A REIT Primer, Part VI

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Get sick, see a doctor. Get sick on the weekend, go to the ER. Get old and need a doctor, find a retirement home. Die, get buried in a cemetery.

All of the above involve some facet of health care, but they also have another common denominator -- real estate. The clinic, the hospital, the retirement community and, yes, even the ground you'll be buried in, is real property with real value.

The quest to maximize the value of real estate has led companies in many industries to sever their operating assets from their real estate, which can then be placed into a real estate investment trust, or REIT. In turn, REITs have been quick to form to securitize this real estate, in the health care industry as well as

many others.

A REIT is a corporation that owns real estate and can avoid the expense of corporate income tax if certain conditions are met. (A complete description of the nuances of REITs can be found in

Part I of this primer.

Part II covered retail REITs,

Part III focused on multifamily housing REITs,

Part IV discussed hotel and hospitality REITs, and

Part V looked at office property REITs.)

In our continuing review of segments of the REIT market, today we focus on health-care REITs -- companies that can help make you and your portfolio well, or at least keep you from getting ill.

The Case for Health-Care REITs

American's spend more than one trillion dollars a year on health care, or more than 13% of the U.S. gross domestic product. Health-care expenditures are currently increasing at a $50 billion clip annually, and such increases are expected to continue, as the graying of America will only increase money spent health-related expenses.

As health-care costs grow, so do the proposals for change aimed at making the system more efficient. The primary vehicle, managed care, has succeeded in slowing the annual growth of health-care expenditures from 10.7% in the 1980s to only 3.5% in the past three years. One way to further reduce costs is to shift inpatient services to an outpatient experience. Another cost-saving measure is to focus on more efficient physical plants for both in- and outpatient programs.

These changes are good news for health-care REITs, as they offer substantial growth opportunities. Clearly these companies will benefit from the continued growth in health-care expenditures. Additionally, health-care real estate companies will benefit from continued consolidation and efficiency measures in health care. This is especially true as health-care providers move capital away from real estate and into information systems and medical technology, says

Legg Mason

analyst Jerry Doctrow.

Healthcare REITs will also benefit from strong growth and consolidation in the long-term care sector. As America ages, heavy demand for senior housing will continue. In addition,

Schroder

analyst Jeff Bagley sees continued consolidation in the long-term care industry that will generate additional financing and securitization needs.

While a relative newcomer to the equity investment landscape, health-care REITs have certainly immunized portfolios from any bearish disease. On a total-return basis health-care REITs have outperformed the

S&P 500

in six of the last eight years. With the average dividend yield of the health-care REIT universe (15 companies) just more than 7% and a price-to-FFO (funds from operations, the accepted measure of a REIT's profitability) ratio of just over 12 times 1998 estimated earnings, the sector appears attractively valued. Consensus estimates call for annual dividend growth of approximately 5% in the next two years and FFO growth of anywhere from 6% to the low teens.

Health-care REITs may not have the sexiest growth patterns, but they can provide good long-term growth prospects with relative stability -- a trait attractive to investors who think the best of the bull has already come and gone. Call it preventative medicine, but Schroder's Bagley thinks the 7% yield provides good downside protection. In addition, he cites the reliability of health-care cash flows, and the tight supply of medical facilities as defense from bearish pressures.

Healthy Returns for Patient Investors

Unlike the other crowded real estate sectors, there are only a dozen or so REITs that call health-care their specialty. Of those, two are worth a closer look, and caution is advised when considering the largest of the group.

Capstone Capital

(CCT)

specializes in financing health-care facilities throughout the United States. The company is a hybrid REIT, meaning that it both owns properties and provides mortgage financing for other companies acquiring health-care facilities. Capstone's portfolio is highly diversified, including investments in more than 130 health-care facilities located in 21 states and operated by 34 different health-care management companies. While the bulk of these properties are owned directly by the company, mortgage loans constitute 19% of the portfolio.

