About the Editor
Equities strategist Josh Peters is the editor of Morningstar DividendInvestor, a monthly newsletter that provides quality recommendations for current income and income growth from stocks.

Josh manages DividendInvestor's model dividend portfolio, the Dividend Select Portfolio. Josh joined Morningstar in 2000 as an automotive and industrial stock analyst. After leaving in 2003 to join UBS Investment Bank as an equity research associate, he returned to Morningstar in 2004 to develop DividendInvestor.

Peters holds a BA in economics and history from the University of Minnesota Duluth and is a CFA charterholder. He is also the author of a book, The Ultimate Dividend Playbook, which was released by John Wiley & Sons in January 2008.

Investment Strategy

Dividends are for everyone regardless of age. The outcome of owning dividend-yielding stocks is the key variable-higher-yielding stocks with safe payouts being less risky while affording investors who don't need current income the ability to reinvest/reallocate the capital.

The goal of the Dividend Select Portfolio is to earn annual returns of 9% - 11% over any three-to-five year rolling time horizon. We further seek to minimize risk, as defined by the probability of a permanent loss of capital. For our portfolio as a whole, this goal is composed of:

3% - 5% current yield
5% - 7% annual income growth

Dec 01, 2015
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Josh Peters, CFA
Equities Strategist and Editor
Equities strategist Josh Peters is the editor of Morningstar DividendInvestor, a monthly newsletter that provides quality recommendations for current income and income growth from stocks.Josh manages DividendInvestor's model dividend portfolio, the Dividend Select Portfolio.
Featured Posts
Trade Alert: Sold NGG, Added to DUK and VTR

This morning I made three trades in our Dividend Select portfolio. Combined, these trades affected our cash balance only slightly while adding value through more annualized income, better long-run dividend growth potential, and substantially more capital appreciation potential. To summarize:

  • Sold 165 shares of National Grid NGG at $69.93 each, closing our position with a total return of 107.8%.
  • Bought 100 more shares of Duke Energy DUK at $67.82 each, bringing our position to 275 shares.
  • Bought 90 more shares of Ventas VTR at $53.90 each, bringing our position to 375 shares.

Valuation was a key motivating factor behind these changes. At our selling price, National Grid was priced to yield 4.6% and traded at a 13% premium to our fair value estimate. Together, the capital I deployed with add-on buys of Duke and Ventas garnered a 5.1% current yield and a 25% discount to fair value.

Transaction: Sell
Company: National Grid ADR
Ticker Symbol: NGG
Fair Value Estimate: $62.00
Price/Fair Value: 1.13
Morningstar Rating: 2 stars
Economic Moat: Narrow
Fair Value Uncertainty: Low
Dividend: Traded ex-dividend on Nov. 24 for an estimated $1.12 an ADR, payable on Jan. 13. Annualized dividend rate of $3.22 an ADR at current GBP/USD exchange rate.
Current Yield: 4.6%
Shares Sold: 165 shares (zero remaining)
Sale Price: $69.93 (net of commission)
Total Return: 107.8% (reflects multiple purchases; cumulative income of 46.3% plus capital gain of 61.5%)

We first purchased National Grid in July 2009, followed by add-on buys June 2010 and December 2011. For the position as a whole we more than doubled our investment with dividends included; this corresponds to an annualized internal rate of return of 16.1%--a very good result from a regulated utility, even with the tailwind of a recovering stock market in general. I have no specific concerns about the safety of National Grid's dividend, and if the stock had been more attractively priced, I might have continued to hold our stake. As it is, I would consider owning the stock again in the future, and I've added it to our Income Bellwethers watchlist.

However, in the December 2015 issue of DividendInvestor, I downgraded National Grid's role in our portfolio from core to supporting. Grid was once distinctive among utilities for an unusually high dividend yield while still providing acceptable dividend growth. But the stock's yield is no longer as attractive as it used to be, especially in a relative sense--Duke and Southern SO both offer higher yields at present. Grid's previous status as a core holding also reflected the inflation-linked regulatory framework in the U.K., which provides a hedge against inflation that few U.S. utilities enjoy. I still find this point appealing, but it appears the growth potential of Grid's regulated rate base in the U.K. is slipping due to changes in government policies, and the company's utilities in the northeastern U.S. produce poor returns on equity compared to U.S. industry averages.

Finally, Grid's dividend growth rate has slumped to just 2%, hindered in large part by the low inflation rate in the U.K. That alone didn't oblige me to sell; 2% seems likely to match U.S. inflation in the near term, and the link to U.K. inflation provides U.S. investors with at least an indirect hedge against inflation in developed economies generally. We also think the pace of dividend growth could improve a bit going forward; I've been using (but losing confidence in) a five-year forecast of 3%. Still, the low rate of dividend growth makes National Grid's persistent premium to our $62 fair value estimate hard to justify, particularly given our expectation that Duke will raise its dividend at a 4% annual clip over the next five years.

Transaction: Buy (add-on)
Company: Duke Energy
Ticker Symbol: DUK
Fair Value Estimate: $82.00
Price/Fair Value: 0.83
Morningstar Rating: 4 stars
Economic Moat: Narrow
Fair Value Uncertainty: Low
Dividend: $0.825 a share paid quarterly ($3.30 annualized); traded ex-dividend on Nov. 10 for payment on Dec. 16.
Current Yield: 4.9%
Shares Purchased: 100 shares
Cost Basis: $67.82 (including commission)
Total Shares Held: 275 shares, average cost of $72.17
Portfolio Weight: 4.2% (up from 2.6%)
Portfolio Role: Supporting

This is my second purchase of Duke; I bought our first 175 shares on August 12 at $74.66 each. Since then, Duke announced the acquisition of Piedmont Natural Gas PNY. Piedmont has long been one of my favorite utilities, and the deal looks good from a strategic point of view. The problem is that Duke paid a very rich price--double our standalone fair value estimate for Piedmont. While I don't like the situation, Duke is so large relative to Piedmont that our fair value estimate dropped only $1 a share (including other adjustments to our model), and the premium for Piedmont is offset in part by a low cost of financing.

