The real estate investment trust HCP (NYSE:HCP) has been busy restructuring its portfolio to focus less on skilled nursing and more on life sciences, and that could allow it to deliver dividend increases to investors. With interest rates rising, is it OK to include this dividend stock in income portfolios?
In this segment from The Motley Fool's Industry Focus: Healthcare podcast, host Shannon Jones and Fool.com contributor Todd Campbell explain how this REIT hopes to keep its funds from operations flowing.
A full transcript follows the video.
This video was recorded on Nov. 28, 2018.
Shannon Jones: Let's turn our attention to the two stocks I pulled out from the market. The first one is actually a type of equity that, Todd, you and I don't talk about a whole lot, but I certainly think this one has its place. That is a healthcare real estate pick, specifically a company called HCP, Inc. It is what is known as a REIT, or real estate investment trust.
Oftentimes, many of our listeners aren't familiar with what a REIT is. Just to give you an overview, traditionally, most of us, myself included, can't just go out and buy real estate at will. But what we can do is pool our resources together as investors and buy a collection of properties or real estate assets. That's exactly what REITs do. REITs also have a very special tax status, which basically requires them to pay out at least 90% of their income as dividends. If they do, they aren't taxed at the corporate level like most other businesses. The business model for an equity REIT in particular -- which is what we're talking about, not a mortgage REIT, which you certainly want to stay away from -- they buy properties, lease those properties to tenants. This provides a nice, steady stream of income, most of which is then passed to us, the shareholders.
Todd Campbell: What's really interesting about these REITs is, you look at other REITs, like mall operators, and how e-commerce is causing places like Sears to abandon stores. Those mall operators are under pressure. I'm not going to say you wouldn't have closures or high vacancy rates with healthcare REITs like this, but I think it's less likely. Healthcare is relatively inelastic to the economic cycle. If you need healthcare, you're going to go out and seek healthcare. Right now, there's a tremendous amount of money that's sloshing around in drug development and specialists, you name it, providing care to all those baby boomers. As a result, that's leading to these companies having pretty stable and high occupancy rates.
Jones: Absolutely. To put some stats behind that, right now, $1.1 trillion worth of healthcare real estate is in existence, but only 15% of this is actually REIT-owned. Compare that to commercial real estate, like you were mentioning, Todd, like retail shopping centers, malls, even hotels -- that's about 40% REIT-owned. So, I feel like the opportunity is certainly massive for healthcare REITs. You mentioned the aging baby boomer population. We know that's going to be a massive growth opportunity in the healthcare space. You also mentioned the economy. If things start to turn south, generally healthcare expenses are one of the last to go.
Also, we talked about it on last week's show with our telemedicine, telehealth show -- you see insurers and payers favoring a lot more of these off-site, lower-cost facilities. That's what a lot of these really strong REITs are going after, are these assets that are not hospital-based, but they are separate, stand-alone facilities. That's why I think healthcare REITs in particular make such a compelling investment.
HCP has been an interesting equity to follow for a number of reasons. I'd say No. 1 is that it's truly a turnaround story if there ever was one. If you go back to 2016, this particular stock was down, I want to say, almost 40% at one point. A lot of that was because of its exposure to skilled nursing facilities. Skilled nursing facilities are basically long-term care for patients who have difficulty doing regular, day-to-day activities. Back then, HCP's portfolio was heavily concentrated in these skilled nursing facilities. In 2016, it was about 26% or so.
They've actually now diversified their real estate portfolio to move away from those skilled nursing facilities. The reason is because those facilities are much more dependent on government reimbursement. Now, they are much more focused on private payers, which provides a much steadier stream of income, and also allows for a much more diversified base.
Campbell: Right. And those contracts have built-in escalators and those types of things that can help offset some of your rising costs. One of the concerns that some people have had lately is that in a rising interest rate environment, some dividend stocks look less attractive. Now, you can go out and you buy short-term bonds and get relatively competitive yields to what the S&P 500 may be yielding, especially if rates continue to climb over the course of the next year. That's made some of these higher-dividend-paying stocks more attractive. If I earn less than 2% on the S&P, why would I want to take on that risk? I can go out and I buy this short-term bond instead with lesser risk. Now, if you're talking about a much higher dividend than that, it becomes a little bit more compelling.
Jones: Absolutely. Right now, their dividend, I believe they're right at about a 5% yield, which is pretty impressive, especially for those that are looking for a steady stream of income. The shares are trading for about $29 a share. You did see in January and February of this year most REITs going back to the interest rate sensitivity. Most REITs did take a hit as the Fed has continued to raise rates. What's been interesting with HCP in particular is that they've been able to not only recover those losses but are actually doing quite well even after the tumble they took in October. At $29 a share, they're up about 40% from its lows from January and February. This really does go against conventional wisdom with REITs, where the mantra truly is, stay away when the Fed interest rates are at play.
This stock has a lot to offer in terms of long-term growth. I would also add, there were some management missteps along the way that I think got them into a portfolio that was so heavily concentrated in an area that was declining. But they've been able to spin off assets. They spun off their skilled nursing assets into a newly created REIT called QCP. They did sell a substantial amount of its Brookdale occupied properties, transitioned 35 others to new operators, and also exited several other non-core investments. Strategically, now this company is much more in line to have predictable revenue streams, now a much more diversified and focused company.
It has three core areas: senior housing, life science properties, and medical offices. Those areas that I mentioned are much less reliant on government reimbursement, but also are the core areas that you see the industry transitioning to.
Campbell: Yeah. I think those properties are increasingly valuable. Sometimes they have to be built out specifically with things like ventilation, certain ventilation, etc, etc. That creates a stickiness with the people who are renting those spaces from you.
Obviously, in in the future, you've got to keep an eye on things like what's going on with the National Institute of Health's funding budget, and how much money is going into research. You have to keep an eye on how much money is going to venture capital that's allowing some of these university researchers to spin off and create their own new businesses. Those kinds of things will play a role in determining vacancy rates in the future. But for now, like you said, this company is doing a pretty good job in getting itself back on track.
Jones: Yeah. And not only that, the balance sheet is also improving. HCP has basically been paying down a lot of its debt. Its net debt to adjusted EBITDA has dropped from 6.5X to 6X on a pro forma basis. This actually led to an improved credit rating from the S&P recently. That's freed up a lot more cash for them to go after a lot of these strategic moves and go into those more lucrative assets.
Definitely one to watch. I do think, like the other company, this will be a bumpy road ahead. We're still in a rising rate environment. The Feds are expected to raise rates in 2019 at least three more times from what I've heard. Still in a transformation phase, still has a long way to go. But I think this company is certainly one to watch.