2023-06-14 10:39:10 ET
Summary
- CareTrust REIT is currently trading at a 5.8% dividend yield while maintaining a very conservative 76% payout ratio.
- Rent coverage of the tenants is exceptionally high with occupancy steadily increasing.
- Long escalator-based leases provide good financial stability.
- Low debt leverage and interest payments increase safety and leave room for future investments.
- The fair value of the stock indicates 20% upside potential.
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Investment thesis
Many dividend income investors consider REITs as a crucial cornerstone of their portfolio. Healthcare REITs are often viewed as attractive opportunities due to forecasted increases in demand as a result of ageing demographics - the so-called Silver Tsunami . Furthermore, REITs operating in the healthcare industry pay above average dividends compared to their peers from other industries while having rather well-capitalized balance sheets . But while the hard hit the sector took during Covid-19 might offer some strong rebounds and short-term growth, many investors fear that healthcare REITs could actually experience problems to recover from occupancy declines and shrinking rent coverage of their tenants. Especially Omega Healthcare Investors ( OHI ) and Medical Properties Trust ( MPW )- two REITs that are very popular due to very high dividend yields - face growing pressures of shrinking rent coverage and relatively high debt-levels. Increasing concern has been voiced whether dividend cuts might be a result, discouraging many investors from buying. This concern is perhaps not true for CareTrust REIT ( CTRE ). While the dividend yield of CareTrust REIT of 5.8% looks less spectacular, the dividend safety and growth potential appears significantly higher than for its struggling peers due to: i) continuous business growth and expansion, ii) low payout ratios, iii) a solid balance sheet and iv) financially healthy tenants. In my view, this makes CTRE one of the safest healthcare REITs and more than compensates for the lower dividend yield, especially for risk-averse investors looking the buy into the industry.
Company overview
CareTrust REIT is one of the smaller healthcare REITs covered on this website with a market cap of just below $2 billion. CTRE operates 153 skilled nursing facilities, 24 multi-service campuses and 28 seniors housing facilities totaling 21,833 operating beds/units across 24 states in the US. Like for most healthcare REITs that took a hit due to COVID-19, CTRE sees resident occupancy improving gradually again. Since 2014 CTRE has been steadily investing in new facilities seeing its operating units/beds grow from 10,053 to 28,748 with the initial yield - calculated from the initial rent - consistently around 9% (with the exception of 2021).
CTREs business expansion (Author's own calculation based on latest quarterly report)
In the first months of 2023 alone 564 new operating bed/units have been added with an average initial yield of 9.5% indicating that the robust growth and lucrative expansion of CTRE is still well intact.
Key metrics and comparison with peers
Tenant structure and rent coverage
A downside to CTRE's tenant portfolio is a lack of diversification, especially concerning their single largest tenant - The Ensign Group ( ENSG ) - which represents 35.9% of total rent. The five largest tenants combined account for 70.2% and the ten largest tenants combined for 89.3% of total rent. Each are considerable higher values than OHI and MPW report, so tenant diversification of CareTrust REIT is lacking behind its peers.
CTRE | OHI | MPW | |
Top 1 Tenant | 35.9% | 9.0% | 29.6% |
Top 5 Tenants | 70.2% | 39.7% | 61.4% |
Top 10 Tenants | 89.3% | 62.6% | 72.6% |
Compiled by Author using data from the respective companies
While potentially a reason for concern, I believe the exceptional rent coverage of The Ensign Group (3.26x EBITDAR coverage, 4,10x EBITDARM coverage) can well compensate for the lacking diversification. In fact, the average rent coverage of all of CTRE's tenants (2.07x EBITDAR coverage, 2.64x EBITDARM coverage) shows a huge safety net. Combined with growing occupancy rates of 75.3% for skilled nursing and 77.3% of seniors nursing this makes unexpected rent losses highly unlikely. While posting a similar occupancy of 77.0% OHI tenants have inferior rent coverage compared to CTRE ( 1.38x EBITDARM coverage, 1.04x EBITDAR coverage ). MPW recently only commented on the EBITDARM coverage which stood at 2.4x while giving no information about current EBITDAR coverage of its tenants or occupancies. Although the general EBITDAR coverage looks fine, large tenants of MPW are experiencing financial troubles with the need to refinance credit lines .
