IFGL - Healthcare REITs: Recovery And Relapse

2023-09-22 10:00:00 ET

Summary

• For Healthcare REITs - the physical epicenter of the pandemic - the road to recovery has remained inconsistent across its distinct sub-sectors. Senior Housing has emerged as a leader while others regress.
• For Senior Housing REITs, the long-awaited recovery is finally taking hold. Robust rent growth is being fueled by rising resident incomes from record-high Cost-of-Living-Adjustments (“COLA”) to Social Security benefits.
• Public-pay segments - Hospital and Skilled-Nursing - have seen a re-intensification of tenant operator issues amid pressure from soaring labor costs and waning government support, triggering some missed rents and lease renegotiations.
• Lab Space fundamentals have softened as a wave of supply growth hits the market just as biotech hiring slowed from robust pandemic-era levels. Oversupply conditions will persist through 2024.
• As with Lab Space, the linkage of Medical Office Building ("MOB") fundamentals with the conventional office market is largely unwarranted, given their vastly different tenant mix and 'clustering' network effects.

REIT Rankings: Healthcare

Within the Hoya Capital Healthcare REIT Index , we track all 16 healthcare REITs, which account for roughly $125 billion in market value. Healthcare REITs - which were literally "ground zero" of the COVID pandemic - will experience lasting effects - both positively and negatively - from the (hopefully) once-in-a-generation pandemic. The road to recovery has been inconsistent across its distinct sub-sectors. Senior Housing has emerged as a leader in recent quarters as the long-awaited post-pandemic occupancy recovery is finally taking hold, but other sub-sectors have regressed of late amid a combination of macro and sector-specific headwinds. Previously seen as one of the more "bond-like" REIT sectors due to the predictable nature of healthcare demand, healthcare real estate fundamentals have gradually normalized after several years of dramatic dislocations, but many REITs aren't entirely out of the woods yet as near-term headwinds persist.

The healthcare REIT sector is a compilation of five rather distinct sub-sectors, each with different risk/return characteristics, and these five sectors can be further defined along the "Private-Pay" versus "Public-Pay" delineation. The "private-pay" side is comprised of Senior Housing ("SH"), Medical Office Building ("MOB"), and Lab Space (also called Life Sciences). The senior housing sub-sector is further segmented based on lease structure: triple-net leased ("NNN") properties and senior housing operating ("SHOP") properties. The public-pay side is comprised of the Skilled Nursing ("SNF") and Hospital segments - both of which rely more directly on Medicare and Medicaid reimbursements and other government programs. Healthcare REITs across all five sub-sectors typically lease properties to tenant operators under a long-term triple-net lease structure. Reliance on these third-party tenant operators is a relatively unique feature of the healthcare sector.

For Healthcare REITs - the physical epicenter of the pandemic - the road to recovery has remained inconsistent across its distinct sub-sectors, with "private-pay" segments now showing notable improvement while "public-pay" segments have generally regressed in recent quarters. The public-pay segments - Hospital and Skilled-Nursing - have seen a re-intensification of tenant operator issues amid pressure from soaring labor costs and waning government fiscal support, triggering some missed rents and lease renegotiations. On the private-pay side, the long-awaited recovery is finally taking hold for senior housing REITs, the segment that incurred the most direct hit from the pandemic. Conditions have been more stable throughout the pandemic in the MOB segment, where nursing labor and payor issuers aren't significant considerations, but along with Lab Space, the adjacency to the battered office sector has taken a toll on sentiment and valuations.

Triple net leases are only as "safe" as the tenant's ability to pay the rent, and questions over the financial health of many operators are certainly nothing new for healthcare REITs but remain the primary source of near-term and medium-term risk. Already dealing with challenges on the labor-front before the pandemic, staffing shortages became critical issues at healthcare facilities across the care spectrum during the pandemic as intensely challenging work conditions prompted a surge in early retirements and career shifts. While the overall workforce recovered to pre-pandemic employment levels by mid-2022 and is now 5% above 2019-levels, employment in the Nursing & Residential Care category remains nearly 10% below pre-pandemic levels. Lack of competitive pay and inefficiencies in the U.S. higher education system are the most commonly cited reasons for the nursing shortage, while the later-withdrawn vaccine mandates also drove many nurses out of the field in 2021. The average pay for registered nurses rose to $37/hour by the end of 2022 - up 7% from 2021 - which was the highest wage increase since 2022.

