A Good Bet on Aging Baby Boomers

Everyone knows that the aging Baby Boomers will likely create unprecedented demand for health-care services. Yet a whole host of reasons--product recalls, patent expirations, thin drug pipelines, Medicare and Medicaid cuts, and uninsured patients--increase the risk of investing in health-care stocks. Investors seem to agree; the  Health Care Select Sector SPDR (XLV) has underperformed the S&P 500 the past three years. While we think health-care companies such as  Boston Scientific (BSX),  Johnson & Johnson (JNJ), and  Watson Pharmaceuticals  are trading at bargain-basement prices, we're sympathetic to investors' concerns about the future of the health-care sector. Volatility is high, with small changes in the industry landscape producing large swings in stock prices--shares of health-care operator  Kindred Healthcare  tumbled 25% one day in January because of a proposed Medicare rule change. How can investors gain exposure to health-care without opening themselves up to unmitigated risk?

Luckily, one such way exists. By buying shares of health-care real estate investment trusts, investors can play the aging American demographic while avoiding most of the downside associated with health-care services companies.

What's a Health-Care REIT?
Health-care REITs own hospitals, skilled nursing facilities, independent and assisted-living facilities, medical office buildings, or any type of health-care real estate. Because of federal laws, REITs cannot provide health-care services, so they hire operators such as Brookdale Senior Living (BKD) to perform these services. As a result, the actual residents of these facilities are not particularly important to the REIT; the trusts are more concerned about the quality of the operator, which helps determine the REIT's credit rating.

Health-care REITs were created in the mid-1980s when health-care services companies such as Kindred and  Universal Health Services (UHS) spun off their real estate; most REITs have since diversified their portfolios so that their parent companies account for less than half of revenue. Like other REITs, a health-care REIT must pay out at least 90% of its taxable income as dividends, making for hefty dividend yields of 4%-7%.

Health-Care REITs Are Less Risky
Several factors contribute to a health-care REIT's relatively low risk profile. For starters, the REIT's revenues are effectively guaranteed by its long-term leases. Operators sign leases ranging from three to 20 years that hold them responsible for property operating expenses (utilities, insurance, taxes, etc.) and include annual 2%-4% rent escalators. These stipulations provide a hedge against inflation and shield the REIT from rising energy costs.

The leasing structure also makes it difficult for an operator to break its lease. First, it's against the law to stop providing health-care services (as part of the license required for most facilities), and second, the REIT is in constant contact with the tenant and is aware if its financial condition deteriorates. More often than not, the REIT will simply sell the property or find a replacement tenant given the recessionproof demand for health-care real estate. Above all, the REIT still owns the property and can take the proper steps to ensure that a healthy operator is in place.

However, this scenario rarely plays out because REITs choose their operators carefully. Before signing a new tenant, a REIT meticulously reviews the operator's financial statements to ensure that cash flows comfortably cover the estimated rent payments. Some REITs, such as  Nationwide Health Properties , protect themselves further by requiring tenants to sign one lease for all the facilities they rent from the REIT. That way, the operator cannot "cherry pick" the best assets and drop the less-profitable properties when their lease expires.

Perhaps the smartest way health-care REITs reduce business risk is by lowering their exposure to Medicare and Medicaid, which are prone to government cuts. Although a REIT's rents are still protected by the terms of the lease, it can lose out on bonus rental opportunities (rents based on increases in a facility's revenue) and see the profitability of its operators decline precipitously. As a result, REITs tend to limit their ownership of hospitals and skilled nursing facilities--two property types that receive most of their revenue from Medicare and Medicaid. These government sources generally account for less than half of the income generated by a REIT's tenants, and in standout cases such as  Senior Housing Properties Trust (SNH), account for about 20% of total operator revenue. REITs prefer to own private-pay facilities such as independent and assisted living facilities that only admit patients who can afford their services. With this less price-sensitive demographic, REITs can raise rents without much problem.

By comparison, health-care providers operate in an environment littered with risk. Their main customer, the government, sets prices unilaterally and often fails to cover the costs of providing health-care in its reimbursement. Hospitals must also admit uninsured patients in order to participate in the Medicare program. Finally, the business is extremely capital intensive, with labor shortages and bad debt expense only compounding rising costs. The stringent lease terms it accepts from the REIT exacerbates these problems, and illustrates how the landlord (the REIT) comes out ahead of the tenant (the operator) in the health-care industry.

Buy the Landlord, Not the Tenant
Here's why: Net operating income margins (a REIT's measure of profitability, which is determined by subtracting property operating costs from rental revenue) are 100% because of the REIT's leases that require the operator to pay property expenses on top of monthly rent. Administrative costs are low, with employee headcount below 100 at most of these firms. Consequently, average operating margins come in at 66%-70%, compared to 8%-12% for a health-care operator.

REIT management teams have been adept at managing their portfolios. Health-care REITs have an excellent track record of investing in properties that generate returns well above their cost of capital. These firms' return on real estate assets (a REIT's version of return on invested capital) regularly reaches 13%, which towers over our REIT universe average of about 10%. Health-care REITs' immense profitability enables them to reinvest free cash flow in high-return projects, creating value for shareholders in the process.

The outlook for the sector is strong, too. High demand for health-care services and slow supply growth has created a perfect storm for health-care REITs. Certificate of need laws existing (and rigorously enforced) in most states limit the construction of new hospitals and skilled nursing facilities. Though these barriers to entry do not apply to assisted-living facilities, construction of these facilities remains relatively low.

Our Picks
Good health-care REITs are diverse in terms of geography and tenants, have a portfolio heavily weighted toward private-pay assets, possess savvy management teams with health-care and real estate experience, and maintain clean balance sheets and fully covered dividends. With this in mind, our favorite name is  Health Care Property (HCP), the largest health-care REIT by market capitalization and revenue. We think this company is a leader in the industry, setting the standard for other REITs with its highly diversified portfolio, opportunistic business strategy, and investment-grade credit ratings. Another REIT we're fond of is  Ventas (VTR). Under the direction of CEO and chairman Debra Cafaro, Ventas has evolved into a top health-care REIT with one of the highest returns on real estate assets--16% per year--in our universe. Finally, we also like  Nationwide Health Properties . We believe that it has a bright future after restructuring its leases and lowering its dividend payout ratio. In our opinion, all of these stocks are fairly valued now, but we would eagerly scoop up shares should they fall into 5-star territory.

REITs to Avoid
Our least-favorite health-care REITs tend to fall short on our criteria listed above and have sticky corporate governance issues.  Universal Health Realty (UHT) receives nearly half of its revenue (excluding joint venture revenues) from its former parent company  Universal Health Services (UHS). Complicating matters is the fact that Universal Health Realty shares its executives with Universal Health Services, creating a situation in which the tenant (UHS) is also the landlord. Another health-care REIT for which we'd require a large margin of safety before investing is  Senior Housing Properties Trust (SNH). One operator, Five Star Quality Care , is responsible for more than 60% of annualized rent. Still, we believe our risk ratings accurately reflect our concerns about these REITs, and would still consider shares if they dropped to 5-star levels.