I graduated many moons ago from Presbyterian College in Clinton, SC.
In case you’re interested, “PC” is a small liberal arts college with a student population of around 1000 students. One of my daughters graduated from “PC” in 2020 which means the family legacy of being a “blue hose” becomes generational.
That’s right, I said blue hose.
That’s because the school’s mascot is "Scottie the Scotsman," a medieval Scottish warrior, and “blue hose,” which refers to the name originally referred to the socks worn by the football team. I played college basketball at “PC” and was an ROTC cadet for all four years.
Within the business school, one of my most challenging classes was statistics, in which I learned about the concept of probability. I never thought that I would use statistics, except perhaps when I played an occasional hand of blackjack in Las Vegas.
Up until now…
Over the last few days, I’ve received numerous messages regarding the probability of a dividend cut for Medical Properties Trust, Inc. (NYSE:MPW).
As you may know, the pure play hospital REIT is now sporting a dividend yield of 15.7% and one of the lowest P/FFO multiples (4 4.7x) in the REIT sector.
I’m finishing up a new book called REITs For Dummies in which I address the concept of payout ratios and the importance of using Adjusted Funds from Operations (AFFO) as the safety metric when evaluating REITs, since AFFO is designed to be a closer proxy for actual normalized cash flows per share:
AFFO = FFO – Straight-Lined Rents – Recurring Capital Expenditure (CAPEX) + Equity-Based Compensation + Lease Intangibles + Deferred Financing Cost
Keep in mind that AFFO is non-GAAP and not sanctioned by the SEC, therefore, it isn’t always consistently reported. Plus, not all analysts view it the same, so some make their own adjustments to it. That said, AFFO disclosure is very helpful to determine a company’s high-level estimate of normalized cash flow per share.
Our team has gone 3-for-3 over the last 30 days in terms of predicting dividend cuts for City Office REIT, Inc. (CIO), Vornado Realty Trust (VNO), and Hudson Pacific Properties, Inc. (HPP) – all office REITs.
Of course, we had no way of knowing whether the management teams of these REITs would cut the dividend, as we relied solely on our research, with a keen eye on normalized cash flow per share.
I might also add that we also signaled possible dividend cuts for Broadmark Realty Capital Inc. (BRMK), Gladstone Commercial Corporation (GOOD), and Global Net Lease, Inc. (GNL), and many others. Importantly, all of these REITs were yielding around 10% or higher before they cut the dividend.
- CIO was yielding 10.0%
- VNO was yielding 9.9%
- HPP was yielding 9.9%
- BRMK was yielding 17.0%.
So, as I pointed out, MPW is now yielding 15.7%. This means the probability of a dividend cut is somewhere between “even chance” (coin toss) and certain (100% probability).
Of course, you know that there is no way that I can conclude with 100% accuracy that MPW is certain to cut its dividend, so we must examine the data we have which is the purpose of this article today.
Medical Properties Trust is an internally managed real estate investment trust (“REIT”) that specializes in acquiring healthcare properties that are leased to operators on a net-lease basis. As of year-end 2022, MPW’s portfolio consisted of 444 facilities and around 44,000 licensed beds.
427 of their facilities are leased to 55 tenants, MPW issued mortgage loans on 5 facilities, 7 facilities are under development, and 5 properties are not currently leased. 202 of their facilities are general acute care hospitals, 67 are behavioral health centers, 112 are rehabilitation hospitals, 20 are long-term care hospitals, and 43 are urgent care facilities.
MPW has properties in 31 states in the U.S. and international properties in Europe and South America.
MPW’s stock has fallen over the past year by almost 60% due to macroeconomic factors such as inflation and interest rates, but also due to company-specific issues related to their tenant concentration and the financial health of their tenants. The stock's decline has pushed its dividend yield up to 15.87%, but is it safe?
Or will it be cut in the near future?
Of course, we don’t have a crystal ball, so we are going to look at MPW’s adjusted funds from operations from several different angles to see how well the dividend is covered and what the probability is of a dividend cut.
In MPW’s first quarter earnings release, they reported funds from operations of $186.2 million, or $0.31 per share, and adjusted funds from operations of $178.9 million, or $0.30 per share.
