The Only REIT to Buy Now?

05/04/2010 11:24 am EST

Focus: REITS

Josh Peters

Editor, Morningstar DividendInvestor

Josh Peters, editor of Morningstar DividendInvestor, and analyst Jason Ren say a health care REIT offers a secure dividend, steady earnings growth, and a solid balance sheet.

Medical office buildings and senior living spaces dominate Health Care REIT’s (NYSE: HCN) stable of around 600 properties. Medical office buildings account for about 23% of revenue.

Obsolescence and tenant occupancy issues are generally mitigated by targeting offices that are near hospital campuses, or are otherwise affiliated. The company takes a similarly conservative path in senior living, which makes up around 69% of revenue. There, Health Care REIT seeks residences that offer varied levels of care, which lowers the risk of patients switching out of necessity.

All of its senior living and 85% of its medical office buildings are triple-net-leased, which means operating costs are passed on to the operators. These leases are typically signed for 10 to 15 years, with inflation-based escalators.

With so much of Health Care REIT’s bottom line riding on its top line, working with the right tenants is critical. Almost two-thirds of tenants’ revenue comes from private-pay customers rather than government reimbursement programs, which mitigates the risk posed by legislative changes.

While long-term demographics remain favorable for this firm, we’re somewhat concerned about the $600-million-plus worth of development projects that Health Care REIT will deliver through year-end. Initial returns could come in lower than expected in the current economic environment.

But with other owners delaying completion, Health Care REIT’s newer properties should be able to withstand new competition and command higher rents when the economy conclusively turns the corner.

Though Health Care REIT is paying out 85% of its funds from operations (a metric that describes a REIT’s dividend-paying capacity), the dividend has already been tried by fire. While most REITs slashed dividend payments in 2008 and 2009, a very conservative balance sheet (debt is just 40% of its properties’ value at original cost) and steady revenue should continue to support this hefty payout.

We also like its diversification: The firm’s top five tenants account for just 24% of its total investment, with no one making up more than 7%.

With rent hikes that are tied to inflation built into most of its leases, Health Care REIT has a base line cash flow growth rate of 2%–3%. Adding its construction pipeline leads us to forecast an overall dividend growth rate of 4%, though as much as 6% is possible if the firm can obtain a meaningful spread between the returns on acquisitions and its cost of capital.

With a dividend yield of 5.9% at our Dividend Buy price of $46 (where it closed Monday—Editor), we estimate an average total return profile for Health Care REIT of 10%–11% annually. We think this roughly 15% discount to our $54 fair value estimate provides adequate protection against the possibility that growth falls short of our forecasts.

This is the only real estate investment trust I would consider buying at current prices.

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