Omega Healthcare Investors (OHI): Safe, High-Yield Income or Value Trap?

Certain real estate investment trusts (REITs) can be an excellent way for investors to meet their income needs, especially for folks living off dividends during retirement.

 

That being said, as with all investments, it’s important to be careful and focus on high quality stocks with a long-term-focused management team, a safe dividend, a strong balance sheet, and good growth prospects.

 

So let’s take a closer look at Omega Healthcare Investors (OHI), America’s largest skilled nursing facility (SNF) REIT and one of the 30 best high dividend stocks here, to see if it still meets all of these criteria given the fast-changing healthcare landscape.

 

Business Overview

Founded in 1992 in Hunt Valley, Maryland, Omega Healthcare Investors is America’s largest SNF and senior housing REIT, with 972 properties rented to 77 operators across America and the UK.

 

The company’s largest state (Ohio) accounts for 10.4% of total rent and Omega’s three largest tenants generate 24% of total rent (Ciena 10%, Signature 7%, Genesis 7%), so the business is fairly diversified.

 

 

Approximately 83% of Omega Healthcare’s total revenue is from rents paid by its tenants, which receive revenues through Medicare and Medicaid reimbursements as well as private pay for their services.

 

Omega receives fixed rent payments from its tenants with annual escalators and uses triple net lease agreements, which are generally thought to be lower-risk deals because they require the tenant to pay property taxes, insurance, and maintenance expenses.

 

The remaining 17% of Omega’s revenue comes from loans and mortgages it finances to construct third-party facilities.

 

 

Of the company’s total rental revenue the vast majority is derived from SNF facilities, which are Omega Healthcare’s specialty; senior housing accounts for the remaining 15% of rental revenue.

 

Business Analysis

Omega Healthcare has a great long-term track record of providing superior total returns, both compared to the S&P 500 and its rival medical REITs.

 

 

That’s courtesy of Omega’s impressive 10.8% annual dividend growth over the past 14 years, a result of very fast, acquisition-fueled growth in the REIT’s property portfolio and adjusted funds from operation (AFFO – the REIT equivalent of free cash flow and ultimately secures and grows the dividend).

 

You can see that Omega Healthcare’s spending on acquisitions (purple bars) has dwarfed its annual capex investments (dark blue bars) over the last decade.

 

The company boosted its property count by nearly 50% with its $3.9 billion acquisition of Aviv on April 1, 2015, which helped Omega gain operating, growth, and cost of capital efficiencies while increasing its diversification by state and operator.

 

 

Thanks to its aggressive acquisitions, the company’s gross investment base, core revenue, adjusted EBITDA, and AFFO have all compounded by at least 20% per year since 2004.

 

 

However, the key to Omega Healthcare’s success isn’t just its fast growth in a highly fragmented industry; it’s also due to three major factors.

 

The first is that Omega Healthcare is a triple net lease REIT, meaning that the tenants pay the property taxes, maintenance, and insurance costs. Combined with very long-term and staggered contracts, this gives Omega Healthcare a profitable and dependable source of recurring cash flow from which to fund its steadily growing payout.

 

You can see that fewer than 5% of Omega Healthcare’s leases expire any given year until 2022, and 90% of its portfolio expirations take place after 2021.

 

 

The second important factor is management’s disciplined approach to growth. Specifically, that means targeting properties run by strong operators, meaning an EBITDARM (earnings before interest, taxes, depreciation, amortization, rent, and management fees) coverage ratio greater than one. That helps ensure that the operator is profitable enough to pay its rent.

 

While operating conditions can change quickly as the healthcare landscape continues evolving, only 3.4% of Omega Healthcare’s rent is from distressed operators with EBITDARM coverage ratio below one today, and its overall portfolio carries a reasonable EBITDARM coverage ratio of 1.69.

 

Another major factor to Omega’s success is management’s excellent capital allocation track record, which has resulted in some of the industry’s best profitability and returns on shareholder capital.

 

 

Now part of this impressive profitability, especially the high AFFO margin, is due to Omega benefiting from growing economies of scale. That means that the administration costs of running the REIT get amortized over a steadily-growing property portfolio and the cash flow it generates.

 

However, the other major reason that Omega is arguably the gold standard in its industry is that management is highly disciplined in only buying properties that are immediately accretive to AFFO per share.

 

That’s important because REITs must payout 90% of taxable income as dividends by law, meaning that most growth capital to acquire new properties must come from debt and equity markets.

 

Or to put it another way, the REIT business model is one where new capital is constantly flowing into the company. That means that poor management teams can sometimes grow the REIT’s portfolio for its own sake, because it can increase their management fees (for externally-managed REITs) while diluting shareholders to the point where the dividend can’t grow or must even be cut.