Comparison of tenant rent coverages (Author's calculations based on current data from Seeking Alpha)
All three healthcare REITs have a majority of their leases ending beyond 2030 offering reliable revenues. Whereas MPW currently profits from having primarily issued CPI-based rent escalators, OHI has mainly fixed-rate escalators with an average annual increase of 2.3% and CTRE a CPI-based escalator capped at 2.5% which limits potential growth but may provide financial stability to pressured tenants.
According to my estimation, increasing occupancies and very strong rent coverage across all tenants provide a high level of rent security and revenue stability for CTRE while leaving a considerable margin for healthy growth. In contrast, MPW and especially OHI could see some of its financially struggling tenants have increasing problems to keep up with rent payments.
Dividend growth and safety
Many dividend investors are attracted to the high dividend yields of OHI (currently 9.2%) and MPW (currently 15.1%). Compared to these figures, CareTrust REITs current dividend yield of 5.8% is significantly less appealing. However, increasing attention has come to the question whether OHI and MPW will be able to increase or even sustain their current dividends in the near future. CTRE pays a quarterly dividend of $0.28 while posting normalized FFO of $0.35 and FAD of $0.37 in Q1 2023. This translates to a healthy payout rate of 80% on an FFO basis and 76% on an FAD basis. MPW posted similar numbers, with a dividend of $0.29 and a normalized FFO of $0.37 while sadly not reporting on FAD. In contrast, OHIs quarterly dividend of $0.67 exceeded both FFO ($0.66) and FAD ($0.60) for the last quarter.
Another impressive stat for CareTrust REIT is the recent dividend growth rate with a 3-year CAGR of 14.26% and a 5-year CAGR of 12.67% , while its peers struggled to achieve large dividend increases over that time. MPW's dividend grew steadily at a pretty consistent CAGR of 3.8% over 10 years while OHI's 10Y CAGR of 4.5% is overshadowed by a 5-year CAGR of just 0.5% indicating increased difficulties to maintain the rate in line with the high payout ratio. In fact, no healthcare REIT except CTRE even has a 3-year or 5-year CAGR above 4% underlining CTREs huge lead in recent dividend growth.
While its peers - especially OHI - come under rising pressure to keep up dividend increases, I'm confident that CTRE's low payout ratio will give it plenty of room to keep up with its recent double-digit CAGR. In fact, even assuming a stagnating FAD, two more dividend hikes of 10% would result in a payout ratio around 90% and a > 7% dividend yield.
Debt structure and interest payments
The total debt of CTRE is $735 million of which $200 million are due in 2026 and the remaining $535 million in 2028 . This results in a very manageable Net Debt to EBITDA of 4.1x and Net Debt to Enterprise Value (EV) of 26.8%. The debt burden of MPW is much higher, with a Net Debt to EBITDA of 7.6 x and a Net Debt to EV of 68.8%. With a Net Debt to EBITDA of 7.5x and a Net Debt of EV of 41.7% OHI also has a significantly higher debt burden than CTRE.
While the debt of CareTrust REIT was tied to a rather high interest rate of 4.9%, cash interest paid of $31.2 million corresponded to 18% of EBITDA a lower proportion than for MPW (26.4% of EBITDA with 3.8% interest rate) and OHI (32.8% of EBITDA with 4.6% interest rate).
CTRE | OHI | MPW | |
Net Debt / EV | 0.27 | 0.42 | 0.69 |
Net Debt / EBITDA | 4.1 | 7.5 | 7.6 |
Interest Payments / EBITDA | 0.18 | 0.33 | 0.26 |
Compared to its peers, CTRE is less leveraged while at the same time needing to spend a lower proportion of their earnings to fulfil interest payments. Together this decreases financial risk - especially with rising interest rates - while increasing the funds that might be spend productively for new investments and long-term revenue gains.
Fair valuation of the stock
In the following paragraph I want to present my estimation of the fair value for CTRE using two different approaches - based on the discounted dividends and based on FFO-multiples relative to other healthcare REITs.
Dividend discount model
The Dividend Discount Model ((DDM)) - also referred to as Gordon Growth Model - aims at valuating a stock based on its discounted future dividend payments. Given the generally high payout ratios of REITs and the predictable revenues due to the long lease contracts of CTRE it is certainly an appropriate valuation method. The fair value is calculated from the Dividends per Share ((DPS)), the Cost of Capital Equity ((CCE)) - sometimes exchanged for a required rate of return - and the Dividend Growth Rate (DGR).
