Read This Before You Buy These 3 High-Yield Dividend Stocks

When you spot a great opportunity it is easy to overlook the downside. For instance, once such opportunity can be found in real estate investment trusts, or REITs, Senior Housing Properties (NYSE: SNH), Sabra Health Care (NASDAQ: SBRA), and HCP (NYSE: HCP), which offer a big dividend and the chance to cash in on an emerging trend. 

These companies own and lease portfolios of health care real estate like senior housing and skilled nursing facilities. And, according Administration on Aging, the population of those 65 and older is expected to more than double – from 45 million to 98 million – over the next 45 years, which should create plenty of opportunity for these companies. Also, as REITs, these companies receive hefty tax breaks in exchange for paying 90% of their taxable income toward dividends. This leads to some of the highest dividend yields.

However, despite what looks like an obvious home run, there is a substantial amount of risk with these companies that you should consider before buying. 

Conflict of interest
One significant risk for the $3 billion Senior Housing Properties is the company's management structure. 

The company pays an external manager, the RMR Group, to run their business. Unlike the other two health care REITs, which pay their executives based on performance, RMR collects fees based on a percentage of the company’s market cap or book value. This structure can create an incentive to grow the size of the business, rather than focusing on improving earnings per share. The chart below shows how that has worked out for shareholders. 

Starting at the top of the chart, over the last five years, Senior Housing Properties has doubled its assets. This has doubled the company's general and administrative fees (G&A), yet shareholders have only seen their dividend per share grow by a measly 5.4%. 

Remember, REITs are required to payout 90% of taxable income towards dividends. So if the dividend isn't growing, then earnings per share isn't growing. Whether or not the potential conflict of interest is to blame, it is worrisome to see a company rapidly grow assets without any meaningful improvement to earnings per share. 

Private pay 
Sabra Health Care may not have management issues, but one of the $1.2 billion company's more notable drawbacks is that it depends on government reimbursements like Medicaid and Medicare. 

Here’s a quote from the company’s 2014 annual filing: “Revenues from government reimbursement have been, and may continue to be, subject to rate cuts and further pressure from federal and state budgetary cuts and constraints.” This lack of predictability is why many health care REITs attempt to focus their portfolio on tenants that create their income through more reliable private pay sources.

As of November 2015, 47% of Sabra Health Care’s revenue is dependent on government reimbursements. For comparison, 14% of HCP’s rent, and just 3% of Senior Housing Properties' revenue relies on tenants depending on government reimbursements. 

Struggling tenant 
Finally, all three companies are highly dependent on one tenant. There are only so many large health care operators to choose from, so this is common. But it does leave these companies vulnerable to the loss, or under-performance, of one tenant damaging earnings.

One way to judge a tenant's financial strength is with a fixed charge coverage ratio. The metric identifies how much cash flow the tenant is generating above their fixed expenses, like rent. A ratio of 1.00 means the company is earning exactly enough to cover fixed expenses. The higher the figure is above 1.00 the better.

An appropriate coverage ratio will vary by industry, but for health care operators a ratio of 1.20, or 20% above fixed costs, is considered fairly safe. However, even at that level, it does not leave much wiggle room if these tenant's earnings fall.   

In March 2015, this risk became real for HCP. The coverage ratio for its top tenant (HCR ManorCare) fell below 1.00, and HCP was forced to reduce its rent by $68 million per year, or 13%. As a $16 billion company, HCP will survive the loss of rent. But HCP also has a 9% equity interest in HCR ManorCare, and with the tenant's coverage ratio still low, and it is possible HCP will have to reduce their rent again.  

Are health care REITs a bad investment? 
I don't think so. In fact, I think all three of the companies I mentioned have the potential to be great investments. In particular, my opinion about HCP has not changed since I recommenced it last September. But it is helpful to know where you are likely to get burnt. With that in mind, if you decide to buy, or currently own, one of these companies, you will want to keep a close eye on these risks.