many investors as effective “bond proxies.” As a result, healthcare REITs are among the more interest-rate-sensitive real estate sectors and tend to perform best in lower-rate economic environments.
Healthcare REITs have historically used acquisitions, funded with a favorable cost of equity relative to private market companies, to fuel accretive external growth and have produced the best average annual return out of the major REIT property sectors since the mid-1990s. 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.
Healthcare REIT Stock Performance
Following three straight years of underperformance, healthcare REITs showed signs of life in 2018, returning a positive 8% total return compared to the 4% decline in the broader REIT average. 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.
Powered by lower interest rates and a broader bid for defensive and domestic-oriented equity sectors, along with improving underlying fundamentals in the senior housing sector, healthcare REITs have continued this positive momentum through the first three quarters of 2019. Healthcare REITs are higher by roughly 27% YTD, outpacing the 25% gains from the broad-based REIT ETF (VNQ).
Senior Housing REITs also comprise roughly 3-4% of the Hoya Capital US Housing Index, the benchmark that tracks the performance of the US Housing Industry. All eight Housing Industry Sectors are higher on the year, with the Residential REIT sector matching the healthcare REIT YTD return of roughly 27%. The Housing Industry benchmark closed last week at new record-highs and has gained roughly 29% so far this year.
Leading the gains so far this year have been the small-caps with Universal Health Realty jumping 71%, Community Healthcare gaining 57%, and New Senior Investment Trust gaining 66%. The senior housing-focused “Big 3” have delivered solid gains as well, led by the 31% gain in Welltower. Senior Housing Properties remains the only healthcare REIT in negative territory this year.
Healthcare REIT Fundamental Performance
Signs of life! Fundamentals across the healthcare REIT sector have stabilized – and for the senior housing sector, even reaccelerated – following a half-decade of weakening occupancy and rent growth. In 2Q19, same-store NOI growth jumped to the strongest TTM growth rate in two years at 2.12% following years of deteriorating performance. This strong performance was led by a recovery in senior housing NOI growth following a downright dismal year of NOI metrics in 2018 due largely to a dip in occupancy, which we’ll discuss in more detail below.
While demand has been predictably steady for most sub-sectors outside of skilled nursing, relentless supply growth over the past several years (almost entirely within the senior housing and MOB sectors) has continued to pressure same-store NOI growth. The internal development pipeline from REITs themselves illustrates the boom in construction activity that began in 2014 and is expected to continue into the next decade.
As a percent of inventory, housing starts per year in the senior housing sector will have averaged 3-4% per year from 2015 through 2020, outpacing demand growth during this time. As we’ll discuss below, demographic-driven demand growth in the critical age cohorts is just now beginning to accelerate after sub-2% growth for the last decade. The pipeline reached a new record high in the last quarter at $3.37 billion. While healthcare REITs have indeed created value through development, the REITs themselves are also responsible for a significant and growing share of total development activity. Investors are hoping to see signs of receding supply growth across the category in 2019.
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. The REIT Rejuvenation – and its impacts on equity valuations – have been a jolt of adrenaline for a sector that relies on a strong cost of capital to fuel external growth.
Healthcare REITs were net buyers in 2Q19 for the first time in five quarters, buying a net $1.1 billion in assets in the first quarter alone. With the sector now trading at a 10-20% average premium to Net Asset Value, we think that the renewed cost of capital advantage enjoyed by these REITs will spur further acquisition activity through the end of the year, which will do wonders to jump-start AFFO growth. Acquisitions have historically been the key driver of AFFO growth for not only the healthcare REIT sector, but also for the broader REIT industry.
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. While M&A activity continues to be relatively quiet, we tend to see increased deal activity in REIT sectors trading at sizable NAV premiums.
Deeper Dive: Senior Housing
Coming off a downright dismal year in 2018, senior housing fundamentals have bounced back in recent quarters, consistent with our call last year in “Healthcare REITs: Demographic Boom Within Sight” that we were indeed at an inflection point in senior housing fundamentals ahead of a decade of robust demographic-driven demand. 2Q19 earnings season was generally better-than-expected, led by strength from the Big 3: HCP, VTR, and WELL.
The Big 3 reported a solid acceleration in RIDEA (operating) same-store NOI growth a bottom of -4.8% in 4Q18 to a more respectable -1.1% in 2Q19. This recovery was driven by an uptick in RevPOR and a moderating in expense growth. Portfolio cash same-store NOI grew 2.3% in 2Q19, just below the best rate of growth in two years. HCP and Welltower boosted same-store NOI growth guidance while Ventas maintained guidance.
Just-released NIC data for the third quarter of 2019 was fairly strong with an uptick in occupancy and more signs of moderating supply growth. While the Independent Living sub-sector has strengthened this year, the Assisted Living continues to see significantly elevated supply growth and near-record-low average occupancy levels. Annual rent growth decelerated to 2.7% across the senior housing sector.
For senior housing REITs, the demographic-driven demand growth is coming and it will be felt in this sub-sector long before it’s felt in the skilled nursing REITs. It’s just a matter of whether supply growth will moderate enough to let these REITs enjoy. While not quite out of the woods yet, recent data has suggested that new development is indeed cooling which should support further improvement in fundamentals into the next decade.
Deeper Dive: Skilled Nursing and Hospitals
While the outlook has brightened 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 will won’t hit this sub-sector, which caters to a much older demographic than senior housing, until closer to 2030.