We shall assume the current dividend of $1.12 as a conservative estimation of next year's dividend and a CAGR of 4% which seems more than justified considering the fixed rent escalator with CPI as lower boundary and the steady acquisition of new facilities. Given the 3-year and 5-year dividend CAGR of >10% this will likely even underestimate near-term dividend growth. Using the Capital Asset Pricing Model (CAPM) with a current beta of 1.15, a risk-free rate of 3.7% and a market-return of 8% we get a CCE 8.6% for CTRE. Using the Weighted Average Cost of Capital ((WACC)) and deriving the cost of equity ((COE)) via the Dividend Capitalization Model and 10% growth results in a CCE of 10.3% which might be on the higher side since a 10% dividend growth will probably not be sustainable. While both - WACC and CAPM - have their downsides, both result in similar estimates for CCE of around 9% which is also reasonable if we follow the interpretation of this value as our required rate of return.
Taken these values together, the fair value of CTRE calculated as 1.12/(0.09-0.04) would be $22.4 which would represent a 21% upside from the current price. Even a lower dividend growth rate of only 3% would make the stock fairly valued with a fair value of $18.67.
Comparison to industry averages
A popular metric to compare REITs is the P/FFO derived from the current market cap and the (adjusted) funds from operations (FFO). Using this metric, CTRE appears expensively valued at a P/FFO of 12.7 compared to the 11.6 industry average which translates to a 9% premium. Only 4 out of the 13 other healthcare REITs covered on this page are valued higher in this metric.
P/FFO ratios for healthcare REITs (Author's own calculations based on numbers from Seeking Alpha)
However, many investors prefer using the enterprise value instead of the market cap when calculating multiples since it takes into account the debt of a company as well. Since many healthcare REITs have significantly higher debt ratios, CareTrust REIT has a comparatively low EV/FFO. Only MPW and Sabra Health Care REIT ( SBRA ) appear cheaper according to this metric with CTREs EV/FFO of 16.9 being well below the 20.7 industry average. To reach this average EV/FFO CTRE's share price would have to increase 23% from current levels to $23.1.
EV/FFO ratios for healthcare REITs (Author's own calculations based on numbers from Seeking Alpha)
Both, the DDM approach as well as the EV/FFO comparison indicate a fair price of $22 to $23 with a potential upside of just above 20% from current levels. Even on a P/FFO basis CTRE doesn't look overvalued and I think paying a small premium due to the healthy balance sheet and strong outlook appears justified.
Current stock price compared to the fair values obtained from the valuation methods (Author's calculations based on numbers from Seeking Alpha)
Risk to thesis
The main risk for any healthcare REIT is decreasing rent income. As mentioned above, I believe the long lease durations, rather small yearly rent escalator and strong financial health of CTREs tenants offer great stability for future rent incomes. The main tenant related risk is the relatively large exposure to the single greatest tenant - The Ensign Group. For now, I estimate this risk is mitigated due to the high rent coverage of this tenant, making a rent default highly unlikely. Especially if newly acquired facilities are rented out to other tenants, this risk will become obsolete in a few years. Nonetheless, this large exposure constitutes a potential risk that should be kept in mind. If exposure to The Ensign Group rises above 50% or its rent coverage starts to drop, investors might re-evaluate their thesis. The same of course holds true should rent coverage of the tenants in general drops.
Another strength of CTRE is the strong growth reflected in steady addition of facilities, fueling revenue growth and ultimately also dividend growth. A decrease in new acquisitions or a drop of initial rent yield significantly below 9% constitutes another warning sign to re-evaluate the investment.
Conclusion
CareTrust REIT has the highest rent coverage among its tenants, the tied-lowest dividend payout rate, the best 3-year and 5-year dividend growth, the lowest financial leverage as well as interest payments compared to OHI and MPW. Furthermore, it is slightly undervalued both based on a Dividend Discount Model as well as on an EV/FFO comparison. My view is that these safeties compensate for the lower dividend yield and make CTRE an attractive investment for more risk-averse investors looking to buy into a healthcare REIT.
For further details see:
CareTrust REIT: Decent Yield And Attractive Risk Profile