Low Cost of Capital in Fragmented Health Care Real Estate Industry
TWST: Please start with a snapshot of your coverage universe.
Mr. Bernstein: I co-cover with Rob Mains. He was brought on a couple of weeks ago. Rob and I cover 10 health care REITs, six senior housing companies, as well as four skilled nursing/postacute companies. Rob also has additional coverage as well.
So we cover a broad spectrum of both real estate owners and operators on the health care side, several different subsectors within health care, and health care real estate.
TWST: What's your overall sentiment or outlook on your universe right now, and how does that differ, if at all, between the property owners versus the operators of the facilities?
Mr. Bernstein: Real estate owners are benefiting from a very low cost of capital, increased access to capital, and a still-fragmented industry’s growth opportunities, acquisition growth opportunities. However, we've been cautious on some of the valuations — maybe somewhat overcautious — thinking that maybe the economy would do a little bit better, and historically defensive health care real estate would underperform that. So we've been "underperform" on the health care REITs, notwithstanding where interest rates have gone.
And then, the senior housing operators, the fundamentals in senior housing are particularly good. If you look at the NIC MAP data, occupancy is up almost 100 basis points the last 12 months. And in the top 100 metro areas, construction is subdued. New construction starts to supply have been hovering around 1%, and absorption to supply has been hovering around 2%, and so we think the senior housing fundamentals for occupancy and rate are going to be very good. Four of the six companies in our universe in senior housing have a "buy" rating on them.
There is also a catalyst on the senior housing names, we think, for them to monetize their real estate. In the names we have "buy" rated, they have anywhere between about 25% and 40%-plus ownership of the real estate, and we think there's some upside opportunity for them to sell the real estate to a real estate investment trust or perhaps to a private investor, and there is an alternative even of a REIT OpCo split as we saw on the skilled nursing side several years ago with Sun Healthcare (SUNH) and Sabra Health Care REIT (SBRA).
On the skilled nursing side, we've remained "neutral" on all our names with a "hold" rating. The reimbursements coming up for fiscal 2013 don't have any surprises. It's obviously better than last year after our very harsh 11% cuts to Medicare reimbursement, and the stocks have performed very well as a result of that near-term moderating reimbursement risk. But longer term, we remain very cautious given what Congress is going to do, the election cycle and just the overall perception that the growth of public reimbursement of health care services needs to be curtailed over time to fix the U.S. and state budget deficits. So we remain cautious on the skilled nursing and postacute operators, but we don't see any real near-term risk in reimbursement, but it’s not a real positive picture long term either.
TWST: What kind of growth prospects do these companies have? And whether it's by property acquisitions or development or M&A, how much activity do you expect to see?
Mr. Bernstein: On the health care REIT side, these are still primarily triple-net operators, though you do, on some of the large-cap names, have senior housing operating assets under the taxable REIT subsidiary structure. Some companies like Ventas (VTR) have upward of 25% of their net operating income from senior housing operating assets, and Health Care REIT (HCN) and Senior Housing Properties Trust (SNH) have significant senior housing operating assets.
But for the most part, health care REITS are triple-net leased, and so you may get the 1.5% to perhaps 2.5% internal growth from triple-net leases. For some of the large-cap names, including HCP (HCP), Ventas and Health Care REIT, you may see internal growth of perhaps 3% to 4%. So it's modest growth internally. There remains an external acquisition opportunity.
Obviously, there is a law of large numbers. For the large-cap names, when you get to be a $15 billion or $20 billion health care REIT, it's harder to find more multi-billion-dollar portfolios as you have the last past couple of years. But the industry — senior housing, medical office — is fragmented enough that these large companies still will find acquisition opportunities. And certainly the smaller-cap names in health care REITs, they're looking at offers for more portfolio acquisitions. They're not competing with the large-cap investors, but they probably will find their fair share of acquisition opportunities as well.
On the senior housing side, you also have Fannie Mae and Freddie Mac financing for stabilized assets, so the senior housing operators also may find acquisition opportunities. In particular, one company doing that is Capital Senior Living (CSU), which we have a "buy" rating on and a $13 price target. Capital Senior Living is making a lot of these acquisitions using Fannie Mae or Freddie Mac financing for 60%, 70% of the loan-to-value, and cash for the remainder.
Essentially, they're borrowing money at 4.5% to 5%, and then buying these assets at 8% to 9% yields. So for small acquisitions, you get a very high spread between your cost of capital and the initial yield. So there are some very good acquisition opportunities for the senior housing, potentially, as well.