The bifurcation in operating performance between these healthcare sub-sectors is apparent in their reported same-store Net Operating Income ("NOI") metrics - which reflects property-level performance - and Funds From Operations ("FFO") metrics - which reflects corporate-level performance. Lab Space REITs have consistently been at the top of the charts across both metrics throughout the pandemic and will have delivered cumulative FFO growth of over 25% since the end of 2019 if their full-year 2023 outlook is met. MOB REITs delivered steady performance throughout the pandemic, but these REITs' relatively elevated use of variable rate debt has taken a toll on FFO metrics this year. The other three sub-sectors have also seen volatility in FFO performance. Senior Housing REIT FFO plunged over 25% from 2019 through 2021, but the SH segment is expected to be among the fastest growers in 2023. For Skilled Nursing and Hospital REITs, after solid performance early in the pandemic, the outlook for 2023 indicates a significant FFO decline resulting from missed rents and lease renegotiations.

Skyrocketing labor costs from the reliance on third-party nursing agencies to plug staffing gaps have been the most pressing issue for this "public pay" segments, but recent data suggest that the pressures may be easing ever so slightly. According to the most recent NIC Executive Insights Survey collected in June and July, roughly 80% of skilled nursing operators reported that they were still experiencing a staffing shortage - an improvement from late 2022 when over 90% of respondents reported shortages. According to Bureau of Labor Statistics data in the JOLTS report, the number of job openings in the Health Care and Social Assistance category peaked in March at nearly 2.1 million but has declined about 23% through the most recent July report, consistent with other employment reports and industry commentary suggesting that the worst of the labor crunch is easing - potentially removing one of the more immediate headwinds on operators.

For senior housing - a sub-sector that was as beaten down as any sector during the pandemic - the long-awaited recovery is finally taking hold, and is being amended by a combination of intersecting tailwinds. Some relief on the labor-front is certainly beneficial and much-needed, but the most notable trends of late have been the record-setting rent growth. Historically, SH market rent growth has been closely linked with the Cost of Living Adjustment ("COLA") to Social Security, which increased monthly benefit payments in 2022 by 5.9% and again in 2023 by 8.7%. Following that correlation, market rent growth has accelerated significantly in recent quarters and will likely accelerate even faster in 2023. Remarkably, the total increase in COLA in 2022 and 2023 (15%) is roughly equal to the previous 12 years combined (16%). Together with the moderation in new supply growth, we expect SH fundamentals to be among the best in the REIT industry over the next several quarters.

Healthcare REIT Performance

Healthcare REITs were slammed during the early onset of the COVID pandemic and underperformed the broader Equity REIT Index for three-straight years between 2019 to 2021, but were among the better-performers in 2022 and are once again outpacing the Equity REIT Index in 2023. The Hoya Capital Healthcare REIT Index is higher by roughly 3% so far in 2023, outpacing the 5% decline this year from the market-cap-weighted Vanguard Real Estate ETF ( VNQ ). Healthcare REITs have lagged the broader Equity REIT Index over most longer-term measurement periods, however, producing average annual returns that trail the benchmark by about 3% per year since the start of 2015 and by about 4% per year since 2010.

Reversing the sub-sector performance trends from last year, senior housing REITs have been the leaders this year, led on the upside by Welltower ( WELL ), while SNF REITs Omega Healthcare ( OHI ), CareTrust ( CTRE ), and Sabra Health C are ( SBRA ) have also been among the leaders. Small-cap Diversified Health Care ( DHC ) - which plunged nearly 80% last year - has soared more than 200% this year, fueled in part by the acquisition of DHC's largest tenant - AlerisLife ( ALR ) - by ABP Acquisition, an affiliate of RMR Group, at an 85% premium to its prior close. DHC owns a 32% stake in ALR and agreed to tender its shares. Hospital operator Medical Properties ( MPW ) has been a notable laggard over the past two years - a name that has become a fiercely contested "battleground stock" after coming into the cross-hairs of short-sellers, which have focused their critique on financial health and complex relationship between MPW and its largest tenant - Steward Health Care.

