An Alternative Way To Play Health Care

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David Evanson and Nick Schorsch, Winter, 2011

There are several macro trends that make health care investing as much a sure thing as that principal applies to investing. It’s not just the trends that matter, it’s the immutable facts that go with them.

Here are the facts: First, as people age, they need more health care services. Second, as people age, more and more of their income is devoted to health care expenditures. Third, government health care expenditures as a percent of GDP will continue to rise.

Now the trends. According to U.S. Census Bureau projections, the 40.2 million seniors today, will grow by more than 50% to 63.9 million in 2025, on it’s way to 88.5 million in 2050. The impact of this trend on national health care expenditures cannot be underestimated. According to the Centers for Medicare and Medicaid, health care expenditures for people over the age of 65 are 5.6 times more than children and 3.3 times more than working age persons.

That, in a nutshell, is the primary driver behind the “hockey-stick” like projections in total health care spending from $2.5 trillion today, to $4.6 trillion in 2020.

Even under the most rudimentary of valuation metrics–price to sales–it’s fairly easy to project a continued rise in health care-related assets.

Selection of the right health care assets is of course far more difficult. One less obvious way to play this trend is through health care related REITs–for example, those that focus on buying health care- related properties. At the broad-brush level, health care properties bear much less execution risk than health care equities. That is, regardless of how successful companies are at developing and marketing new cancer therapies, or spinal implants, they will nonetheless, maintain and expand their facilities to do so.

Getting deeper into the weeds with health care related REITs offers more interesting, and perhaps more profitable dynamics. As health care expenditures continue their inexorable rise, the focus on cost containment is driving consolidation. This can be seen not only in the appetite of Johnson & Johnson for M&A, but of the largest health care REITs too such as Ventas (VTR) and HCP (HCP), which have been buying other health care REITs.

The existence of liquidity at the top end of the market offers investors opportunities to earn income–the average for health care REITs is 5.2%–and capital gains in the form of a takeover premium. Higher yielding health care REITs include Medical Properties Trust (MPW) with a yield of 8.9%, Healthcare Realty Trust (HR), which yields 7.4%, and National Health Investors (NHI), which currently yields 6%.

The obvious play here are the smaller health care REITs, of which there are several. The less obvious, though perhaps more palatable, alternative for individual investors is the class market of so-called non-traded REITs. Non-traded REITs are just what they sound like, at least initially, and what they take away in liquidity, they make up for in yield, which are generally 100 to 200 basis points higher than publicly traded health care REITs. Examples of non-traded REITs include Healthcare Trust of America and Inland American Real Estate Trust.

The absence of liquidity is a double edge sword, in my view. While the inability to convert these investments into cash quickly is an obvious drawback, on the other side, investors are shielded from the volatility inherent in publicly held equities. In most cases, non-traded REITs ultimately do go public. Thus, for investors who can afford to wait, like to sleep at night, and allow the macro trends to exert their influence, a non-traded REIT might be one of the best ways to play inevitable rise in the value of health care related assets.