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What Healthcare REITs Do, and Why You Might Want to Invest in Them

It's crossover week at Industry Focus! In this week's Financials edition, Motley Fool analyst Gaby Lapera talks with Motley Fool healthcare bureau chief Michael Douglass about healthcare sector real estate investment trusts. The duo explains what REITs are, why investors might want to have some in their portfolio, one area where healthcare REITs have a bit more of a safety net than other REITs, and more.

Plus, they examine two healthcare REITs, Welltower (NYSE: HCN) and HCP (NYSE: HCP). Find out how the companies are different, what kinds of investors might like either company, and which one Gaby and Michael prefer.

A full transcript follows the video.

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This podcast was recorded on Nov. 14, 2016.

Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market everyday. You're listening to the Financials edition, taped today, on Monday, Nov. 14, 2016. My name is Gaby Lapera, and joining me in the studio is our deputy managing editor and healthcare bureau chief, Michael Douglass, who specifically asked me not to stroke his ego, but I couldn't help myself.

Michael Douglass: Well, Gaby, I appreciate it anyway. I'm sure it will be good for everyone.

Lapera: Well, welcome to the show! I'm really thrilled to have you here because, listeners, this is crossover week/Venn diagram week/cameo week/whatever you would like to call it week.

Douglass: And we're kicking it off.

Lapera: Exactly. And you might be asking yourself, "But MD isn't on any shows!" And that's true. But he used to host the Healthcare show.

Douglass: And, at one point, the Financials show.

Lapera: And, at one point, the Financials show.. So, not only are we having a crossover week, we're also having a throwback week. Double whammy. Top that, other Industry Foci. Haha. I'm also personally really excited to have healthcare this week. I brought my new medicine mug. If you happen to be watching this on YouTube, you can see that it's incredibly hideous.

Douglass: It's a very busy mug.

Lapera: It's a lesson in bad graphic design. If you really want to see it, I'll email you a picture at industryfocus@fool.com, if you email us there. It's worth it. So, how do healthcare and financials intersect? The obvious answer, if you're Michael and I, is healthcare REITs, of course. I just want to take a second to tell our listeners a little bit about REITs, because I've been told that I could slow things down to the beginner level a little bit more, and I'm taking that criticism and running with it. A REIT is a real estate investment trust. REITs are businesses that invest in property, and they lease out that property to other companies. There are all types of REITs: healthcare REITs, retail REITs, industrial REITs.

Douglass: Office REITs.

Lapera: There's a REIT for everyone, just like Oprah, except with boring financial companies.

Douglass: It's a REIT buffet.

Lapera: It's a REIT buffet. It's that kind where you go to the Chinese buffet and there's tacos and Mongolian and all kinds, it's not just Chinese. That's what REITs are like. So, why do we care about REITs? Special rules govern REITs, it turns out.

Douglass: Yes, they are required to pay out 90% of their otherwise taxable income to investors as dividends, which means that these companies usually have high dividend yields, especially compared to the S&P 500. So, for people who like cold hard cash every quarter or every month, REITs are a nice opportunity. Now, they trade off with that, to some extent, usually, on growth. This is not your high-flying tiny-cap healthcare that could become a 30-bagger or something like that. This is a slow, stolid, and usually, we hope, steadily growing company -- but it's not going to get you those amazing gains in a year that you could potentially get elsewhere.

Lapera: Yeah. That being said, REITs do have their risks, just like any other business with higher dividends. They're really exposed interest rate risk. And, they're also exposed to real estate instability. And, also, people being stupid in management, but I guess that's a risk for every company.

Douglass: Yes. And, on the interest rate side, when you think about it, what equity REITs do -- equity REITs is the subsection of REITs we're talking about today -- is buy buildings, and they lease out the space. So, when interest rates increase, their cost of capital, the amount of money they have to pay to borrow that money, increases. So, that then makes additional acquisitions less attractive to them. And if their current debt isn't pegged to a specific number -- like, on your mortgage, you might have a 4% interest rate or something like that. But a lot of corporate debt is based on, "Whatever benchmark amount plus 2%." So, if that benchmark shoots up 2%, your previously 3% debt becomes 5% debt. And if you're running at a relatively narrow margin of safety, that can get pretty ugly pretty quickly.

Lapera: Yeah, which is why smart management matters, because they do a good job of keeping debt in check, which is the main way these businesses grow -- debt. It's rare for a REIT not to grow primarily through debt.

