Health Care REITs: Factors Behind 5.5% Payouts

by Dee Gill

Poor returns from Health Care REIT (HCN) and competitor HCP (HCP) this year provide reminders that investors can lose money while collecting big dividends, even when the underlying companies are sound. They offer cautionary tales for income investors attracted to their 5.5%-plus dividend yields now.

Both Health Care REIT and HCP get Three-Rolaids ratings on the YCharts Dividend Stress-o-meter, a bogus device that uses serious fundamentals analysis to measure the level of risk in big dividend stocks. Most stocks with large dividend yields create the need for at least a little antacid, because high yields often come from troubled or slowing businesses. One-Rolaids investments are most likely to create only a low level of stress. Two-Rolaids investments have a higher potential for causing moderate anxiety. Three-Rolaids investments are most likely to create serious heartburn.

An earlier column dissected the prospects of Windstream Holdings (WIN), and its 12.5% dividend yield.

HCN Total Return Price data by YCharts

Health Care REIT and HCP have offered a couple of the best dividends in the S&P 500 in recent years, with current yields now running 5.6% and 5.8% respectively. But steep share price declines mean that their shareholders are losing money this year. Investors in these companies lost money in total return terms (dividends plus share price changes) while S&P 500 investors have collected about 28% total returns this year.

Until 2013, health care REITs provided grand income for investors. Each of these companies, which own properties like senior housing facilities, outpatient clinics and medical office buildings, more than doubled total investor returns between 2008 and January 2013. Theoretically, our aging population should bring both companies more business in years to come. But several issues make buying their shares much riskier today.

Much of their revenue comes directly or indirectly from federal and state governments, which are doing everything possible to cut medical costs now. Stricter caps on rent or other payments would make income gains more difficult. Dividend payments in REITs are based on income; roughly a 90% payout of whatever the company collects. If payments drop, so could dividends, although the companies usually increase the percent paid out in lean quarters in order to maintain good track records.

HCN Dividend data by YCharts

Interest rate changes also present a threat to investor returns here. These shares have been popular in large part because there are few other places for income seekers to put their money. Right now, even junk bonds pay little more than the dividend yields of Health Care REIT or HCP. Treasuries and corporate bonds still yield less than 3%, as illustrated here by the yields on iShares Barclays Immediate Credit ETF (CIU), Vanguard Short-Term Corporate Bond Index ETF (VCSH) and PIMCO Investment Grade Corporate Bond Index ETF (CORP) and SPDR Barclays High Yield Bond ETF (JNK).

CIU Dividend Yield (TTM) data by YCharts

10 Year Treasury Rate data by YCharts

This lack of choice for income has propped up valuations on both companies' shares. Although moderately cheaper than they were earlier this year, the prices still look high for companies with very little earnings or revenue growth in their forecasts next year. Few analysts see value in buying either share at these levels.

Share prices likely will fall further if interest rates rise, when more income investors likely would return to more diversified portfolios. Already, we can see this waning of enthusiasm for REITs generally in the falling share price of the Vanguard REIT Index (VNQ).

VNQ data by YCharts

HCP gave investors further cause for concern in October-- when its board unexpectedly ousted Chairman and Chief Executive James Flaherty, saying it had lost confidence in him after a decade of leadership. Although the board immediately filled the CEO position with a respected outsider, Lauralee Martin of Jones Lang LaSalle, there's still concern about what conspired to warrant the change. The board says it just wanted new blood.

Health Care REIT, which is more focused on senior housing and care, has fared a little better in market opinion. A recent strategy change has led the company to enter profit sharing agreements with its tenant operators, which gives the company a revenue stream in addition to rent. But Health Care REIT faces the same broad market hurdles as HCP, and its share price fall has been nearly as harsh in the past six months.

HCN data by YCharts

Health Care REIT and HCP are shares best held by investors who are comfortable with a high level of risk on the promise of high dividend payments. Pressure from customers to cap prices, paired with the high likelihood that rising interest rates will sap interest in both of these shares, could create a high level of stress for conservative income investors who sign up for these dividends. Those comfortable with risk can unleash some equity research tools on the stocks.

Disclosure: No positions

Source: Health Care REITs: Factors Behind 5.5% Payouts

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