Trading places with Jerry Doctrow

NOTED ANALYST USUALLY ASKS THE QUESTIONS, BUT HE’S GOOD AT ANSWERING, TOO

 

By John Mugford

 

Jerry Doctrow is probably the best known of the securities analysts who cover the healthcare industry, including senior housing and healthcare real estate investment trusts (REITs).

Mr. Doctrow has been an analyst since 1997, spending most of his time – until just recently – as a managing director with Legg Mason’s Capital Markets group. But on Dec. 1, Stifel Financial Corp. of St. Louis acquired Legg Mason’s Capital Markets business from Citigroup Inc.

For Mr. Doctrow, the transaction meant he could remain in his Baltimore office and sit at his familiar desk. In fact, about the only things that changed were the sign on the door and the name of the firm on his business card: Stifel Nicolaus & Co. Inc., a subsidiary of Stifel Financial Corp. Prior to becoming an analyst, he was with Legg Mason’s Real Estate Consulting Group from 1988 to 1997.

Though he would undoubtedly balk at being called an industry guru, there’s no denying that Mr. Doctrow is one of the most knowledgeable people in the business – and one of the most visible. When he’s not publishing insightful research reports for his clients, he’s a fixture at industry events – giving presentations, participating in panel discussions, and grilling corporate executives during the question and answer sessions at the end of quarterly earnings conference calls.

Recently, Healthcare Real Estate Insights^™ had the opportunity to reverse roles with Mr. Doctrow, asking him questions during a Q&A session of our own.

HREI™^™: Tell us a little bit more about the change from Legg Mason to Stifel Financial Corp.

Doctrow: I would say that in terms of the research, the focus and the people who are working here that it’s very much business as usual. If anything, there’s more energy in the new firm now that our fate is settled. We all have bigger ownership stake in the new company, so it’s a bit of a motivation.

HREI™: Anything else about the transaction?

Doctrow: Well, what’s remarkable is that the entire Capital Markets Group, about 500 people in total, moved en masse to Stifel.

HREI™: Many people in the industry are familiar with your work, but refresh our memories on what areas you cover, such as for-profit public hospital companies, publicly traded REITs (real estate investment trusts) in both healthcare and senior living. Is that correct?

Doctrow: Sure, as group we don’t actually cover the hospitals per se, but that’s something we’re looking to add this year. But we do a lot of small- and mid-cap healthcare providers, things like long-term acute-care hospital companies, inpatient rehab hospital companies, and a lot of specialty providers in skilled nursing, home health, hospice, and of course the healthcare REITs.

HREI™: Do you have an updated count on the number of healthcare REITs there are currently in the market?

Doctrow: We cover nine, and there are a total of 17 if you include the two life science REITs, Alexandria and BioMed.

HREI™: We all know that you have a strong background in covering healthcare and healthcare real estate from an analyst’s point of view. In your opinion, is there anything that stands out in terms of how the industry has changed in recent years?

Doctrow: Well, for one, the industry has been discovered by private real estate investors and rediscovered by the public markets. A couple of things you could point to are the rebound this year in senior housing stocks, with the Brookdale (Senior Living Inc.) IPO, and the strong rebound last year for Sunrise (and others). So the rediscovery is there. And there’s certainly the cap rate compression in medical office buildings and also senior housing prices, which really indicates the strong entry or the re-entry of the institutional real estate investors and private real estate investors.

HREI™: Can you elaborate a bit on the re-entry of institutional investors?

Doctrow: Well I would say that senior housing – private pay senior housing, as we call it  – was obviously very hot in the mid-to late-‘90s in public markets. It attracted some institutional money at that time. But when the industry got overbuilt, people walked away from it for four or five years. Now it’s being rediscovered as it’s rebounding.

HREI™: What about medical office? Is this a totally new discovery for institutional investors?

Doctrow: Yes, I would say that it’s only very recently that institutional money has discovered the class at all. And that’s because it’s being viewed as something that’s more stable, has better fundamentals than general office but is close enough to general office that it’s easy enough for real estate investors to understand.