Douglass: Yeah, particularly in the early life cycle, a lot of them will issue a fair amount of equity as well. But it really depends on your REIT. Frankly, all of them do it at a different mix. The key thing is to look into how they're funding their acquisitions.

Lapera: Absolutely. So, healthcare REITs. Why should you be interested?

Douglass: I'm glad you asked, Gaby! (laughs) One of the really nice things about healthcare is, it has some seriously enormous demographic tailwinds behind it. The big one is, stop me if you've heard this before --

Lapera: What Michael is trying to say is that people are getting older in America, and a large segment of the population is aging rapidly. Baby boomers, we're looking at you.

Douglass: Yes, they are rapidly turning 65, and they're going to be doing so at a substantial clip for the next several years. So, we have this big opportunity as folks age and America in general grays. These folks tend to spend more on healthcare, so healthcare spending will increase. Therefore, REITs are a nice, broad play on that. If you're invested in the right asset class, the right group of buildings that will most benefit from this and this type of healthcare, they should see increasing demand, and therefore increasing price, and therefore lots more money for shareholders.

Lapera: Absolutely. Another thing that's really interesting about the healthcare REIT space is how highly fragmented it is. I don't think any one company has more than, max, 5% share.

Douglass: It is pretty fragmented. Healthcare in general has been pretty fragmented. What you're seeing is, in healthcare across the board, a lot of growth by acquisition, where folks are buying each other. You see this in hospitals, in pharma companies, in insurance. Long-term, you can expect to probably see a fair amount of this in REITs, as well.

Lapera: Yeah, you'll see consolidation. You'll probably see a few companies on their rise to power eventually, but not quite yet. So now is the time to start looking to see who's well-positioned in this space. Another thing that's really interesting about healthcare REITs is the amount of regulatory risk that they carry.

Douglass: Yeah. That's because healthcare in general carries a lot of regulatory risk.

Lapera: And rightly so.

Douglass: Absolutely. But, when you think about, on the provider side -- like a hospital or a skilled nursing facility, a seniors' house, something like that -- a lot of these are, Medicaid or Medicare get involved, so you have a lot of stuff riding on how much is reimbursed per day for stays in those settings. Of course, on the biotech and pharma side -- if you have a REIT that is investing in office space or lab space for a biotech or a pharma, 90% of drugs that enter phase I, which is an early stage human trial, fail to make it to market. So, you have this enormous fail rate, you have companies that are boom and bust, you have companies that slash their workforce, that reposition things. So, there is a fair amount of risk related to regulation throughout the spectrum of healthcare.

Lapera: But, interestingly, healthcare REITs are generally protected from something that retail REITs are not, which is that people very rarely can go to the internet and get an MRI from the internet. People actually have to go to a facility to get medical treatment frequently.

Douglass: Yeah. There is certainly some healthcare spending that is elective -- elective is kind of the wrong word. But, if you're having a hard year, it's possible you might skip some things. But there are some things that really have to happen, particularly for folks with chronic diseases. Dialysis is not optional, it has to happen. And, a lot of the other things, like, if you're going to the ER, chances are pretty good that it's because you need to go to the ER. So, they do have a certain demand protection at the bottom and that enables this bottom table of things that occur.

Lapera: Yeah. So, not to sound gleeful about other people's pain and suffering, but it is built-in protection to this type of business. So, we have picked out two different healthcare REITs to cover today. We're going to look at Welltower and HCP. I tried to marry those two and it did not go well.

Douglass: Well? Well? See what you did there?

Lapera: It was a towering failure!

Douglass: (groans) But, you did it so well.

Lapera: (laughs) God, we need to stop. If you were to look at the most basic metrics of these companies, they look pretty similar. Both are running at about a 15 times FFO with around 5% dividend yields, which is, coincidentally, about 2.5 times more than what the S&P 500 has. And, you're looking at me because, I realize, I have not defined FFO. 

Douglass: Yes. Why don't I go ahead and define it? FFO, or funds from operations, is an alternative way to look at earnings for REITs. Generally accepted accounting practices, GAAP, goes for EPS -- earnings per share. The thing with FFO is, real estate, according to GAAP, is depreciating in value. But when you own real estate as an investment and you are figuring out how to juice more rent out of it each year, and things like that, there's a possibility that real estate increases in value, or at least stays the same. There are a lot of different ways to think about that. What FFO does is it takes earnings, or net income, and adds back in depreciation. So, it remove that as an expense. And there are a few other minor adjustments, but that's the big one. So, you're looking at it net of what might be happening to the real estate property itself, and just thinking looking more at the operating metrics within that investment.

