Are Health Care REITS on the Mend?

At the NAREIT Law and Accounting Conference a few weeks ago AG Edwards REIT analyst Art Havener hinted there were values to be found in health care REITs. That got me thinking about the group and places you might put cash to work. (It also generated a lot of questions from you!)

The Recovery Room

The cream of the health care REIT crop is Health Care Property Investors (HCP). The company, led by health care REIT pioneer Ken Roath, has executed its business strategy through the good and bad of the last four years. The company's first-quarter Funds from Operations (FFO) -- a REIT measure of cash flow -- increased 6.3% from a year earlier and consensus estimates suggest the company can grow its FFO at a 7% to 8% annual rate over the next couple of years. Add a nearly 11% dividend -- about an 85% FFO payout -- and the total return potential is pretty attractive. At just under 27, the stock trades at a very reasonable 7.8 times current FFO and just 7.5 times next year's estimates.

What makes Health Care Property unique? Unlike most health care REITs which hold mortgages, Health Care Property owns nearly 90% of its assets. The company does have exposure to health care operators with financial issues. About 19% of its properties are leased to Tenet Healthcare (THC) and more than 5% are leased to HealthSouth (HRC); both companies have encountered financial stress as a result of government changes in health care reimbursement. However, many analysts, including Morgan Stanley's Byron Wien, say the worst is over.

That should bode well for Health Care Property, and possibly other health care REITs. However, unlike some of the smaller operators, Roath runs his company with the best interest of shareholders in mind. If you're looking for currency to play the health care turnaround bet, this may be it.

... Or Still on the Critical List?

Still, a number of health care REITs remain troubled. Omega Healthcare (OHI), LTC Properties (LTC) and Health Care REIT (HCN) all face debt maturity issues in the face of rising interest rates. Combined with the uncertain future of many of those REITs' tenants, investors in these stocks are likely to experience slower FFO growth and, more importantly, slowing dividend growth if not outright cuts.

The most ailing of the health care REITs, Meditrust (MT), is no stranger to readers of this column. And the story continues to erode, as the chart below shows. (The lighter line is Meditrust; the darker line, the Morgan Stanley REIT index.)

Meditrust vs. the REITs Change over one year

Yet, with Meditrust selling below $2 a share and working hard to reposition itself as a pure lodging company, some investors wonder if now is the time to pick up a distressed company at bargain prices.

While it does appear the company is having some success in selling its health care assets and reducing and refinancing its $2.4 billion in debt, the risks are huge. First, a rising rate environment could be devastating for Meditrust. Goldman Sach's David Kostin calculates that every 100 basis-point increase in interest rates translates to an additional interest rate expense of $5 million, reducing already paltry FFO estimates by about 4 cents a share.

And if the company is successful in parsing its health care assets to the highest bidders, it is left with its midpriced, limited-service LaQuinta Hotel chain. While LaQuinta has worked diligently to reposition the brand to attract price-conscious business travelers, so too have Hampton Inns, Fairfield Inns, and a host of other limited-service flags. In fact, Price Waterhouse recently cited limited-service hotels as the most overbuilt lodging segment. "If LaQuinta sees declining revenue per available room in a growing economy, I don't want to be around if the economy really does slow down," says Craig Silvers, head of REIT research at Sutro and Company. He rates Meditrust "source of funds."

While some argue the fact that the company trades at only 1.4 times 2000 FFO estimates makes it a bargain, Goldman's Kostin just released 2001 estimates, which suggest the company's FFO will decline to $1.14 a share, a 21% drop from 2000 estimates of $1.45 a share. Kostin rates Meditrust market perform and Goldman has provided banking services to the company.

So, while the company may benefit if the lodging sector ever recovers, the risks remain too high for the average investor. Says Silvers, "The story is just too volatile. You might get a bounce, but with so much debt and a weak market, I'd stay away."

Off to the Roundtable

Coming next, the semi-annual TSC REIT Roundtable, featuring some of the best and brightest minds from the real estate investment world. Participants include, Art Havener of AG Edwards, Jim Kammert of Goldman Sachs, Larry Raiman of Donaldson, Lufkin & Jenrette, John Kriz of Moody's, Ritson Ferguson of CRA Real Estate Securities, Dan Pine of Alliance Capital, and Todd Voigt of Cliffwood Partners.

I'll quiz our panelists on Monday in New York about the recent rally in REITs and whether it can last. We'll also cover the bases: the outlook for various property types, access to new capital, REIT debt loads and even accounting issues.

I also want to know what you would like to know. Here's your chance to ask the experts. If you have a question for the panel, put it in an email and shoot it to me before Monday at [e-mail]. If we use your question, a dandy TSC trinket will be on its way to you. (Include your full name and hometown, please!)

Next stop, New York!

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