After RExIT, A REITurn? What it Could Mean for the Market
If you want to know what is going to happen in the senior living mergers and acquisitions (M&A) market, following the stock prices of the public real estate investment trusts (REITs) in the sector is a good forward indicator. If you want to know what is going to happen to the REITs’ stock prices, stay tuned.
REITs are often in the headlines in the senior living space as they play a large part in setting the pace for M&A activity in the sector. Public REITs, or REITs whose shares trade on a stock exchange, are the largest and most influential type of senior living REIT. The “Big 3” public senior living REITs consist of Ventas (NYSE: VTR), Welltower (NYSE: HCN), and HCP (NYSE: HCP). Those three are the most talked about and followed, but there are approximately eleven other public REITs that are active in senior living.1 Because of their disclosure requirements and desire to increase demand for their stock, these public REITs are also the most transparent with information and investment objectives, making them a good source for tracking the market.
How the Cost of Capital Impacts REITs
To understand what drives these REITs’ appetite for acquisitions, it is important to understand the dynamics of their cost of capital. REITs are in the business of capturing an arbitrage between their cost of capital and the rate of return on their acquisition investments. Their cost of capital is a weighted average of their cost of debt and their cost of equity. Generally speaking, the rate of return for these REITs is the triple net lease rate received for individual properties divided by the purchase prices for those assets (also called the lease yield). The higher the spread between the lease yield and the REITs’ cost of capital, the higher the profits are for REITs. Therefore, changes in the REITs’ cost of capital is a direct indicator of changes in the REITs’ profitability for a given acquisition, and eventually, those changes impact their activity in the market and the prices they are willing to pay for assets.
A public REIT’s cost of capital is directly impacted by the stock price of the REIT (i.e., the cost of equity component). Most REITs purchase assets using a revolving line of credit. The debt on these lines of credit increases to a palatable leverage level, and then is paid down by using cash generated by the issuance of new shares of the REIT’s stock. As stock prices increase and a REIT needs/wants to sell new shares, the REIT needs to sell less shares to raise the same amount of capital. For example, if its stock price is $20 a share and a REIT needed to raise $100 million in funds to pay down the revolver, the REIT would need to issue five million shares. However, if the stock price is $25, the REIT only needs to issue four million shares to raise the same $100 million. Therefore, raising capital is less dilutive, and thus more favorable, in an environment when stock prices are high.
REITs’ stock prices also affect the market capitalization (the stock price times the number of shares outstanding) versus net asset value ratio (the value of all assets owned by the REIT) that many analysts track. If the market capitalization of the REIT exceeds the mark to market net asset value, the REIT has the opportunity to take advantage of another arbitrage opportunity (public market valuations of health care real estate are higher than private market valuations). This means a hypothetical $100 million private market portfolio acquisition would have a greater than $100 million impact on the market capitalization of the REIT, allowing public REITs to bid more aggressively compared to other buyer types.
What it Likely Means for the Current Market (Next 12 Months)
Because of a REIT’s high sensitivity to cost of capital changes, meaningful stock price volatility has a large impact on the senior living M&A market. This can be seen by looking at the stock prices and activity of REITs during the last year.
The senior living REITs experienced stock pressure in the second quarter of 2015. This trend continued as further declines were experienced in the beginning of 2016. The impact on M&A volume was profound as public REITs not only slowed the pace of acquisitions, but some even became net sellers. According to the market data published by NIC MAP, the second quarter of 2016 was the fourth straight quarter with closed transaction market volume declines. This resulted in a rolling four-quarter total closed transaction volume decline of 33.5% from the previous quarter. For the first time since the fourth quarter of 2014, this rolling figure was below $20 billion.
Despite this rough patch for REIT shareholders, the recent performance of the senior living REIT stocks has been extraordinary, providing encouragement for a “REITurn” to the acquisition market that could set the table for REITs becoming aggressive and once again boosting M&A activity. During the third quarter of 2016, REIT stock prices were sharply higher, up an average of 40% from the lows earlier in the year. Eleven of the thirteen public REIT stocks charted are within 10% of their 52-week highs. The expectation for market participants is that this newly realized strength in public REIT equity prices will be a tide that lifts all boats, as more aggressive acquisition activity by the public REITs in building their pipelines will drive the market higher.
What Forces are the Key Drivers for the Future of REIT Stock Prices
Although it is impossible to know which way the stock market is going to move in the future, there are some key developments in the senior living sector worth monitoring as they will likely impact the stock prices of the REITs.
On the bearish side, headwinds created by fears of oversupply remain in the market and could negatively impact REIT stock prices moving forward as the influx of new units coming on board has resulted in a decrease in the pace of absorption, especially for assisted living. Second, the public market has developed a “distaste” for the skilled nursing industry, mostly due to reimbursement and regulatory pressures and hospitals taking control of bundled payments in an effort to lower overall health care costs.
Because of the high dividends paid, REIT stocks are considered bond equivalent stocks, meaning purchasing these stocks is an alternative to purchasing bonds. During periods of low interest rates, bond equivalent stocks are especially attractive to investors looking to earn yields higher than what is offered in the compressed bond market. Therefore, the REITs’ status of a bond equivalent stock has been a tailwind the past few years, but this could switch to a headwind as rates rise and investors return to bonds. However, health care REITs typically carry dividend yields between 5% and 8%, thus institutional and retail investors rolling out of bond equivalent stocks as interest rates rise will typically sell shares that have lower dividend yields (2% to 4%) early in the rising interest rate environment, as 5+% dividend yield rates will not be achievable in the low risk bond market for some time.
On the bullish side, REITs already have and will continue to get a boost from Standard & Poor’s creation of a new Global Industry Classification Standard (GICS) category specifically for REITs, effective September 16, 2016. The exact amount of the inflow of new capital into REITs can be debated, as predictions range from $5 billion on the low side all the way to $100 billion on the high side. Despite the wide range of the potential fiscal impact, all are in agreement that this change will be a net benefit for REITs as money managers adjust their holdings due to their need to be diversified across all GICS categories. This will continue the trend of increased Wall Street analyst coverage created by institutional capital’s changing mindset of treating REITs as a distinct asset class. The additional coverage results in increased transparency and understanding of the REIT business model, which will continue to bring more capital into the space. This inflow of capital into REIT stocks will increase demand and therefore drive stock prices up. Another possible tailwind for the REIT equities is the defensive nature of the senior housing sector because of the demographic trends and needs-based component of the higher acuity senior care. Lastly, public REITs are the main consolidators for private REITs, private equity, and mom and pop owners and have low overall penetration for the sector so far, thus REITs will be presented with prime acquisition opportunities as the trend of consolidation continues and REITs look to grow market share.
It remains to be seen which side wins the battle between the bearish factors on the horizon versus the bullish factors. Either way, one can be certain that it will impact the senior living M&A market, so watch the public REITs closely.
1. The other public senior living REITs include a few acuity level specific REITs, such as the three primarily SNF focused REITs, Care Capital Properties (NYSE: CCP), MedEquities Realty Trust (NYSE: MRT, first priced 9/29/16), and Omega Healthcare Investors (NYSE: OHI) a primarily independent living (IL) focused REIT, New Senior Investment Group (NYSE: SNR), and then seven more general senior living health care real estate REITs (or senior housing (IL/AL/MC) only focused), CareTrust REIT (NYSE: CTRE), Healthcare Realty Trust (NYSE: HR), LTC Properties (NYSE: LTC), National Health Investors (NYSE: NHI), Northstar Realty Finance (NYSE: NRF), Senior Housing Properties Trust (NYSE: SNH), and Sabra Health Care REIT (NYSE: SBRA).