HREI™: What impact does the new capital have on medical office: compressed cap rates, higher prices, etc.?

Doctrow: Sure, in medical office there really aren’t the same measurements you see in some general office real estate classes. But I think there’s been a couple hundred basis points of cap rate compression, going from the nines to the sevens, or even sub-sevens recently, as well as a lot of increases in prices just over the last one or two years. And somewhat the same is true in private pay senior housing – there’s sort of a gradual downtrend. When Sunrise started selling some of its properties to institutional investors in 2000, 2001, they were selling properties at, say, 10-and-a-quarter cap rates. Those same properties are selling for seven or sub-sevens today.

HREI™: What does the future hold for increasing prices and compressed cap rates?

Doctrow: Obviously, a lot of that is predicated on where interest rates are going, and I’m not any better of a prognosticator than anyone else. But I think the interest in these properties is and will be sustained now that it’s been discovered. I don’t think the institutional investors are going to leave the sector. I think there will be continued interest, even if there are fluctuations within the general market.

HREI™: What about demand?

Doctrow: There’s really a scarcity of product right now – there’s a lot more capital than product. And I don’t see that changing anytime soon.

HREI™: You’ve indicated that healthcare REITs provide unspectacular but stable growth. That must obviously be what the people who invest in them are looking for.

Doctrow: Investors come in with a variety of objectives. But what makes medical office attractive is that it tends to have relatively high and stable occupancy, and steadily rising rents. One of the things we’ve noticed recently with some of the healthcare REITs is that they are much more focused on raising rents and driving growth and income in their properties. So I think many investors see it as a stable and growing income stream on these properties. In general office, you still have some rent roll-downs in some markets from the peak of three to five years ago, even though rents are, in general, rising in general office.

HREI™: Do these new buyers of MOBs need to understand that there are some complications that come with owning such properties, as opposed to general office?

Doctrow: I think medical office is more complicated to manage than a general office building. For one it has a lot more traffic – it’s more characteristic of a retail space in that respect – and you’ve got to have more amenities in terms of parking and bigger lobby spaces. In terms of tenants, you have more tenants, and smaller tenants, to deal with. And they’re all small business people who are focusing on their business and patients. In terms of rents, the issue is whether there’s a value proposition – of course you have Stark requirements to charge market rents. It’s very important how a property owner handles that. The hospital is involved because it’s on the campus, which can complicate things. But medical office is moving to more of a market-rate business, and rents are being driven by the market. Raising rents needs to be presented to tenants so that they understand it and are comfortable with it.

HREI™: Does it create a dicey situation when a new MOB owner increases rents? Can’t that make the doctors angry, who in turn complain to the hospital?

Doctrow: In many cases the doctors want to see value in the building, and we’re seeing examples where a new MOB is built on campus and charges $30 per foot in rent and the old building is charging $20 a foot, or the high-teens. It’s clear to everyone that that gap needs to be closed. The owner may have to retrofit the old building to make it more comparable, but again the market is the main driver of rents.

HREI™: What are some of the challenges that REITs face in the not-to-distant future?

Doctrow: I think the biggest issue for REITs in medical office is the fact that they’re having trouble paying the prices given their cost-to-capital, so you see REITs being less able to compete with private sources of capital or institutional sources of capital. We’re seeing this in the high-profile acquisitions taking place.

HREI™: What can the REITs do?

Doctrow: You’re seeing them make adaptations. This was clear in the recent earnings calls. They are now starting to focus on development, such as Healthcare Realty Trust, and I think for some of the others as well. Also, there are some REITs that are saying, ‘If you can’t beat ‘em, join ‘em.’ HCP is talking about having joint ventures with pension funds and other institutional partners in which they will act as the asset manager or co-investor for institutional equity. There are others focusing on specialty niches. For example, Cogdell Spencer is focused on deals where physicians have a stake in the building. You’ve got Medical Properties Trust, which is sort of focusing on specialty hospitals, such as long-term acute-care hospitals. And maybe a niche could be smaller acute-care hospitals in smaller towns. So you’ve got the REITs adapting to the new environment, which can help them drive more earnings growth.