Lapera: Yeah, which honestly makes a ton of sense, because most of the time, these properties do go up in value over time. Welltower. They are really into senior care.

Douglass: Very much so. I talked about the big tailwind for healthcare broadly, which is aging. Of course, moving to senior care, aging population, it's not rocket science. This is definitely something that looks pretty good. And there's pro forma expectations for Q4 2016 that about 70% of their net operating income is going to be flowing through senior housing. About 17% is going to be from outpatient medical, about 13% from long-term and post-acute care. But the other point I think we really need to think about with healthcare is, we've had a lot of changes to healthcare over the last seven years, since the Affordable Care Act passed. Of course, there are a lot of questions because of the election about what will happen long-term with all of this. 

But, one of the key things that we also have to think about with healthcare is that everyone is looking for ways to save money. Insurers are looking for ways to make their cost of care lower. Medicare is looking for ways to reduce cost of care. One of the points of the Affordable Care Act was to figure out how to reduce emergency room visits and some of this very costly care. One of the things that Welltower has done is they have shifted their portfolio away from the most expensive healthcare settings -- these are things like hospitals -- and into lower-acuity, lower-cost settings, things like senior housing. So, the idea there is, if you're moving toward what is cheaper healthcare, then long-term, you hope the regulatory risk will be reduced because the government will be trying to incentivize people to head in that direction. So, that gives you a twofer, you're both growing because of the senior population, and you're growing because you're figuring out a cheaper way to deliver healthcare.

Lapera: Yeah. This is really interesting, and I think it's a great model, especially in the United States and Canada. I know that HCP is looking to continue to grow. One thing to keep in mind is that senior housing works very differently internationally than it does here. So, if they look to grow in other countries, their business model is going to change. That's mostly because a lot of other cultures tend to have senior care focused in the family, rather than facilities. Interestingly, HCP also had a focus in senior care.

Douglass: Yes. HCP is an interesting story. They just made a big change to their portfolio. They essentially spun off a significant portion of their portfolio, the ManorCare portion. I think it closed Oct. 31, so very recently.

Lapera: Yes. So, in the most recent earnings, it's done, but if you look at their most recent earnings, it's kind of wonky because they have all these write-offs that they normally wouldn't have in there. So it's kind of a wait-and-see, in terms of what actually happens with them. But the whole reason for this spinoff is because ManorCare wasn't doing great.

Douglass: Right. So it makes sense, when you have a part of the business that you don't love so much, you offload it -- or, in other ways, figure out how to exit, or turn it around. What's interesting about HCP is, they're about 43% senior housing, 22% medical office building, 21% life science. What that means is, it's a lesser bet on specifically senior care than you see with Welltower. The 22% medical office building, a lot of that is hospitals. I tend to be a little bit more skeptical of hospitals as an investment long-term because, in a lot of cases, they're price-takers instead of price-makers, and you want to be a price-maker when you can. The idea here is, you're a hospital in X County. Insurer comes and says, "Hey, how much do you charge for a broken arm?" And the hospital says -- I'm making up this number, "$1,000." The insurers says, "That's cool. Hospital B charges, we worked it out with them, $150, so that's what we're going to pay you. If you don't like that, you don't have to be in our network."

Lapera: Yeah, which is what makes the hospitals a price-taker as opposed to a price-maker. It's always better to be the maker and not the taker.

Douglass: Yes. So, I'm always a little bit skeptical about medical office buildings because I think -- hospitals are also subject to a great deal of regulatory risk because Medicare and Medicaid reimbursements drive so much for a lot of hospitals that it's always kind of questionable: How stable is medical office buildings long-term? The other thing is, hospitals often have a lot of capital expenditures. Think about it, if you have two hospitals that charge roughly the same amount, and one of them has the new robotic surgery or the new *insert really cool gizmo* and the other one doesn't, where are you going to go, if they're both in network? You're going to go with the one with a new gizmo. I'm a little bit skeptical of hospitals as a business model, in terms of their ability to juice profits long-term, and I am therefore a little bit skeptical of almost 25% of HCP's portfolio being in medical office buildings.