They also announced that during the first quarter, they generated roughly $135.6 million of cash flows from operating activities ($.30 per share) that primarily consisted of rent and interest, and that its board had authorized a quarterly dividend of $0.29 per share, which will be paid on July 13, 2023. So, from this angle, the dividend is covered with an Adjusted FFO payout ratio of 96.66%.
Now, one of the complications in accessing a REIT’s financial performance is that there are no GAAP guidelines on how FFO or AFFO should be formulated. Nareit has attempted to solve this problem by issuing guidelines on how the earning metrics should be calculated, but as of now, there is no standardized approach that all REITs follow.
For the most part, REITs will calculate FFO by adding depreciation and subtracting gains on property sales from GAAP net income. However, most REITs will arrive at AFFO differently, depending on what they add on to, or subtract from, FFO.
As already pointed out, AFFO is the best measure of a REIT's true cash flow and how much it exceeds the dividends paid, but the lack of standardization in calculating AFFO can lead to issues on how reliable the reported figure is. Below is a widely accepted way to calculate both FFO and AFFO:
Using these formulas above, we get a total AFFO for the first quarter of $131,808 vs $176,580 paid in dividends (~134% payout ratio).
So, by calculating AFFO in this manner, MPW’s AFFO cash flow does not cover the dividend. In order to get to a 100% AFFO payout ratio the dividend would have to be cut by $44,772, or approximately 25%.
You may notice that we have no capital expenditures (“CapEx”) listed in our calculation. MPW is a net-lease REIT that generally structures its leases on a triple-net basis so that the tenant/operator is responsible for any capital expenditure.
In our view, MPW deducts a higher amount of straight-line rent and around $25 mm of impairment interest was from tenant Prospect Medical Holdings (more on that later). Normally, MPW’s cash from operations and AFFO are close to the same, but the fact that Prospect rents have not been paid has put more pressure on the dividend.
We also expect modest dilution ($79 million of impairments) in charges in Q2 2023 as a result of the sale of the Australian investments operated by Healthscope. This deal should close in Q2 2023, and proceeds ($830 million) will be used for debt reduction. Positively, CommonSpirit is much stronger than Steward, which is a positive.
Analysts expect AFFO per share for the full year to come in at $1.26 vs an estimated dividend of $1.16 for a 92.1% AFFO payout ratio. Annualizing MPW’s first quarter AFFO of $0.30 per share gives us $1.20 for the full year, and annualizing their first quarter dividend of $0.29 gives us a dividend payout of $1.16, which would be an AFFO payout ratio of 96.66%.
As previously mentioned, using the AFFO we calculated would put the AFFO payout ratio around 134%. Whether we go by MPW’s payout ratio of 96.66% or the analysts' estimated AFFO payout ratio of 92.06%, or our estimated payout ratio of 134%, under each scenario the payout ratio is very high, which of course is what’s prompting the 15% yield.
I think by now we’ve established that MPW’s AFFO payout ratio is uncomfortably high, regardless of which estimate you use. But just because their payout ratio is near or above 100% does not automatically mean that they will cut the dividend.
From the chart below, you can see that there have been multiple times in the past where MPW’s AFFO payout ratio was over 95%, and once when it was over 100%, yet the dividend was not cut. There was a three-year period when the dividend was not raised, but it was not cut, either.
Prospect represents ~10% of MPW’s revenue, and the REIT should be getting rent later in the year. Earlier this year, MPW’s management cited a 12-to-18 month recovery time for Prospect, which means MPW should be able to claw back EBITDA.
As I read the WSJ article from last week, I did not see anything new whatsoever. It’s no secret that Prospect is in the process of a complex restructuring, and that’s the reason the company hired an advisor. Both landlord and tenant are aligned to sell the managed care business which should result in reduced exposure.
With the information we have right now, we don’t believe MPW will cut the dividend - but won’t raise it, either. This may be the case for several years if MPW is unable to increase its cash flow to sufficiently cover the dividend.
Also, I’ll point out that MPW could continue to sell assets, which would give them another tool to cover the dividend, although not sustainable over time.
Analysts expect AFFO to fall by -12% in 2023, increase by 3% in 2024, and then fall by 2% in 2025. If the projections are on target, then AFFO will continue to cover the dividend, but at a high payout ratio. Analysts also expect the dividend to remain at $1.16 per share over the next several years, which we tend to agree with.
