Omega Healthcare: It's Not Too Late To Buy This 8% Yielding REIT
Omega Healthcare Investors (OHI ) is one of the highest yielding REITs, with an 8.0% current dividend yield. It has rallied 30% in the last four months, mostly thanks to positive results in its last two earnings reports and improved guidance. Such a rally is likely to deter most investors from purchasing this REIT. However, while the stock may lose steam in the short term, as it cannot keep rising in a straight line, it still has the potential to offer great returns to long-term shareholders.
Omega Healthcare is a healthcare REIT that generates 83% of its revenues from its skilled nursing facilities and 13% of its revenues from senior housing developments (4% comes from ‘other’). Before its recent rally, Omega Healthcare had dramatically underperformed the market for two reasons. First of all, as interest rates are on the rise, investors can find decent yields elsewhere and hence the yields of REITs become less attractive. As a result, their valuation comes under pressure. REITs and utilities are the most vulnerable holdings to rising interest rates.
Moreover, Omega Healthcare underperformed for another reason. Two of its tenants, Orianna, and Preferred Care are in bankruptcy. While Preferred Care was a small tenant, whose lost revenues could be easily absorbed, Orianna was the 5th largest tenant, with annual contractual revenues of $47.3 M. To provide a perspective, Omega Healthcare has posted revenues of $881 M in the last 12 months. The REIT is doing its best to transition the Orianna facilities to new tenants but the issue continues to exert a drag on its results.
However, investors should realize that this is a temporary headwind, which will fade in the upcoming quarters, while the long-term growth prospects look strong for Omega Healthcare. As the baby boomer generation ages and the average life expectancy is on the rise, the senior population of the U.S. is expected to significantly grow in the upcoming years. In addition, elderly people have the highest spending power, as their average net worth exceeds $640,000 per capita. As a result, healthcare spending is expected to grow by 72% in the next seven years, from $3.2 T this year to $5.5 T in 2025. This trend certainly bodes well for the growth potential of Omega Healthcare.
While the REIT has enjoyed a strong rally in the last four months, it is still trading at a cheap valuation, with a P/FFO ratio of 10.8, which is much lower than its 10-year average ratio of 12.4. As the issue with Orianna will fade over the next five years, the REIT is likely to revert to its average valuation level during this period. This will result in a 2.8% annualized expansion of its valuation level. Moreover, Omega Healthcare has grown its FFO at a 4.5% average annual rate in the last decade and can be reasonably expected to continue to grow at a similar pace from next year, as it will complete its asset repositioning this year.
Overall, given a 4.5% annual growth rate, a 2.8% annualized expansion of the P/FFO ratio and its current 8.0% dividend yield, Omega Healthcare is likely to offer a 15.3% average annual return over the next five years. This is an exceptional return, which is extremely hard to find elsewhere given the almost decade-long bull market and the current all-time high level of S&P.
Moreover, investors should realize that this expected return comes with a reduced risk level, as Omega Healthcare is markedly resilient to recessions thanks to its reliable cash flows. During the Great Recession, when most companies saw their earnings collapse, Omega Healthcare saw its FFO decrease only 3%. The resilience to economic downturns is a very important attribute of Omega Healthcare, particularly given the absence of a recession for nine consecutive years and the rising interest rates.
To sum up, Omega Healthcare had dramatically underperformed S&P in the last two years but the market has realized lately that its issues are temporary and has thus rewarded the stock with a 30% rally in the last four months. Nevertheless, the REIT still has the potential to offer an exceptional 15.3% average annual return over the next five years. Moreover, as its funds from operations are sufficient to cover its dividend and are expected to keep growing, investors can initiate a position in the REIT with an 8.0% initial yield and rest assured that the dividend will not be cut anytime soon. Overall, the REIT has a markedly favorable risk/reward profile.
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