Health Care REITs

[tucker]

Dear RainFrog Partners,

The four companies in the following research are real estate investment trusts, or REITs. REITs are similar to mutual funds, but rather than investing in stocks or bonds they invest primarily in real estate.

The REITs below specialize in health care properties. All four own skilled nursing and assisted living facilities, and two, Health Care Property Investors and Health Care REIT, also own hospitals, clinics, and medical office buildings. Skilled nursing facilities offer a high degree of patient care and sometimes rehabilitative services. Residence may be short-term for post-acute care patients or long-term for patients with age-related or chronic conditions. Assisted living facilities offer less intensive care generally on a long-term basis. (One might think of them as apartments with an on-call nurse.) Many senior citizens’ housing facilities fall into this second category.

REITs do not directly provide health care services at the properties they own. Rather, REITs rent facilities to licensed third-party health care providers. By supplying quality health care facilities and expertise in property management, REITs can help to reduce the burden on providers and facilitate the delivery of medical care.

There are more than a dozen health care REITs traded publicly in the US. The companies below were selected because they offer both preferred and common shares. Preferred shares entitle holders to fixed dividend payments generally at a higher rate than common shares. All of the preferred shares below have call dates after which the issuing company can require investors to redeem the shares for some predetermined “call price.â€

[tucker]

The companies in the research below are real estate investment trusts (REITs) specializing in health care facilities. The RainFrog Income Portfolio has a standing authorization to invest in the preferred shares of several health care REITs including one of the companies covered below (Health Care REIT), and we have done so with some success in the past (see http://rainfrog.j-talk.com/bb/viewtopic.php?t=5550 for discussion surrounding the current authorization).

In general, REITs are considered to be relatively lower risk than other equity investments. Because REITs are more focused on income than growth, share price tends to respond only weakly to economic slowdowns. Of course, the companies exhibit a correspondingly small potential for share price appreciation. For example, in the last 14 years HCN has appreciated by a total of only 225%, for an average annual share price appreciation of 5.56%. This has been coupled with a mean annual dividend yield of more than 8%. However, together these have provided an attractive risk-weighted return.

REITs also differ from other equity investments in their tax structure. Unlike most publicly traded equities, REITs do not pay taxes on earnings. Instead, they pass their earnings directly through to their investors, and the investors are responsible for all taxes. Instead of being taxed at the 15% dividend rate common to most shares, investors are taxed on REIT dividends at their own marginal tax rate. For RainFrog partners in the US this rate would vary from person to person according their annual income, and for non-US citizens living outside the US tax withholding on REIT dividends would be 30%. I have assumed a 30% effective tax rate in all pricing estimates below.

Several risk factors are general to the health care REIT industry. Health care REITs share some of the risks associated with their tenants’ businesses. If the business climate in the health care industry becomes unfavorable, some tenants may face bankruptcy. The recent increase in the size and success of legal claims against independent health care providers may increase this risk. If a tenant of an REIT files for bankruptcy, the REIT may be unable to recover all or a portion of unpaid rent on the that tenant’s lease. Moreover, in the event that a tenant fails, health care REITs may find it more difficult than other property owners to find replacement tenants for their properties.

Health care REITs may be affected by changes in government reimbursement regulations for programs such as Medicare and Medicaid. State and federal governments in the US are struggling with increasing health care costs. Most US citizens agree that the current health care system is unacceptable, but there is no wide agreement on how the system should or can be fixed. While the reimbursement climate appears to be improving for many health care providers, there is no guarantee that future changes to the health care system, including changes to Medicare and Medicaid, at the state or federal level will not adversely affect health care providers. If this happens, health care providers may find it increasingly difficult to meet the terms of their leases and health care REITs may suffer.

Finally, REITs are real estate investors and as such are responsible for the environmental management of their properties. None of the companies covered below has a history of environmental violations. However, all of the companies engage in the acquisition of real estate, and each may from time to time acquire properties that require environmental remediation. In general REITs seek to avoid acquiring property with environmental liabilities and attempt to negotiate terms of acquisition under which previous owners retain liability for conditions that arose during their tenure as owners. However, if unexpected environmental liabilities are discovered and previous owners are unable to meet the requirements of environmental remediation, an REIT may incur significant remediation expenses.

Despite these risks, REITs are generally considered to be conservative investments, and investment in REITs is usually felt to be a defensive strategy. By moving capital to REITs, RainFrog would likely stabilize its portfolio and protect against a market correction or minor economic slowdown. Given the record-setting performance of the Dow Jones Industrial Index over the past few months, such redistribution might seem appealing. However, there is a potential cost. If the Dow and NASDAQ continue upward REITs are likely to underperform the wider market. Moreover, due to several years of low interest rates, REITs are trading with historically low dividend yields. If the US economy regains the strength it saw under the Clinton administration interest rates will undoubtedly rise. In this case, the mean current REIT dividend yield of 6.1% will be forced back toward the historical range of >8%, and REIT share prices will likely fall as a result.

