While I have been religiously covering Global Medical (NYSE:GMRE) since early 2019, and it is included in my current investment portfolio, after the release of Q1, 2024 earnings results I issued a bit more conservative article.
The reason for this was that GMRE carries relatively aggressive AFFO payout ratio, which in the context of high interest rate environment introduces a notable risk of a dividend cut in case the refinancings take place before the interest rates have managed to go down. The probability of such a situation taking place is not low given that the weighted average fixed rate debt (which yields below market level) maturity for GMRE stands at ~ 2.5 years. On top of this, a very narrow margin of safety in the AFFO payout ratio leaves inherently no meaningful room for an error (e.g., tenant bankruptcies, higher vacancy rates).
Yet, at the same time, I decided to keep GMRE in my portfolio due to extremely cheap multiple (FWD P/FFO of ~11x), potential benefits of divesting parts of the portfolio at low cap rates and acquiring new properties at higher ones, and the overall expectation of falling interest rates.
Recently, GMRE circulated its Q2, 2024 earnings deck, which embodies some interesting dynamics that are definitely worth contextualizing with the current investment case of GMRE.
Thesis review
Performance-wise, GMRE managed to register relatively stable results, which continue to warrant sufficient dividend coverage levels. The FFO per share came in at $0.20, marking a $0.01 per share drop relative to Q2, 2023 period. The AFFO per share result exhibited a similar pattern, where it also dropped by $0.01 per share reaching $0.22 per share level in Q2, 2024. If we compare the recent results to those that were achieved in Q1, 2024, we will arrive at the exact same observations (i.e., AFFO and FFO contracting a bit).
Now, we have to understand the main reason behind this movement. At the core, it was mostly explained by the recent divestitures of several properties that were not offset by the new investments due to some lag between these two processes. In Q2, 2024, GMRE’s revenues dropped by 6% relative to the prior year quarter result because of the previously mentioned disposition effect. Furthermore, GMRE recognized reserves for $800,000, which were related to Steward Health Care being in the chapter 11 process.
However, here it is also critical to underscore that from the cash flow perspective, GMRE is still doing fine as the rents have been serviced so far in a pre-stipulated fashion. Namely, in the post-bankruptcy period, GMRE has captured base rent payments from the Steward leases for the months of June, July, and August. This cash flow effect is already baked into the above reflected FFO and AFFO figures.
The total expense side was lower and landed at $32.8 million compared to $35 million in the prior year quarter, where again the primary driver behind this decrease was the asset disposals carried out by GMRE. Another benefit from the obtained liquidity was that it allowed GMRE to reduce interest expense by ~ $1.5 million compared to Q2, 2023 period.
Having said that, it is clear that the drag on the top-line from the disposition activity is temporary, as GMRE directs its surplus liquidity towards acquiring new facilities at relatively attractive cap rates. In Q2, 2024, we could already see evidence of this. During Q2, GMRE entered into a sales and purchase agreement encompassing a 15 property portfolio of medical offices buildings at a total aggregate price of $80.3 million, and at a blended average cap rate of 8%. While this deal covers 15 properties, the transaction is divided into two separate tranches, where right after the end of Q2, 2024, GMRE successfully closed the first tranche acquiring 5 properties for $30.8 million. These five properties had an 8% ingoing (or initial) cap rate, 5.4 years of weighted average lease term and 2.2% average rent bumps, which provides an attractive organic growth opportunity.
According to the Management, the base case is that the second tranche goes through and that there will be additional 10 properties consolidated at GMRE’s books. However, GMRE is not forced to transact. So, in case the market conditions turn south during this period or that there are unfavorable findings in the due diligence process, GMRE could easily step away from the deal.
A separate and an important element that I would like to underscore here is that GMRE seems to continue the inherently attractive strategy of asset recycling, where lower cap rate portfolio properties are sold to access liquidity and fund new opportunities at higher cap rates. This way, GMRE is able to benefit from positive spread capture and effectively accommodate growth on a leverage neutral basis.
For example, during Q2, 2024, GMRE sold one property, receiving $8.1 million, and subsequent to Q2 close, the Management divested one more asset obtaining $11 million of gross proceeds.
By listening to Alfonzo Leon – CIO – commentary in the recent earnings call, we could theoretically assume that GMRE will tap the secondary equity market to fund growth:
Looking ahead, we will remain persistent and disciplined in seeking opportunities that align with our investment strategy and underwriting standards. We plan to leverage our competitive advantages, including scale, access to capital, the potential use of OP unit deal structures to unlock opportunities and drive value. As Jeff mentioned, our current investment pipeline consists of approximately $120 million of healthcare assets.
However, given the depressed multiple and dividend yield of ~ 9.3%, I highly doubt that we will see GMRE diluting its shareholder base with so expensive capital. It does not make sense from the currently available cap rate perspective either.
Considering GMRE’s target leverage range is between 40% and 45%, where the current level is at 43.8%, we should not assign a notable growth expectation from GMRE until its share price materially rebounds (or until the cap rates increase further at a point in which it would make sense for GMRE to fund M&A through its own equity).
The bottom line
GMRE continues to remain a stable medical office building players in the secondary and tertiary markets. The key elements of GMRE’s investment case remain intact – depressed multiple, high yield, exposure to secular tailwinds, and prudent capital structure. However, the issue of tight dividend coverage is still there, which does increase the probability of experiencing a dividend cut in case the interest rates remain higher for longer or if there are some material idiosyncratic events (e.g., tenant bankruptcies, elevated vacancy rates). The only way how GMRE could resolve this is through growth. In order to grow in a sustainable manner, GMRE has to rely on equity markets, where higher multiple is required, which, in turn, will emerge once the overall REIT market gets pushed higher through reduced interest rates.
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