This week was relatively slow, with just a few stocks featured here reporting earnings. So, we decided to skip discussing those in this piece and do them next week.
As always, our updated reports on the companies we cover are available on our website. Typically, we’ll have a fresh report within a few days of the company reporting earnings.
This week we decided to do some digging on a very popular REIT here in Canada that is gaining popularity now because of its high yield. We’re not alarmed by this trend, as typically, the higher a yield goes, the more interest is generated by our members and readers overall.
So, we felt the need to discuss it today. That REIT is NorthWest Healthcare REIT (TSE:NWH.UN).
But first, lets go over an important primer about REITs
Real Estate Investment Trusts (REITs) have been the topic of many conversations in recent months. In general, REITs have been under pressure due to the rapid rise in rates. Typically, in an inflationary environment, REITs have done quite well.
However, last year REITs were one of the worst-performing asset classes, and despite an excellent little rebound to start 2023, they are still well below highs.
In simple terms, REITs do well during periods of inflation because rents are typically indexed to inflation and property values rise. The difference this time around is that hyperinflation has caused rates to grow at an exponential rate.
REITs can’t raise rents fast enough, and since rates are rising at a pace not seen in decades, there is a real chance we will enter a recession. Why is this important? Property values tend to drop in a recession, impacting REIT valuations. This is an oversimplification but a simple explanation of what is happening with REITs right now.
That said, REITs are still a key source of income for investors. REITs are among the most reliable income stocks and usually have attractive starting yields. You may also have noticed that we have avoided the term ‘dividend’ thus far, as REITs pay a distribution which can be a combination of dividends, interest, capital gains, etc.
It is an important distinction to make especially come tax time. It is also why the general recommendation is to keep REITs in registered accounts to avoid the complicated tax implications of holding in non-registered accounts.
Analyzing the distribution
There has been much discussion among members about high-yielding REITs, and it would be an excellent opportunity to explain how one might analyze the safety of distributions.
For starters, ignore any ‘payout ratio’ number you might find on your typical financial site. These ratios are usually the standard earnings payout ratio, irrelevant to REITs. For REITs, it is best to compare the distribution against funds from operations (FFO) and adjusted funds from operations (AFFO).
The bad news? These are non-GAAP (Generally Accepted Accounting Principles) ratios, and their calculations vary from company to company. That said, FFO is usually more reliable than AFFO, which tends to have the most variation. This is because, much like adjusted EBITDA or adjusted earnings, what companies are “adjusting” for can vary.
Unfortunately, investors usually have to go digging for this information. It is not typically available online, and when it is, it is likely not very accurate. Case in point, Ycharts has an FFO payout ratio data point but doesn’t even come close to company-disclosed ratios.
The good news? Every REIT in Canada does disclose FFO ratios. Worth noting that they don’t all disclose AFFO. More good news – we dig into every REITs quarterly report and update the Stocktrades Screener to accurately reflect the company’s payout ratio against FFO. In other words, we do the work for you. All you need to do is head to our stock screener on the website and download the REIT data sheet to have full access to many data points not available online from Canada’s top REITs.
Generally, any company with an FFO payout ratio below 90% is considered well covered, and we’d have no immediate concerns. Obviously, the lower the number, the better.
We consider anything between 90% to 100% to be something worth monitoring. There could be a few factors that impact short-term payout ratios, so while it doesn’t mean that the distribution is in jeopardy and companies can effectively sustain a high payout ratio for years, these aren’t companies we would ‘set and forget.’ This is especially true if your central investment thesis is safe and reliable income.
You could have guessed, but anything above 100% we wouldn’t consider safe. Once again, there are situations in which a company can maintain a payout ratio above 100%, but overall, it is not sustainable over the long term. These would be at the most risk of a distribution cut.
There are other factors to take into consideration beyond just the payout ratio. Debt loads are equally important – the higher the debt, the higher the interest paid. Since the interest paid is a cash outflow, it directly impacts cash flows. That is why looking at critical data points such as Debt-to-Equity (D/E), Debt-to-Assets (D/A), and interest coverage (FFO/Interest) ratios are equally as crucial to good fundamental due diligence. And as mentioned, they’re all available in our REIT screener.
Of note, we are currently working on front-end capability to pull up REITs much like you can stocks on our screener. For now, you have access to download the data itself.
