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No. of Recommendations: 45
This was posted about a month ago on SNL, for those who might possibly be interested.

The healthcare sector of the REIT industry, consisting primarily of seniors’ housing, skilled nursing facilities (SNF), medical office buildings (MOBs) and various types of hospitals and rehab centers, has been growing rapidly. According to a March 2015 Green Street Advisors report, its share of the MSCI REIT index was only 3% in 2000, but rose to 5% in 2007 and is presently about 12% , almost as large as the apartment and mall sectors of REITdom. So healthcare, while not your standard institutional property type, i.e., residential, office, retail or industrial, can no longer be ignored by REIT investors.

This size expansion has been driven, in substantial part, by the ability of healthcare REITs to grow their investment portfolios at a rapid pace; this may be credited to a relatively low cost of capital enjoyed by most REITs in this sector, along with the fragmented nature of healthcare property ownership. The “Big 3” healthcare REITs, HCP Inc (HCP), Health Care REIT (HCN) and Ventas (VTR), in particular, have become very large companies, each with in excess of $30 billion in assets. In addition, more specialized healthcare-related REITs, including Alexandria Real Estate (ARE) and BioMed Realty (BMR) (life science, i.e., drug research, properties), Omega Healthcare (OHI) (skilled nursing), and Healthcare Realty Trust (HR) and Healthcare Trust of America (HTA) (primarily MOBs), each own at least $4 billion in assets.

I have owned REITs in this property sector ever since one of the first, HCP, went public in 1985. These REITs have not only grown in size, but – more importantly – in management and capital allocation skills. The largest have become much more diversified in the types of properties they own, and much less reliant upon government reimbursement programs, i.e., Medicare and state Medicaid, so that now only SNF REITs are heavily exposed to the shifting sands of government reimbursement rates. Furthermore, the Big 3 have even ventured beyond the shores of the United States, particularly into the UK.

This property sector has long been regarded as “slower growth” relative to its non-healthcare peers, as the properties have traditionally been leased on a triple-net basis to lessee-operators, with small annual rent bumps built into long-term leases. But, commencing with the passage of the REIT Investment Diversification and Empowerment Act of 2007 (RIDEA), which allowed REITs to, among other things, participate more directly in the revenues generated at these properties, the larger REITs, in particular, have become more sensitive to the fortunes (and the risks) of seniors’ communities. Both HCN and VTR now have over 30% of their assets in RIDEA properties. Due to their heightened exposure to the ups and downs of seniors’ housing, their shares should be less interest rate-sensitive.

All that said, investors should not expect rapid internal FFO/AFFO growth from these critters. The vast majority of the assets are non-RIDEA, suggesting modest SS NOI growth; and MOBs, although an attractive property type due to their stability and low cyclicality, haven’t historically generated rapid NOI growth. But investors are at least partially compensated by ample acquisition opportunities, high earnings predictability, and the higher than average dividend yields in the healthcare sector – yields averaged 4.4% in mid-March.

An interesting phenomenon of healthcare REITs is that the stocks trade at sizable NAV premiums, and have done so for quite some time – ranging, roughly, from 10% to 30% above estimated NAV during the past 10 years. When this occurs in REITdom (and when REITs in other property sectors trade near NAVs, as they do now), it is due to either (a) perceived superior external growth prospects, or (b) investors’ belief that the properties are being undervalued in the private markets (private market values determine REIT NAV estimates). The latter is unlikely at the present time, as private market values in this space have already risen substantially; cap rates have declined to the high 5% range for most healthcare property types (SNF cap rates are substantially higher).

So investors are betting that the large public REITs can continue to create substantial shareholder value by using their attractive cost of capital to acquire. So far, they have done so – although deal pace is lumpy. Using equity priced at a 20%+ premium over NAV to buy properties, even at market prices, can do wonders to boost a REIT’s NAV. Investors just don’t want them to overpay. This model works until it doesn’t, and if these voracious critters run out of prey, it can get ugly in a hurry.

Another situation to watch is the increasing supply of new seniors’ communities that will be brought onto the market over the next few years (Green Street estimates 4% supply growth versus 2% demand growth). The 5% SS NOI growth enjoyed by the owners of these properties over the past couple of years is going to abate as quickly as Justin Bieber’s popularity, perhaps to just 2% – more rapid operating expense growth, driven by higher payroll costs, may be a contributor. If this occurs, the REITs that are heavily invested in RIDEA seniors ‘communities will have to offset reduced internal FFO/AFFO growth with even more acquisitions if they are to drive per share profit growth beyond the mid-single digits.

I continue to have confidence in this property sector over the long-term, as eventually new supply will abate (as it always does), the demographics of seniors’ housing will (thanks to the baby-boomers) become a more powerful wind at the backs of the property owners, and it will generally remain recession-resistant. For now, however, I am modestly underweight – and very selective.

I continue to really like ARE – but which is not a healthcare REIT in the traditional sense. ARE owns and develops life science properties in major research clusters, e.g., Boston, the San Francisco Bay area, New York City and San Diego. I believe it can grow FFO/AFFO in the high single-digits and, unlike most healthcare REITs, the stock trades at an NAV discount.

I also particularly like HCN, which is very well-managed and is developing close relationships with outstanding healthcare operators; hopefully, this will enable it to source acquisition deals without having to engage in value-destructive bidding contests. Finally, I remain loyal to Debbie Cafaro and her management at VTR. This team has proven to be excellent deal-makers and capital allocators, as evidenced by their recent decision to spin off their SNF portfolio into a new REIT and to acquire Ardent Health Services, a hospital owner and operator. VTR should be a core holding for REIT investors.

So, what’s the prognosis for these healthcare REITs? They are still reasonably healthy, but they may suffer a few aches and pains, like most of us when reaching a certain age, over the next couple of years. Last year their average total return, per NAREIT, was 33.3% (ahead of most other sectors), but this year (through March 15) they were modest under-performers. That’s likely to continue until – well, until it doesn’t.

Market Commentary: At their closing prices on Friday, REIT stocks were in negative territory for 2015 (-1.6%, as measured by the MSCI REIT index). I have been searching for a logical explanation for REITs’ back-sliding from their highs in late January, but have been no more successful in this endeavor than the Milwaukee Brewers have been recently. This weakness certainly isn’t due to falling property values (commercial real estate prices and REIT NAVs are still rising gently). Nor, based on the Q1 earnings reports and guidance issued during this REIT earnings season, is it due to deteriorating space market fundamentals. What can it be?

Let’s put things in perspective. Making money in today’s market has been challenging for investors in every asset class. The broader equities market hasn’t been going anywhere; at Friday’s close, the S&P was up just 2.4%. It is certainly frustrating to see REIT stocks flounder despite some very good Q1 earnings reports. But REITs are – rightly or wrongly – regarded by most as “interest rate-sensitive,” and will normally sell off, at least for a time, when bond yields rise – or are even expected to rise.

The yield on the 10-year has jumped recently, concurrently with Euro bond yields (although it’s still below last year’s closing yield of 2.17%). And we should ask ourselves why that yield isn’t closer to 3%, or 100 bps of return above inflation. So we need to understand that bond yields will be a headwind for REIT stocks from time to time, and will certainly affect short-term performance. But, if they don’t get to really crazy levels, rising bond yields won’t necessarily trash commercial real estate values or REITs’ NAVs if property NOI continues to grow nicely.

So, for now, and because I continue to pray at the Church of New Normal, I am sucking it up and deploying available cash into attractive REIT stocks. After all, even my Golden Retrievers, Riley, Kacie and Maggie, are smart enough to want to buy good merchandise when it goes on sale.
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