Morningstar.com
A Good Bet on Aging Baby Boomers
Friday September 29, 7:00 am ET
By Heather Smith


Everyone knows that the aging Baby Boomers will likely create unprecedented
demand for health-care services. Yet a whole host of reasons--product
recalls, patent expirations, thin drug pipelines, Medicare and Medicaid
cuts, and uninsured patients--increase the risk of investing in health-care
stocks. Investors seem to agree; the Health Care Select Sector SPDR
(AMEX:XLV - News) has underperformed the S&P 500 the past three years.
While we think health-care companies such as Boston Scientific (NYSE:BSX -
News), Johnson & Johnson (NYSE:JNJ - News), and Watson Pharmaceuticals
(NYSE:WPI - News) are trading at bargain-basement prices, we're sympathetic
to investors' concerns about the future of the health-care sector.
Volatility is high, with small changes in the industry landscape producing
large swings in stock prices--shares of health-care operator Kindred
Healthcare (NYSE:KND - News) tumbled 25% one day in January because of a
proposed Medicare rule change. How can investors gain exposure to
health-care without opening themselves up to unmitigated risk?

Luckily, one such way exists. By buying shares of health-care real estate
investment trusts, investors can play the aging American demographic while
avoiding most of the downside associated with health-care services
companies.

What's a Health-Care REIT?
Health-care REITs own hospitals, skilled nursing facilities, independent
and assisted-living facilities, medical office buildings, or any type of
health-care real estate. Because of federal laws, REITs cannot provide
health-care services, so they hire operators such as Brookdale Senior
Living (NYSE:BKD - News) to perform these services. As a result, the actual
residents of these facilities are not particularly important to the REIT;
the trusts are more concerned about the quality of the operator, which
helps determine the REIT's credit rating.

Health-care REITs were created in the mid-1980s when health-care services
companies such as Kindred and Universal Health Services (NYSE:UHS - News)
spun off their real estate; most REITs have since diversified their
portfolios so that their parent companies account for less than half of
revenue. Like other REITs, a health-care REIT must pay out at least 90% of
its taxable income as dividends, making for hefty dividend yields of 4%-7%.

Health-Care REITs Are Less Risky
Several factors contribute to a health-care REIT's relatively low risk
profile. For starters, the REIT's revenues are effectively guaranteed by
its long-term leases. Operators sign leases ranging from three to 20 years
that hold them responsible for property operating expenses (utilities,
insurance, taxes, etc.) and include annual 2%-4% rent escalators. These
stipulations provide a hedge against inflation and shield the REIT from
rising energy costs.

The leasing structure also makes it difficult for an operator to break its
lease. First, it's against the law to stop providing health-care services
(as part of the license required for most facilities), and second, the REIT
is in constant contact with the tenant and is aware if its financial
condition deteriorates. More often than not, the REIT will simply sell the
property or find a replacement tenant given the recessionproof demand for
health-care real estate. Above all, the REIT still owns the property and
can take the proper steps to ensure that a healthy operator is in place.

However, this scenario rarely plays out because REITs choose their
operators carefully. Before signing a new tenant, a REIT meticulously
reviews the operator's financial statements to ensure that cash flows
comfortably cover the estimated rent payments. Some REITs, such as
Nationwide Health Properties (NYSE:NHP - News), protect themselves further
by requiring tenants to sign one lease for all the facilities they rent
from the REIT. That way, the operator cannot "cherry pick" the best assets
and drop the less-profitable properties when their lease expires.

