Medical Properties Trust (MPW -1.10%) stock looks particularly tempting thanks to its jumbo dividend yield of 14%. It's also an investment that I initially called the wrong way, then changed my view on after following the company for a few quarters.
Join me as I recount and explore my decision-making process with this stock, including the factors that made me change my tune and eventually decide that it's something worth selling rather than buying.
Awareness of a problem is often slow to build
Because Medical Properties Trust is a real estate investment trust (REIT) that focuses on buying and renting out hospital buildings to healthcare companies, I initially considered its business model to be sound. It's true that there will always be some demand for hospital space, and it's also true that REITs can be attractive choices for generating dividend income thanks to their rent-powered revenues. So long as the business uses leverage responsibly -- which is to say, so long as it carefully balances the amount of debt it takes on to buy new properties -- it's possible for a REIT to slowly expand while collecting rent from tenants for many decades, paying down its debts along the way.
Scrutinizing its process of taking out new debt and gradually paying it off is actually the thing that broke my investing thesis for this business, but I didn't fully understand everything all at once. Let's work through the steps that show weakness at the heart of Medical Properties Trust's business.
Obviously, sometimes tenants fail to pay their rent, which lowers the effective rate of return that a landlord gets from their properties. Plus, sometimes the costs of borrowing rise, which means that a REIT's take-home money from newly placed investments will be less than it was with older investments. And over the last year or so, those borrowing costs have risen dramatically because they're largely based on the federal funds rate, which the Federal Reserve has significantly hiked in its efforts to get inflation back under control.
For Medical Properties Trust's approach to work, there needs to be a big enough spread between the interest rates on its new debt and the annual rates of return that it makes by renting the properties it buys with that debt. If, for example, it takes out $100 million to buy a new hospital at an interest rate of 7% annually, but the annual rent it charges is only 3% of the amount it borrowed, it'll never bring in enough money to break even on the real estate -- at least not without massively hiking the rent later. And massively hiking the rent for any existing tenant would likely violate the terms of the lease's annual (small) built-in rent increases, so it can't happen. Nor are new potential tenants likely to want to pay high rents. Nor are many of the company's leases up for renewal anytime soon.
Coming to grips with the implications of these facts was what led to me changing my mind about the stock.
The debt situation is looking ugly
Eventually, I realized that as long as interest rates remain elevated, Medical Properties Trust's ability to generate returns from newly acquired properties will be weaker than it was in the past. That will generate a serious headwind pushing against its ability to break even on pretty much any investment it decides to make in the near term, which is strike one against the stability of its share price and dividend.
But climbing interest rates aren't within the company's control, and since all REITs are affected relatively equally by rate hikes, this point wasn't a deal breaker when I first figured it out.
Strike two, however, concerns an issue that was very much in management's hands, which alerted me to a more serious set of problems. Due to a large amount of borrowing activity, it engaged in during prior years, Medical Properties Trust has several massive balloon payments on its debt coming due over the next few years, including a $2.5 billion payment in 2026. The REIT will struggle to cover those payments unless it sells some of its currently rented real estate or issues new stock. Both actions would hurt shareholders, as selling property means less rental income while issuing new stock causes share dilution. And the company has already sold off several properties over the last couple of quarters.
Alarm bells about Medical Properties Trust were starting to ring urgently for me toward the end of 2022. Its share price kept falling, indicating that the market understood something about the stock that I was missing, but my perspective was getting more and more bearish.
Lessons learned
The third strike was when I encountered a passage in the 2022 annual report in which management stated that "we will likely need to refinance at least a portion of [our] debt as it matures. There is a risk that we may not be able to refinance debt maturing in 2023 and future years or that the terms of any refinancing will not be as favorable as the terms of the then-existing debt." Given that prevailing interest rates now are higher than they were previously, refinancing debt at lower rates is an implausible outcome for the time being, and likely will remain so for the next few years.
At the same time, the impact of the company selling off some of its assets in late 2022 was finally visible, and the company's top line was shrinking. I understood that REITs don't need to be revenue-growth powerhouses to be good investments, but with its other problems in full view, the path forward for Medical Properties Trust looked even more fraught than before. And at that point, I recognized that its dividend might be at risk of a cut far sooner than I had originally thought was possible.
Ultimately, I could no longer see how Medical Properties Trust's shares could be a good investment for most of the people who might be interested in buying them to capture some income from its colossal yield. The risk of its dividend getting slashed has grown, and now it looms larger than I had imagined it could become. So I've started advocating that people avoid this stock or sell it, and I doubt much would change my position anytime soon.