Operator struggles – including bankruptcies and lease restructurings – have plagued the skilled-nursing REITs over the last half-decade. Fundamentals haven’t gotten any worse in 2019, at least, which has been enough to power the largest skilled nursing REIT, Omega Healthcare, to a strong two-year run of performance. Rent coverage and occupancy metrics reported by these REITs were fairly stable in 2Q19.
Per NIC data released last week, national SNF rent growth averaged 2.5% in 2Q19, steady with the 2.5% rate achieved last quarter. Occupancy declined 20 basis points from last quarter while annual absorption ticked up to 0.4%. 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.
Skilled nursing remains very 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 11.7% 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.
The Bullish Thesis for Healthcare REITs
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 far 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.
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. The financial health of the Boomer generation, we believe, is stronger than most presume, driven by the strong post-recession recovery in home values and strong 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 lingering and widening housing shortage across major US markets continues to put upward pressure on home values and rents. While bad news for millennials looking to enter the ownership markets, rising home values are certainly good news for the nearly 80% of individuals in the 65+ cohort that owns their home, as home equity levels continue to breach record-highs at more than $15.5 at the end of 2018. We believe that this accrued savings will be a key source of future spending power for healthcare services – including potential senior housing – among the aging Boomers.
On a more near-term perspective, the REIT Rejuvenation since the middle of last year – and its positive impacts on equity valuations – should be a jolt of adrenaline for a sector that relies on a strong cost of capital to fuel external growth. These improved capital market conditions come at a time of continued dislocations in the public-pay segments, opening opportunities for continued consolidation in the space, which we think benefits these REITs with relatively ample access to capital. Below, we outline five reasons that investors are bullish on healthcare REITs.
The Bearish Thesis for Healthcare REITs
The “aging population” investment thesis has been no secret, however. The healthcare real estate industry – especially senior housing – continues to battle an “addiction” to new supply growth, though we’ve seen a moderation in recent quarters. While private-market metrics suggest that development starts have pulled back in recent quarters as rising construction costs and weaker development yields dampen builder appetite, supply pressures will continue to linger into 2020.
The issues faced by the private-pay sectors, however, pale in comparison to the continued mess on the public-pay side. In an attempt to control rising healthcare costs, the Affordable Care Act effectively pushed more of the financial cost burden from payors (private insurers and government) onto healthcare providers (doctors, hospitals, healthcare facilities), which has pressured these sub-sectors at the higher-end of the cost spectrum.
The result has been lower reimbursement rates and lower occupancy, coming at a time when operators deal with their own issues with rising costs of care. The Trump Administration has not been much friendlier to the SNF operators and 2018 saw some major collapse at Orianna Health, Senior Care Centers, and Skyline Healthcare while major SNF REIT tenants Signature and Genesis (GEN) are in a continued fight for survival.
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.
In general, seniors have always tended to stay in their homes for as long as they physically and mentally are able to do so, but pushing that age back from 83 to 85 has significant effects on total senior housing and skilled nursing demand. 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.
Healthcare REIT Valuations
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 have been relatively few and far between over the past since 2016.
Healthcare REIT Dividend Yields
Healthcare REITs have historically been strong dividend payers and continue to rank towards the top of the REIT sector in that regard. Healthcare REITs pay an average yield of 4.2%, which is above the REIT sector average of 3.5% (Note that our REIT Average is skewed lower by our cap-weighted indexes and coverage universe which generally excludes externally-managed and small-cap REITs under $1B in market capitalization.) Healthcare REITs paying out more than 75% of their available cash flow, based on our estimates powered by the iREIT Terminal.
Dividend yields of the individual names in the healthcare REIT sector range from a low of 2.4% (Alexandria Realty) to a high of 8.0% (Sabra). Investors seeking of 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.
Healthcare REITs & Interest Rates
Healthcare REITs are among the most “bond-like” REIT sectors, meaning that these REITs are heavily influenced by movements in interest rates. The sector’s high interest rate sensitivity is a function result of longer-than-average lease terms (10-15 years for triple-net healthcare leases), high dividend yields, and lower long-term growth prospects than the REIT average.
Healthcare REIT fundamentals have gradually improved in 2019. For senior housing, the construction pipeline is finally moderating just as demand growth is accelerating. As we pointed out last quarter, we’re ready to say that last year was indeed the “bottom” of a long-term downtrend in operating performance given our outlook for demographic-driven demand growth through the 2020s.
The skilled nursing and public-pay side, however, remains troubled by lower reimbursement rates, rising cost of care, and declining occupancy and sees limited remaining upside after a solid run over the last two years. While the high-single-digit dividend yields can be enticing, we see continued demand challenges until the older 85+ population really begins to grow in the 2030s.
The financial health of the Boomer generation, we believe, is stronger than most presume, driven by the strong post-recession recovery in home values and solid outlook for future home price appreciation. Medical and communications technology, however, remains a wild-card as even small changes in penetration rates can have big impacts on fundamentals.
Rising home values and the broader housing shortage are an often-overlooked factor that will positively affect senior housing REITs as seniors tap home equity savings to pay for health services. While bad news for millennials looking to enter the ownership markets, rising home values are certainly good news for the nearly 80% of individuals in the 65+ cohort that owns their home, as home equity levels continue to breach record-highs at more than $15.5 at the end of 2018.
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Disclosure: I am/we are long VTR, WELL, HCP, 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.
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