With Baby Boomers entering old age, U.S. demographics favor one particular sector: healthcare. And within that sector, investors seeking sizable yet stable dividend returns may want to look at healthcare and senior housing real estate investment trusts (REITs).

Generally speaking, real estate is an attractive source of reliable dividends because rental yields provide steady income, with few expenses required to maintain them. In addition, rentals tend to rise with inflation, which should ensure future dividend increases.

Senior care and medical real estate offer the additional benefit of demographics, and demand for such facilities should remain robust in the years to come. These properties are also somewhat less prone to leveraged speculation than other forms of real estate – and since many medical costs are paid by the government, they’re less likely to lose rental income in a downturn.

However, caution is needed. Too many healthcare REITs are paying dividends far in excess of their earnings, making their income streams unreliable in the long run.

Indeed, with interest rates so low and monetary conditions so easy, companies can borrow money to pay dividends – and for REITs whose share prices are sustained by dividend yield, there’s a strong temptation to do so.

In addition, depreciation allowances on real estate provide cash flow from which dividends can be paid, while capital investments can be financed with new share issues from a buoyant stock market. This tempts real estate companies to pay dividends greater than earnings – which, in moderation, may not be a problem. However, in the longer term, companies that increase leverage or allow their real estate to age without being replaced will be unable to maintain earnings as available rents decline. In such cases, the dividend cannot be relied upon for long-term income.

I kicked the tires on five healthcare and senior housing REITs to see which ones offer the best investment at this point in time.

Breaking Down the Opportunities

• Physicians Realty Trust (DOC), a self-managed company that leases medical properties to doctors and hospitals, offers a 5.7% yield with an annual dividend of $0.90 per share. However, it consistently makes modest losses, making the dividend unlikely to be sustained in the long run.
• HCP Inc. (HCP), which invests in both healthcare buildings and mezzanine loans, earned just $0.92 per share in the last four quarters compared to its dividend of $2.26. Even though this company is a Dividend Aristocrat, having increased its dividend annually for more than 25 years, I think its fine track record looks certain to be broken in the next downturn.
• A better investment is Omega Healthcare Investors Inc. (OHI), which invests primarily in long-term healthcare facilities. OHI has a long track record of increasing dividends, and its latest quarterly dividend of $0.55 is more than double the $0.22 it paid in the equivalent quarter of 2005. Its current trailing four-quarter yield is a healthy 6.1%. While its earnings per share in the past four quarters were just $1.61, compared to dividends of $2.16, its operating cash flow of $337 million was enough to support dividends of $258 million. New investments, meanwhile, were financed with low-cost borrowings. I wouldn’t regard OHI’s 6.1% dividend yield as risk free, but the chance of increases is also substantial, so the risk-reward tradeoff looks worthwhile.
• Another healthcare REIT that appears to be providing solid dividends is Sabra Health Care REIT (SBRA), which invests mostly in skilled nursing facilities. SBRA pays quarterly dividends of $0.39, to give it a yield of 5.8%. In the last four quarters, Sabra only earned $1.21, less than its $1.56 dividends, but its cash flow was again ample to cover dividend payments. Plus, its dividends have increased 22% since its founding in 2011.
• An alternative approach to healthcare REIT investing is to buy preferred stock, where the dividends don’t increase year over year but are better protected against downturns. When the stock market is high, as at present, I prefer this approach to income seeking, because it involves somewhat less capital risk, as well.

For example, Health Care REIT, Inc. (HCN), which invests in a broad spectrum of healthcare and senior living properties, has $1 billion of preferred stock capital in addition to its ordinary shares and has issued two series of preferred stock, I and J. Its ordinary shares yield 4.8%, but the dividends are currently about twice earnings. On the other hand, its series J preferred shares currently yield 6.3% and have the additional advantage of being senior to the dividends on common stock.

Good investing,

Martin Hutchinson