Over the coming decades, the aging of the U.S. population is going be one of the largest demographic and economic megatrends, creating potential investment opportunities for long-term dividend investors.
Let’s take a look to see if Ventas (VTR), America’s second largest medical Real Estate Investment Trust, or REIT, could be a sensible choice for low risk investors to ride the coming financial wave of growing medical spending.
Ventas stock has slumped nearly 20% over the last three months and offers a dividend yield near 5%, potentially providing an appealing entry point. Let’s take a closer look at the business for consideration in our Conservative Retirees dividend portfolio.
Ventas is one of the two dominant players in medical real estate assets. After the 2015 spinoff of its skilled nursing facility, or SNF, properties into a separate REIT, Care Capital Properties (CCP), its business is dominated by 1,275 properties, mostly in the senior housing, medical office buildings, and hospital sectors.
As seen below, the company’s largest assets by net operating income (NOI) are seniors housing – operating (31%), seniors housing – NNN (24%), and medical office (19%). Ventas also has several large operators, with Atia, Lillibridge, Sunrise, and Kindred accounting for 19%, 11%, 9%, and 9% of NOI, respectively.
Source: Ventas Investor Presentation
The medical REIT industry is over $1 trillion in size and highly fragmented, with only about 15% of U.S. medical assets owned by medical REITs. Compared to other industries, healthcare REITs control a relatively small percentage of real estate assets and should have opportunities for consolidation.
Source: Ventas Investor Presentation
This means that sales and cash flow growth (specifically free cash flow, or what Ventas calls Funds Available for Distribution, or FAD) can be lumpy. This lumpiness is reflected in Ventas’ solid, though volatile, growth track record.
Most recently, the company’s quarterly revenue grew by roughly 5%. Note that two of the most important metrics to watch, growth in FAD/share (which funds the dividend) and the FAD payout ratio (how safe the dividend is), were the result of two countervailing deals.
|Metric||Q3 2016||Q3 2015||YoY Change|
|Revenue||$866.6 million||$827.6 million||4.7%|
|Normalized FAD||$314.2 million||$231.6 million||35.7%|
|Shares Outstanding||354.2 million||336.3 million||5.3%|
|Dividend Payout Ratio||82.3%||106.0%||-22.4%|
Source: Earnings Supplement
The first deal disposed of over $4 billion in skilled nursing facilities (SNFs) by spinning them off into a new REIT, Care Capital Properties (CCP). The CCP spin off resulted in a decline in cash flow that resulted in last year’s Q3 payout ratio rising above 100%. However, the spinoff strengthened Ventas’ portfolio, improving its mix of private pay contributions, reducing its exposure to SNFs, and boosting occupancy.
Thanks to a stronger balance sheet, Ventas, unlike its rival HCP (HCP), which is also spinning off its SNF properties into a separate REIT, was able to maintain its dividend.
In comparison, HCP just announced that the loss of cash flow from its spinoff would require a 36% dividend cut, ending its streak of 30 consecutive years of dividend increases, and its dividend aristocrat status.
The big differentiator between Ventas and HCP was in its balance sheet and the quality of its management team.
For example, Ventas has continued to grow through acquisition, with over $1.4 billion in net investments during the first three quarters of 2016. This is mainly made up of the $1.5 billion acquisition of Wexford Life Sciences, which consists of 25 current, and under construction research labs used by some of America’s most prestigious research institutions such as Yale, Duke, and Washington University.
It also gives Ventas about a 10% market share in the fast growing, $38 billion university R&D industry, itself part of a far larger $259 billion global R&D industry. Better yet, this industry is only set to grow as drug makers race to create new drugs to treat the world’s increasingly older citizens.
Of course, all these growth acquisitions could hurt long-term dividend investors if management were to go overboard with debt, as HCP’s did in recent years, and create a balance sheet that threatened its ability to grow, or even maintain the current payout.
However, Ventas’ world class management team, led by Chairman and CEO Debra Cafaro, (who has generated 27% total returns since she became CEO in 1999), has done an exemplary job of balancing growth with a strong, and steadily improving balance sheet. As seen below, Ventas maintains a reasonable total debt to enterprise value ratio of 31%, and its fixed charge coverage sits at 4.7x.
In fact, Ventas has one of the strongest balance sheets of not just any medical REIT, but any REIT period, which allows it to access debt at super cheap levels; including its revolving credit facility which has an interest rate of just 1.5%.
This gives Ventas a low weighted average cost of capital below 5% and allows management to generate more accretive investments (i.e. that grow FAD/share quickly and allow for a highly secure and growing dividend).