HREI™: What are some of the challenges the owners or buyers of senior living facilities are currently facing?

Doctrow: You certainly want to separate private-pay senior housing from skilled nursing because they are very different. But in private-pay senior housing there are some of the same phenomena in terms of competition for assets, compression of pricing, making it harder for REITs to compete. But I think the difference in senior housing is that the industry is undergoing a lot of consolidation, which is bringing more transactions to market. As a result, the supply of properties is responding to increased demand. On the other hand, in medical office so much is controlled by not-for-profits, who, basically are not putting properties on the market, meaning the supply is more constrained in medical office. But there is increased competition for senior housing assets as prices are coming down and more players in the public markets are getting involved. You’ve got companies like Brookdale looking to compete with REITs, conceivably to buy properties, as well as institutional buyers. But I think it’s a very healthy market and I think consolidation is one of the themes keeping that market active in the coming years.

HREI™: What about skilled nursing?

Doctrow: You’re also seeing some consolidation activity. Cap rates have not come down for skilled nursing because of nervousness about reimbursements, so the yields on those assets are still in the 8.5 percent to 10 percent range. They are certainly more attractive in terms of the healthcare REITs for acquisitions and return on investment.

HREI™: Talk about supply of MOBs. Are there still a lot of hospital-owned properties that could be put on the sale block at some point?

Doctrow: I think only a small fraction of what could be sold has been sold. The issue is that for many not-for-profit health systems there has not been the groundswell of interest in selling real estate.

HREI™: Could that change?

Doctrow: Well, my broad view on healthcare is that there are two dynamics that you have to understand as an investor. One is the inexorable growth in healthcare spending because of the aging of the population and advancements in medical technology. The other is the constant battle by payers, both the federal government and private payers, to reign in healthcare. That constant struggle between the two is what drives investment opportunities.

HREI™: How would such a scenario play out?

Doctrow: We think that – less so this year – but perhaps in 2007 that there will be a tightening up on reimbursement, particularly Medicare reimbursement. That could put additional pressure on hospital systems, which could lead to more hospital real estate privatization. But right now the president’s budget proposes some changes but nothing quite that dramatic. But because this is an election year, we don’t think much will happen in 2006. But 2007 might change the reimbursement dynamic.

HREI™: What would the effect be on healthcare REITs?

Doctrow: Well, what’s interesting for healthcare REITs is that some of the executives have told me that they would almost like interest rates to go higher, and they’d almost like to see some reimbursement pressures so that some of this institutional money leaves the sector, which would give them more opportunities. I’m not sure that will happen, but healthcare REITs are going to stay in the game one way or the other. If we do see pressures on reimbursements – and the chances are greater in 2007 – that might prompt an increase in real estate privatization.

HREI™: It makes sense that if hospitals and health systems feel financial pressures they might look to sell non-core assets.

Doctrow: Sure, let’s say that in 2007 hospital reimbursements are cut. Some hospitals might be under some financial strain. You could see some hospitals consolidating – for-profit hospital systems buying not-for-profits, which can create opportunities. Some hospitals might also decide to monetize real estate to invest in new services, new technologies to try and make themselves more efficient. And I do think we will continue to see the development of new types of campuses and facilities. So financial pressure tends to create transactions, and the general institutional investors will tend to pull back when there is uncertainty. That could create less competition for healthcare REITs, who specialize in that market and can evaluate the risks better than general purpose investors.

HREI™: What about 2006? What do you foresee for the remainder of this year for healthcare REITs?