Importantly, many of the larger healthcare REITs operate with some of the more well-capitalized balance sheets across the real estate sector, and ample access to capital is one of the persistent strengths of the sector, allowing for accretive external growth via acquisitions which we believe may be more plentiful over the next several years as weaker private operators get "shaken out" by the pandemic's impacts. Eight of the eighteen REITs command investment-grade bond ratings from S&P. The average healthcare REIT had a debt ratio of 35% compared to the 30% REIT sector average, and the sector trades slightly above the REIT Average based on Debt/EBITDA metrics and based on variable rate debt exposure. While most REITs have minimal variable rate debt exposure, three REITs do have variable rate debt percentages above the 10% threshold - CareTrust ( CTRE ), Universal Health ( UHT ), and Diversified Healthcare ( DHC ).

Senior Housing Fundamentals

The rebound for Senior Housing REITs this year has been driven by a strong slate of earnings reports and encouraging private-market data. As noted in our Earnings Recap, Welltower ( WELL ) boosted its full-year guidance, driven by another upward revision to its NOI expectations for its Senior Housing Operating Portfolio ("SHOP"). Benefiting from COLA increases, pricing power remains robust as well, with WELL recording record-high rent growth of 6.7% in its occupied facilities, which combined with moderating expense pressures, has driven a "meaningful improvement" in operating margins. Ventas ( VTR ) maintained its FFO and NOI guidance as strength in its SHOP assets offset underperformance in its triple-net segment resulting from ongoing operator struggles. VTR achieved same-store NOI growth of 14% across its SHOP portfolio in Q2, driven by improved occupancy rates and a record-high 6.6% increase in Revenue per occupied room ("RevPOR") growth.

Earlier this month, Welltower raised its full-year guidance once again, citing "continued strength" in its Senior Housing Operating Portfolio ("SHOP") and "robust and accretive capital deployment activity." WELL now expects full-year FFO of $3.56 at the midpoint of its range - up from its prior midpoint of $3.54 - representing a 6.1% year-over-year increase. Welltower commented that "expense growth continues to moderate, fueled by further progress on full-time employee hiring" while "favorable demand/supply conditions" have resulted in "favorable occupancy trends across all geographies." Utilizing its at-the-market equity issuance program, Welltower has been among the most active REITs on the acquisitions front in recent quarters, noting that it has completed $1.3B in transactions so far this quarter, fueled by "motivated sellers" and "minimal competition on deals" which has resulted in "increasingly attractive returns." Ventas was also in focus this month after activist investor Land & Buildings renewed its campaign for board changes in a new letter to Ventas shareholders, which hinted hints that L&B may restart a proxy fight.

The closely-watched National Investment Center ("NIC") quarterly senior housing report confirmed that senior housing owners are enjoying significant pricing power in their senior housing operating ("SHOP") portfolios. Occupancy increased nearly 1% in Q2 to 83.7%, which is up 5.9% from the pandemic occupancy low of 77.8% in the second quarter of 2021. NIC also reported that rents increased by 5.7% year-over-year in Q2, the largest increase since the record began in 2006. Also of note, NIC reported a continued slowdown in inventory growth to the lowest since 2013 - good news for senior housing REITs as supply growth had been the most persistent headwind for the senior housing sector before the pandemic. Total units under construction amounted to 4.9% of total inventory, which is the lowest seen since 2014.

