2023-12-13 15:55:45 ET
Summary
- Healthpeak is undervalued and has the potential to trade at a higher multiple due to its high-quality characteristics.
- The decline in market price is primarily due to multiple contraction, not a decline in earnings power.
- The concentration of lab exposure in San Francisco is a concern, but the market may have priced it in too harshly.
Healthpeak ( PEAK ) has become a deep value play within the healthcare REIT sector, but it has some high quality characteristics that suggest it could trade at a significantly higher multiple. While the San Francisco lab exposure is a legitimate headwind, I think the market is overly fearing it in the context of PEAK’s overall business resulting in the stock being undervalued.
Let me begin with a look at the crash in market price, reasons for it, and follow with an analysis of PEAK’s fair value.
How/why PEAK got cheap
PEAK is down 38% in the last five years.
The bulk of the declines came in the last two years.
Essentially all of the declines have been multiple contraction with the earnings power remaining largely untouched.
Below is a graph of PEAK’s FFO multiple over time.
Historically, PEAK has traded at a premium, hovering around 20X FFO.
Today it is closer to 10X.
Nothing all that bad has happened yet, in fact, leasing has come in quite strong with consistent same store NOI growth.
Instead, the multiple decline is related to anticipation of something bad happening. The epicenter of worry seems to be PEAK’s high concentration in San Francisco with fully 31% of income coming from the MSA. 68% of PEAK’s lab income comes from the Bay area.
So what is wrong with San Francisco?
It is a high household income MSA, but its population has stalled with essentially flat population projected through 2028. Natural population growth is being canceled by young people leaving the area resulting in an aging population with an 11.6% increase expected in the 70+ category.
The U.S. as a whole has a somewhat inverting population pyramid so these sort of demographic trends, while concerning, are not all that atypical.
PEAK’s upcoming challenge with the area is more specific to biotech labs. There has been an influx of developments of labs in general, but the concentration of development in San Francisco’s campus is extreme at a time when its demand drivers do not seem as strong as San Diego or Cambridge.
PEAK’s current lab occupancy is great at 97.5%
The tenants are generally quite strong, consisting of most of the large cap pharmaceutical companies.
Thus, I don’t think the market is concerned about delinquency, but rather what happens when these leases expire.
As seen above, PEAK has a 6.2 year weighted average remaining lease term and it is quite staggered in maturity so we will get early previews of the re-leasing environment starting in 2024.
According to the Kidder Matthews market report , the leasing environment for San Francisco remained favorable through the end of 2022 with positive net absorption.
“The Bay Area Life Science market produced 959,769 SF of gross absorption and 222,682 SF of positive net absorption in Q4 2022”
However, in 2023 construction overtook demand and vacancy started to increase. Going forward, the MSA may be headed for oversupply with 10 million square feet of development coming.
“Roughly 10 million square feet of new life sciences space is currently under construction in the Bay Area,”
I think the market is right to worry about re-leasing as these leases expire.
New developments tend to offer significant incentive packages to attract tenants which I think will result in three things for PEAK:
- Very high tenant improvement and leasing commissions as these leases roll (TI and LC)
- Increased vacancy
- Flattish revenues compared to historical rent increases for life science.
Overall, it is a real headwind, but perhaps the market has priced it in too harshly.
Analyzing the magnitude of headwind
PEAK is a somewhat diversified healthcare REIT with outpatient medical and CCRC (continuing care retirement communities) in addition to its labs.
Other portions of PEAK’s business seem to be performing quite well. The senior housing rebound we discussed more thoroughly here is bolstering PEAK’s CCRC which had an ample 20% growth YTD.
Outpatient medical had solid same store NOI growth of 3.2% YTD and the non-San Francisco labs are also performing well. San Diego and Boston remain in very high demand and the supply there is more moderate.
Diversification is about to go even further with the acquisition of Physicians Realty ( DOC ). We will discuss the merger in greater detail in a bit, but for now the key aspect with regard to diversification is that it is roughly 30% or PEAK’s size.
