Real estate investment trusts (REITs) usually have a reputation as being stodgy slow-growth companies, and there's some truth to that. But when I analyze a REIT, I'm looking for a higher-growth dynamo that can compound for years, and I think investors still have a great opportunity with CareTrust REIT (NASDAQ: CTRE).
But there's one important reason that investors shouldn't buy it today.
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The new kid on the block
CareTrust is a relatively new company, having spun off from The Ensign Group (NASDAQ: ENSG) in 2014. Ensign is an owner-operator of skilled nursing facilities and decided to spin off its real-estate interest to shareholders and let CareTrust grow that portfolio of assets. And grow it has -- since becoming public, the REIT has expanded its real-estate assets from $436 million to nearly $1.2 billion.
CareTrust focuses on owning skilled nursing facilities and senior living centers, and it inks long-term triple-net contracts (typically 10 years or more) with its operators. The contracts have annual escalators built in so that rents keep rising year after year. That provides stability of income along with a deep view into the company's future revenue stream. And it's great that as the company acquires real estate, it has a leader at the helm who's spent so much of his career being a healthcare operator himself.
CareTrust's CEO Greg Stapley has a long pedigree at Ensign, one of the most successful operators. He was a co-founder of Ensign and helped identify underperforming properties that could be turned around. Stapley has a solid command of the industry, and on quarterly conference calls, it's refreshing to hear him calmly discuss industry dynamics, especially when the market becomes afraid -- say, about reimbursement issues or census -- as it sometimes does in healthcare. He has the REIT keenly focused on its process for identifying attractive properties and sticking to its discipline.
Since it spun from Ensign, CareTrust has been working to diversify away from its former parent. In the latest quarter, the company has reduced its rent exposure to less than 43%, even as Ensign has some of the strongest rent coverage in the portfolio. Rent coverage across the portfolio is 1.66 times, a solid figure, bolstered by Ensign's performance. Strip out Ensign and a few transitional facilities, and rent coverage is still an average to slightly above average 1.36 times. So rent is secure, even if the company maintains high exposure to Ensign.
But what about the dividend? It's one of the best-covered in the industry, with a relatively low payout ratio relative to funds from operations (FFO), a measure of cash flow.
FFO payout ratio*
Sabra Health Care REIT (NASDAQ: SBRA)
Ventas (NYSE: VTR)
Omega Healthcare Investors (NYSE: OHI)
*Midpoint of estimated normalized 2018 AFFO. Data source: CareTrust Q2 earnings releases.
And CareTrust hasn't stretched its balance sheet in financing its business either. It has a history of prudently taking on debt and keeping its leverage modest, as you can see below.
The company maintains debt at reasonable levels. Data source: CareTrust Q2 Investor Presentation.
The company's debt is relatively low at $550 million at an average 4.65% interest rate, and maturities are staggered over the next seven years, with the next in 2020 for $150 million.
Part of this prudence is due to the fact that the company acts opportunistically to issue equity when its stock is priced favorably. For example, in the latest quarter and shortly thereafter, the company sold 4.9 million shares at $16.50 per share as part of an at-the-money capital raising program. So management thinks that price is sufficiently high to meet its hurdle rate for future investments.
But stay away today
As much as I think CareTrust is a well-managed business that has a great future, I think investors should put it on their watchlist rather than take a stake today. The only reason: valuation.
CareTrust is nearing the high end of its valuation range, typically no more than about 15 times FFO. And the market tends to reward those high valuations only to well-diversified, blue chips such as Ventas. So I estimate the high-end value on CareTrust's at $20-$21 per share over the next year, assuming FFO grows to $1.40 per share. With the stock at $18.45, that just doesn't leave much margin of safety.
So when should you buy? My usual metric for buying CareTrust is 10 times FFO. That's been a reliable gauge for when to acquire shares, and it's an overall cheap level that assumes little growth in the company. Earlier this year the stock approached that level and then bounced quickly higher. And I've seen the stock perform similarly previously. At that price, you'd be looking to pay less than $14 per share (again, assuming some growth over the next year) and would be able to lock in a dividend higher than 5.8%. So that's a much more attractive proposition than today's price.
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