Consider 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, the idea of cashing in on an emerging trend, while collecting a big dividend check, almost seems too good to be true. But that is exactly what real estate investment trusts, or REITs, Senior Housing Properties (NYSE: SNH), Sabra Health Care (NASDAQ: SBRA), and HCP (NYSE: HCP) can offer.

These companies own and lease portfolios of health care-related real estate like senior housing and skilled nursing facilities. And with the U.S. Census projecting the population of those 65 and older to more than double – from 43 million to 92 million – over the next 50 years, there should be 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.

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

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

Senior Housing Properties 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 earns fees based on a percentage of the company’s market cap or book value. The chart below shows how that has worked out for shareholders.

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Over the last five years, Senior Housing Properties general and administrative fee (G&A) has doubled. This has been driven by the company doubling their total assets. However, shareholders have only seen their dividend per share grow by a measly 5%.

Remember, the company is required to payout 90% of its taxable income in dividends. So if the dividend isn't growing, then earnings per share isn't growing. Ultimately, it is not surprising investors have fled from a company that does not seem willing, or able, to improve per share earnings. 

Private pay
Sabra Health Care may not have a management issue, but one of the $1.2 billion company's more notable drawbacks is that it generates a substantial portion of its income from government reimbursements like Medicaid and Medicare.

Here’s a quote from the company’s annual filings: “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 September 2015, 47% of Sabra Health Care’s income is dependent on government reimbursements. For comparison, 12% of HCP’s income, and just 3% for Senior Housing Properties income relies on government sources. 

Struggling tenants
Finally, all three are highly dependent on one tenant. This leaves them vulnerable to the loss, or under-performance, of one tenant damaging earnings.

One way to judge financial strength is with a fixed charge coverage ratio. The formula varies from company to company, but the idea is the find how much cash flow the tenant is generating above their fixed expenses, like rent. A ratio of 1.00 mean the company is earning exactly enough to cover fixed expenses. The higher the figure is above 1.00 the better.

The tenants shown above are earning 11% to 27% above their fixed costs. To put it plainly, that’s not good. Senior housing and skilled nursing facilities are expensive to operate, which is why tight coverage ratios are fairly common. But being highly concentrated toward tenants that are just barely covering fixed charges keeps these companies from being able to raise rent, and potentially exposes them to having to reduce rent.

In March 2015, this risk became very 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. However, with the tenant's coverage ratio still low, it is possible HCP will have to reduce their rent again, and this will hurt particularly bad considering that HCP has a 9% equity interest in HCR ManorCare. 

Are health care REITs a bad investment?
Not necessarily. I think all three of the companies I mentioned have the potential to be great investments. But it is helpful to know where you are likely to get burnt. And, for me, that is what investing is all about. It is one part finding opportunity, and one part protecting yourself from risk.

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 how they are managing these risks.