This REIT’s as Healthy as They Come

05/17/2011 5:30 pm EST

Focus: REITS

Josh Peters

Editor, Morningstar DividendInvestor

The Health Care REIT is one of the few that doesn’t look overpriced and its dividend, already yielding 5.6%, should grow nicely, write Josh Peters and Jason Ren of Morningstar DividendInvestor .

We remain very cautious on real estate investment trusts overall; many are now trading at ridiculously high prices. Health Care REIT (HCN) though, is not among them—and recent transactions are likely to boost dividend growth over the next few years.

Health-care real estate has its fair share of tailwinds, and Health Care REIT has a history of earning attractive returns.

Demand demographics are favorable, as Baby Boomers approach retirement age and life expectancy rises. Government also limits competitive supply in skilled nursing, benefiting key tenants.

These forces help explain why Health Care REIT’s appetite for growth remains strong. Once planned-for 2011 acquisitions and developments are completed, the company will own about $13 billion in assets, comprising 880 properties.

Triple-net leases will constitute about four-fifths of the company’s rents, and should continue to afford Health Care REIT a baseline level of stability, since the structure passes on property-level expenses to tenants. Most of its triple-net leases also contain fixed or CPI-based (inflation-indexed) rent escalators, so rents should see small, steady gains.

Health Care REIT has a clean bill of financial health. The company has long preferred to fund more than half of its real-estate acquisitions with equity, and few near-term debt maturities are on the docket.

A conservative approach toward leverage, combined with the steady revenue of its portfolio of largely triple-net leases (tenants are responsible for taxes, insurance, and maintenance), allowed Health Care REIT to be one of a handful of REITs to avoid cutting its dividend despite a fairly high payout ratio (89% of funds from operations in 2010).

The firm’s finances are clearly geared toward maximizing and preserving shareholder dividends, and the payout ratio for 2011 is likely to come down to around 85%, thanks to recent acquisitions.

Historically, dividend growth has been modest, running at or slightly below the rate of inflation with a trailing ten-year average growth rate of 2%. However, we expect Health Care REIT’s dividend growth to accelerate over the next few years, primarily as the result of changes in the firm’s mix of property types, more acquisitions and a larger book of development projects.

With inflation-driven rent bumps providing a baseline for future growth, funds from operations per share should rise at a 6% to 7% clip over the next five years. However, we also think the firm will trim its payout ratio modestly in order to fund more of its growth with internally generated resources, which results in an outlook of 4% to 5% average annual dividend increases.

While we like the stability and growth prospects for Health Care REIT’s dividend, a fair-size chunk of our $59 fair-value estimate is based on our appraisal of development and acquisition activity. Since these projects are harder to appraise than a fully stabilized portfolio, our buy price of $50 suggests a 15% discount to fair value. [Shares traded at $50.85 recently—Editor.]

At $50, the stock would offer a current yield of 5.7%—well above the 3.6% median for all the REITs we cover—while its 4%—5% yearly dividend growth potential points to average total returns of about 10% to 11% per year.

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