 

Fortunately Omega Healthcare is an internally-managed REIT, meaning that management is directly employed by shareholders and has its interest aligned with ours. Specifically this means that Omega is careful to only buy a new property, partly funded by the dilutionary sale of new shares, if the REIT’s AFFO per share will increase as a result, and thus allow for continued dividend growth.

 

Finally, the third major factor to look at is Omega’s access to cheap capital. Since the REIT industry is highly commoditized, one of the only competitive advantages a REIT can have is a weighted average cost of capital (WACC) low enough to allow it to profitably grow.

 

As you can see, thanks to Omega Healthcare’s relatively high proportion of retained AFFO, its overall cost of capital is below its trailing 12-month return on invested capital (ROIC).

 

This means that management is being good stewards of investor capital, only taking on new debt or selling new shares if they have a profitable investment opportunity that will ultimately grow long-term shareholder value.

 

 

All of these factors (quality management, a large diversified portfolio of properties rented out to generally strong operators, and a low cost of capital) help explain why Omega Healthcare is one of the best SNF REITs. However, there’s more to the investment thesis.

 

That’s because Omega is likely to benefit from one of the century’s strongest secular themes, the aging of the world’s population. And given the underinvestment in SNF facilities over the past decade, demand for these facilities is expected to outpace supply in the coming decades.

 

You can see below that the supply of facilities and beds to meet increasing future demand has been limited due to Certificate of Need (CON) restrictions, which are aimed at restraining health care facility costs and have helped industry occupancy rates.

 

However, it’s also true that there just hasn’t been a big need yet for more supply with the industry’s occupancy rate hovering around 80% and the number of patients in certified beds flat to down since 2009. Many of the demographic benefits have yet to show up in the numbers.

 

 

Similarly, despite various changes in Medicare and Medicaid, which have affected rates and shortened lengths of stay, the continued aging of America’s population means that overall patient volume and pay per day is expected to increase in the future.

 

 

Overall, SNFs seem likely to remain a primary choice for post-acute care because they offer one of the most cost-effective environments for rehab services due to their relatively smaller footprints and lower staff counts.

 

As seen below, SNFs have about 50% market share of patients sent to post-acute care.

 

 

All of which means that the SNF industry is likely to see reasonable growth in the coming years, and Omega Healthcare, thanks to its consolidation of the best properties in this industry, will likely continue to play a meaningful role in the future.

 

Key Risks

While Omega Healthcare has the wind at its back when it comes to acquisition-fueled growth and favorable demographic trends, there are nonetheless several important risks to keep in mind.

 

The first is that Omega’s property portfolio is highly dependent on government spending, with just 11.6% of its rent coming from private payers; Medicaid and Medicare / Insurance accounted for 52.6% and 35.8% of revenue, respectively, during the fourth quarter of 2016.

 

 

While the company’s percentage of revenue from private payers has been gradually climbing over time, thanks to management’s decision to decrease its reliance on government healthcare funding, Omega’s prosperity is unfortunately at the mercy of Washington for the foreseeable future.

 

For example, if the Senate GOP version of the healthcare reform bill were to pass, Medicaid funding would likely fall, potentially hurting Omega’s senior housing tenants.

 

Here’s what Fitch noted earlier this year:

 

“SNF margins are being pressured by increasing coverage under Medicare Advantage, Department of Justice investigations potentially influencing billing practices, and pilot programs for bundled payments and coordinated care. While the Trump administration appears to be in favor of slowing the growth of bundles and making participation voluntary, we believe the long-term demographic and economic factors will continue to drive the market towards these programs over the long run. We view these as long-term headwinds that stronger operators should be able to manage given they are fairly well-telegraphed.”

 

While Omega has enjoyed rising Medicare and Medicaid rates over time (see below), lengths of stay are declining under alternative payment models such as bundling and managed care. The largest, most conservatively financed operators are best positioned to handle these well-known challenges, but it’s a situation worth monitoring as the legislative and regulatory environments evolve.

 

 

Even before considering the Senate’s health bill, the SNF industry has been facing some trying times. For example, over the past few years numerous other healthcare reforms have resulted in declining industry profitability and EBTIDARM coverage.

 

One of Omega’s three largest tenants, Genesis Healthcare (GEN), has seen its stock price crumble nearly 80% since the start of 2015 as it faced charges for submitting false claims to Medicare and Medicaid for unnecessary therapy.

