If real estate investment trusts are in a race to generate income for investors, health care REITs are the tortoises, pitting their steady and substantial dividends against the more volatile performance of other real estate asset classes.
“Health care REITs are seen by investors as more bond-like [than mainstream REITs],” says analyst Jerry Doctrow, managing director at St. Louis-based Stifel Nicolaus & Co. “Yields are dramatically higher, usually 2% to 3% higher, than other REITs, and they tend to have slower earnings growth and are less affected by the economy.”
Dividend yield is the chief draw to health care REITs, which own hospitals, nursing homes, seniors housing or laboratory space (see sidebar page 28). The group paid out a healthy 6.34% dividend in the first 10 months of 2005 compared with 4.70% for the Equity REIT Index, according to the National Association of Real Estate Investment Trusts.
Barring a major spike or dip in interest rates, Doctrow expects health care REITs to increase funds from operations (FFO) by about 7.6% in 2006, not including the juicy dividends that characterize this group. “It's not unreasonable to expect 10% to 14% growth in this space,” he says.
While they are widely considered to be a great dividend play, health care REITs underperformed NAREIT's Equity REIT Index during the first 10 months of 2005. Total returns for the Equity REIT Index registered 7.84% vs. 2.56% for health care REITs. Even so, the group outperformed Wall Street during roughly the same period, outstripping the S&P 500's 1.6% return.
Unique risks, common challenges
Most health care REITs share a resistance to real estate cycles. Demand for retail, industrial, office and multifamily properties may rise and fall with the economy, but occupancy in health care properties is closer aligned to trends in government reimbursement for medical expenses.
How can reimbursement changes hurt the sector? When a shift in government policy cut reimbursements for nursing care in 1999, five of the nation's seven largest skilled nursing operators filed for bankruptcy, Doctrow says. “The government backed off, everybody came out of bankruptcy and the industry recovered, but that's still fresh in people's minds.”
Health care REITs aren't entirely immune from real estate cycles, either. At greatest risk is private-pay seniors housing, which is driven by the market forces of supply and demand and has fewer barriers to entry than other asset types in the health care sector.
The seniors housing market is still recovering from an oversupply created by intensive construction in the 1990s. Occupancy hit bottom at 84.5% in 2001 and had only recovered to 88.5% as recently as midyear 2005 — well below the 95% occupancy rate in 1997, according to the National Investment Center for the Seniors Housing Industry.
Cap-rate induced headaches
In a commercial real estate market awash in excess liquidity, REITs are finding themselves outbid for acquisitions by non-traditional investors willing to accept lower initial returns. Capitalization rates for medical office buildings on hospital campuses have averaged between 8% and 9% historically, but are now in the 6% to 7% range, according to Bethany Mancini, an associate vice president at Nashville-based Healthcare Realty Trust.
“There are still acquisitions to be made, but the accretions on new investments are much lower than in years past,” she says. “It's difficult to get much growth from external investments when you're not getting the capitalization rates you used to get.”
Cap rates are higher in the higher-risk seniors housing property sector, but are still well below historical averages. The stabilized portfolios of independent living properties have traded in the range of 6% to 8% recently, which is down from 8% to 10% just one or two years ago, according to Ray Braun, who is the president and CFO of Health Care REIT based in Toledo, Ohio. For assisted living, cap rates have fallen to between 6.5% and 8% vs. the previous 10% to 12%; cap rates on skilled nursing facilities now range from 8.5% to 9%, down from a 13% to 16% range.
“Exit cap rates will likely be higher due to the historically low interest rate environment of the last few years,” Braun says. “Consequently, we view investing in stabilized, long-term-care assets at these cap rates as risky.”
If interest rates rise this year, cap rates should follow suit as the buyer's cost of capital increases. But that poses a different problem: Health care REITs lose their luster when rising interest rates bring better returns from alternative investments.
Case in point: The share prices of health care REITs fell in the first quarter of 2005 when concerns about a potential rise in interest rates sent investors scurrying to the broader equities market. “Health care REITs are most attractive when the economy is declining and interest rates are flat or down,” Doctrow says. “They're less attractive when the economy is improving and interest rates are rising.”
But share prices aren't the only measure of performance. “While the stock price may not perform as well in a rising interest-rate environment, our earnings growth has been better in a rising interest rate environment because of the higher accretion, or returns, on new investments,” says Mancini of Healthcare Realty Trust.
How do health care REITs mitigate their unique risks and increase revenue? One solution is to diversify leasing or lending to a variety of operators over a wide geographic region.
