There’s nothing mutual fund managers like better than exploiting misperceptions in the stock market. That's what Kevin Bedell says he's doing in the market for health-care real estate investment trusts, or REITs, which own nursing homes, assisted living facilities and medical labs. “There’s a disconnect between the business these companies are in and the substantial noise out there about health care risk,” says the co-manager of the J.P. Morgan U.S. Real Estate Fund.
That risk is from recent cuts to Medicare and Medicaid reimbursements for skilled nursing facilities. These outlays declined by $3.87 billion, or 11.1 percent for 2012. The misperception is that health-care REITs rely on those reimbursements. “If you look at the largest companies in the sector, the portion of their net operating income that‘s tied to Medicare and Medicaid is 25 percent to 30 percent,” says Bedell. “The rest comes from other sources.” That’s because, of the properties that the biggest REITs own, only nursing homes usually take government money while assisted living facilities and labs are privately funded.
Moreover, even REITs with significant nursing exposure are usually just owners of the property and not the homes’ operators, which are the ones dependent on government payments. As long as the operators stay in business, their first priority is to pay their own rent, insulating the revenue streams of their REIT landlords, says Bedell. REITs typically only lease to operators whose cash flow covers their rents by at least 150 percent.
The largest health-care REITs are Ventas Inc., HCP Inc. and Health Care REIT Inc. As of May 31 Bedell had all of three in his portfolio. While he won’t discuss individual positions, other fund managers also find these stocks attractive. “These three companies have spent a long time diversifying their portfolio of properties so they get their cash flows from non-government sources,” says Reagan Pratt, manager of Aston/Harrison Street Real Estate Fund. “We like that business model.” Of the big three, Pratt favors Ventas: “We think management is very talented at Ventas and have done a very good job underwriting their portfolio of properties.”
Ventas also has a regional advantage. “If I had to choose one of the three it would be Ventas because its properties are located in higher barrier to entry markets in the northeast,” says Philip Martin, Morningstar’s director of REIT research. “Those markets have higher population densities with higher personal incomes, net worth and home values.” That provides further insulation from downturns as wealthier retirees who choose to move into an assisted living facility are less likely to encounter problems paying their rent if the economy weakens.
“Profit margins on assisted living facility residents are roughly the same regionally, but the sustainability of residents is not,” says Martin. “If you’re in Memphis, Tennessee, and your mother needs to be in assisted living, what you may do is say, ‘Let’s give it a year and then we’ll get a live-in nurse or maybe one of the family members will live with mom.’ But in wealthy parts of upstate New York, if mom needs assisted living, she won’t live with her kids. She’ll write the check and go into assisted living and stay there. That’s the difference.”
Resistance to market downturns is part of the appeal of the health-care sector. “Health care is a need-driven as opposed to want-driven industry,” says Martin. “Good market or bad market economically, if you need health care you need health care. But in retail and office REITs a lot of demand is driven by employment and the economy.” Yet because of the misperceptions about government reimbursements, the average health-care REIT had a 4.9 percent dividend yield compared to 3.5 percent for the average equity REIT as of June 30, according to trade group NAREIT. Pratt notes that the average health care REIT has a 2012 price-to-cash flow ratio of 14, while the average REIT has a ratio of 18.9.
While bellwether Ventas has an attractive 3.8 percent yield, higher payouts may be found in smaller REITs like Sabra Health Care REIT, which Pratt holds. It yields 7.4 percent, but comes with increased risk as 89 percent of its portfolio of properties is in nursing homes. “The way health care is broken out is there are three large diversified REITs and the remaining nine REITs in the sector are property-type specialists,” says Pratt. “A lot of what they are specializing is what the three are shedding -- hospitals and skilled nursing." Unless the operators of Sabra’s nursing homes go broke - and Pratt does not foresee cash flow issues that would lead to that -- he thinks Sabra's 7.4 dividend yield should be fine.
(Lewis Braham is a freelancer based in Pittsburgh.)
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