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Healthcare REITs Battle Headwinds

Healthcare REITs Battle Headwinds

Healthcare REITs are getting a tough diagnosis from industry analysts on their short-term outlook. In its recent third quarter REIT earnings preview, investment banking firm Jefferies called out healthcare REITs as one of the sectors that is most at risk for poor performance in the coming months. Some of the factors that Jefferies cited to support that view include a rise in new supply in the seniors housing space, notably assisted living. Jefferies also noted concerns about healthcare REITs’ ability to fund capital commitments and a possible over-reliance on lines of credit.

REITs have been battered in the stock market this year with negative returns year-to-date and—for many—market caps that have dropped below their net asset value (NAV). All equity REITs reported total year-to-date returns of 1.67 percent through the end of October, while healthcare REITs reported a loss of 11.07 percent, according to FTSE NAREIT.

“I think the sharpness of the downturn has to do mainly with fear, and that fear is not likely to abate until the seniors housing industry provides positive news to counteract that fear,” says Dan Bernstein, an equity research analyst at brokerage and investment banking firm Stifel in Baltimore.

The toughest issues for healthcare REITs, and public REITs in general, to overcome is that today they don’t seem to have a cost of capital advantage compared to private capital buyers, says Bernstein. As such, public REITs should probably slow down their acquisition pace and shore up their balance sheets. If healthcare REITs do not act judiciously in this environment, they are going to be penalized in the public market for overpaying for assets or stretching on quality of assets, he adds.

The second big issue facing healthcare REITs is the growing supply on the seniors housing side due to an increase in new construction. New supply as a percentage of inventory jumped to 7.9 percent for assisted living facilities in in the third quarter of 2015, according to data from the National Investment Center for Seniors Housing and Care (NIC). That new supply is getting closer to the 9 to 10 percent levels seen during the last supply-driven downturn, which could create downside risk for stocks such as Ventas and Welltower, as well as to a lesser extent HCP and Senior Housing Properties Trust, according to Jefferies.

One of the factors fueling new construction is that the seniors housing sector has seen cap rates compress to a point where it’s about 20 percent cheaper to build a new property than buy an existing one, says Bernstein. That cost incentive, along with availability of financing for new construction, makes oversupply a bigger threat in the near term. Stifel expects seniors housing supply to grow by about 3 percent of inventory in 2016, and likely accelerate a little more in 2017 and 2018, notes Bernstein.

There are headwinds that could create more challenges for healthcare REITs—most likely in 2017 and 2018. However, it also is important to look at healthcare REITs on a case-by-case basis related to the make-up and risk exposure in individual portfolios, says Bernstein.

Each REIT portfolio within the healthcare sector has its own characteristics and its own unique exposure to potential risks of over-supply based on the markets the REIT operates in and the types of assets it holds.

“Right now, people are reacting to a very broad fear without looking at portfolio specifics,” says Bernstein.

Ventas, for example, is likely to be less impacted by new construction because the company tends to focus on locations with higher barriers to entry. However, Ventas did not have a particularly strong quarter. So that exacerbates fears about that portfolio, notes Bernstein.

In fact, Ventas CFO Bob Probst believes the company is in an even stronger position today in the wake of its recent spin-off of CCP and the acquisition of Ardent’s hospital assets.

“We have a best-in-class seniors housing operating business with assets in top markets and partnerships with the nation’s leading operators,” says Probst. “Coupled with demographic tailwinds and a great value proposition, we continue to see seniors housing as an attractive long-term business.”

Healthcare REITs also have the potential to navigate through those headwinds by shifting investment strategies. For example, they have the flexibility to shift to related asset classes that have more upside, such as medical office properties. They can invest in triple net lease assets to generate stable cash flows, or they can form more joint venture partnerships on new investments to not over-stress their own balance sheets, says Bernstein.

“The healthcare REITs have many, many options to grow,” he says.

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