Skilled Nursing & Hospital REIT Fundamentals

On the public-pay side, we've seen an intensification of tenant rent collection from struggling tenant operators. Gibbins Advisors reported earlier this year that bankruptcy filings for healthcare companies nearly doubled in 2022 compared to the prior year, which it attributes to this "COVID hangover" resulting from waning government support and higher labor costs. Medical Properties Trust ( MPW ) has been the prime example, which trimmed its full-year outlook and reported ongoing operating struggles with two of its largest tenants - Steward Health Care and Prospect Medical. MPW noted that it would contribute up to $140M as part of a $600M credit facility to Steward - its largest tenant at roughly 20% of annual revenues - as part of a private credit lending syndicate. MPW also noted that Prospect - its fourth largest tenant at 6% of revenues - paid equity in lieu of cash for its 2023 rent, an equity interest that was appraised at $655M. One of the best-performing REITs during the 2010s, MPW fell into the cross-hairs of short-sellers last year - who have raised questions over the firm's corporate governance and tenant relationships - while its business model simultaneously received flak from media outlets. The critique has landed especially hard given the industry-wide headwinds.

For Skilled Nursing REITs, strength in the senior housing segment has helped to offset some of these operator headwinds, as Omega Healthcare ( OHI ) and Sabra Health Care ( SBRA ) each reported better-than-expected results in Q2, highlighted by progress in restructurings and commentary indicating confidence in these REITs' ability to cover their dividend. NIC data showed that SNF occupancy rates recovered to 81.9% in Q2, continuing a recovery from its pandemic low of 74% in the first quarter of 2021 but still far below its pre-pandemic level of 86.6%. Rent growth accelerated 20 basis points to 4.3%, while annual inventory growth remained negative as more beds are currently being decommissioned than being built. While overall supply/demand trends appear encouraging, margins remain a concern as a recent survey by NIC found that only 20% of SNF operators anticipate that staffing challenges will improve in the next year with an increasing number of operators expecting expenses to outpace revenue growth over the coming year.

Healthcare REIT Dividend Yields

Healthcare REITs have historically been strong dividend payers and continue to rank toward the top of the REIT sector in that regard. Healthcare REITs currently pay an average dividend yield of 4.9% - well above the market-cap-weighted REIT sector average of 4.1%. While several healthcare REITs have delivered very strong dividend growth in recent years, on average, the sector has seen muted dividend growth over the past half-decade. As noted above, of the 16 names in the healthcare REIT space, 8 REITs are currently paying higher annualized dividends per share compared to full-year 2019, 2 pay the same rate, while 6 REITs pay dividends that are below that of 2019. With a payout ratio of around 70%, on average, we believe that current dividend levels for private-pay healthcare REITs are healthy and sustainable, but several of the public-pay REITs are pushing the upper limits of coverage.

Four healthcare REITs have boosted their dividend this year, including a 2.5% bump from Al exandria Real Estate ( ARE ), 2% increases from CareTrust ( CTRE ) and Community Healthcare ( CHCT ), and 1.5% increase from Universal Health ( UHT ). On the flip side, embattled hospital owner Medical Properties Trust ( MPW ) slashed its dividend by roughly 50% - one of the more significant dividend reductions across the REIT space this year. MOB REIT Healthcare Realty ( HR ) trimmed its dividend by 3% following its acquisition of Healthcare Trust of America. Dividend yields of the individual names in the healthcare REIT sector range from a low of 1.75% from Diversified Healthcare ( DHC ) to a high of 10.85% from Medical Properties ( MPW ) followed by Global Medical REIT ( GMRE ) at 9.1%.

Takeaway: Life After The Pandemic Favors Private-Pay

For Healthcare REITs - the physical epicenter of the pandemic - the road to recovery over the past three years has remained inconsistent across its distinct sub-sectors. Senior Housing has emerged as a leader in recent quarters as the long-awaited post-pandemic occupancy recovery is finally taking hold, but other sub-sectors have regressed of late amid a combination of macro and sector-specific headwinds. We reiterate our view that investors should skew their longer-term exposure toward the "private pay" sectors - senior housing, medical office, and lab space - which should more directly benefit from structural tailwinds associated with the aging population and shift towards lower-cost healthcare settings while taking a more tactical approach on the higher-yielding "public-pay" skilled-nursing and hospital sectors.

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