Real estate investment trusts, or REITs, are well known for their above-average dividend yields, but they aren't always safe. Healthcare REIT HCP (DOC -2.12%) currently pays a 5% dividend yield, but it slashed its payout last year after spinning off its skilled nursing properties into QCP (QCP).
Now that the spinoff has been complete for nearly a year and HCP's other ambitious plans have started to play out, let's revisit the question that is probably on the minds of many of the company's investors: "Is HCP's dividend safe now?"
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The current state of HCP
As of September 2017, HCP has 799 properties, most of which are senior housing, life science, or medical office properties. With an enterprise value of $23 billion, it is the third largest healthcare REIT behind Welltower and Ventas.
In addition to spinning off QCP, the company has taken several other steps to improve asset quality and reduce risk. The company has sold some of its Brookdale Senior Living properties to reduce its exposure to its largest tenant and has reduced the leveraged debt investments in its portfolio. After $3.7 billion in debt repayment, HCP has no significant debt maturities until 2019, and less leverage on its balance sheet.
As a result, HCP's top three tenants make up 38% of the portfolio, down from 54% before the spinoff, and 95% of HCP's tenant revenue sources are private-pay, one of the best ratios in the industry. HCP's credit spreads have improved, meaning the company's cost of capital has fallen.
Now that the company has pared down its portfolio to its three core property types and improved its balance sheet, HCP has begun to pursue growth opportunities. The company currently has a development and redevelopment pipeline of approximately $1 billion and has significant opportunity for further development, with about 1.8 million square feet of land entitlements.
HCP's 2016 dividend cut
After the spinoff of QCP was completed in October 2016, HCP reduced the amount of its quarterly dividend by 36%, from $0.575 to $0.37. This was the company's first dividend reduction in more than 25 years.
Now, this dividend cut did not come about because HCP was struggling, or anything of the sort. Rather, since it spun off a large portion of its properties, there were simply fewer income-generating assets left from which a dividend could be generated.
However, for HCP's shareholders, this certainly turned into an effective dividend cut. Nearly one year after the spinoff, QCP has yet to pay a single dividend, nor has the company given much clarity on its future dividend policy -- or on many other aspects of its operations.
This isn't too surprising, since QCP represents the riskiest, most distressed assets that HCP formerly held. In fact, QCP is in the process of suing its primary tenant, HCR ManorCare, to gain control of the properties because of unpaid rent. So it's understandable that there may not be a ton of money to be paid out. Even so, the overall dividend reduction has certainly been a disappointment for shareholders who had been relying on their HCP shares to generate a steady income stream.
Is the current dividend safe?
One of the best ways to determine the safety of a REIT's dividend is to look at its FFO payout ratio. Since the traditional method of calculating "earnings" isn't too effective when it comes to REITs, we look at the dividend as a percentage of funds from operations, or FFO, which takes into account real estate-specific issues such as depreciation.
A FFO payout ratio of less than 100% shows that the company is generating enough income to cover its dividend, and ideally, there will be a significant amount of cushion. I like to see REIT payout ratios in the 70%-80% range, as this generally provides a nice amount of income, while also not exhausting all of the REITs distributable income.
HCP's dividend is currently $0.37 per quarter, or $1.48 per year. During the second quarter of 2017, HCP generated adjusted FFO of $0.48, which translates to a 77% payout ratio.
In addition, the company expects adjusted FFO for the full year in the range of $1.89 to $1.95. Based on the midpoint of this range and HCP's current dividend, this means the company plans to pay out 77% of its distributable cash to shareholders. In other words, HCP could generate 23% less cash than it expects and still have enough to maintain its dividend.
What the future holds
To sum it up, the reasonable payout ratio, combined with HCP's improved asset quality and balance sheet, gives investors no reason to believe that the company's dividend is unsafe. For most of its 32-year history, HCP has made dividend increases for its shareholders a priority, and I'd be surprised if the company didn't restart its streak of dividend increases in the near future.