Lapera: Right. And then, there is about 25% in life sciences, which is basically research -- which, as we discussed, has its ups and downs.

Douglass: It does. Although, as a point in HCP's favor, most of the companies and research groups in their space, these are a lot of big names: Amgen (NASDAQ: AMGN), AstraZeneca (NYSE: AZN), Johnson & Johnson (NYSE: JNJ), Duke University. These are household names, so I'm less nervous about it. The nice thing about HCP is, this does give you an opportunity to do a broad-based bet on medical innovation through their life sciences space. So, there's some opportunity there, too.

Lapera: Definitely. So, one thing that you always have to look at when you look at REITs is their leverage. How much debt do they have versus their assets? Again, this is difficult for HCP because pre-spin off, they had a lot of debt, so much that their credit rating dropped. Post spin-off, they have a very manageable amount of debt. They're at about 45%, which is pretty average for REITs.

Douglass: Yeah, and that's where Welltower is too, right around 45%. So, one of the things with REITs is, I tend, historically, to be debt-averse. I like my companies with fortress balance sheets. But with REITs, debt is a really good opportunity for them to juice their returns on equity.

Lapera: Especially right now, with interest rates as well as they are. If they can get fixed rate -- which is very unlikely -- then it's a great business bet for them.

Douglass: Yeah, absolutely.

Lapera: Do you have anything else to say about these two companies?

Douglass: If you asked me to pick one...

Lapera: That's exactly where I was going with this.

Douglass: (laughs) Did I read your mind?

Lapera: (laughs) Yeah. You pick one first, then I will give my bland summation.

Douglass: I like Welltower better. That probably came through already. A lot of investors want to spread out their bets, and I understand that. I get that. But I do think long-term senior care looks like a pretty obvious winner. The fact that Welltower is so much more focused on that is something that I like. This is one of those things where diversification can become diworsification. Yes, bad puns, what did you expect when you put me on the show? This is what's going to happen. (laughs) But, I think that 70% push into senior living is really an attractive move, and I think it's a reasonably bold bet, and one that could really do well for them long-term.

Lapera: I am interested in HCP, (laughs) because I think it's interesting what they did with the spin-off. They're on my watch list, they're not on my buy list. Welltower, I'm just not as interested in. This one just comes down to me having feelings. But, as we've covered over the course of this show, each company has its pros and cons. Watch/buy/sell accordingly. Thank you very much for joining us.

Douglass: Yeah. And, by the way -- this was a 15-minute talk or something like that -- if anyone is interested in digging in more, certainly, I think we would be very happy to talk about it. We both came to The Motley Fool because we invested in our spare time, and we really enjoy this kind of stuff and had it as a hobby. So, the fact that we get paid now to do our hobby is cool. So, send us an email at industryfocus@fool.com. We're happy to continue the conversation if you have questions or thoughts or ideas, like, "Have you thought about this/What about this issue/What do you think about this?" We'd be happy to answer anything on your mind.

Lapera: Absolutely. Michael has just promised to answer your emails.

Douglass: (laughs) All of them! I may regret this.

Lapera: (laughs) No, it's true. Michael and I both have a circuitous route to The Motley Fool. Michael was actually a hospital consultant for a while. That's how he ended up interested in the healthcare space. I was getting my Master's -- well, I got my Master's.

Douglass: Yes, finished it.

Lapera: I finished it, and it's in my office somewhere. My home office, because I have no office at The Motley Fool, just a desk.

Douglass: We have an open floor plan, just to be clear.

Lapera: Yeah, he didn't just put me out in a hallway. My Master's is in biological anthropology. Biological anthropology is a lot of healthcare-related stuff. You might remember that diabetes episode I did with Kristine. Diabetes is one of my favorite topics. But not one of my favorite diseases. Diseases are bad. 

Douglass: Yes. But, if you're interested in getting a copy of that episode, I'm sure we would be happy to send you the link. Again, email us at industryfocus@fool.com.

Lapera: Or by tweeting us @MFIndustryFocus. Thanks, everyone, for joining us. I hope you enjoyed this short, snappy episode. I know I did. Thank you, Austin Morgan! You're a star! Everyone have a great week. As usual, people on the program may have interests in the stocks that they talk about, and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. Think critically, folks. Have a great week!

Gaby Lapera has no position in any stocks mentioned. Michael Douglass owns shares of Johnson and Johnson. The Motley Fool recommends Johnson and Johnson and Welltower. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.