Right when CareTrust REIT (NYSE:CTRE) delivered its previous earnings package, I issued an article arguing that the Company was a hold even though the fundamentals improved across the board.
The key reason for a somewhat conservative stance despite solid like-for-like figures and strengthened balance sheet was the divergence between the expectations of buyers and sellers on how to price the properties.
Namely, for CTRE to grow it is necessary to transact in the M&A markets at cap rates, which are below the cost of capital. Given that both debt financing and equity have become rather expensive and the sellers are still not in a position to embark on unattractive sale decisions (mostly due to fixed rate debt and distant maturity profiles, which have delayed the effects of higher cost of debt), I saw no major reason for CTRE to outperform the market.
At the same time, there were no indications that could potentially justify an exit from position in CTRE, so a rating hold seemed optimal.
Yet, over the Q3 period, CTRE has managed to outperform the REIT market in a significant fashion.
Let’s now take a look at the most recent results and understand whether there is still a reasonable potential for CTRE to deliver alpha despite the recent run-up in the share price.
Synthesis of Q3
The overall results of Q3, 2023 came in strong. CTRE managed to register an increase in the FFO of 1.5% over the prior year quarter. FAD figure grew a bit more at 2%.
The key drivers of this growth were incremental rents from net M&A activity over the prior quarters coupled with the embedded CPI bumps. The increase in the top-line number was greater than that of the underlying FFO or FAD. The difference is mostly attributable to the higher interest costs that are primarily stemming from the additional funding associated with the recent acquisitions.
An important takeaway here is that CTRE’s external growth strategy of acquiring new properties pays off even against the backdrop of higher cost of capital. In other words, the acquisitions are accretive.
Furthermore, if we look at the underlying performance of the overall portfolio, we can notice that the resiliency is still there.
For example, the cash collections for the quarter came in at 97.5% of contractual rent under a situation, where the properties are fully occupied. According to the Q3 earnings call, the collection rate improved in the last month of Q3 period to 99.3%.
Top 10 rent coverage position in terms of EBITDAR coverage continued to improve exceeding the pre-pandemic level.
In addition to the positive dynamics on the business operations end, CTRE’s capital structure further improved reaching an all-time low when it comes to the net debt to EBITDA ratio (at 2.5x). This is not only low in the context of CTRE’s history but also if we compare to the sector average, which as of October 2023 stood at 10.2x (here it is expressed as debt to EBITDA so if we adjusted for cash positions the ratio would be a bit lower; yet, it should not affect it materially).
CTRE was able to strengthen its balance sheet from already relatively safe levels mostly due to the issuance of additional equity. Over the quarter, CTRE sold $420 million of equity to fund new acquisitions, which amounted to $79 million.
The decision to attract fresh equity capital was based on the fact that CTRE’s valuation was high enough to make the cost of equity more attractive relative to additional debt (including the additional credit risk in the equation). Plus, this kind of issuance enables CTRE to act opportunistically in case notable (large-scale) opportunities emerge.
Because of the issuance of new shares, the quarterly FFO dropped on a per share basis compared to the Q2, 2023 result. However, considering that FFO payout is still at ~75% and the fact that now CTRE carries a huge amount of dry powder with a de-risked balance sheet, shareholders should still feel comfortable.
CTRE’s ability to execute new deals is further strengthened by very distant debt maturity profiles. Put differently, we should not only count on the recently attracted equity proceeds but also on the incremental debt capacity, which is significant and could be safely assumed without worrying about any concentration of near-term maturities.
Now, the question is whether the Management team will be able to spot attractive opportunities in the market to get enough yield that could generate value considering high financing costs. Given the recent gains, already solid valuation levels and a slight dilution of existing shareholder base, CTRE has to showcase to the market it can keep finding accretive deals. New transactions are also necessary to register further like-for-like growth, thus justifying the recent dilution.
First, in my opinion, CTRE has already proved that there are some lucrative opportunities available by acquiring over ~$280 million of property on a YTD basis at double digit initial yields.
Second, I highly doubt that CTRE would decide to raise new equity without being confident of signing additional deals that would create value on a per share basis.
Third, according to James Callister – Chief Investment Officer (per Q3, 2023 earnings call), CTRE has already identified potential targets:
The pipeline today is around $175 million and mainly consists of singles and doubles. We are also continuing to review a few larger portfolio opportunities that would not only strengthen existing tenant relationships but would also allow us to further diversify our tenant base by commencing relationships with outstanding operators that we have been pivoting for some time.
The bottom line
All in all, CTRE continues to remain a solid investment with strong fundamentals to either weather any financial (economical) headwinds or make opportunistic maneuvers in the M&A segment.
While waiting for CTRE to deploy its dry powder in accretive transactions, shareholders can access ~5% dividend that is backed by ~75% FFO payout and one of the strongest balance sheets in the industry.
Yet, with all of this being said, I still would not feel comfortable going very bullish on the Stock because:
CareTrust REIT: Still Hold Despite Solid Performance