Overall, Ventas has a portfolio of diversified healthcare properties run by best-in-class operators who should collectively benefit from favorable demographic trends over the coming decades. Management has shown capital allocation skill over the last 15+ years, and the large and fragmented nature of the market provides numerous opportunities for continued growth.
However, there are risks to every investment.
There are two big risks with investing in any medical REIT: government changes in healthcare spending policy, and interest rates.
Because of the rising cost of treating America’s aging seniors, changes in Medicare policy, away from a fee-for-service model and towards one based on outcomes, can be a risk to Ventas’ tenants and operating partners.
This is especially true given that certain sub sectors of the industry, such as SNFs, run on razor thin margins. This can result in some long-term care providers running into hard times. For example, Kindred Healthcare, (KND), just reported a horrible quarter and announced it was exiting the SNF industry all together.
Now Kindred represented 9% of Ventas’ net operating income, or NOI, and management is confident that it will be able to come to a mutually beneficial agreement in which it sells the properties operated by Kindred and further de-emphasizes the importance of SNFs to its cash flow.
After all, this was the main reason why Ventas opted to spin off Care Capital Partners and focus on more stable businesses such as senior housing, and medical office buildings, which are mostly funded by private payers, and not the government. In fact, before the Kindred announcement Ventas was obtaining just 17% of its NOI from Medicare/Medicaid, and that figure is sure to drop even further now.
However, in the short-term, the need to further sell off SNF assets means that Ventas’ short-term cash flow growth might dim, and the prospects for short-term dividend increases along with it.
In fact, the company announced it reached an agreement with Kindred Healthcare to sell its 36 SNF facilities on Monday, November 14. However, the market was happy about the deal and pushed Ventas’ stock higher by nearly 4%. This strategic move further derisks Ventas’ business, reducing its SNF rent exposure to just 1% of its total business.
On the topic of government changes to healthcare spending policies, Donald Trump’s impact on the entire healthcare value chain is worth paying attention to. If part or almost all of ObamaCare is repealed, some of Ventas’ tenants could be negatively impacted.
Hospitals are one group that comes to mind. According to the U.S. Department of Health and Human Services, there are 20 million newly insured people under the Affordable Care Act (ACA). While their lengths of stay are shorter, hospitals have still benefited nicely from the volume increase.
What impact could Trump have on patient volume in hospitals? Presumably growth will slow, or maybe the number of insured people would meaningfully decrease. It’s really hard to say since so much is up in the air right now.
Ventas’ exposure to hospitals is around 12% of its NOI – material, but not something its entire business hinges on. Importantly, Ventas is also aligned with some of the best operators. As seen below, all of Ventas’ NOI from hospitals is by top-ranked operators, which are presumably better positioned to navigate the changing landscape.
The other major risk to Ventas is rising interest rates, but not necessarily for the reason you think. Yes, Ventas has $1.8 billion in floating rate loans, and yes the REIT business model, being both highly capital intensive and necessitating the use of debt capital funding, means REITs in general are interest rate sensitive.
However, another thing that many REIT investors might not realize is that conservative management teams such as Ventas’ also need to tap equity markets via the periodic sales of new shares. Since so many investors have recently been buying REITs as bond alternatives, rising interest rates represent a threat to growth potential of REITs.
That’s because, in recent months, as the market prices in the high likelihood of a December rate hike (81% and climbing), REITs have sold off 12% as a sector, and Ventas in particular is down around 18%. While that makes for a great long-term buying opportunity, it also means the Ventas might not be able to raise as much cheap equity capital with which to grow in the future.
Dividend Safety Analysis: Ventas
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.
Ventas has a Dividend Safety Score of 69, meaning the company’s dividend is very secure and reliable.
Starting with the payout ratio, it’s important to remember that REITs, because of the legal requirement to pay out 90% of taxable income as dividends, naturally have higher payout ratios. For example, while Ventas’ 82% FAD payout ratio may appear alarmingly high if it were a regular c-Corp, in a REIT this is actually a very safe payout ratio.
That’s especially true considering that the leases that underpin Ventas’ cash flow are usually very long-term (and with very strong counterparties), as long as 20 years in duration, providing exceptional cash flow predictability. The company’s total leases have a weighted average maturity of nine years. You can see that the company’s free cash flow payout ratio has remained between 70% and 80% for nearly a decade.
Combined with the large scale diversification of Ventas’ properties and asset types, as well as the high quality of its tenants, Ventas turns out to be one of the industry’s safest dividend payers. In fact, Ventas is widely considered a “Sleep Well At Night,” or SWAN stock (i.e. something safe for widows and orphans).
That’s partially because the industry in which it operates, mostly private payer funded long-term care, hospitals, and medical office buildings, is one of the most defensive (i.e. recession resistant) around.