However, no one knows what the future holds, and if there is a significant negative development with any of their major tenants it would definitely change the equation. As things stand now, we expect MPW to maintain the dividend at its current rate at least for the next year or two.
Balance Sheet & Liquidity
There is another driver of dividend cuts. It’s a factor that usually stays behind the scenes but is important. The Board of Directors, not the CEO, set the dividend policy. If they believe there may be a liquidity crunch in the near term, that increases the probability they decide to reduce the dividend. That can be the case even if cash flow covers the dividend.
MPW’s balance sheet includes $10.5 billion in debt. Most are unsecured notes, which is another name for bonds. Only 13.6% of total debt comes due in 2023 and 2024 combined.
If that was more like 25%, then the chance of a dividend cut is even higher. The Board of Directors will always prioritize debt servicing above the common stock dividend. And The Board of Directors are aware that MPW would absorb a lot higher interest rates and expense in today’s environment. Per the latest 10-Q, liquidity for MPW stands at a healthy $1.0 billion.
Based on interest coverage ratios and the debt maturity schedule, the MPW Board of Directors isn’t likely to let the balance sheet drive their decision making on the dividend. At least not until late 2024.
Other Known Facts
Most readers are familiar with the news related to MPW’s short sellers (see article here), and I pointed out the recent Wall Street Journal article earlier regarding two of MPW’s operators: Steward Health Care and Prospect Medical Holdings. These have “brought on financial advisers to help refinance credit lines after some recent financial struggles.”
While it’s true that MPW’s exposure to Steward drops from 27% to 20% (Prospect has 10% exposure), the fear of potential bankruptcy for either hospital franchise casts more doubt on MPW’s ability to cover its dividend.
And, of course, the other probability question is whether or not a future dividend cut is already priced into MPW shares or not?
Shares tumbled last week (and again yesterday) by 13% and are now trading at $7.26. The multiple is getting close to the GFC multiple of 2.7x.
I’ll point out, however, MPW has a much better platform that it did in 2008:
From 51 properties and $1.3 Billion in assets in 2008 to 444 properties (in 10 countries) and $19.7 Billion in assets in 2023.
Also, since we’re on the subject of probability…
What is the probability that MPW shares go to zero?
Keep in mind, MPW is not a theater REIT like EPR Properties (EPR), that’s having to reduce exposure because supply exceeds demand, which has led to an acceleration of closures and bankruptcies.
MPW owns mission critical infrastructure, and the operators rely on the brick and mortar to serve their customers 24-7. Mr. Market has valued the equity of MPW at $4.4 billion, 60% below its normal valuation level.
In my view, and our team agrees with me, MPW is a freaking bargain buy, and the only reason we downgraded the company to a Spec Buy is to telegraph the likelihood of a dividend cut (coin toss).
Thus, upon further review and analysis, I’m putting more capital to work and increasing my stake with MPW, recognizing that dividend “could” be cut.
As I see it, if MPW were to lose 20% of its customer base (by closing facilities), our healthcare system would be in utter turmoil.
Politics aside, I don’t think any lawmaker would want to be responsible for shutting down hospital systems that save lives. If that happens, rest assured, I will be running for Congress, and who knows, maybe President of the United States.
So in summary, the probability of an MPW dividend cut is elevated, and the probability that hospitals will close is unlikely. Ignore the media and focus on fundamentals.
“You are neither right nor wrong because the crowd disagrees with you. You are right because the data and reasoning are right.” Ben Graham.
Much like hospitals, many believed the outlet center model would crash. Just before Covid, the shorts piled into Tanger Factory Outlet Centers, Inc. (SKT) and management was forced to cut the dividend in May 2020 simply because no cash was coming in the doors. SKT had to reboot its dividend after a 27-year record of dividend increases.
Of course, we all know that the business model is intact, and investors who would have believed in the business during the darkest hours could have been rewarded with 68% annual returns (400% total return since March 2020).
Of course, the big difference here is that hospitals are mission critical assets that should stand the test of time.
"Be fearful when others are greedy, and be greedy when others are fearful." Warren Buffet.
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