Another common practice is to group properties under a single lease. Even if performance deteriorates at one facility, the tenant will keep up payments on a master lease rather than jeopardize the rest of its portfolio.
It's also a smart practice to grow revenues by building rent increases into leases. Health Care REIT's leases typically increase rent by 20 to 25 basis points each year above the initial lease yield.
Some health care REITs are stepping up construction to circumvent the difficulty of finding accretive acquisitions. Healthcare Realty Trust purchased a $130 million portfolio in the Dallas-Fort Worth area from Baylor Health Care System in 2004 and leased the acquired 20 buildings back to the seller.
In 2005, the Healthcare Realty Trust developed two new medical office buildings for lease to Baylor, and it plans to expand its relationship with that health care system through more construction in 2006.
“We invest with a long-term view,” Mancini says. “We may acquire a 20-facility portfolio at a marginally accretive cap rate, but we believe it has long-term potential for the development of new facilities.”
Analysts say health care REITs suffered in 2005 because investors feared a spike in long-term interest rates would make other investments more attractive by comparison.
Those concerns are abating, now that the Federal Reserve's measured increases in the short-term federal funds rate are showing a governing influence over the economy. In raising the fed funds rate to 4.25% on Dec. 13, the Fed described inflation expectations as “contained.”
That bodes well for health care REITs, which are more sensitive to changes in interest rates than mainstream REITs. “The general sense is that the economy is more likely to be a little slower [in 2006], with less concern about interest rates rising,” Doctrow says.
Market fundamentals are solid, with a stable supply for acute-care and nursing facilities and the more volatile supply of seniors housing, at least for the moment, experiencing rising occupancy and climbing rental rates.
In the long term, demand for health care properties should increase. Those born in the Roaring '20s, between 1918 and 1929, are adding to the number of U.S. residents above the age of 85 at the rate of about 3% each year, and increasing the demand for skilled nursing, Doctrow says.
The Baby Boomers, born between 1949 and 1964, are beginning to hit their mid-50s and will increase demand for the rest of the health care sector.
“They're not ready for a nursing home,” says Doctrow, “but they are more frequent users of hospitals and other active health care services.”
Matt Hudgins is based in Austin.
TAKING THE PULSE OF HEALTH CARE REITS
While total returns of health care equity REITs have recently paled in comparison with other property sectors, their dividend yield remains highly attractive.
|Yield||Total Return*||Dividend |
|* Total return includes stock price appreciation and reinvested dividends.|
|Source: NAREIT's REIT Watch|
Dissecting the business of health care REITs
Health care real estate investment trusts operate in a different space than mainstream REITs, so it pays for investors to learn the sector's peculiarities. At least 14 REITS focus on health care, while a few others specialize in laboratory space for life-science companies. Their assets are typically concentrated in one or two property types.
Nearly half of health care REITs own hospitals, surgery centers or medical professional buildings, also known as acute- care facilities. Most of the other REITs in this sector emphasize seniors housing, which can range from nursing homes to assisted-living communities. Life-science companies, which cater to pharmaceuticals and research rather than patient care, make up the remainder of the group.
REITs are prohibited from providing health-care services directly except in special, temporary circumstances, such as a financial workout. Most health care REITs acquire properties from an owner/operator and then lease those assets back to the seller under a long-term lease, typically for 7 to 15 years on the initial term.
Most leases require the tenant to operate, maintain and even replace the property, if necessary. Capital expenses may affect a tenant's ability to pay rent, but rarely will a REIT need to factor capital expenses into its leases.
“They are more finance companies than true building operators in most cases,” says analyst Jerry Doctrow, managing director at St. Louis-based Stifel Nicolaus & Co.
Risks vary by property type, but changes in Medicare payments or state-level Medicaid reimbursements for care to the indigent can threaten a tenant's performance. The risk is pronounced for skilled nursing centers, which receive 60% to 70% of their income from Medicaid and 20% to 25% from Medicare, according to Philip Martin, a senior vice president at Stifel Nicolaus.
A strength of the skilled nursing set is that high barriers to entry make overbuilding unlikely. States require a Certificate of Need to verify demand before a new nursing center can open. Likewise, the complicated nature of running a hospital is an effective curb against unneeded construction.
The sector with the most to fear from overbuilding is private-pay seniors housing, which is largely free from government regulation and driven more by supply and demand forces, Martin says. “With private-pay senior living, you run the risk of overbuilding and falling prey to a real estate development cycle.”
— Matt Hudgins