Doctrow: Because of some of the adaptations they are making, we are starting to see some pickup in growth, even though it’s not necessarily uniform. It’s becoming much more dependent on each company’s ability to find new strategies and adapt to a tougher pricing market. Some companies are finding strategies to drive growth higher. We’ll have to see how that plays out. Our view is fairly positive on healthcare REITs right now because they offer very attractive dividend yields relative to the rest of the REIT world, relative to interest rates. And if your outlook is for stable interest rates in a slowing economy, then healthcare REITs, to us, look attractive as investments.

HREI™: So, without naming names, you do see healthcare REITs as a solid investment right now?

Doctrow: My primary clients are institutional investors, mutual fund companies, Fidelity, T. Rowe Price and any number of others. What makes healthcare REITs attractive right now is a stable and attractive income yield. The healthcare REITs’ average dividend yield is probably 6.5 percent right now. There are some individual healthcare REIT stocks that offer yields of up to 7 or 7.5 percent, and if you believe their situation is stable or slightly improving, those are just very attractive yields in what may be a slowing economy. Individuals looking for income see these as attractive, and from a mutual fund’s perspective wanting to balance income with growth in their portfolio, and in particular the rest of the REITs have over the course of the last year and this year to date have appreciated much more than healthcare REITs, so healthcare REITS look like a relatively more attractive on a value basis and on a yield bases than the rest of the REIT sector right now.

HREI™: We all know that demand for healthcare services is going to keep climbing. How will providers pay for all of the new facilities and equipment?

Doctrow: The future of healthcare funding is a big issue. There are a lot of questions about it and as a nation we have not faced the question squarely yet. As an advisor, we’re no necessarily in the position of having to answer that question. Instead we look at how or where it creates investment opportunities. For example, in the post-acute arena the feds seem to be pursuing a policy that is intending to serve patients in the lowest cost appropriate settings, so they’re driving patients out of things like rehab hospitals and out of long-term acute-care and into skilled nursing. So, we do look at those types of changes and changes in reimbursement policy and determine how that creates investment opportunities. But I can’t tell you how it’s going to play out. I think about it a lot, but I’m afraid I don’t have a definite answer.

HREI™: Jerry, let’s finish up with a few personal questions, such as, How did you end up doing what you’re doing?

Doctrow: I would say that I somewhat fell into it. I was a Johns Hopkins undergrad in social behavioral science and came out and got a master’s degree in public administration and a minor in urban planning. Early in my career I was in housing and housing finance. That led me to landing at Legg Mason’s consulting group. But throughout my career I’ve focused on the interface and interplay between the public and private sectors. That’s what a lot of affordable housing is about, what a lot of my consulting work has been about. And if you look at healthcare and healthcare real estate, it’s all about that as well. The payers, the not-for-profit organizations, and the for-profit developers – again you’re looking at that interface. I just happened to land at Legg Mason, which happens to be a securities firm, and when Legg Mason was expanding its capital markets and starting to look at healthcare REITs at that point, I was somebody who had a lot of expertise in that area. That’s how this happened.

HREI™: Do you remember what you wanted to be when you were young?

Doctrow: I grew up in Harrisburg, Pennsylvania. But I was one of those people who went to school not sure of what I was going to do. My career really has more to do with tutoring in the ghetto in Baltimore and being interested originally in social issues – that’s why I have my degree in social behavioral science and why I started my career in housing and housing finance. But it’s taken some turns since then.

HREI™: You started out working in the inner city?

Doctrow: I was doing some tutoring while I was still at Johns Hopkins, and then I went into affordable housing and community development. At one point I was director of home ownership and rehabilitation services for the city of Baltimore. Then I made the shift when I got into consulting.

HREI™: When you’re away from the job, what do you enjoy doing?

Doctrow: You know, I enjoy being with my family, my wife Carol, and my son, Brian, who’s 22 now. I like to play some golf, travel.

HREI™: What’s a perfect day for Jerry Doctrow? Get some good work done, then go out and have a nice dinner, some fun?

Doctrow: Well, it probably would not involve work. Instead it would probably be while vacationing at Hilton Head, playing a round of golf with my son and then having dinner with my family – something like that. That sounds pretty good. q