Monday, July 9, 2007

Some REITs are better than others

I have been writing for some time now about REIT ETFs. For the last few months I have been negative on these funds due to valuation and interest rate concerns. There is, however, one corner of the REIT universe that might be worth a closer look: health care REITs.

These companies finance, own, and lease health care related and senior housing facilities including nursing facilities, assisted living facilities and hospitals. To my knowledge there isn't an ETF targeted precisely on this sector so I will describe two individual REITs that appear to be poised for a comeback.

The first company is called Ventas Inc. (VTR) The market cap is around $4B and the company is trading around $38 per share or about $10 (almost 20%) below its all-time high of $48. It is currently yielding 4.9%.

The second company is Health Care Property Investors Inc. (HCP) The market cap is over $6B, it is trading at around $30 per share or $12 (about 28%) below its all-time high of $42. It is currently yielding 5.4%. This company is a leader in the industry, with a highly diversified portfolio, effective business strategy, and investment-grade credit ratings.

Both companies have recently engaged in acquisitions with HCP acquiring Slough Estates USA for $2.9 billion (which includes 83 life science/pharmaceutical properties in California, including the campuses of the world's two largest biotech companies, Genentech and Amgen) and VTR purchasing $1.96 billion worth of assisted-living communities from Sunrise Senior Living REIT.

Both companies have solid fundamentals. With share prices falling, yields are now becoming attractive. In terms of the technical aspects, HCP is just now generating a TradeRadar BUY signal (see the chart below) and is poking its nose above the downward trend line that has been in place since early February. VTR is also generating a BUY signal but its strength is currently borderline.

BUY signal for HCP. Click for larger image.

Risks facing these companies fall into two main categories: interest rates and government. Just as other REITs have faced headwinds due to recently rising rates, these two companies have also succumbed and seen their share prices tumble. This reduction in price, however, has made the yield that much more attractive. In terms of the government, properties that have an exposure to Medicare and Medicaid, which are prone to government cuts, can face unpredictable bouts of reduced profitability. Luckily, these two companies are sufficiently diversified that this risk is less of a factor than it is for many of their competitors.

There are certain benefits to operating in this segment. Operators typically sign leases ranging from three to 20 years that hold them responsible for property operating expenses (utilities, insurance, taxes, etc.) and include annual 2%-4% rent escalators. These stipulations provide a hedge against inflation, shield the REIT from rising energy costs and enable the REITs to post high operating margins. There are "Certificate of need" laws in most states that limit construction of new hospitals and skilled nursing facilities. This has the effect of slowing the growth in supply of health care related properties and has created opportunities for health-care REITs to maintain strong pricing.

Conclusion

VTR and HCP are both sporting good dividend yields. Both are well off their highs but are currently displaying interesting charts that indicate they may be ready to turn to the upside.

Both companies, and others in this sector, will certainly benefit over the long-term as the demand for health care will continue to grow, especially in the areas of senior living and assisted living facilities where demand will be driven by the aging of the baby-boomer generation.

A list of major health care REITs (Company/Symbol/Yield):

Ventas Inc. (VTR) 4.944%
Health Care Property Investors Inc. (HCP) 5.772%
Health Care REIT, Inc. (HCN) 6.266%
Healthcare Realty Trust Inc. (HR) 5.4%
Nationwide Health Properties Inc. (NHP) 5.8%
Manor Care Inc. (HCR) 1.1%
Senior Housing Properties Trust (SNH) 6.3%

[ UPDATE ] - Since writing this post, further problems in the housing and corporate lending markets have caused the major averages to experience a serious pullback. REITS have been hard hit and the BUY signal described above has been undone. Read this post for more detail.



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