Recently, REITs have been selling off because interest rate yields have been rising. This tends to dampen growth in the real estate market and can drive investors who are holding REITs for income back into bonds when those yields become more attractive. In the next chart you can see how the bubble in REIT prices popped just after yields in the 10-year U.S. Treasury note rose began to rise in May 2013.
Click to Enlarge Although the price-shock in yields and REITs in May was disruptive it also brought some of the best REITs to historically low prices. We have been looking for a good opportunity within the group that also has exposure to a leading stock industry group, which is why we focused in on Omega Health Care Investors (OHI).
Omega Health Care Investors (OHI)
No matter how you slice the data, the U.S. population is aging and that means elder-care is big business and likely to get bigger. Although demand has been consistent and likely to rise in the future, the number of long term, skilled-nursing care centers has been declining. This is OHI’s sweet spot and opportunity for the future.
OHI owns the real estate and provides lease or mortgage financing to the operators of skilled-nursing care centers. The portfolio is diversified across 477 different holdings in 35 states run by 46 different operators (tenants). With the share of Medicare and Medicaid spending allocated to long-term nursing care growing, this is an attractive sector for reliable growth.
Click to Enlarge OHI has been consistently growing top-line and FFO “bottom line” numbers over the last several years and leverage has been stable. However, following a big beat in earnings on July 31, 2013 the stock sold off again to June lows. As you can see in the second chart, despite the attractive fundamentals, opportunity, and growth prospects the company’s stock is sitting at support – why?
REITs (including OHI) are often leveraged in two respects. First, OHI has to obtain financing for property acquisitions. Although the company has a low but still “investment grade” debt rating, that leverage will be more difficult to maintain in a higher interest rate environment. Traders are a little nervous about that exposure but its not the first time they have gotten cold-feet about OHI’s leverage. After each of the last few yield-scares, OHI doubled or nearly tripled in price.
Companies like OHI are also leveraged indirectly through their tenants (OHI calls them “Operators”). If the tenant struggles with reimbursements for care or becomes overleveraged themselves then OHI’s income stream is endangered. The recent cuts to Medicare due to the sequester and implementation of the Affordable Care Act has put some pressure on these tenants and investors are understandably discounting that into the stock. Nearly the same thing happened during the debt ceiling crisis of 2011 just before the stock more than doubled in price.
If higher interest rates in the future aren’t offset by economic growth then bonds will compete more effectively with REITs and other income stocks for investment dollars. The decline in consumer-defensive, utilities and REITs in the second quarter of 2013 is a good example of what happens when capital leaves income stocks and moves into higher risk equities and/or bonds.
These are valid concerns but we believe OHI has done a good job securing its debt against rising interest rates in the short term and is in a very defensive industry in case the economy begins to decline again. The Fed seems determined to keep rates low through 2014, which eases the pressure on OHI and its tenants. Overall, we think the potential for a bounce at trendline support is very high.
Recommendation: Buy OHI at current prices with a 2013 price target of $38 per share.
Option Alternative: Buy to open the OHI December 30 calls for $2.00 per share or less. As of the open, they’re trading at $2.05, so be patient for a pullback.
InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.