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National Health Investors (NHI)

Formed in 1991 when National Health Corp (NHC) spun off its senior housing properties, National Health Investors (NHI) is one of America's oldest healthcare REITs. The company has built a small but diversified portfolio of properties across various industries, including independent, assisted living and memory care communities; entrance-fee communities (gated retirement communities); skilled nursing facilities; medical office buildings; and specialty hospitals.

Today the REIT owns 220 properties in 32 states, leased to 32 medical facility operators. The vast majority (95%) of National Health Investors' revenue is derived from triple net leases on sale-leaseback deals (NHI buys a property and then leases it back to operator under long-term contract with annual rental escalators tied to inflation), in which the tenant pays maintenance, insurance, and taxes.
Source: National Health Investor Earnings Presentation
Since being spun off in 1991, National Health Investors has become far more diversified, with its single largest operator now representing just 15% of rent. That's compared to 100% 26 years ago.
Source: National Health Investors Earnings Presentation

However, note that 67% of assets are still concentrated in the senior housing industry, with another 28% from skilled nursing facilities. While senior housing relies primarily on private pay sources, note that a significant portion of the revenue of National Health's skilled nursing facilities tenants is derived from government funded reimbursement programs, such as Medicare and Medicaid.
Source: National Health Investors Earnings Presentation

Business Analysis

To achieve long-term success, a REIT usually needs three things. The first is a quality management team characterized by disciplined capital allocation, a conservative approach to debt, and a long-term dedication to steady and safe dividend growth. 

NHI's management certainly appears to be top shelf, led by President and CEO Eric Mendelsohn. Mr. Mendelsohn has over 20 years of experience in medical properties including serving for close to a decade as Senior Vice President of Corporate Development for Emeritus Senior Living. Prior to that he was the transaction officer for the University of Washington, where he oversaw development, acquisition and financing of research, clinic and medical properties.

The second key factor for any REIT is a good business model, one with strong and stable recurring cash flows. National Health Investors specializes in triple net lease REITs, which means that it has very low overhead costs and merely serves a landlord collecting high-margin rent. Its leases are usually 10 to 15 years in duration (no major lease expirations through 2025), ensuring excellent cash flow predictability from which to fund its generous and safe dividend.

The final component of a good REIT is an ability to grow profitably. This requires two things: a low cost of capital, and a large pool of assets it can purchase at attractive cash yields (cap rates).

National Health has managed to strike a good balance between seeking highly profitable acquisitions, with high cap rates (historically 7.75%). This is combined with its low cost of capital (about 4.5%) to create gross cash yields of 3% to 3.25%, which is among the highest in the industry.

In other words, despite funding about 60% of its growth through equity (selling new shares), National Healths’ adjusted funds from operation, or AFFO (similar to free cash flow for a REIT), per share rises with each new property purchased.

In 2017 the REIT purchased $214 million in new properties at a cap rate of about 7.7%, which is in line with what it has been buying locations at the last few years. This led to 8.2% growth in AFFO per share, and management rewarded shareholders with a 5.2% dividend increase for 2018.

In the coming year, the REIT anticipates $173 million in new purchases at a weighted average cap rate of 7.6%, driving about 5.5% AFFO per share growth. Despite the fast-changing healthcare landscape, National Health continues to deliver more of the same reliable results. 

Importantly, management has an unofficial policy (baked into its conservative corporate culture) of growing the dividend slower than AFFO per share. This is in order to increase dividend safety over time, as well as provide the REIT with larger amounts of retained cash to reinvest into future growth.

Remember that all REITs are legally required to pay out 90% of taxable net income as dividends. This means that REITs are highly reliant on debt and equity markets to fund most of their growth. Maintaining a lower AFFO payout ratio results in a lower cost of capital and reduces a REIT's dependence on fickle stock prices to fund its growth. 

In other words, National Health continues to be highly conservative with its capital allocation, preferring slow and steady growth. It also chooses quality over quantity when it comes to growing its property portfolio.

For example, the company's average EBITDAR/rent coverage ratio (tenant's cash flow/rent) is 1.66, which is very reasonably safe. National Health's senior housing properties average 1.21 rent coverage (1.2 is considered safe in this industry) and remain stable. In skilled nursing, the firm's average tenant rent coverage is 2.52, which is far above the industry average of 1.35 (1.3 is considered safe for this industry).

So where some REITs will "reach for yield" and buy higher cap rate properties (as high as 9% to 10%) leased to distressed operators, National Health prefers to deal with the strongest operators in the industry.

That same kind of conservatism is seen with its use of debt. For example, historically National Health has had very low leverage ratios (debt/Adjusted EBITDA). In addition, its fixed-charge coverage ratio (EBITDA minus unfunded capital expenditures and distributions divided by total debt service) is much higher than its peers.

For instance, National Health has a firm policy of maintaining its leverage ratio between 4.0 and 5.0 (industry average is closer to 5.5). This ensures that the company has ample financial flexibility and can borrow very cheaply.
Source: National Health Investor Earnings Presentation
When combined with National Health's 20% retained AFFO (i.e. the company distributes 80 cents of every $1 in free cash flow it generates as a dividend, retaining the other 20 cents for growth projects), the REIT, despite its small size, has been capable of very profitable growth. The ultimate proof of National Health's conservative and disciplined growth approach can be found in its industry-leading historical growth in cash flow (FFO) per share, steady and fast-rising dividends, and solid long-term total returns.