On the skilled nursing side, most of the operators are conserving their cash — post last October’s CMS cut, Medicare rate cuts — and focusing on their internal business rather than external business. Given a modest CMS market basket increase for fiscal 2013 offset by sequestration, our general thought is if you have a flat reimbursement environment, a good skilled nursing/postacute operator, between changes in mix and volume, probably can go ahead and increase their EBIDTAR 3% to 5%. So we would expect that the skilled nursing operators will be able to grow internally at about that rate, perhaps higher than that given their financing and operating leverage, but we don't see a lot of external opportunities for the skilled nursing operators. We don't necessarily see them having the financial capability to make a lot of external acquisitions in skilled nursing or postacute.
TWST: So the health care REITs have the best access to capital right now?
Mr. Bernstein: Absolutely, the health care REITs have the best access to capital. Their access is, as I mentioned, both Fannie Mae/Freddie Mac financing and secured financing, but their preferred financing is going to be in the public markets, equity and debt issuance. We've seen a fair amount of equity issuance and debt issuance this year from the health care REITs to fund their acquisitions, but also to prepare their balance sheets for additional acquisitions that we think will happen in the second half of the year and into 2013.
If you look at the unsecured debt, for the mainly investment-grade companies, it is sub-4%; for the large-cap REITs, it's near 3%; and for some of the skilled-nursing-focused operators in lower-quality health care REITs, it may be 6% or so — but that's still a very low cost of capital compared to what it has historically been.
Again on the senior housing side, it's mainly Fannie Mae and Freddie Mac financing, and internal cash flow. On the skilled nursing side, you do have access to HUD financing for skilled nursing facilities, that is a route they can take. We don't see a lot of public market debt or equity issuances likely for the skilled nursing or post-acute operators.
TWST: What are your thoughts on the recent Supreme Court decision? How does it stand to impact the companies you cover?
Mr. Bernstein: There has been a lot of speculation that the Supreme Court ruling will help health care REITs. There's some chatter about that, but I think in reality these companies will not be driven by those major changes. They have to be aware of the changes happening to the health care delivery system when they make acquisitions, when they think about the underwriting of the facilities. But the primary driver here is they’re triple-net leased assets, typically with very good lease coverage, and the Affordable Care Act is not likely to impact the rents, up or down, being paid to the health care REITs in these, again, long-term, triple-net contracts.
For senior housing, that's mainly private-pay revenue sources, individuals paying the monthly rent similar to multifamily housing, so I don't see a major change to senior housing fundamentals based on the Affordable Care Act. In the end, the health care REITS are going to be driven by cost of capital and lease coverage on their triple-net leases.
For senior housing operators, it's mainly the same story. The exception is Brookdale Senior Living (BKD), which is "buy" rated; about 20% of their income comes from Medicare or public-pay sources, and so anything that influences Medicare reimbursement, public reimbursement, potentially can hurt or benefit Brookdale. But the reimbursement for home health and for therapy, that's mainly set by CMS each year at the end of July, so I don't see a major impact from the Affordable Care Act near term on those companies.
Although, with changes that we're seeing in the health care delivery system — particularly, pay for quality, penalties to hospitals for rehospitalization, accountable care organizations — there are opportunities perhaps for some senior housing operators like Brookdale and postacute operators like Ensign (ENSG), Skilled (SKH), Genesis, HCR ManorCare and Kindred (KND), to gain some additional market share as they build relationships with hospitals to help those hospitals reduce their readmission rates. But again, it's hard to see the actual direct benefit to these operators and to the REITs from the Supreme Court ruling.
TWST: What are you top stock picks right now?
Mr. Bernstein: Right now, our top pick on the health care REIT side is Sabra Health Care REIT. Sabra was created from the split of the property from the operator at Sun Healthcare in late 2010. We like the company. There is some risk affiliated with the company. About 70% of the NOI is with one tenant, currently Sun Healthcare, which, if the acquisition of the company by Genesis is completed, will become Genesis. But as Sabra diversifies its tenant mix away from Sun, and also potentially later on, maybe a year or two out, begins to diversify away from postacute/skilled nursing and into senior housing, as their cost of capital comes down, we think there's potential for Sabra's multiple to increase from where it is today.
If you look out on a 2013 FAD basis, they trade at 9.5 times. Maybe the closest comparable, though larger cap, is Omega Healthcare (OHI). Omega trades at over 12 times 2013 FAD. So we think there's some room for multiple expansion as they diversify the portfolio.
On the large-cap side, we continue to like HCP, which is "buy" rated at a $49 target. We like HCP for mainly defensive reasons at this point. They're primarily triple-net leases set-rate growth, very little exposure to the economy, very little exposure to government reimbursement at this point, direct reimbursement given their lease coverages.
