Investing in real estate investment trusts, or REITs, is one of the best ways to enjoy high dividends andthe potential for capital growth. On a valuation basis, REITs specializing in healthcare properties are trading cheaply right now, and two seem to be a particularly good bargain:HCP Inc. and Medical Properties Trust .
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Why healthcare real estate?
This type of real estate should be an excellent long-term investment for three main reasons: demographics, increased healthcare spending, and market opportunity.
Demographics indicate a growing demand for healthcare properties over the coming decades. Simply put, the population is getting older -- fast. The 65-and-up population in the U.S. is expected to nearly double by 2050 as baby boomers age and live longer. Older individuals require more healthcare, therefore the number of healthcare facilities will grow to meet the demand.
Image source: HCP investor presentation.
Furthermore, healthcare costs are rising at a faster rate than other expenditures, as you can see in the chart below. Given that commercial properties derive most of their value from their ability to generate rental income, healthcare properties should appreciate faster than other property types as long as this trend continues.
Finally, the healthcare real estate market is about $1 trillion in size, and no REIT has more than a 3% market share. The industry is highly fragmented, meaning there are plenty of opportunities for new investments from existing properties, in addition to the opportunities that will come from future growth of the industry.
Things are about to get interesting for HCP
HCP is one of the "big three" healthcare REITs, and it owns 1,179 properties in a variety of categories -- mainly senior housing, post-acute care, life science, and medical office buildings. Essentially, the business model is to acquire attractive properties and team up with some of the best operating partners in the business, such as Brookdale Senior Living.
The company pays a notable 7.1% dividend yield and has an even more impressive record of dividend growth. In fact, HCP has increased its dividend for 31 consecutive years and is a member of the S&P 500 Dividend Aristocrats.
HCP's biggest recent news item is the planned spinoff of its HCR ManorCare assets, which include virtually all of the post-acute/skilled-nursing properties in the company's portfolio. You can have an in-depth look at the spinoff, but the general goal is to allow HCP to focus on its private-pay senior housing, life science, and medical office properties, thereby improving portfolio quality and giving the company more financial flexibility to pursue future growth opportunities. The spun-off assets, meanwhile, will be placed in a newly created REIT that will strive to maximize their value.
According to HCP, once this happens, the company can employ several new strategies with these properties, including some that are not possible or practical while the assets are still a part of HCP.
Data source: HCP company presentation.
Why Medical Properties Trust?
Medical Properties Trust focuses on hospital properties, which, according to the company, produce better initial yields than other types of healthcare real estate. In fact, the company is the fourth-largest owner of for-profit hospital beds in the country.
Data source: Medical Properties Trust.
The company has 204 properties located in 29 states and four foreign countries, and the long-term plan calls for even further international diversification. This way, if one market faces headwinds (say, the U.S.), it won't represent virtually all of Medical Properties' assets.
The company does have a relatively high debt load for a REIT: Debt represents 51.6% of Medical Properties' assets, so there's added risk to consider. However, 98% of the portfolio's leases have annual rent increases built in, and the company's payout ratio is less than two-thirds of FFO -- lower than that of most peers.
In short, there's no reason to believe Medical Properties Trust will have any debt-related issues going forward, with a growing stream of income that's already more than enough to cover the dividend.
Valuation: Healthcare REITs are cheap
When valuing REITs, it's important to use funds from operations (FFO), as the traditional metric -- net income, or "earnings" -- doesn't really give a clear picture of a REIT's profitability. (For more about REIT valuation, check out this article.)
With that in mind, here's how these two REITs stack up to some leaders in other forms of commercial real estate:
Note: Share prices and guidance are current as of 5/23/16. Normalized or adjusted FFO guidance is used when available.
The bottom line
No stock with double-digit growth potential is without risk, and these two are certainly no exception. In fact, a higher level of perceived risk is responsible for the low valuations. Healthcare spending could slow, operating partners could face greater financial difficulties, or there could be a shortage of attractive acquisition opportunities in the target property types. Any one of these factors could cause these stocks to take a dive.
However, I think the growth potential and the solid track record of delivering profits in a variety of economic climates more than make up for the risks. Either of these healthcare REITs would make a solid addition to a well-diversified dividend growth portfolio.
The article These 2 High-Yield Dividend Stocks Are Ridiculously Cheap originally appeared on Fool.com.
Matthew Frankel owns shares of HCP and Realty Income. The Motley Fool has no position in any of the stocks mentioned. 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.
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