Additional diversification is found in Capstone's property types. Thirty percent of the portfolio is classified as ancillary hospital facilities, defined as medical office buildings and supporting services structures adjacent to regional hospitals or medical centers. Eighteen percent of the portfolio is nursing homes, 16% is in rehabilitation hospitals and facilities, and additional investments are in inpatient mental health facilities, assisted living units, physician clinics and outpatient surgical clinics. More than 70% of the facilities are operated by publicly traded companies, including

HealthSouth

(HRC) - Get Report

,

Columbia/HCA

(COL)

and

MedPartners

(MDM)

. (Capstone's chairman, Richard Scrushy, is also chairman and CEO of HealthSouth and a director of MedPartners).

A recent offering of over five million shares provides the company with additional acquisition power. This also provides additional evidence of the company's conservative capital structure, attempting to maintain a debt-to-capital ratio of under 40%. Bagley sees 1998 as a critical year for the company on the acquisition front, and feels the company is well-positioned to continue the conservative, accretive growth started in the second half of 1997. The stock currently trades at 24. With Bagley's target stock price of 27 in 1998 and a dividend of close to 8%, a healthy return of about 20% is certainly a possibility.

Another favorite of the Schroder analyst is

Omega Healthcare Investors

(OHI) - Get Report

. Omega invests and provides financing for the long-term care industry. Its portfolio consists of 269 health-care facilities with more than 25,000 licensed beds in 27 states, operated by 29 operating companies.

The company is one of the purest plays in the graying of America, focusing on long-term care (nursing home) facilities. The company has strong relationship with some of the largest publicly traded players in long-term care management, including

Sun Healthcare

(SHG) - Get Report

and

Res-Care

(RSCR)

. In addition, the company's strategy of acquiring middle-market players in the long-term care business is mostly accretive to earnings.

The company obtained investment grade ratings for its debt in 1997, significantly reducing its cost of debt capital. While a public offering from the company is expected sometime in 1998, the dilution should be minimal.

Omega is in the process of spinning off its interest in

Principal Healthcare Finance

, a United Kingdom company with a similar mission to its domestic operations. The spinoff should have little impact on the core company.

With estimates of $3.35 in FFO for 1998, the stock should trade up to the $44 range this year. With a current price hovering around 39 and a dividend of about 7%, a return of over 15% could be available for patient investors.

* * * * *

The largest health-care REIT is

Meditrust

(MT) - Get Report

. With assets in excess of $3 billion, Meditrust has investments in 491 health-care facilities operated by 38 different health-care companies in 41 states. The health-care portfolio is also diversified by property type: 57% in nursing homes, 22% in assisted living and retirement facilities, 10% in rehabilitation hospitals, 7% in medical office buildings, 3% in acute-care hospital campuses, and 1% in psychiatric, alcohol and substance abuse treatment centers. Almost half of these facilities are operated by publicly traded health-care companies, the largest being

Sun Healthcare Group

(SHG) - Get Report

, administering almost 15% of Meditrust's real estate portfolio.

While Meditrust's leadership as a healthcare REIT has provided healthy benefits for shareholders in the past, its activity outside the health-care area has made the news of late. Late in 1996, Meditrust merged with the

Santa Anita Companies

, creating a paired-share REIT. In addition to providing the benefit of paired-share status, the merger allowed the company to gallop into the thoroughbred racing business as well.

Meditrust's quest for diversification didn't end with the ponies. In January, the company announced its intention to jump into bed with

La Quinta Inns

(LQI)

for the cool sum of $3 billion. The merger further diversified Meditrust's holdings, providing entrance into the hotel business. La Quinta Inns is the largest owner/operator of mid-priced hotels in the United States, with 234 La Quinta Inns and 36 La Quinta Inn & Suites, totaling approximately 35,000 rooms.

While the company remains a leader in health-care facilities, investor concern over the loss of focus in the industry is reflected in its recent performance. Many analysts feel Meditrust overpaid for Santa Anita. It is also possible that recent stock weakness could jeopardize the La Quinta deal. Until these issues are resolved, investors may continue to shy away from the stock, although further downside appears limited.

Next, we'll take a look at REITs of the international variety. Happy building.

Christopher S. Edmonds is vice president and chief market strategist with The Guardian Trust Co., a Topeka, Kan., trust and asset management concern. He welcomes your feedback at

csedmonds@gtrust.com.