Source: Flickr / Nicholas Eckhart.
It's a scary world for investors in real estate investment trusts, which face a potentially difficult future due to the looming prospect of rising interest rates. For any stocks whose business models are reliant on debt financing within their capital structures (as REITs are), the onset of higher interest rates likely means higher interest expenses.
However, despite headwinds in the past year due to rising rates, high-quality REITs like HCP (DOC 1.21%), Health Care REIT (WELL 1.44%), and Realty Income (O 0.11%) exhibit long-term visions for their business that should appeal greatly to Foolish investors.
Stable business models
Real estate investment trusts utilize debt to purchase properties, which they then rent out. Using debt to buy property may sound scary. However, the nature of the portfolios can lead to a great deal of stability in the business.
Realty Income owns more than 3,800 properties rented under long-term leases. These properties are primarily rented to retail tenants that come from various industries such as distribution centers, health and fitness facilities, and drugstores. A unique aspect of Realty Income's business model is that it engages in "net" leases, meaning the tenant is responsible not just for paying rent every month, but also for covering the major operating expenses such as taxes, maintenance, and insurance.
HCP and Health Care REIT are both involved in acquiring and leasing health-care related properties, such as senior housing, medical facilities, and hospitals. It goes without saying that the aging population in the United States will serve them well. Tens of millions of people are in or nearing retirement, and will require lots of health care services.
For evidence of their stability, look no further than their tremendous track records of rewarding shareholders. Consider that Realty Income has paid 524 monthly dividends since 1994, and has increased its payout 75 times since then. HCP happens to be the only REIT included in the S&P 500 Dividend Aristocrats index, and recently raised its dividend for the 29th year in a row. Likewise, Health Care REIT recently paid its 171st consecutive quarterly dividend, and earlier this year raised its payout by 4%.
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The first part of the bull case for REITs like HCP, Health Care REIT, and Realty Income is that they're fairly cheap stocks, especially when compared to the broader market. Despite the rate-related worries, these businesses posted growth last year even as their share prices faltered. The end result is that they're trading at cheap multiples based on the financial metrics most important to them.
To illustrate, consider that HCP and Health Care REIT trade for 13 times and 15 times trailing funds from operations, respectively. This is a non-GAAP equivalent to earnings per share that is a better measure of a REIT's financial performance. Realty Income trades for about 17 times its trailing funds from operations, which isn't quite as cheap, but it's still a notable discount to the broader market.
High-quality REITs like HCP, Health Care REIT, and Realty Income have been sold off over the past year, mostly due to the market worrying over the prospect of higher interest rates. While this would make it difficult to refinance debt at favorable rates, each company has been around long enough to endure previous environments just like this.
Despite this worry over rising rates, it did not actually have as adverse of impact on the businesses as the market would believe, as each company was able to increase funds from operations. Plainly stated, their management teams are capable enough -- and have proven to be able -- to get in front of the rising rate environment and adjust their investment strategies accordingly.