We expect the dividend to continue to grow at HCP. We're predicting a FAD growth rate at HCP at almost 11% this year, and I think the dividend will grow probably in the midsingle digits for them as well.
TWST: Are there any other important trends, whether it's from the real estate perspective or the health care industry perspective, to discuss?
Mr. Bernstein: I think with the cost of capital decreasing — mainly because of the decrease in the 10-year Treasury — particularly for large portfolios of high-quality senior housing and medical office. We are continuing to see and expect further cap rate compression, perhaps 25 to 50 basis points of compression from the acquisition rates that we saw some of the large caps make last year. The increasing real estate value is, I think, an indicator of potential for increased stock prices in the health care REIT sector.
The other interesting trend I think worth mentioning is the lack of construction in senior housing. As I mentioned earlier, for the top 100 metro areas, according to NIC MAP, new starts are hovering around 1% of supply. That should provide a good backdrop for good senior housing fundamentals. There may be demand for senior housing construction, but senior housing construction lending is still constrained, and that again should create a good supply/demand balance for senior housing.
On the medical office side, one place the Affordable Care Act could influence is perhaps the need for increased medical office facilities on or near campus. If you see any constraints on physician reimbursement, that may drive a continued consolidation of physicians to affiliate with hospitals, and the need for those hospitals to have modernized medical office facilities for those physicians.
We also continue to see a trend in health care toward more outpatient services, where surgery procedures can be done more in the office than in a hospital. So we see a need for both more space for physicians on or near campus, and then also for more modernized facilities where you can do more outpatient surgery. So there may be some demand for medical office development over the next five to 10 years. It won't be a huge spurt, but slowly over time, I think you'll see some more demand for MOBs, and then, maybe an opportunity for the health care REITs to either directly fund the development or actually develop the assets themselves.
TWST: In the next round of quarterly earnings calls, what you will be looking for or paying attention to the most?
Mr. Bernstein: For the health care REITs, it continues to be a question of what acquisition opportunities are out there and at what price, especially for the large caps. For the smaller caps, we think the industry is fragmented enough that the small-cap names will probably find their acquisitions, but their pipeline will also be of importance.
In senior housing, we'll be watching both construction trends and the overall occupancy rate trends. We don't see any wage pressure, but we'll ask about wage pressure given that's the largest expense at the senior housing names. Senior housing fundamentals will also be applicable to the large-cap health care REITs, except perhaps HCP, where there are significant holdings of senior housing operating assets.
On the skilled nursing side, we continue to watch the mitigation progress from last year's CMS Medicare rate cuts. That had been progressing very well in the fourth quarter and first quarter of this year, and we certainly expect continued good mitigation from both the revenue and expense sides of the postacute operators.
We also are watching some consolidation trends in the skilled nursing space and postacute space, with the announced acquisition of Sun Healthcare by Genesis. You wonder whether that will spur additional consolidation in the industry. One thing to keep in mind is that that is a merger between two companies that have primarily leased assets, so it's a merger based on economies of scale, and not necessarily a real estate value proposition.
It will be interesting to see if operators who are performing well and have real estate value, will they be inclined to also look for consolidation opportunities? At this point, we don't think there is an imminent wide-scale industry consolidation about to happen, but there are certainly some smaller operators and regional operators who probably are looking for additional scale. And probably some operators who did not mitigate well and may be acquisition opportunities; perhaps, not the public companies that we see, but there's likely to be somebody who needs to sell the company at this point.
TWST: Is there anything else you would like to discuss?
Mr. Bernstein: I think the one other really interesting item is that although we are effectively "neutral" with our ratings, when you look at the historical valuations and valuations relative to NAV — which, especially on a price to FAD basis or an NAV basis, the dedicated real estate investors might look at — health care REITs are going to look overvalued. However, when you look at a number of metrics based on interest rate spread, such as dividend yield to interest rates or implied yield of the portfolio to interest rates, health care REITS still look like there's some room for them to increase in value.
For example, if we look at HCP, since 2005 their historical spread has been about 2.8%. The current spread is 3.6%. Whenever that implied yield to Treasuries is trading wider than historical values, there may still be some room in these stocks to move higher. And across the health care spectrum that is, for the most part the case, that they are not trading expensive relative to interest rates. So as the 10-year Treasury continues to march down, health care REITs with their high dividends and good dividend growth may continue to be a beneficiary as stock prices could go higher.
TWST: The dividend is definitely one of the appeals of REITs in general, no?
Mr. Bernstein: Absolutely, I think even more so for the health care REITs than perhaps other sectors, given the size of the dividend yields.
TWST: Thank you. (MN)
Note: Opinions and recommendations are as of 07/09/12.
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