Healthcare real estate investment trust HCP, Inc. (PEAK 1.40%) had an interesting year in 2016. After getting rid of its most troubled assets, this is a new-and-improved company, consisting mainly of predictable, high-quality private-pay healthcare properties. HCP's stock didn't perform well in 2016, but here are three things that could cause HCP's next leg up.
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Interest rates could remain low
Low interest rates are good for REITs for a few reasons. Most obviously, low interest rates make it cheaper for these companies to borrow money to fund new acquisitions, which generally translates to higher profit margins.
Furthermore, low interest rates make REITs more appealing to income investors, which can result in upward pressure on the stock prices as buyers rush in. Think of it like this -- if a 10-year Treasury bond yields just 1.5%, a REIT paying 4% may seem attractive, and worth the additional risk. However, if the Treasury yield spikes to say, 3%, the added risk of the REIT may seem less worthwhile.
Finally, this upward pressure on the stock's price has the added effect of making the company's cost-of-capital lower when issuing new equity. As a simplified example, if HCP wants to issue equity to acquire a $10 million property, it would need to issue 400,000 shares if it was trading at $25. If the stock was trading for $40, it would only need to issue 250,000 shares to fund that exact same acquisition.
Right now, the Federal Reserve is projecting three interest rate hikes in 2017, and a target federal funds rate of 3% by 2020, all of which is priced into HCP's stock. If this aggressive rate-hiking doesn't happen, it could be a positive catalysts for HCP and other REIT stocks.
HCP could be successful in improving its financial condition
Now that the spin-off of QCP (NYSE: QCP) has been completed, one of HCP's main strategic priorities is to improve its balance sheet and otherwise reduce risk.
When the spin-off was announced, HCP believed it could get its net debt/EBITDA ratio down to 6.5x. Now, the company is aiming to do even better than that in 2017 and eventually reduce this to the 5.5-6.0x range. The company has similarly ambitious targets for reducing its overall leverage, as well as its fixed-charge coverage.
One major concern from a risk standpoint is HCP's reliance on its largest tenants, particularly Brookdale Senior Living, which made up 35% of HCP's revenue immediately after the split. Thanks to already-announced transactions, this will drop to 27%, and HCP plans to continue to actively seek ways to lower its dependence on its largest tenants.
The goal here is to regain the company's Baa1/BBB+ credit ratings over time (currently Baa2/BBB). If HCP is successful in doing this, it will not only lower its cost of capital, but it will increase investor confidence in HCP and open up the stock to a whole new group of investors who like higher-rated companies.
Industry growth could lead to abundant opportunities
Perhaps the biggest reason I own shares of HCP and a couple other healthcare REITs is because the aging U.S. population should produce tremendous growth in the healthcare industry over the next few decades, which will especially benefit senior housing and medical office properties -- HCP's bread-and-butter.
Image Source: HCP.
The 65-and-older population is expected to roughly double by 2050, and the 75+ and 85+ age groups are growing even faster. Not only that, but healthcare costs are increasing faster than overall inflation. Since commercial real estate derives most of its value from its ability to generate income, this could boost HCP's property values and produce growth opportunities.
The best news -- all three are likely to happen
Personally, I'd be surprised if the Fed is able to increase rates as quickly as it currently expects. And, HCP is taking the right steps to lower risk and improve its balance sheet, which should allow it to regain its previous credit ratings. Additionally, as I've written before, the growth prospects in the healthcare sector make it one of the best real estate opportunities in the market. None of this is guaranteed to happen by any means, but if all three of these things happen, HCP shareholders could have a bright future ahead.
