Health care real estate investment trust HCP, Inc. (PEAK -0.86%) cut its dividend in late 2016 after more than 25 consecutive years of dividend increases. This understandably put questions about HCP's dividend stability into the minds of investors, but it's important to understand why the dividend was reduced, and what to expect going forward.

HCP's dividend "cut"

In late 2016, HCP announced that its quarterly dividend payment would be reduced from $0.575 to $0.37, a reduction of 36%. At first glance, this may seem like a big red flag for investors, since it's the first time in more than a quarter of a century that HCP slashed its payout.

Nurse helping an elderly woman in a senior housing facility.

Image source: Getty Images.

However, it's important to know the reason behind the reduction. Just before the dividend cut was announced, HCP spun off its post-acute/skilled nursing properties into a newly created REIT known as Quality Care Properties, or QCP for short (QCP).

Think of this as a similar situation to a stock split. If a stock that trades for $50 pays a $2 annual dividend, and the shares split two-for-one, they can be expected to trade for $25, and the dividend paid by each would now be $1. This is certainly a reduction, but it's not truly a dividend cut. Each share simply represents less of the company's assets, and therefore pays out less. The same logic applies here. HCP's dividend cut wasn't really a cut at all -- the shares just represent fewer properties now, so it makes sense that the dividend would be lower.

The portfolio that's left is solid

The main reason for the QCP spin-off was to get the riskiest and most unstable assets out of HCP's portfolio, with the goal of leaving a collection of stable, private-pay, healthcare properties that can generate year after year of worry-free income.

Post-spinoff, HCP's portfolio is made up of 94% private-pay assets, which is among the top ratios among healthcare REITs, and is mainly composed of senior housing, life science, and medical office properties.

Graphic of HCP's portfolio, as well as the entire healthcare real estate industry.

Image source: HCP investor presentation.

HCP feels that the higher asset quality, combined with the lower leverage that resulted from the spin-off, will result in greater financial flexibility to pursue future growth opportunities, as well as improved credit quality and lower borrowing costs.

The company feels that among its three core property types, there is an "investable universe" of about $650 billion, so there should be no shortage of safe growth opportunities going forward, especially considering the expected rise in demand for healthcare over the coming decades, brought on by the aging U.S. population.

Graphic of projected growth of U.S. senior citizen population through 2050.

Image source: HCP investor presentation.

The dividend is well-covered by HCP's earnings

HCP's $0.37 quarterly dividend translates to $1.48 per year. When it comes to dividend payout ratios, REITs are somewhat different than other stocks. First of all, with REITs, we don't use net income, or "earnings," as we would with most other stocks. Instead, it's best to look at funds from operations, or FFO, as this is a better indicator of how much money a REIT is making.

Additionally, REITs tend to pay out most of what they make to shareholders. In other words, a payout ratio of 60% of earnings would be on the high end for most other sectors, but would actually be quite low for a REIT.

Having said that, HCP generated FFO of $2.04 in 2016, after backing out the pre-spinoff earnings from QCP. Also, the company's latest quarterly report calls for 2017 adjusted FFO in the range of $1.89 to $1.95. This means that the current dividend represents just about 77% of the company's expected FFO for the year, a pretty low payout ratio as far as REITs go.

The point is that HCP is making more than enough money to cover its dividend, so the company could even absorb a substantial reduction in earnings and still maintain the current dividend.

The Foolish bottom line

Even though the recent dividend drop wasn't really a cut, it does understandably raise the question of HCP's dividend stability, both in the immediate sense and over the long run. However, it's important to realize that the reason for the cut in the first place was to get the unstable assets out of HCP's portfolio and create a stable portfolio of income-generating assets that can produce a strong dividend yield that can grow over time. While I certainly can't predict the future, as a shareholder, I'm not too worried about HCP's ability to pay its dividend, and you shouldn't be, either.

Having said that, HCP isn't a low-volatility stock, and certainly isn't without risk. There are several reasons that HCP, and/or the entire REIT sector, could fall. Therefore, while I have no worries about HCP's dividend, or its long-term performance, it's important to invest in HCP only if you have the time frame to ride out the ups and downs that will inevitably happen along the way.