Why Medical Properties Trust (MPW) is my largest position, and probably will be for the next 12-24 months.

Medical Properties Trust (MPW) appeared on my radar as a part of pair trade with Healthcare Realty Trust (HR) as the short.  The idea came from one of my students, I am a former university finance professor.

I am not a dividend investor, and I am not particularly fond of REITs.  I am a small cap value junkie, and if I were a bit smarter, I probably would not be.  MPW is the landlord of primarily acute care hospitals; a few rehab centers, but 65% acute care hospitals.  

There is a large short interest in this security, 35% or 206 million shares.  The short thesis is primarily that MPW has crummy tenants.  And make no mistake, it is absolutely true, MPW’s tenants are the worst.  Remember that for later.

What caught my attention regarding MPW is that from December 2014 to June 2022, book value per share compounded at 10.59%.  Not too shabby, considering how mind-bogglingly boring it must be to spend your entire career being a hospital’s landlord.  Edward Aldag, in Birmingham, Alabama seemed to be doing a hum-dinger of a job.  But more than that, REIT’s are required to pay out 90% of income as dividends to maintain favorable tax treatment.  So book value per share compounded at a double digit rate, while paying a dividend yield of 6%-8% that whole time.  And I don’t like REITs.

As a value investor, it was my hope that with rising interest rates, REIT prices would fall, and the momentum crowd would push things too far, so that my degenerate value-sniffing self could jump on in.  It did, they did, and I did, just as predicted, but rising interest rates put pressure on MPW’s crummy tenants too, and MPW’s share price plunged far below any reasonable prediction, to about $3.07 per share at the low, or about 25% of tangible book. The price has since bounced back to about $5.11 per share, or about 44% of tangible book.  And remember, their tangible book is acute care hospitals.  I would have to put the risk of technological obsolescence at pretty darn low, and the massive newbuild cost and unavailability of large plots of land in an urban center is a pretty solid barrier to entry to the industry.  What’s more, property rent is a very small part of a typical hospital operator’s expenses when compared to doctor’s salaries and machines that do PET scans and CAT scans. 

But my big “aha” moment came when I learned more about the commercial real estate business; triple net leases, thin margins, and massive losses from tenant turnover.  In most commercial real estate, when a tenant leaves, it typically takes at least 6 months to find a new one, and during that time, the landlord is on the hook for taxes, insurance, and maintenance.  Commissions to Colliers for finding a new tenant is somewhere around 4 months rent, and in today’s market, a lot of landlords have to give the new tenant 4 months free rent as well. That is a huge hit to profitability on a very thin margin business.  For this reason, there is a massive discrepancy between property values for tenanted commercial real estate with stable tenants with good credit ratings versus unstable tenants with poor credit ratings.  Buying a commercial property with a bad tenant might have a cap rate of 9% or higher, but with a good tenant might have a cap rate of 7% or lower.  In other words, a building with a bad tenant might sell for $6.4 million, but that same building with a good tenant might sell for $7.0 million.

One of the ways a landlord can get a windfall is to replace a bad tenant with a good tenant.  But, they have to eat the cost of the turnover.  Sure, their property increases in value, but it was a very expensive 12-18 months in the meantime.

Now consider what happens when an acute care hospital’s crummy tenant goes bankrupt.  The bankruptcy judge and the local municipality prioritize above all things that the hospital must stay open, and the hospital operation needs to get transferred to someone who can handle it as soon as possible.  They can’t leave a city without a hospital after all.  Beyond that, all rent accrued after the declaration of bankruptcy is not a part of the bankruptcy process, the new operator is on the hook for that full amount.  The legal system prioritizes landowners, and rents are seldom renegotiated; the rents were market rate, and a small part of costs anyway.  

So the landlord of an acute care hospital who’s tenant goes bankrupt does not have a six month period of losses while searching for a new tenant, and they don’t have to pay Colliers’ commission to the bankruptcy judge, and they don’t have to give the new tenant 4 months of free rent.  Their hospital which would sell at a cap rate of 9% suddenly gets a new, better, tenant, and is worth a cap rate of 7%, but without the lost income of the turnover period.

So to the shorts who have sold 35% of this business, I propose to you that yes, MPW has the worst tenants in the entire hospital industry.  But maybe, just maybe, a sly Alabama fox was doing sale leasebacks to the worst of the worst hospital operators in the country on purpose.  A fourth of their hospitals are in front of a bankruptcy judge right now, which means their rent is the liability of a new, better tenant.  MPW has about $3 billion of acute care hospitals that are about to adjust from a cap rate of 9% to a cap rate of 7% without missing any rental payments.  

Sure, they took a hit to book value with rising interest rates, everybody did.  But not everybody has figured out how to hack commercial real estate.  I believe MPW will return to about 80% of book value, give or take a double from here, but with any asset sales, book value will increase as capital is recycled from older hospitals purchased at pre-pandemic-money-printing prices.  Then, MPW will turn around and sale-leaseback the worst of the worst acute care hospital operators again, because they can lower their cap rates without losing two years of rent in the meantime.  

I would be surprised if MPW doesn’t see a share price of $10 within two years, and $20 within ten years, paying a dividend all the while.  That would represent a two year IRR of 50%, and a ten year IRR of 27%, dividends included.  Assuming an average dividend of $0.60 over the next two years, and $1.00 over the next ten years.  And that should be a moderately conservative estimate of the average dividends, as their dividend tripled in the ten years from 2013 to 2023.

Furthermore, their fixed rate debt averages 4.19%, and I am firmly in the camp that predicts higher sustained inflation over the next ten years.  MPW’s leases all have clauses to adjust upwards with CPI, but their fixed rate debt doesn’t.  This is an asset that I want to own for a while, and I probably would not sell unless I saw a historically abnormal valuation like a price to book of 105% or over. 

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