This explains how Ventas was able to sail through the Great Recession without cutting its dividend, as well as its impressive long-term payout growth record. As seen below, the company has also been an outstanding free cash flow generator, which is unusual for capital-intensive, growth-focused REITs.
Of course, as I mentioned earlier, another reason that Ventas is a SWAN stock is its strong, balance sheet; which has only been getting stronger in recent years. Ventas maintains a BBB+ credit rating from S&P and a stable outlook.
Having a conservative amount of debt isn’t just about keeping down interest costs and being able to borrow cheaply to grow through acquisitions. It’s also important because a REIT’s revolving credit facility has certain debt covenants, or metrics, that need to be honored lest a REIT’s creditors be able to immediately call in its debts.
As you can see, not only is Ventas nowhere near breaching its covenants, but its financial strength has been improving in recent years as management has focused on using cheap equity to fund growth, and thus allowing its relative debt levels to continue to fall.
Source: Ventas Earnings Presentation
This actually represents an important long-term competitive advantage for Ventas because smart, conservative management will use high share prices to raise cheap equity growth capital, and thus build up a REIT’s equity over time. Then, when share prices fall, such as they are now and might continue to do so if interest rates keep rising, Ventas will have a low enough debt to capital ratio that it will be able to turn to debt to fund growth.
In other words, smart REIT managers will take advantage of high share prices to purposefully dilute existing investors in order to make accretive acquisitions (i.e. FAD/share continues growing), and build up potential borrowing capabilities for when share prices are lower.
In this way, no matter what interest rates or the economy is doing, blue chip REITs like Ventas are able to consistently grow over time, enriching long-term dividend investors along the way.
And of course, that growth in FAD, combined with slower share count growth when prices are low, also helps to maintain a relatively low and secure payout ratio, which is the hallmark of any blue chip, dividend SWAN stock.
Dividend Growth Analysis
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Ventas has a Dividend Growth Score of 47, indicating investors can expect continued long-term moderate growth in the payout. As seen below, Ventas has paid uninterrupted dividend since going public in 1999 while rewarding shareholders with 7.8% annualized dividend growth over the last decade.
While Ventas’ most recent low dividend increase may worry some investors, you need to remember that this was largely a result of the Care Capital Properties spin off, which reduced FAD/share.
In other words, management made the smart call to hold off raising the dividend at its historical 7% per year pace to let it focus on growing its property portfolio in other, more stable sectors of the medical space such as private senior housing, medical office buildings, life sciences, and hospitals.
When you take into account the fact that the medical property market still has so much consolidation potential, as well as Ventas’ $1.9 billion in total liquidity (enough to fund an entire year’s worth of growth without selling a single new share), I think that long-term investors can realistically expect continued 5% to 6% dividend growth over the coming years.
When it comes to valuations, P/E ratios aren’t the best metric to use for REITs because GAAP earnings include depreciation and amortization. These are non-cash charges that don’t affect a REIT’s ability to pay its dividend, especially since properly maintained properties tend to appreciate in value over time.
This is why the two best valuation methods are yield, specifically compared to a REIT’s historical yield, and price to AFFO, or adjusted funds from operations, which Ventas calls FAD. Remember that AFFO is what ultimately sustains and supports dividend security and growth over time and is the equivalent of a REIT’s free cash flow.
|Dividend Yield||5-Year Average Yield||P/FAD||Historical P/FAD|
As you can see from the above table, the recent sell-off in REITs, and Ventas in particular, has brought its shares down to somewhat historically undervalued levels. While it may not be a screaming buy yet, at least from a P/AFFO perspective, the generous yield of 4.8%, when combined with the likely 5% to 6% long-term dividend growth, has potential to generate solid annual total returns near 10% over time.
However, don’t forget that Ventas, like many REITs, is far less volatile than the market in general with a beta of just 0.18, which means that its potential risk adjusted total returns are even more impressive. It’s hard to say what impact rising rates could continue to have on REITs over the short term, but long-term dividend investors could see some attractive opportunities soon.
Thanks to the recent REIT correction, Ventas is now selling at a historically undervalued price that makes this high-yield, blue chip SWAN stock a potentially appealing option for many long-term dividend portfolios.
With a growth runway that could stretch decades into the future, one of the best management teams in the industry, and a strong balance sheet that supports its generous, yet highly secure payout, Ventas appears to be a solid REIT for long-term dividend growth investors looking for some healthcare exposure. However, be aware that Donald Trump’s presidency seems likely to bring major changes to the healthcare value chain, impacting many different dividend stocks in potentially unpredictable ways.
Given the recent 30% decline in VTR, an update to this last note would be particularly interesting.