Co-produced with “Hidden Opportunities.”
Recently, we have been discussing the risk of a recession next year and positioning for a more defensive portfolio. We are bullish on equity real estate investment trusts (“REITs”), as physical real estate benefits from rising rents and it also provides stability.
The healthcare sector has faced headwinds in 2022 in dealing with inflation. Healthcare is a sector that tends to experience inflation quickly, especially through higher labor expenses, but it takes time for prices to be raised. These issues are improving in the second half and will continue to improve in 2023.
Historically, healthcare has been recession-resistant as demand remains stable even in difficult times. Being a landlord to healthcare operators is even more recession-resistant, as even if a particular tenant struggles, the demand for the service and medical space remains, and the tenant can be replaced.
For these reasons, we are looking at Healthcare Realty Trust Incorporated (NYSE:HR) today. Some readers might remember Healthcare Trust of America (HTA), a REIT that owns medical office buildings, or MOBs. HR did a reverse merger with HTA, and a decline in price gives the new company a 6.6% yield. This makes it an ideal time to enter this sector, collect a nice yield, have the potential for future dividend growth, and make your portfolio more defensive.
HR primarily operates MOBs and outpatient care facilities, a significant force behind convenient and affordable treatments and surgeries. Post-merger with HTA, HR has improved occupancy metrics, expedited the realization of synergies, and increased its incremental cash flows.
HR’s post-merger selloff has resulted in a materially undervalued REIT with an 11.8x forward P/FFO and a 10+ year high yield. The dividend is well-covered at a respectably low 77% payout, and HR is self-funding its development pipeline. It is time to lock in a respectable 6.6% yield from this undervalued investment-grade REIT in a recession-resistant sector.
HR owns and manages medical office buildings with a portfolio of 728 properties in 35 states. Source.
The image above shows a collection of leading healthcare provider logos in the U.S. Notably, HR maintains relationships with 57 of the top 100 health systems in the U.S., making them a significant player in the industry. 92% of HR’s properties are Medical Office Buildings (‘MOB’) and outpatient facilities.
Background On MOBs
I’d like to explain a bit about MOBs, since they form the premise of this report. MOBs are among the highest-quality property types in the healthcare space. These have been designed specifically for health care providers such as doctors, dentists, and other clinicians, and are often structured with patient waiting areas, exam rooms, and specialized building systems and materials. Over the past several years, MOBs have been better shielded from overbuilding and wage inflation when compared with labor-intensive senior housing, skilled nursing facilities, and hospitals. HR presents attractive prospects by being the largest pure-play MOB REIT.
Over 70% of HR’s properties are on or adjacent to hospital campuses. Why does this matter? Typically, on-campus and hospital-affiliated properties carry a significant rent premium. This inflates the average rents of MOBs that are close to hospitals. Source.
Cash flows from medical office buildings are known to remain secure during periods of economic slow-down, mainly where the facilities are leased to investment-grade quality health systems and physicians supplying highly demanded outpatient services. The high occupancy protects from high inflation, while proximity to hospital campuses helps offset high construction costs.
HR Merger With HTA
In July, HR announced closing its reverse merger with Healthcare Trust of America, bringing together two of the largest operators of MOBs in the U.S. The merger also resulted in the surviving entity, HR, being included in the S&P MidCap 400 Index.
Since closing the merger, HR has sold 29 properties for $922 million at an impressive 4.6% cap rate. Additionally, the combined company reported higher occupancy than the individual entities pre-merger, which is increasing the incremental cash flow by $57 million annually ($0.15 per share).
Discounted Valuation And High Yields
Amidst rising rates, HR stock has continued to sell off post-merger and is down 40% YTD. A large part of this is the bearish sentiment towards healthcare and REITs in general. Additionally, large mergers tend to put downward pressure on prices for a period as shareholders of the acquired company decide to move on, plus there are extra expenses while the company consolidates operations and determines which employees are redundant.
While past performance provides good color into how the company has navigated challenging situations, it is essential to look at the current fundamentals and prospects ahead. HR pays $0.31/share quarterly, a 6.6% annualized yield at current prices. This puts the yield in the range of the highest in 10+ years. The REIT trades at 11.8x forward P/FFO presenting a bargain at current levels.