Typically, you can compare the debt ratios against the company’s historical or industry averages. A D/E ratio below one and a D/A ratio below 50% are generally considered solid. For the interest coverage ratio, the higher, the better, but in general, a coverage ratio of 3x is a strong ratio and between 2.0-3.0x is good. Anything below 1.0x should be flashing red warning signs.
Is NorthWest Healthcare REIT distribution safe?
The primary reason for this type of content in the newsletter this week is that we have received many inquiries about a popular high-yielding REIT here in Canada. That REIT is NorthWest Healthcare (NWH.UH).
Today, NWH pays out an attractive 8.15% yield, and as a result, it is not surprising to see income investors take notice. Let’s walk you through some steps for proper due diligence.
Of note, make sure your mailing client has images enabled so you can see the charts.
First, we like to see if the company has any history of distribution cuts. As you can see, there have been no cuts in the past decade. There is no dividend growth either, which is why you see a completely flat line over the last decade. But only a handful of REITs in Canada have a history of dividend growth. So far, this is a good sign.
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Next, we like to look at the company’s historical yield. Right away, I’d expect it to be higher than usual since REITs have been under pressure. While the yield is higher than its 6.55% average, as shown below, the company has managed high-yield situations before. Once again, no immediate red flags despite the yield being much higher than usual.
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Here is where it gets interesting, however.
We now turn our attention to the company’s FFO payout ratio. NorthWest’s FFO payout ratio is 109% through the first nine months of the year. Immediately, we are concerned, and this is a red flag.
This is where one will likely have to dig deeper into company reports, but in NorthWest’s case, the pandemic significantly impacted operations. In fact, many REITs had their short-term payout ratios greatly affected by pandemic-related events.
NorthWest’s FFO payout ratio has been above 100% all year, and so too has its AFFO payout ratio (which it does publish). That said, this also marks the first year that NWH’s payout ratio has consistently remained above 100%. Is it a short-term blip or a sign of more significant issues? As we’ve said, this does not necessarily mean a cut is on the way, but it is not sustainable over the long term. Any further signs of weakness in the coming quarters will amplify the chances of a cut significantly.
Let’s turn our attention to the debt ratios for more insight
As of the end of Q3, NorthWest’s D/E and D/A ratios stood at 1.62 and 0.41, respectively. You can take the D/A ratio further and see if the company publishes a debt-to-gross book value ratio. NorthWest does, and it currently sits at 47.7% – which is not too bad, but it also represents a 3.9% increase over last year.
Likewise, a D/E ratio of 1.62 is not great. It’s in the bottom third of all TSX-listed REITs and well above the average of 1.09. Of note, we would typically compare against the industry, but NWH is a unique company in the healthcare industry, and there are no good comparisons.
Here comes the kicker. NorthWest’s interest payout ratio is only 1.32x, which means that the company’s FFO barely covers the interest on their debt. Once again, this places the company in the bottom third of all TSX-listed REITs and well below the average (2.38).
As we can see, NorthWest’s debt load is a concern. Especially when one considers the current pace of rate hikes. When our members ask, is NorthWest REIT’s distribution safe? The answer is clear. While the numbers above could change, at this point, we could not, with any level of comfort, say that the distribution is safe.
It is not good business practice to pay out more than 100% of FFO and AFFO when rates are rising, debt loads are increasing, and as a result, interest coverage ratios are low.
Does it mean a distribution cut is on the way? Not necessarily
In fact, the company recently announced that it had renewed its At-The-Market (ATM) Equity program, which enables it to issue up to $200M of units at any given time. The company says, “Proceeds from the ATM program will be used to repay debt, fund acquisitions, for capital expenditures and other general purposes.”
This means the company could issue shares and improve its financial situation by paying down debt. The wording in press releases is usually very purposeful, and the fact ‘repay debt’ was first on the list is all you need to know about their mindset.
This would have the net effect of improving most of its leverage and distribution payout ratios. That said, relying on issuing shares to maintain the distribution is not what an investor wants to see.
All this said I (Mat) have owned NWH for several years. While the company has always had higher than average debt loads, it managed well (low rate environment) and was acceptable since it had one of the higher REIT growth profiles. Likewise, today’s debt ratios are lower than their historical averages.
Unfortunately, the pandemic and recent rate hikes have impacted the company’s growth profile, and we are starting to see that reflected in some of the numbers. While the company could turn things around, the safety of the distribution must be questioned even if there are levers NorthWest can pull (IE ATM program) to help sustain it in the short term.
I am holding the company right now, with no plans to add any more, considering the situation. I will be monitoring the situation closely moving forward as well.