Source: National Health Investor Earnings Presentation
America's aging population is expected to push up annual U.S. healthcare spending by 5.8% a year between 2014 and 2024, according to Ventas (VTR). As notes, the fastest-growing segment of the population is the oldest old - those 80 and over. That group in the U.S. is expected to rise from 5.7 million in 2010 to 12 million by 2030 and 19 million by 2050. As this demographic shift places out, demand should rise for senior housing and skilled nursing facilities. 

And given that only about 15% of America's medical properties are owned by REITs, this means that National Health Investors has a potentially long growth runway to fuel its generous and rising payout.

However, while National Health appears to be one of the more impressive REITs in its industry, be aware that there are numerous challenges that it will have to face in the coming years. 

Key Risks

National Health Investors has done a great job of navigating very challenging industry waters in recent years. That's thanks to management's strong focus on buying only high-quality properties which are generally leased to strong operators with above-average rent coverage metrics.

However, that doesn't mean the company doesn't still face a substantial amount of risk from ongoing struggles in the skilled nursing and senior housing industries. For example, in recent years the Center for Medicare and Medicaid Services (operate government healthcare spending) has been making painful but necessary changes to federal healthcare spending policies.

Most recently, CMS released a rule outlining just a 1% increase in their Medicare reimbursement for fiscal year 2018. National Health estimates that its tenants will be able to withstand this nominal increase for now thanks to their credit quality, profitability, and generally conservative debt coverage ratios. 

Regardless, CMS' actions have resulted in shorter patient stays and lower reimbursement rates at skilled nursing facilities (28% of NHI's assets). When combined with rising labor costs, operator margins are getting squeezed and rent coverage ratios have declined. This includes some of National Health's largest tenants, who still maintain reasonable coverage metrics today but could eventually run into trouble being able to pay their full rent.

  • Senior Living Communities (16% of cash revenue): 1.21 EBITDA coverage ratio
  • Bickford Senior Living (15%): 1.22 coverage ratio
  • National Healthcare Corporation (15%): 3.61 coverage ratio
  • Holiday Retirement (14%): 1.16 EBITDA coverage ratio

The good news is that management has done a great job of managing risks, via use of long-term master leases backed by collateral and securitization, such as an operator's credit lines.

However, the ongoing troubles of both the skilled nursing industry, as well as senior housing (which is battling oversupply and low occupancy), is probably why the REIT has wisely chosen to grow its dividend slower than AFFO per share. This causes the payout ratio to decline over time, creating a larger safety buffer in case several major tenants run into trouble

What investors need to realize, however, is that the demographic tailwinds expected to provide strong demand growth to the skilled nursing and senior housing industries may not arrive until the early to mid 2020's. Omega Healthcare (OHI), America's largest skilled nursing facilities REIT, says that its detailed demographic studies indicate that the industry's fortunes might start turning around as early as 2019.

But even if that optimistic scenario proves true, the skilled nursing and senior housing industries might continue to struggle, especially since wages are now rising faster. So is inflation, and Medicare/Medicaid reimbursement rates are only changed once a year. As a result, some of National Health's tenants have far less pricing power and are thus at risk of inflation compressing margins even further.

If enough tenants eventually get pushed over the edge, then National Health might eventually be put in the unfortunate position to have to once again cut its dividend, which it last did in 2000.

                                  National Health Investors Dividend History
Source: Simply Safe Dividends
Back in 2000 and 2001, sweeping Medicare changes caused devastation through the skilled nursing industry at a time when National Health was far less diversified. So when a major operator went bankrupt, this triggered a technical default (covenant breach) that forced it to slash its payout.

Today the REIT is far more diversified, and its relatively low and steadily falling payout ratio means that such a drastic cut isn't very likely. Still, the risks of this kind of worst-case scenario have been rising in recent years, as the supposed benefits of the America's fast-aging demographics (10,000 people reaching retirement age each day) have failed to stem the falling profits of the skilled nursing and senior housing industries.

In other words, despite its solid financial position today, National Health Investors could prove to be merely the "nicest house in an unsafe neighborhood" as the healthcare sector continues evolving (reimbursement model changes, demographics, etc.).

Closing Thoughts on National Health Investors

Over the past quarter century, National Health Investors’ management has proven to be long-term focused, disciplined with capital allocation, highly conservative with debt, and very friendly to dividend growth investors. 

Some healthcare REITs find themselves under financial pressure today as parts of the industry battle excess supply, rising labor costs, and shifting reimbursement models. However, National Health Investors' relatively low debt ratios, focus on stronger tenants, and increasingly conservative payout ratio have allowed it to continue growing its business and dividend (including a 5.2% boost for 2018).

With that said, income investors considering National Health still need to recognize the meaningful risks the business could face in the years ahead. Approximately 60% of the firm's revenue is generated by four operators (critical they remain healthy and able to pay their full rent obligations), and skilled nursing facilities, which are under some of the most pressure in the sector (high dependence on Medicare and Medicaid reimbursement), account for close to 30% of its assets.

Simply put, an investment in National Health probably requires greater monitoring and may not be appropriate for the most conservative dividend investors, even despite some of the company's impressive industry-leading metrics.

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