Health Care REIT, Inc (HCN)
Recent Price: $43.03
Revenue: $355.6mil
Market Cap: $3.46bil
EPS: $1.29
Shares Outstanding: 80.5mil
P/E: 33.33
Avg. Volume: 702,692
Dividend: $2.64
Book Value: $22.53
Yield: 6.14%

Health Care REIT is the third largest health care REIT in the US, with over 600 properties in 37 states. The company’s holdings include senior care facilities, specialized nursing facilities, hospitals, clinics, and medical office buildings.

HCN has a Jaywalk consensus rating of 3.16 (down from 2.68 three months ago, note 1=strong buy, 5=strong sell), but is rated a “strong buyâ€

[tucker]

The following questions are from Craig. As he suggested, I am posting my reply publicly.

Hi Tucker

Thanks again for your further research on the REITs on this month's ballot. I understand and agree with your concern about a possible market correction. However, from what I have read, over the last few months the US property market prices have fallen a bit. Is that what you have read? Do you think it has bottomed out? If the US property market continues to trend down, will that have a significant impact on the REITs' performance?

With a possible share market correction in the future, it is hard to know where to put our money. REITs may be the best option. I guess it is either property or bonds, right? Or Japanese shares? You think property is a better alternative at the moment? Are there any Japanese REITs you know of? I think the Japanese property market has quite a bit of potential for growth.

What shares would be sell and move across to REITs? To we have sell authorisations?

Since we are thinking that a correction may be imminent, should we consider putting sell authorisations on other shares?

(feel free to answer these questions on the forum, if you think other would benefit too)

Hi Craig,

You are right about the US property market, and based on various indicators I expect it will get worse before it gets better. The section of the market hardest hit so far has been residential. Commercial property has been somewhat sheltered, but a lot of people are reasonably concerned that weakness in the housing market will spill over into the commercial market as well.

In general, a weakening housing market is bad for REITs. One might expect health care REITs to be somewhat immune to this effect, since their properties are highly specialized. Excess housing can’t simply be turned into hospitals, the health care market is relatively inelastic, and tenants of medical facilities often have no where else to go. In practice, health care REITs that invest principally in senior care facilities are often more rather than less volatile than the broader property market. If potential senior care residents can’t sell their homes at a reasonable price they often stay in their homes, and senior care units go empty. Historically REITs that specialize in hospitals or research facilities have tended to outperform the broader property market. Still, these REITs tend to track dips in the property market, although it is difficult to tell if they are responding to the property market or responding with the property market to external factors such as interest rates.

Myself, I am more concerned about interest rates than I am about the housing market. If competing interest rates rise, REIT share prices will have to go down. So far it looks like any change in US interest rates will be at a measured pace, but last week’s price action shows that investors are more than a little nervous about getting stuck in the market if rates change more suddenly.

For these reasons, I lean a little more to MPW than to the other REITs in the research. If MPW can meet its 6% growth projections, the company should be a fair buy now even if REITs return to their historical P/E of 12.5. Moreover, since the company specializes in hospitals, there is a fair argument that it could be better priced by comparison to ARE or BMR than HCP and HCN. If the market eventually decides this is the case, the stock might have some significant upside. Of course, because of its size MPW is one of the more volatile health care REITs, and this should be factored into its ability to stabilize our portfolio.

It is possible to invest in the Japanese REIT market from the US. Most of the investments that are available track the Tokyo REIT index rather than any particular fund. That makes them relatively stable, and some of the products are even insured. The disadvantage, however, is that it is very difficult o chose specific REITs in Japan from the US. Any money we put into a Japanese REIT index fund would be as likely to go to building a new Saty accessible only by car as to sustainable construction in an urban market. If we could find a particular Japanese REIT that appealed to us on sustainability grounds we might be able to invest in it through E-Trade when their foreign trading becomes available, but that seems to be running a bit behind schedule at the moment.

We have a few sell standing sell authorizations that we could exercise at any time, although most of them are rather old. In particular, I have been watching GSH and GWR. However, you are right that we might want to consider some more aggressive sell authorizations as a defensive measure. I wonder how partners would feel about a general authorization that would allow us to sell any stock that exceeds some industry-standard PEG ratio? Ideally I would rather get partners’ opinions on each potential sell, but in a potentially volatile market the ability to protect our gains might justify a “sell first, seek authorizations laterâ€