The high percentage of government-subsidized tenants (i.e. Medicare and Medicaid) of Omega Healthcare Investors (OHI) is often considered to be a bad thing (because the government creates painful pricing pressure that doesn’t exist among private pay tenants). However, in light of the coronavirus crisis, government support has become more attractive, and this shift is strengthened as Omega’s Skilled Nursing Facility (SNF) industry is in a much better place (in terms of supply and demand) than it was just a few years ago. In this report, we review Omega’s asset mix, market dynamics, dividend prospects, risks, and then conclude with our opinion on investing.
Overview:
Omega is a healthcare REIT currently offering a double-digit dividend yield. The company’s core business activity is to lease Skilled Nursing Facilities (SNFs) and Assisted Living Facilities (ALFs), as well as to invest in SNF mortgages. It has investments in 987 healthcare facilities which are located in the US and UK (4.2% of gross real estate investments), out of which 926 properties are owned, 2 are under direct financing leases and 53 are held as mortgages on healthcare properties. The properties owned include 784 SNFs, 114 ALFs and 28 specialty facilities. Omega typically enters into triple net leases under which tenants are responsible for capex, taxes and insurance expenses.
Lease terms generally range from 5 to 15 years with standard annual rent escalators of 2.5%. Omega generates 86% of its revenue from rental properties, while 8% is generated through mortgage notes and the rest 6% through other miscellaneous sources. The company has a tenant mix of 71 operators, with Ciena being the largest, accounting for around 10% of rental income. Below are the company’s top five tenants:
The business is historically recession proof, but the coronavirus is extraordinary
Healthcare REITs are generally considered a defensive play during recessions. Omega is particularly well-placed given the majority of its exposure to the healthcare sector is via triple net leases with automatic rental escalators. Additionally, a significant portion of the revenue earned by Omega’s tenant operators comes from the government in the form of Medicare and Medicaid, thus providing stability that few businesses have in today’s environment. More than 90% of the company’s leases expire after 2023 and only 0.2% of the leases are due for renewal in 2020. Finally, the company has over $1.2 billion of an undrawn line of credit for its use to manage short-term operational and financial volatility.
In order to better understand the company’s correlation to economic activity, we looked at how the Omega’s income generation fared during the last recession. Below is a chart depicting quarterly dividend payments by Omega during the credit crisis of 2008. As evident, the company successfully maintained its dividend during the most difficult part of the crisis and once the crisis subsided, resumed dividend growth. Additionally, the company’s operator tenants maintained a healthy level of coverage through the recession as well.
After several years of declining occupancy rate, trends seem to be bottoming
Occupancy levels had experienced consistent declines in the SNF industry since 2015. In part, this was due to home and community-based services (HCBS) gaining popularity as states looked to cut costs by offering home care alternatives as opposed to more expensive nursing facilities. As a result of the difficult occupancy trends over the last few years, the sector has seen capacity shrink (as evident in the chart below) particularly in rural areas as weaker players closed shop and new investments were paused. Further, low profit margins (i.e. low single digits among SNF operators) discouraged new entrants into the space.
As a result, the reduction in supply has led to better industry equilibrium. As evident in the chart below, occupancy declines seem to have stabilized since the first quarter of 2019, further added to our conviction in the company’s prospects.
Solid demographic tailwinds
Despite mixed trends over the last few years, it is important to note that the industry is expected to benefit from a multi-decade secular trend. Demand for SNFs and ALFs benefit from the aging population, as people over 75 spend significantly more time at SNFs than the 60-75 age group.
Post-World War II, birthrates increased significantly across US (they averaged approximately 3.8 million annually for the next 20 years). These “Baby Boomers” started to turn 75 in 2016, and the number of people aged 75+ is expected to see a strong upward trend in the next 20 years. The number of people above the age of 75, which is currently at around 23 million, will increase to over 45 million by 2040 (growing at an expected 20-year CAGR of 3.5% as compared to the overall population expected CAGR of 0.7%). Omega Healthcare and the broader SNF industry are expected to benefit from this demographic trend.
Selective growth investments
Omega has continued to use a mix of equity and debt to acquire properties in the highly fragmented market. For example, in May 2019 the Omega acquired MedEquities Realty Trust by issuing 7.5 million equity shares and $64 million in cash. Through this acquisition, Omega increased its portfolio by 34 properties. Further in October, Omega acquired 60 more properties through the acquisition of Encore for an investment of $735 million. The company also entered a joint venture with a Chinese private equity firm to buy a 49% stake in a portfolio of 67 care homes in the UK.
Well capitalized with access to ample liquidity
Omega issued $500 million of senior notes in September 2019, taking its total debt from $4.6 billion in 2018 to $5.1 billion by the end of 2019. These notes were issued in order to finance the recent acquisitions made by the company. While the interest rates on these notes is 3.6%, Omega typically generates yields of over 9% on its portfolio, thereby expanding net operating income and AFFO. Additionally, the company’s Net Debt to adj. EBITDA of 5.2 times and Interest Coverage of 4.2 times are right in the middle of the pack as compared to its closest two peers and imply a comfortable cushion in these times of volatility. Further, Omega has over $1.2 billion in an undrawn line of credit available to fund growth initiatives as well as manage any debt maturities.
Consistent history of dividends
Omega has a history of consistent and growing dividends for the last 16 years. In 2019, the company declared a dividend of $2.64 per share which represents a 1% increase from 2018. In the last 10 years, the dividend has grown at a CAGR of 10%. Although recent dividend increases have also been a function of increases in payout ratio, as occupancy in the tenant mix stabilizes and new investments add to AFFO, we expects dividends to grow in-line with AFFO in the future.
Source: Seeking Alpha & Omega Healthcare
Attractive dividend yield post market sell off
Given the market turmoil, there has been indiscriminate selling in most REITs and Omega is no exception. As a result of the sell off, the stock is offering a double-digit dividend yield (over 10%) which is much higher than the typical 6-8% yield Omega has offered over the past five years. Worth noting, just this week the company authorized a $200 million share buyback program.
Risks:
Coronavirus: Coronavirus has a disproportionate impact on seniors and significant loss of lives at senior care facilities during this time could attract government action and tighter controls that could impact the way the industry functions. For reference, there have already been multiple reports of coronavirus outbreaks at various types of healthcare REITs.
Proposed budget cuts: Any government budget proposals that cut (or reduce growth in) Medicare or Medicaid spending will have a negative impact on Omega’s operators. However, any such actions would be met by fierce opposition by various interest groups considering how entrenched these programs are in peoples lives, and the fact that they already run lean. We assign a low probability to any major changes to Medicare/Medicaid programs in the near to medium term.
Conclusion
Omega shares have been indiscriminately lumped together with other healthcare REITs in a market that is shunning risk across the board. However, the company’s cash flow streams are much more stable than the current share price implies. The majority of Omega’s lease income comes from tenants that primarily rely on government healthcare plans such as Medicare and Medicaid for revenue. Given the limited private pay exposure, the company’s tenants typically see minimal volatility during recessions. As such, Omega’s current yield of over 10% offers investors the ability to lock in high income on a stable grower with a history of strength, even during difficult times.