So this is a company that is performing well in the majority of its branches with exception to oversupply of labs in a key MSA. The DOC merger takes PEAK’s exposure to SF down to about 24%.
I think re-leasing SF labs will be tough. NOI in that segment will probably decline a bit along with some capex incurred, but it strikes me as overly punished to have the FFO multiple of the entire company drop almost 50% in response to a headwind that affects 24% of the company.
It is a challenge that has been priced in as a disaster.
I believe the growth in other segments will more than offset the decline in the San Francisco market. Street analysts seem to agree as they have FFO/share and AFFO/share rising steadily through 2027.
With overall growth, the extreme stock price decline seems to be far too much, resulting in today’s price being opportunistic.
DOC Merger looks great
Despite the size difference, it is being executed as a true merger of equals. Much of DOC’s board will be retained and combined with PEAK’s board of directors. John Thomas, CEO of DOC, will be retained as Vice Chair. Additionally, the combined entity will trade under the name Healthpeak, but will use the flavorful DOC ticker symbol.
It is a stock for stock deal in which each DOC shareholder will get 0.674 shares of PEAK. Until an expected close in 2024, both stocks will trade independently which provides potential for an arbitrage.
Presently, the arbitrage gap is quite small with DOC being the cheaper leg by only 0.31%.
At that small spread, I don’t see much value in playing it as an arbitrage presently, but as prices fluctuate it may become an opportunity. Our Arbitrage Tracker on Portfolio Income Solutions tracks the spread of this and other ongoing arbitrages in real time so that we can continuously monitor the gap.
Many market participants were puzzled by this merger as DOC is being acquired at almost no premium to where they traded independently. Both companies have roughly the same FFO multiple so by default it is roughly neutral to FFO/share for PEAK.
However, there do seem to be significant synergies which will make it materially accretive to FFO/share as soon as those savings kick in. Overall synergies are expected to be a run rate of $40 million by the end of 2024 and $60 million by the end of 2025.
PEAK
There are the typical merger synergies that come with efficiencies of scale, but more intriguing is the ability to use DOC’s property management team to in-house property level functions that PEAK previously outsourced.
Essentially, this will make PEAK’s existing outpatient medical portfolio significantly more efficient.
Overall, the merger makes quite a bit of sense for PEAK, especially considering the low pricing they are getting for DOC and the lack of premium paid.
Valuation
Healthpeak trades at 10.1X forward FFO which makes it among the cheapest in the healthcare REIT sector.
It is also among the cheaper on an asset value basis with a P/NAV of 73.8%.
At this sort of multiple one would expect either stagnant or slightly declining earnings, yet PEAK is expected to have growth according to consensus numbers.
This growth comes from three main sources:
- Same store NOI growth in CCRC and outpatient medical
- Strongly favorable mark to market on San Diego and Boston labs offset by potential NOI declines in SF.
- DOC merger cost savings
I don’t think it will be rapid growth, but a steady 3%-5% a year is my base case.
This level of growth would warrant a multiple close to 12X FFO. I actually think the multiple should be a bit higher than 12X due to key quality factors:
Large size – the other $10B+ market cap healthcare REITs trade at significantly higher multiples than PEAK, and yet PEAK is low debt and has an investment grade rating.
Thus, I would spot fair value at somewhere around 13X to 14X FFO which portends about 30% upside to fair value.
Risks to investment
PEAK, like much of the healthcare sector comes with significant risks. Here are the key factors to watch in order to get an early read on how fundamentals will shape up:
- 2024 leasing activity, particularly in regard to lab renewals
- Development starts. Existing in-progress construction can likely be absorbed but continued new starts might make it more challenging.
- Successful completion of DOC merger
- Synergies coming in as expected
Wrapping it up
The best time to buy a stock is rarely when it is sunshine and rainbows. Adversity is what creates opportunistic pricing and the key is to find a little bit of adversity that is being priced in as a disaster. I think that might be the case here.
PEAK looks opportunistic to me.
For further details see:
Healthpeak Opportunistically Cheap As Supply Moderates