Real Estate & REITs

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By Reitnut
April 22, 2002

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What I am about to write may not be a popular topic, given my perception that many posters and lurkers on this Board are heavily into the healthcare REITs. But, as this is an educational forum, I decided to risk the wrath of many.

This past week Green Street Advisors published a report on the healthcare REITs. The firm noted the reasons for the stocks' incredibly good performance in '01 and '02, which include stronger tenants at the skilled nursing facilities (SNFs) due to improved reimbursement rates under Medicare, the low valuations at the end of 2000, the prospects of a strong acquisition environment with yields upwards of 13%, the recession-resistant nature of the sector, the prospects of the end to overbuilding in the assisted-living (ALF) sector, fewer problems with labor shortages (due to the recession and rising unemployment) and low P/AFFO multiples. Indeed, Green Street issued a bullish report on the healthcare sector back in 2001.

However, the firm now feels that investors are ignoring some significant risks that lie ahead. These include: the high operating leverage of the lessees and the possible effects thereon of a cutback in Medicare reimbursement in October 2002, the sensitivity of Medicaid reimbursement to the economic cycle (i.e., states, which must balance their budgets, are the primary revenues sources for SNF operators via Medicaid payments), the prospects of lower coverage ratios of the operator-lessees affecting REIT valuations, the deterioration of prospective returns from acquisitions (which are coming in at 10.5% to 11.5% rather than the 13%+ anticipated not long ago), and P/AFFO multiples that appear "too high" in the context of the still meaningful risks associated with this sector and the relatively low long-term growth rates vis-�-vis the other real estate sectors (i.e., 3.9% vs. 7.2%, per Green Street's estimates).

The firm believes that the implied cap rates of the assets of the healthcare REITs, based on current stock market prices, are in the neighborhood of 8.6 � 9.0%, whereas the cap rates on the assets owned by these REITs tend to be in the 10.0 � 10.6% area. This, of course, implies that they are trading at significant NAV premiums (yeah, we're back to that issue). Indeed, the range of NAV premiums for HCP, NHP and HCN, per Green Street, is 16-22%, compared to its REIT industry average of 12% as of last Wednesday. That said, Green Street does NOT try to apply its standard NAV analysis to healthcare REITs. In any event, the firm recommends an underweighting of this sector on the basis of current relative valuations.

What should all this mean to REIT investors? I suppose it depends upon one's performance orientation, time horizon and need/desire for current yield. Those who are investing in the healthcare REITs primarily for yield, where performance is a very secondary consideration, will probably be safe to ignore Green Street's suggestions � but to focus closely on the health of the industry and its operator-lessees. And, of course, Green Street may be entirely wrong in their analysis.

Personally, I was very late to the healthcare party, and was never able to buy enough when I did jump in due to what I thought were insufficiently attractive prices. I was hoping for lower prices to add to our positions, but haven't yet seen what I consider to be really good bargains. But what do I know? These stocks have performed much better than most of my holdings in recent months. Is this due to their yields, which have been a primary driver of REIT stock performance during the past 18 months? Or is it due to their attractiveness vs. other sectors in a very tough economy? Anyway, I'm passing this information along only for what it might be worth (perhaps something, perhaps nothing).


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