I get a lot of questions from readers about holding real estate as an investment. Indeed, many are in response to another newsletter editor who was recently advocating that the only way for retirees to make decent income was to own property.
Personally, I wouldn’t hold physical property in our portfolio for three reasons.
First, it’s very illiquid; that makes it an instant failure on our Five-Point Balancing Test.
Second, you won’t get yield from a property for three to five years, but will instead pay to own it.
And third, depending on the size of your portfolio, an investment in physical real estate could throw off your balance. Allocating too much of a portfolio to a single industry is never a good idea. With a piece of property worth $100K, $200K, or more, you can suddenly find your retirement very dependent on the outcome of a single asset class.
However, at the same time, it’s hard to ignore that something is happening in real estate. The post-crash taboo around it is starting to disappear as prices increase. Are we so bullish on real estate that we would buy properties in Las Vegas? No, we’re not there; but at the same time, we wouldn’t mind dipping our toe into the shallow end of the pool with some more conservative opportunities.
Furthermore, rather than investing in physical properties directly, we’d rather invest in real estate investment trusts (REITs), which are traded on a stock exchange like any other stock. REITs are corporations that buy, sell, and rent real estate for their shareholders.
To be considered a REIT, 75% of a corporations income must come from real estate in some form. Furthermore, REITs can deduct their dividend payments from taxable income.
Here are a few more of their key advantages over physical property:
-First, there’s the liquidity. You can buy shares this morning, change your mind, and sell them by the end of the trading day. Try that after signing a purchase agreement and the checks have gone through the physical property.
-Second, REITs are required to pay out 90% of their net income to their shareholders or they lose their special tax status. Where physical property doesn’t usually provide a yield right away, REITs will start paying right off the bat;
-And last, you can invest to match your portfolio, whether its purchasing only $1,000 or $1 million worth of shares.
These are some of the advantages of REITs, but there are drawbacks as well. I asked our senior analyst, Vedran Vuk, to find us a REIT worth adding to the portfolio. His pick is a little more conservative than most REITs, but its great way to pick up steady dividend income with capital appreciation potential as well.
HCP (NYSE:HCP) – BUY
As just noted, we’re not looking to dive into the Florida condo market nor to start flipping houses in Vegas. Nonetheless, we still want to dip into the real-estate market… just not in the deep end of the pool.
Healthcare REITs are a more stable area in the real-estate investment world. While they took a hit in 2008 like many other real-estate investments, many bounced back a lot quicker than other REITs. Along with being more defensive, healthcare REITs offer a unique opportunity for retail investors. While most of us could afford a single-unit investment property or even an apartment building, only the wealthiest could even think about investing in a hospital or a retirement home on their own.
While researching the choices in the healthcare sector, HCP stood out. From the firm’s core operating principles, you can quickly see why:
1. Opportunistic investing;
2. Portfolio diversification;
3. Conservative financing.
HCP only invests when a good opportunity presents itself. In a recent earnings call, an analyst asked why HCP was making fewer acquisitions than many others (although the company is still making plenty). One of the executives answered that you don’t swing at every ball the pitcher sends your way. That’s our perspective as well. It’s not just about hitting home runs, but knowing when not to swing as well.
This item is very important to us too. Since this is our entrance into the real-estate sector, we don’t want to put our whole bet on a single part of the country. The map below shows the concentration of properties. While some places like California aren’t our favorite locations, within a diversified portfolio with strong allocations in Texas, Pennsylvania, Ohio, and Florida, among other states, the portfolio is diversified enough to mitigate the risk.
In addition to geographic diversification, we don’t want to get stuck in just one type of property, such as hospitals or medical offices. With more and more healthcare regulation coming through, certain types of buildings will be more affected than others.
For example, for all of the types of healthcare properties, Obamacare will have the most negative impact on nursing homes. The impact isn’t enough to crush those operators, but I certainly wouldn’t want a portfolio of 100% nursing homes in light of the new law. With a diverse mix of properties, HCP protects itself from being exposed to any single change in legislation.
Let’s break down these individual types of properties. “Post-acute/skilled nursing” facilities are essentially nursing homes with skilled professional nurses assisting residents with continuous therapy.
“Senior housing” includes communities designed to help with the requirements of aging. They are not, however, necessarily staffed with skilled nurses. Senior housing includes assisted-living facilities, independent-living facilities, and continuing-care retirement communities. Some of HCP’s primary property operators in this space include Brookdale Senior Living (NYSE:BKD) and Sunrise Senior Living (NYSE:SRZ)The demographics pushing for these two properties are overwhelming. With 10,000 baby boomers reaching 65 every day for the next 19 years, these facilities won’t be running out of customers anytime soon.
“Life sciences” represents office buildings with modifications for pharmaceutical companies and other biotech firms. Currently, almost the entire life-sciences division is located in Mountain View, California (AKA the San Francisco suburbs). However, the company is developing a few new life-sciences projects in Durham, North Carolina.
And last, the “medical offices” classification is self-explanatory. However, note that these physicians’ offices are not scattered around remote shopping centers. Instead, 83% of them are located on hospital campuses. With an almost $21 billion market cap, HCP ownership totals in these properties are: 447 senior housing communities; 313 skilled nursing facilities; 274 medical office buildings; 108 life sciences properties; and 21 hospitals.
Perhaps even more important than diversification is the company’s conservative financing. S&P rates HCP’s credit toward the lower end of investment grade with a BBB+ rating. That’s not bad, but not perfect either.
Beyond the credit ratings, a REIT’s loan structure is a key point to take in to consideration, because interest rates are the Achilles heel of the industry. That’s why we’re putting HCP in our moderate risk category.
When interest rates rise, REITs are sometimes squeezed on two or even three fronts. First, with higher interest rates, there will be fewer buyers in the market, meaning real-estate prices will drop. Second, if the REIT wishes to purchase new properties, it will have to pay higher rates to do so. And third, if the REIT was borrowing with variable-rate loans, costs will go up regardless of what happens.
Unfortunately, there’s not much one can do about the first two factors. However, the third can be avoided by staying clear of variable-rate instruments, and that’s exactly what HCP does. 93% of its portfolio is in fixed-rate loans, with only 7% represented by variable rates.
If interest rates rise, does that mean HCP is toast? Not necessarily; REITs are not like bonds. When rates go up, bond prices must go down. On the other hand, higher rates will put pressure on REITs, but will not necessarily crush them. We could have a scenario where there’s a really strong real-estate recovery matched with rising rates – the surge in demand could possibly offset the higher rates. This is a possibility, but we wouldn’t necessarily bet on it.
When rates start to rise, we’ll likely look for the exit door. Also, be aware of the interest-rate risk in your overall portfolio. If you’re already very heavy in CORP, our PIMCO investment-grade bond fund, consider buying a little less HCP or selling a little CORP prior to adding another asset with interest-rate risk.