Perhaps the smartest way health-care REITs reduce business risk is by
lowering their exposure to Medicare and Medicaid, which are prone to
government cuts. Although a REIT's rents are still protected by the terms
of the lease, it can lose out on bonus rental opportunities (rents based on
increases in a facility's revenue) and see the profitability of its
operators decline precipitously. As a result, REITs tend to limit their
ownership of hospitals and skilled nursing facilities--two property types
that receive most of their revenue from Medicare and Medicaid. These
government sources generally account for less than half of the income
generated by a REIT's tenants, and in standout cases such as Senior Housing
Properties Trust (NYSE:SNH - News), account for about 20% of total operator
revenue. REITs prefer to own private-pay facilities such as independent and
assisted living facilities that only admit patients who can afford their
services. With this less price-sensitive demographic, REITs can raise rents
without much problem.

By comparison, health-care providers operate in an environment littered
with risk. Their main customer, the government, sets prices unilaterally
and often fails to cover the costs of providing health-care in its
reimbursement. Hospitals must also admit uninsured patients in order to
participate in the Medicare program. Finally, the business is extremely
capital intensive, with labor shortages and bad debt expense only
compounding rising costs. The stringent lease terms it accepts from the
REIT exacerbates these problems, and illustrates how the landlord (the
REIT) comes out ahead of the tenant (the operator) in the health-care
industry.

Buy the Landlord, Not the Tenant
Here's why: Net operating income margins (a REIT's measure of
profitability, which is determined by subtracting property operating costs
from rental revenue) are 100% because of the REIT's leases that require the
operator to pay property expenses on top of monthly rent. Administrative
costs are low, with employee headcount below 100 at most of these firms.
Consequently, average operating margins come in at 66%-70%, compared to
8%-12% for a health-care operator.

REIT management teams have been adept at managing their portfolios.
Health-care REITs have an excellent track record of investing in properties
that generate returns well above their cost of capital. These firms' return
on real estate assets (a REIT's version of return on invested capital)
regularly reaches 13%, which towers over our REIT universe average of about
10%. Health-care REITs' immense profitability enables them to reinvest free
cash flow in high-return projects, creating value for shareholders in the
process.

The outlook for the sector is strong, too. High demand for health-care
services and slow supply growth has created a perfect storm for health-care
REITs. Certificate of need laws existing (and rigorously enforced) in most
states limit the construction of new hospitals and skilled nursing
facilities. Though these barriers to entry do not apply to assisted-living
facilities, construction of these facilities remains relatively low.

Our Picks
Good health-care REITs are diverse in terms of geography and tenants, have
a portfolio heavily weighted toward private-pay assets, possess savvy
management teams with health-care and real estate experience, and maintain
clean balance sheets and fully covered dividends. With this in mind, our
favorite name is Health Care Property (NYSE:HCP - News), the largest
health-care REIT by market capitalization and revenue. We think this
company is a leader in the industry, setting the standard for other REITs
with its highly diversified portfolio, opportunistic business strategy, and
investment-grade credit ratings. Another REIT we're fond of is Ventas
(NYSE:VTR - News). Under the direction of CEO and chairman Debra Cafaro,
Ventas has evolved into a top health-care REIT with one of the highest
returns on real estate assets--16% per year--in our universe. Finally, we
also like Nationwide Health Properties . We believe that it has a bright
future after restructuring its leases and lowering its dividend payout
ratio. In our opinion, all of these stocks are fairly valued now, but we
would eagerly scoop up shares should they fall into 5-star territory.

REITs to Avoid
Our least-favorite health-care REITs tend to fall short on our criteria
listed above and have sticky corporate governance issues. Universal Health
Realty (NYSE:UHT - News) receives nearly half of its revenue (excluding
joint venture revenues) from its former parent company Universal Health
Services . Complicating matters is the fact that Universal Health Realty
shares its executives with Universal Health Services, creating a situation
in which the tenant (UHS) is also the landlord. Another health-care REIT
for which we'd require a large margin of safety before investing is Senior
Housing Properties Trust . One operator, Five Star Quality Care (AMEX:FVE -
News), is responsible for more than 60% of annualized rent. Still, we
believe our risk ratings accurately reflect our concerns about these REITs,
and would still consider shares if they dropped to 5-star levels.