 

Many healthcare REITs have decided to exit the SNF space in recent years given the industry’s challenges and reimbursement uncertainties. Some of the biggest names include Ventas (VTR), HCP (HCP), and Sabra Healthcare (SBRA), which are all seeking greater portfolio quality and cash flow predictability.

 

The worst case scenario would be similar to the doomsday scenario that Omega and the entire industry experienced in the late 1990s when Medicare and Medicaid policy was drastically altered, resulting in a large number of bankruptcies in the industry and forcing SNF REITs (including Omega) to slash their dividends.

 

 

Why was Omega forced to cut its dividend in 2000, and could that same risk reemerge in the future?

 

The answer comes from Omega’s 2001 annual report. The Balanced Budget Act of 1997 introduced a new payment system for the reimbursement of Medicare patients in SNFs.

 

A major shift took place in which a cost-based reimbursement system that was historically used was essentially abandoned in favor of a reimbursement system that capped payments per service at a fixed amount. This was done by the government to save money and attempt to balance the federal budget by 2002.

 

While some of these payments changes were reversed by subsequent legislation in 1999-2000, the result was a major reduction in payments made to nursing home operators.

 

Many of Omega’s tenants were forced to declare Chapter 11 bankruptcy and could no longer make their rent payments. They had generally been levering up to fund acquisitive growth in the years leading up to the legislation and were not prepared for the substantial reimbursement reductions.

 

By all means, the reforms made to the Medicare reimbursement system in the late 1990s were nothing short of transformational.

 

While federal policy is still characterized by a healthy dose of uncertainty today, we believe new legislation will likely be relatively more incremental, phased in over a long period of time, and will not result in bankruptcies like those that occurred over 15 years ago.

 

Simply put, another transformational shift seems unlikely. However, the situation is worth monitoring as we all know how unpredictable governmental policies can be.

 

Most recently, Senate Republicans delayed a vote on their health bill by a week. The Wall Street Journal noted that federal funding for elderly Medicaid enrollees could become more robust as the bill undergoes major changes, which would be a positive for Omega:

 

“The delay means the bill, if it does garner enough support, would likely undergo major changes. That could include an expansion of health spending accounts, more funding for opioid-addiction treatment, and more robust federal funding for Medicaid enrollees who are disabled or elderly, according to people familiar with some of the negotiations today and objections of Republican senators. Other changes some conservative lawmakers want include a broader repeal of ACA insurance regulations and a sped-up timetable for Medicaid cuts.”

 

Even if Medicare and Medicaid policy doesn’t end up shifting too severely, the main growth catalyst for the SNF industry (an aging population) is still about a decade away, meaning that the next few years could remain trying for many of Omega’s customers.

 

 

Finally, we can’t forget that REITs can be highly sensitive to rising interest rates. That’s both because higher rates mean higher debt costs, but also because higher rates can decrease demand for REITs as a high-yield bond alternative.

 

 

And while Omega Healthcare has slightly below average rate sensitivity for a healthcare REIT, each 1% increase in the 10-year Treasury yield can still increase the stock’s dividend yield by 1.25%.

 

That means that should 10-year Treasury yields rise by about 2%, as the Federal Reserve is projecting through the end of 2019, then Omega Healthcare’s dividend yield might rise to as high as 10%.

 

Not only might that potentially mean a decline in share price (about 10-15%), which could hurt retirees using the 4% rule, but it would also likely mean that Omega Healthcare’s cost of capital could significantly rise, making profitable acquisitions harder to come by and potentially decreasing Omega’s ability to grow its dividend.

 

Omega Healthcare’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

Omega Healthcare has a Dividend Safety Score of 69, indicating a safe and dependable payout today. That’s not surprising given that, except in times of existential threats to the entire SNF industry such as the late 1990s, Omega Healthcare has a great track record of steadily growing its dividend.

 

In fact, Omega’s steady growth has allowed management to raise the quarterly payout for each of the last 19 quarters.

 

 

This kind of strong, long-term consistency is thanks to two protective factors. First, management has been very disciplined about how quickly it grows the payout; one penny per per share each quarter for the last five years.

 

That’s why Omega’s AFFO payout ratio has remained highly secure over the last few years, meaning below 85%, above which there might not be enough excess cash flow to provide a safety buffer should a distressed tenant fail to make their rent.

 

 

This low payout ratio, generally under 75%, means that Omega also retains a relatively high amount of cash flow with which to fund growth and is less dependent than some rivals on debt and equity markets. That helps explain the other protective factor, Omega’s strong balance sheet.

 

 

At first glance Omega’s small cash position and large debt might make you think that it’s overly leveraged. However, we need to remember that the REIT business model is highly capital intensive which means that we need to keep these debt metrics in perspective.

