THE REIT SWOON: TIME TO POUNCE?

“Price is what you pay, value is what you get”  

-Warren Buffet

If we see share prices falling on our investments and we don’t think that anything has changed with the underlying business of the companies we own, should we be terrified that our investments are shrinking, or should we be excited at the opportunity to buy more shares at a bargain price?   I wish this were just a theoretical question for debate, but anyone who owns shares in the health care REIT sector now faces just this scenario.

In general, healthcare Real Estate Investment Trusts could be described as any corporation that owns the underlying real estate involved in the delivery of healthcare or senior services. Common properties that REITs own are: assisted living communities, skilled nursing facilities (SNFs) , medical office buildings (MOBs) , Scientific Research Facilities, and even hospitals.  These corporations enjoy special tax treatment as long as they agree to pay out 80% of their earnings every year to shareholders. This means that while more standard S&P 500 corporations may buy back shares, hoard cash, or reinvest in R&D, REITS are virtual ATM machines, reliably pumping out cash dividends quarter after quarter. I have been a huge proponent of these investments for three reasons

1. It’s hard to fake cold, hard, cash payout. Most accounting frauds over the years have involved manipulation of intangible assets, hard to measure liabilities, or manufactured revenues. But REITS, which have much fewer imaginary assets and revenues, and more more tangible cash flows and financial obligations, live and die by those regular dividend payments. At some point, either the company produces the cash, or it doesn’t.  If something goes radically wrong, it’s hard to fool the shareholders because payouts would be affected.
2. REITS offer the small, passive investor the opportunity to benefit from commercial real estate ownership, without all of the hassles and drawbacks that typically come with direct ownership of properties. We don’t have to deal with maintenance issues, finding and dealing with tenants, or the daunting capital requirements that we might face if we wanted to own a MOB privately. Additionally, owners of publicly traded REITs have full liquidity; we can sell our shares at the push of a computer button, as opposed to the often lengthy and expensive sales process that we might face as direct owners of commercial real estate.
3. In the context of healthcare, REITS really occupy a special place because healthcare involves proper care, transport and storage of human beings, which will always require a certain amount of physical space. Care of patients or housing of seniors can only be digitized to a certain extent; at the end of the day, Grandma must be physically stored somewhere. Therefore, as the number of Grandmas grows, the demand for these specialized physical spaces can only grow. Try to “Amazon” that!

For many years, healthcare REITS have produced rock solid returns. For example, Ventas, a gold standard company in the senior housing business, has produced average annual returns of 14.4% over the last 20 years for a compounded total return of 1,305%. Over the last 30 years, HCP, another senior housing provider, has produced an astounding total 3,229% return!

So you can imagine my alarm to find my REITs floundering in the red of late. Over the last year, Ventas has plunged from $70 per share, to $55. HCP has slumped from $32 to $24. Welltower, another industry leader in the healthcare REIT business, has seen a melt down almost exactly the same as Ventas, from $75 to $55.  All of these wilting share prices in the face of one of the greatest bull markets in history! Maybe I should be kicking myself for not just putting everything into Netflix and calling it a day?

Not exactly. One of the tools in my analytical toolbox is the search for patterns. Finding patterns across an industry can help us understand the risks and rewards that our investments face. One slumping stock price is an outlier, two slumping stocks is a trend, and three is an obvious pattern.  Although this blog is all about healthcare, I do have some Real Estate Investment Trusts that are not healthcare, as well. and guess what? Anything with the name REIT attached to it has been hammered over the last year. The Vanguard Real Estate Sector index, a broad based index that tracks all kinds of Real Estate Investment Trusts has swooned over the last 18 months, diving from $90 per share to as low as $75.  So does this mean that not only has healthcare become a terrible real estate business, but suddenly the entire field of real estate investing in the United States has gone down the tubes?

Not by a long shot. This pattern merely indicates that Real Estate Investment Trusts, once the darling of Wall Street, have temporarily gone out of favor. When a few influential Wall Street spreadsheet jockeys decide that a certain niche, or even a certain sector, is no longer primed for short term growth, the other analysts often rush to the same conclusion like lemmings to the sea. This idea that certain business sectors may underperform for a few quarters, or even a few years, leads many short term oriented speculators to become blind to the longer term opportunity that us investors cherish. This may lead to valuable opportunities as perfectly good businesses get ignored by the Wall Street “In” crowd.

With 10,000 people per day turning 65 in the United States, and up to 25% of those people destined to live until age 95, why on earth would the shares of healthcare REITS be falling in tandem?  Here are a few reasons given by Wall Street pundits:

1. Rising interest rates make yields from REITS less attractive relative to other investment options, such as bonds. For 10 long years, beginning with the Great Recession of 2008, interest rates only fell throughout the developed world. While it used to be easy for a retiree to get a guaranteed 5% on safe government bonds, those guaranteed returns fell to 1% or less. Desperate investors turned to REITS for income in mass. Now that interest rates are finally returning to a more historical “normal” REITS once again must compete for the investment dollars of retirees and the like. This would theoretically make REIT shares worth less.
2. Just as many individual real estate investors use mortgages to buy investment properties, most commercial REITS rely on mortgages and debt to buy, hold, and expand into new properties. Over the last decade, with interest rates at record lows, this debt was exceedingly cheap. Now that interest rates are going up, the REIT’s “cost of capital” or interest it must pay on borrowed funds, will increase, which could make the whole business of real estate investing less profitable.
3. The Healthcare real estate sector, and especially senior housing, has been overbuilt. So many investors got excited about the demographics around aging in America, that they built too many senior communities, and now they struggle to fill these communities.
4. Anything involving Medicaid or Medicare is at risk of the government cutting reimbursements, harming medical providers, which in turn hurts medical landlords. As our nation’s budgetary woes increase, enormous pressure will accrue to cut entitlement programs, which could eventually filter into financial problems for healthcare landlords.

