High Exposure to Variable Interest Rates Reduces UHT's Dividend Coverage

Dividend coverage is becoming a more considerable concern for medical office REIT Universal Health (UHT) with around 85% of the firm's debt carrying floating interest rates.

Although the small-cap REIT, which primarily owns medical office buildings (67% of properties) and acute-care hospitals (18%), uses interest rate swaps to limit exposure to rising rates, only half of UHT's variable-rate debt is protected.

Considering these swaps, which mature in 2024 and 2027, UHT stated in its 2021 annual filing that "each 1% change in interest rates would impact our net income by approximately $1.4 million." 

That statement was published when the firm's weighted-average variable interest was just 1.4%. Six months later, that rate had jumped to 2.7% and likely exceeds 4% today.

Rising interest expenses can amplify other problems, like the firm's three vacant buildings that we estimate are dragging down funds from operations (FFO), the equivalent of operating cash flow for a REIT, by around 5% compared to last year.

These factors have collectively reduced the dividend's margin of safety and created a more tentative outlook.

We estimate that UHT’s FFO payout ratio may exceed 90% (up from 77% in 2021) if the weighted average variable rate on the company's debt rises just 2% higher than June's reported rate. And the situation would become more problematic if rates remain elevated when the firm's interest rate swaps begin to expire in 2024.

In light of the company's high mix of variable-rate debt, lack of progress in leasing out several vacant properties, and tightening financial flexibility, we are downgrading UHT's Dividend Safety Score from Safe to Borderline Safe.

While we don't necessarily expect an imminent cut, the downgrade reflects a more challenging environment where the risks are beginning to outweigh the upside.

That said, the firm's impressive history of growing dividends for 36 consecutive years is worth noting. And we could see management fighting to keep this streak alive through a challenging period.

But this higher interest rate environment may be around longer than some think, which can prove more challenging for smaller REITs like UHT, which have fewer financing options than their larger peers.

If we were shareholders, we would consider replacing UHT with more financially sound and larger healthcare REITs like Welltower, Healthcare Realty, or Physicians Realty. 

We will continue to monitor UHT's performance and provide updates as needed.