 

For example, while Omega’s leverage ratio (Debt/Adjusted EBITDA) is high on an absolute basis, it’s actually below average relative to its peers. Similarly the debt/capital ratio of 50% is par for the course in this industry.

 

 

Combined with very steady and predictable cash flow, courtesy of its long-term, 10 to 15-year rental contracts, Omega’s leverage ratio has remained steady over time.

 

More importantly, the fixed charge coverage ratio (Adjusted EBITDA over interest and preferred dividend payments) has been steadily rising for many years.

 

 

In addition, the REIT is nowhere near violating its debt covenants, which could trigger its creditors calling in their loans early and triggering a dividend cut.

 

In other words, Omega Healthcare’s disciplined use of debt means that it has one of the few investment-grade credit ratings in the SNF REIT industry, from all three ratings agencies.

 

 

That helps to explain its strong access to relatively low cost debt ($1.1 billion in current liquidity), which is a competitive advantage in a rising rate environment.

 

Overall, Omega’s dividend appears to be on solid ground today, largely driven by the company’s conservative financial leverage, reasonable AFFO payout ratio, and generally stable tenants (only 3.4% of rent is from distressed operators with EBITDARM coverage ratio below one).

 

With that said, legislative and regulatory changes, especially surrounding reimbursement amounts, can significantly impact the profitability of Omega’s tenants going forward.

 

While Omega Healthcare appears to have a reasonable cushion to absorb some unfavorable developments, income investors still need to watch how these potential long-term headwinds play out over the coming years.

 

Omega Healthcare’s Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Omega Healthcare’s dividend Growth Score of 43, indicating that it’s long-term dividend growth might be slightly below average relative to the S&P 500’s 20-year median rate of 5.7%. That might be a bit of a surprise to investors who, except for the temporary dividend suspension in the early 2000’s (which ruined the 20-year growth rate) have enjoyed very strong payout growth over the past decade.

 

However, we have to keep in mind that while the SNF industry remains highly fragmented (creating opportunity for growth through acquisitions), Omega Healthcare prides itself on maintaining a secure dividend and a safe AFFO payout ratio that also allows for retaining 20% to 30% of cash flow for growth purposes.

 

That’s why it’s been raising the dividend each quarter by just a penny, which, assuming the trend continues, would mean that 10 years from now it would be paying an annual dividend of $4.12 per share. That would represent just 5% annual growth, which is still very good for a high-yielding (7.4%) stock.

 

Of course, given the industry’s long-term growth characteristics, it’s possible that Omega will be able to grow a bit faster, especially once the Baby Boomers start requiring SNF services en masse. That might make 6% to 7% dividend growth possible, but shareholders shouldn’t expect much more than that.

 

Valuation

Over the past year, concerns over rising interest rates and ongoing difficulties among many SNF operators have resulted in Omega shares underperforming the S&P 500 by about 7%. However, that potentially means this REIT is now offering a long-term buying opportunity in an otherwise overvalued market.

 

For example, its forward price to AFFO, the REIT equivalent of a forward P/E ratio, is just 10, much lower than the average healthcare REIT’s 19 and the S&P 500’s 17.8.

 

Similarly the dividend yield of 7.4%, is significantly higher than both the average global healthcare REIT’s yield of 5.1% and Omega’s own 13-year median yield of 6.4%. In fact, currently Omega Healthcare has a higher yield than 80% of its global peers.

 

At today’s price, investors have potential to achieve long-term annual total returns in excess of 10% (7.4% yield + 5% annual growth), assuming the company is not materially affected by regulatory changes (especially around reimbursement rates) and SNFs continue to capture a similar proportion of the aging senior population.

 

Given the legislative and regulatory murkiness in this space, it’s not a great surprise to see OHI’s stock looking “cheap.” While the company’s dividend appears to remain secure, investors considering Omega have to contend with an uncertain outlook over the medium-term.

 

Conclusion

The SNF industry is currently going through some major changes, and an investment in Omega Healthcare carries a number of uncertainties due to the company’s indirect dependence on Medicare and Medicaid reimbursements.

 

Given the number of moving parts and the different ways the Senate’s proposed healthcare bill could change before becoming law (especially from state to state), I am taking a “wait and see” approach with most healthcare stocks, including Omega Healthcare.

 

Once we know more about the actual bill we are dealing with and its implications, any necessary investment actions that help us continue generating secure income should hopefully become clearer.

 

Until then, Omega Healthcare’s strong balance sheet, reasonable payout ratio, geographic and tenant diversification, and overall solid rent coverage metrics should allow the company to continue paying safe, growing dividends for investors looking to build a diversified income portfolio.