Wednesday, December 18, 2013

HCN: How Do Interest Rates Impact Value?

Market prices are always fluctuating around true fundamental value.  Sometimes, investors become overly optimistic about a particular company or the market as a whole.  When this happens, prices often increase beyond what long-term fundamental growth can justify.  

Other times, an overly pessimistic outlook drives the price of a stock too far down.  At Donaldson Capital Management, we call these kinds of companies “vexed”.  In other words, the market is discounting a stock based upon a current or upcoming headwind.  These headwinds can come in many forms including concerns about future company growth (IBM), legal problems (JPM), or concerns about a particular economic region (AFL).

The market often overreacts to these headwinds, causing these “vexed” companies to be driven below their true fundamental value.  Investors who can see through the short-term doom-and-gloom have an opportunity to purchase high-quality companies at a temporary discount.

One particular company we believe is “vexed” right now is a real estate investment trust (REIT) Health Care REIT, Inc. (HCN).  HCN owns a diverse portfolio of healthcare real estate that includes senior housing communities, skilled nursing facilities, and inpatient/outpatient medical centers.  The price of HCN has dropped by over 29% from highs near $80 in mid-May 2013.

The most obvious reason for HCN’s decline has been the upward hike in interest rates.  An increase in interest rates is negative for REITs such as HCN for two main reasons:

  1. To receive favorable tax treatment, REITs are required to distribute at least 90% of their earnings to investors in the form of a dividend.  The above-average yield for many REITs (currently 5-6%) makes them very popular for investors who are looking for income - especially in low interest rate environments. When interest rates rise, however, investors demand a higher yield for all income-producing asset classes.  Since yields are inversely correlated to prices, higher interest rates mean falling prices for bonds and high-yielding equities, such as REITs.
  2. REITs finance the purchase of new real estate projects.  When interest rates are rising, associated borrowing costs increase as well.  Higher costs mean less earnings to pass on to shareholders.

Since Ben Bernanke first suggested the Fed would begin tapering Quantitative Easing (QE), the 10-year U.S. Treasury is up nearly 50%.  Many are speculating that interest rates could increase another 50-75 basis points in 2014.  Let’s take a look at how these interest rate changes might impact HCN looking ahead.

HCN Valuation: May 2013

Our proprietary dividend valuation tool measures current price against the predicted intrinsic value based on a number of different variables, primarily dividend growth but also including interest rates and other economic variables. The chart below is a snapshot of HCN in mid-May.

May 2013
The blue lines represent the model’s predicted fair value with the red line representing current price.  As you can see, the 17-year model predicted that HCN was nearly 23% overvalued from its May 2013 price of $76 - well above both its predicted midpoint ($62) and upper statistical range ($69).

What Does HCN Look Like Today?

Below is the snapshot of HCN’s latest 17-year chart as of December 2013:
December 2013
After factoring in the near 50% increase in interest rates, the model now predicts the fair value (represented by the blue bars) is $55 with a trading range roughly 10% to either side of that. The current price of approximately $54 is below its current fair value today. Looking forward to 2014's projected value (represented by the checkered blue bar), the model predicts HCN is undervalued by nearly 10%.

How Do Interest Rates Impact Valuation?

As you saw in the difference between the May 2013 and December 2013 charts, the increase in interest rates lowered the predicted fair value of HCN from $62 to $55.  If interest rates continue going higher, how will that effect HCN?

Not as much as you might think.  We altered the model’s predicted interest rates to see how sensitive HCN’s price is to an increase in interest rates.

The chart below shows the same 17-year December 2013 model with the assumption that interest rates in 2014 would go up by 100 basis points or 1%.

If Interest Rates Increase by 1%
As the chart above shows, the increase in interest rates lowers the December 2014 predicted value from $59 to $54.  With the current price at just under $54, it seems as though the market is trading HCN with the assumption that interest rates are going to go up by 1%.

Our macroeconomic team currently believes that QE tapering will increase rates modestly in 2014, but we don’t believe the 10-year U.S. Treasury will get much higher than 3.5%.  In fact, we anticipate rates will continue to stay low until at least 2015.

The chart below reflects our belief that interest rates will likely rise by approximately a half of a percent in 2014:

If Interest Rates Rise by 0.5%
Assuming rates will rise modestly in 2014, our model suggests HCN should trade at $56.50 next year.  The 5% undervaluation coupled with a 5.7% dividend yield indicates that HCN is likely to produce a total return of 8-10% over the coming 12 months.

What About HCN’s Long-Term Future?

The U.S. Bureau of the Census projects the number of Americans 65 years and older will increase by 120% over the next 40 years.  The aging population means HCN’s facilities will continue to see solid demand for many years to come.

Healthcare is more of a non-discretionary industry, which helps insulate HCN from adverse economic changes.  Furthermore, 82% of their revenues come from private payers - which means HCN is protected from significant changes in Government funding.

Back in 2008-09, HCN and other financially strong REITs were able to buy some really good properties at bargain prices.  They’ve also got a lot of cheap money on their books and have done a great job of re-financing since the Great Recession - spreading out their debt risk across varying rates and maturities.

Conclusion: Even in the Face of Rising Rates, HCN Is a Buy

We believe the market has overreacted to the rise in interest rates and incorrectly priced HCN.  While the short-term reaction to Fed tapering could cause prices to fall even further, we believe HCN is at a value today with a rising dividend income stream and very good long-term prospects.

DISCLAIMER: DCM clients and employees may own HCN and/or JPM.