Top 3 healthcare REITs for 2022
Co-produced by Austin Rogers
This is the story of two sectors in healthcare real estate.
On the one hand, you have medical office buildings (“MOBs”) that have increasingly become the front line for health care as more and more inpatient, formerly inpatient, care has moved to facilities outpatient care. Due to growing demand, MOBs have been the darling of the healthcare real estate space, experiencing the greatest property value appreciation and cap rate compression. Many of the best-located properties leased to the highest quality tenants are now trading at cap rates below 5%.
For example, Physicians Real Estate Trust (DOC) recently announced a $764 million acquisition of 15 Class A MOBs at a weighted average capitalization rate of 4.9%.
On the other hand, you have almost any property geared towards seniors. Skilled nursing facilities and seniors’ housing have been aggressively built by developers across the country in preparation for the much-heralded “silver tsunami” of seniors expected to occupy these properties.
But today, especially in the wake of a pandemic that has wreaked havoc on senior housing communities, this expected massive demand for senior housing and care facilities has yet to materialize. , resulting in disappointing occupancy levels for senior housing and skilled nursing REITs. And with more and more variants of COVID continually cropping up, the option of home health care is looking increasingly enticing for seniors.
Additionally, the weakness of tenant-operators in this space, many of whom have hung by a thread thanks to government subsidies, has resulted in lower rent collections, even for operating buildings and triple net leases. . Virtually no player in this space has been spared the consequences of overbuilding and COVID-19.
The wildcard in the health mix is Medical Properties Trust (MPW), the only publicly traded institutional owner of hospitals, a real estate estate that is just beginning to be exploited by real estate investors. Most hospital real estate remains owned by the health systems occupying the space, in part due to the highly specialized nature of the buildings.
MPW, which acquires properties through sale-leaseback transactions directly with hospital operators, uses the triple net lease structure to insulate it from operational volatility and government whims. Although its tenants have significantly higher rent coverage measures, hospitals tend to trade at cap rates just as high as senior real estate in the 7-9% range.
Cap rates compressed in this sub-sector, as in most areas of commercial real estate, as the low yield environment forced investors to seek higher yields in new locations. Hospitals are one of these new territories for yield-seeking funds, and MPW has the advantage of being the first player in this space as well as the only REIT that is solely focused on it.
Despite the current state of affairs, however, the fortunes of each healthcare real estate subsector may change over time. For example, consider the long-term implications of these possibilities (and I emphasize that these are only possibilities, not necessarily predictions):
- An abundance of vacant office buildings are being redeveloped into medical practices, increasing the supply of MOBs and driving down rental rates.
- High construction costs are putting a significant brake on the already sluggish development of new retirement homes, allowing plenty of time for the steadily returning demand to catch up with supply.
- Ongoing labor shortage issues continue to plague healthcare providers, continually preventing the sector from growing as it would otherwise.
That said, let’s take a look at recent earnings releases for a quick update on three of our favorite healthcare REITs.
Universal Health Realty Income Trust (UHT): We maintain our buy rating. A relatively recent addition to HYL’s retirement portfolio, UHT is one of the few exceptions to our general rule of staying away from externally managed REITs. Decades ago, UHT was spun off from Universal Health Services (UHS) and continues to be managed by it today, but with relatively low fees and significant UHT stock management ownership. At the beginning of December, UHT increased its dividend (admittedly by only 0.7%) for the 36th consecutive year. As you can probably see, the dividend security is a higher priority for management than the timeliness of the dividend growth. In Q3, FFO per share increased by 7%, from $0.86 in Q3 2020 to $0.92 in Q3 2021, and FFO per share year-to-date increased by 10%. Moreover, the payout ratio since the beginning of the year was only 76%. Our biggest concern with UHT is debt. The 50% loan-to-value ratio, while higher than its peers, is not of concern in itself, but it is disconcerting that the bulk of UHT’s debt (83%) is in the form of funds drawn from its line of credit. While this allows the REIT to reduce the cost of debt, letters of credit are obviously not meant to be long-term financing mechanisms. We will be watching UHT’s balance sheet closely in the future to keep an eye on this.
Invest (TSX:IVQ.U) (OTCPK:MHIVF): We maintain our Buy and High Risk ratings. IVQ is a relative newcomer to the North American healthcare REIT space, having floated on the Toronto Stock Exchange in 2016 and quintupled its real estate portfolio to 102 properties since then. Approximately 60% of the properties are net leased to tenant-operators, while the remaining ~40% are operated by IVQ’s management subsidiary. The REIT has struggled a lot since the onset of COVID-19 for the same reasons as other senior housing REITs, only IVQ is also more heavily leveraged with a loan-to-value ratio of 63.5% in Q3 2021 and 65 .8% at the end of 2020. And that’s not even counting convertible debentures and preferred shares. Due to this indebtedness, IVQ sold properties this year at bargain prices in order to deleverage and resize its portfolio for the next phase of growth to come. Due to these divestitures along with lower occupancy and higher operating expenses, AFFO YTD per IVQ share this year fell approximately 42% year-on-year from $0.60 in 2020 in the first nine months to $0.35 in 2021 in the first nine months. In the third quarter, AFFO/share recorded a remarkable decline of 64% year-on-year, from $0.22 in 2020 to $0.08 in 2021. Assuming a simple AFFO of $0.45/share for the year 2021, IVQ is trading at the very cheap valuation of just over 3x AFFO. The dividend (previously an annual amount of $0.72, paid monthly) has been suspended since March 2020, leaving all the money available for recovery.
Medical Properties Trust (MPW): We maintain our Strong Buy rating. MPW finally seems to be taking its time in the sun after growing its property portfolio at a breakneck pace over the past few years. Over the past three years, the value of MPW’s real estate portfolio has increased by more than 120% as the REIT has executed significant sale-leaseback transactions on multiple continents. In the third quarter, total assets increased 8.3% year-on-year, rental income increased 25%, FFO/share increased 7.3% and normalized FFO/share guidance was raised by 5% midway through to $1.83. Adjusted The FFO/share of $0.34 (excluding linear rents) covered the dividend of $0.28 with a payout ratio of 82%, roughly in line with the AFFO payout ratio year-to-date. Even so, the upward trajectory of the MPW share price over the past few months has not been this deep and certainly didn’t seem to like the REIT’s growth trajectory. Given the 2-3% annual rent escalations in MPW’s leases, along with cross-default clauses and better rental coverage than senior housing, the market appears to be perpetually undervaluing MPW. We believe that will change as the company continues to better diversify its portfolio.
What to buy today
Since the start of the pandemic, IVQ has been absolutely crushed by the market – far worse than its peers.
Admittedly, IVQ also performed significantly worse than its peers. But the market priced all this poor performance into the stock price, now valued at around 3x AFFO.
IVQ is far from the strongest in the senior housing REIT space, but if it makes a comeback and returns to a somewhat normal valuation, the returns to shareholders would be huge. Management continues to believe that it will weather this crisis to see recovery, and perhaps it is right.
So, for investors comfortable taking on more risk and buying a stock on the TSE or OTC, IVQ seems like a very cheap way to play the senior housing recovery. It’s priced for bankruptcy but doesn’t appear to be on the verge of bankruptcy yet. Things could of course get worse with the Omicron variant, so keep in mind that IVQ is speculative.
For the most risk-averse investor, it’s hard to go wrong buying MPW on dips. The hospital REIT has amply demonstrated its ability to grow both its asset base and its bottom line over the past few years, and yet the market continues to give it the proverbial red-haired son-in-law treatment.
At 12x normalized FFO, MPW continues to look like an excellent “growth at value price” choice – especially given the dividend yield above 5%.