Q3 Normalized Funds From Operation was reported to be $0.4/share, and the REIT’s Funds Available for Distribution (‘FAD’) came at $0.33. This puts the quarterly dividend at a ~77% FFO payout ratio and ~94% of FAD. This coverage is tight, but FAD should climb in the coming quarters.
A large part of near-term growth will come from inflation. Same-store NOI, which includes the impact of inflation on revenue and expenses, shows that revenue growth is outpacing the expenses that HR is responsible for. This is an advantage of leases that make the tenants responsible for expenses.
Cash NOI is increasing at a faster pace, at 2.8% in Q3, compared to 2% in Q4 2021. This should continue to accelerate as escalators are applied to rents in 2023. Additionally, the company reports that its synergies are ahead of schedule, occupancy levels are improving, and the development pipeline remains strong. This indicates that HR is well-positioned to weather challenging economic conditions and continue paying dividends to shareholders.
Balance Sheet Review
HR’s net debt carries a 4% weighted average interest rate. The REIT maintains an investment-grade rated balance sheet with a pro forma debt-to-EBITDA is 6.3x. Of its total debt, 81% carries fixed interest rates (+85%, including credit swap arrangements). Moreover, the company has limited debt maturities in the near term, providing adequate flexibility with the development pipeline and ensuring they are not forced to refinance at unfavorable rates in 2023.
Although it is not set in stone, the Q3 conference call did reveal that management is open to considering share repurchases with excess proceeds from asset dispositions. However, they mentioned that it would be a consideration alongside prospects of investing in new development.
Strong Growth Pipeline
HR’s development pipeline is quite robust. The merger with HTA brought home two active developments in Orlando and Raleigh with a combined budget of $114 million. Including HR’s original development pipeline, the company has $210 million of active development and redevelopment projects.
The development pipeline is supported by a robust business model with patient trends and preferences aligned with the MOBs and outpatient care.
A Recession-Resistant Business
It is noteworthy that COVID-19 barely changed MOB occupancy levels in the top U.S. metro cities. Healthcare, in general, is better shielded from recessions and weak economic conditions than other industries. Additionally, the sector establishes long-term contracts that delay the immediate impacts of price increases. Source.
Market Research tells us that the number of outpatient procedures will increase by an estimated 15% by 2028. Over the next ten years, surgeries are projected to grow 25% at ambulatory surgery centers and 18% at both hospital outpatient departments and physician offices. The biggest reason for this is cost.
An average gallbladder surgery costs $12,000 when done at a hospital, while the same procedure costs $2,200 at the surgery center – Kemal Erkan, chairman of the board at the American Surgery Center and CEO of United Medical
Over the past decade, minimally invasive surgical procedures have been increasingly performed at outpatient facilities. The demand for diagnostic and ultrasound services, cardiac catheterization, and spinal, bariatric, and cataract surgeries at outpatient facilities has soared. Hospitals are expanding their market share by acquiring outpatient facilities and physician practices, and they are also setting up ambulatory doctor offices on their campuses to benefit from this transition.
Patients are happy due to lower costs and shorter average visit length. Care providers are delighted because of lower complication rates in ambulatory-care services (for example – 1.2% for a total hip arthroplasty vs. 5.2% in a hospital setting). Insurance companies are happy due to all of the reasons mentioned above. This is a win-win for all parties, so it is time for us to wet our beaks from this paradigm shift.
HR is a healthcare REIT with the largest portfolio concentration in MOBs and outpatient care facilities. The merger with HTA has caused HR’s common stock to take a beating along with the broader market decline. Today, HR presents a solid, well-covered 6.6% yield in the range of the highest levels over a decade.
Outpatient care is a growing trend with strong preference from patients, care providers, and insurance companies. HR has a robust development pipeline, and the REIT’s cash flows can fund these projects. Outpatient settings offer ease, convenience, and better price point for care, making patients, insurance companies, and care providers happy with the system.
Bear markets and special situations present meaningful long-term opportunities for patient investors, and we see such a case with HR. Protect your portfolio today with this 6.6% yield from an undervalued healthcare REIT with a recession-resistant business model.
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