Are these points absurd? No. But do these temporary conditions invalidate the opportunity provided by millions upon millions of ageing Americans in need of long term healthcare services? Let’s go over each point and see.

1. Rising interest rates do mean more competition for REITS. It was great being the only yield game in town for many years. However, there can be no long term comparison between the compound total returns of a simple bond, which is simply a loan to be repaid at a fixed interest rate, and a good REIT investment, which represents ownership of a company that must constantly grow to survive. For example, according to the blog Engineered Portfolio, the average corporate bonds returned about 4.5% annually between 1976 and 2016. Ventas Corporation, you may remember, has returned an average of 14.4% annually over the last 20 years. Not even a close contest! Why? Ventas pays out most profits, but does not pay an annual dividend anywhere close to 14%. However, REIT investors benefit from both yield payouts, AND appreciation in share price. REIT investors also employee teams of highly talented executives to maximize shareholder return every waking moment of the day. Bond investors just don’t have the same kind of “killer instinct.”
2. Rising interest rates mean that borrowing money to buy real estate won’t be as profitable. Once again, not an unreasonable fear, but it has become popular for analysts to ignore some relevant facts. First, most large, publicly traded REITS have unparalleled access to liquid debt markets, and have used this access to secure very favorable terms at fixed, long durations. In other words, when money was dirt cheap, wise CFO’s new that the good times couldn’t last forever, and they secured long term financing at bargain basement rates. So, if interest rates spike very high for many years, REIT investment would be curtailed. However, that is not nearly the case! Today’s interest rates are rising from freakishly low rates, and most experts believe that rates will only rise to something more “normal”,  perhaps between 3 and 6%. Remember HCP’s stellar return on investment over 30 years? Somehow HCP returned 3,200% over 30 years across a wide range of interest rates. High rates, medium rates, low rates, HCP just kept minting money, year after year, decade after decade. Why should this suddenly change?
3. Healthcare demographics in America are good. So good, in fact, that too many people have run out and built properties to house seniors. We now face a glut, leading to low occupancy rates and sagging returns. In some cases, this may be true. However, often, the blue chip names in the business (Ventas, HCP, Welltower, etc) have a hammer lock on markets where property is scare and development opportunities represent torturous bureaucratic processes. In urban and semi urban markets such as Southern California, Greater New York, or Boston, developing even a 7-11 is an ordeal. Let alone specialized real estate for fragile patients. Additionally, many executive teams dedicated to healthcare real estate have realized the barriers to competition that exist in markets such as Medical Office Buildings, and allocated resources to building businesses in these markets. The best medical office buildings are often on, or very near, hospital campuses. If you think that these specialized properties in sought after locations are easy to develop, go ahead and try it. I dare you.
4. It’s true that cuts to Medicaid and Medicare constantly hang like a guillotine over most medical businesses. Fiscal pressures that our nation faces on a Federal and State level can lead to almost random cuts in reimbursements, which can create stress for healthcare providers and the landlords that serve these providers. Executive management teams are very well aware of these risks, and employ myriad tactics to manage them. There is no return without risk in business. However, we as a society cannot wish away an incapacitated grandmother who survives in a vegetative state for 10 years after a stroke. The government pencil pushers can cut whatever they want, but until we descend to the point where we are literally dumping vegatiative elderly into the street, someone must provide a roof for these folks. Thus I firmly believe that even REITS that are exposed to the whims of government payers still have an opportunity to thrive over the long term.

So now we see that there is no reason to panic regarding our long term investment in healthcare REITS. Should we sell, hold, or even buy more?   Does this swoon mean a buying opportunity?

Well, prices are certainly low in the sector, at a time that overall equity valuations are stretched, to say the least. For example, Ventas currently has a forward price to earnings ratio of just 13.26. The last time Ventas had such a low P/E was during the depths of 2009, when all global financial markets where in crises. For comparison, the forward P/E ratio for the entire S&P 500 is currently 17.35, which means that Ventas and other gold standard REITS are currently priced substantially below the market as a whole.  Faced with these numbers, an investor must ask himself…..”does the healthcare REIT sector REALLY have much worse long term prospects than Corporate America as a whole?”

Another major pro to buying healthcare REIT shares now is that, as share prices have fallen, dividend payouts have stayed the same, or even risen. This has resulted in some juicy dividend yields! The dividend yield is a metric, expressed as a percentage, that yield investors would use to compare payouts between different investments. For example, a 10 year treasury bond might currently yield 3%, while Ventas is yielding 6%.  This means that if you invested $100 in a treasury bond, you would expect to receive $3 in income every year, while you would expect to receive $6 from Ventas.

Ventas, HCP, Welltower and other well established industry giants are all currently yielding between 5 and 7%, an unheard of level of payout!  More specialized players, who have also had their share prices hammered along with everyone else, can yield between 7 % and 9%.

As recently as three years ago, you would have bought shares in the exact same companies and expected a payout of only 3% or 4%.  Now might be the time!

There is one major risk to loading up on these investments right now. An old investment expression is “Its hard to catch a falling knife.”    In other words, it’s very hard to time the market just right. We know that this entire sector is now in the bargain bin for reasons that have nothing to do with the underlying health of the businesses. However, what no one can know with certainty is if the share prices have already taken their beating, or if the spreadsheet jockeys will talk the share prices down further as interest rates continue to rise.  Neither I, nor any other financial analyst can swear to you that the blood letting is done.

However, if you like steady income, if you have a long time line, and you like bargain shopping, it’s hard to imagine quality stocks ever reaching more of a fire sale scenario than what we are currently witnessing.  

Remember, “price is what you pay, value is what you get.”  Time to get some value!