Furthermore, after dropping 9% since my first purchase, Duke looks quite cheap--it now trades at a 17% discount to our fair value estimate. I suspect this reflects concerns about the Piedmont premium as well as Duke's investments in Latin America, which are being hurt by weak economic conditions and falling currencies. Fortunately, Duke's regulated utilities in the U.S. represent over 90% of expected earnings, with rate base growth likely to sustain dividend growth at a 4% pace over the next five years. Combined with a current yield that approaches 5%, Duke is now my top pick in the utility sector, and this add-on purchase brings our current weighting to 4.2%.

Transaction: Buy (add-on)
Company: Ventas
Ticker Symbol: VTR
Fair Value Estimate: $81.00
Price/Fair Value: 0.67
Morningstar Rating: 4 stars
Economic Moat: Narrow
Fair Value Uncertainty: High
Dividend: $0.73 a share paid quarterly ($2.92 annualized); next dividend payable in late December
Current Yield: 5.4%
Shares Purchased: 90 shares
Cost Basis: $53.90 (including commission)
Total Shares Held: 375 shares, average cost of $59.63
Portfolio Weight: 4.5% (up from 3.4%)
Portfolio Role: Supporting

Though I think Duke represents a much better value at current prices than National Grid, I didn't roll all of the Grid sale proceeds into Duke. (That would have meant pushing our weighting in Duke past 5%, which I'm not ready to do right now.) Instead, I made another add-on buy of Ventas, which is my top pick among real estate investment trusts and our cheapest portfolio holding on a price/fair value basis.

Lately the market has been concerned with potential oversupply of senior housing, a property type that represents more than half of Ventas' portfolio. However, the company is well positioned for what we believe will be a temporary downturn, due both to the high quality of its properties and its sound financial condition. With a yield of 5.4% and long-term dividend growth I estimate at 5% or better, I expect attractive income returns as well as substantial capital appreciation over the long term (our fair value estimate is 50% higher than the stock's current price).

This was my fifth purchase of Ventas since initiating our current position on March 3. While the stock price has declined from the $65.42 I paid for our first 120 shares (this is adjusted for the Care Capital Properties CCP spinoff; $74.32 was the actual price), I'm not unhappy with the chance we've had to build a meaningful position slowly at increasingly attractive prices. The stock now represents 4.5% of our portfolio's value.

Together, these trades reduced our cash balance by only $94; I'm continuing to hold $5,233 of accumulated dividend payments for other opportunities I've been contemplating. Still, we added $62 worth of annualized income (now $18,789 for the account as a whole) and improved the dividend growth rate for this portion of our income stream from 3.0% to 4.4%. Better yet, we added $5,166 to the fair value of our portfolio--this represents the difference between the overvalued National Grid, an undervalued Duke, and a deeply underpriced Ventas. Below, I've included our most recent analyst reports on all three stocks.

Best regards,

Josh Peters, CFA
Director of Equity-Income Strategy
Editor, Morningstar DividendInvestor

Disclosure: I own all of the holdings of the Dividend Select portfolio in my personal accounts.

Duke Energy DUK
Investment Thesis 10/26/2015 | Andrew Bischof, CFA

Duke Energy is the largest utility in the United States. Management wisely continues to transform the company into a pure regulated utility, recently agreeing to purchase Piedmont Natural Gas for $4.9 billion in cash and assumption of $1.8 billion in debt.

Duke's regulated distribution businesses make up about 85% of consolidated earnings. In recent years, Duke's utilities have been able to win higher customer rates from regulators, translating into higher profits. In 2015-19, we anticipate cumulative capital expenditures of $42 billion, of which nearly $30 billion is growth capital. These investments include new power generation, infrastructure, and environmental upgrades supporting our 4.5% earnings growth estimate in line with management's 4%-6% guidance.

We anticipate that Duke will be able to recover these costs through constructive regulatory outcomes, particularly in the Carolinas and Florida. This regulatory support is a key reason for Duke's narrow moat. These constructive relationships formed by management should also help protect Duke in a higher-interest-rate environment.

We believe the unregulated international segment has been investors' biggest concern. However, the unit historically contributes just 10% to total earnings, and we think it faces manageable challenges. Brazil's low-cost hydroelectric generation represents more than half of the segment's total operating revenue. Duke has historically benefited from a highly contracted business with market-based rates and annual inflation adjustments, but recent drought conditions have depressed profits as regulators have dispatched thermal generation before hydroelectric generation. Low electricity demand, anemic economic growth, and foreign currency volatility have also pressured near-term international segment results.

The other unregulated subsidiary is commercial power, which consists of high-quality renewable assets backed by long-term contracts with commercial and industrial customers. The unit represents only 5% of earnings, but management has identified renewables as a growth area and we wouldn't be surprised if Duke pursued more projects with utilitylike contracted earnings.

Duke Energy: Economic Moat 10/26/2015
Service territory monopolies and efficient scale advantages are the primary moat sources for regulated utilities such as Duke. State and federal regulators typically grant regulated utilities exclusive rights to charge customers rates that allow the utilities to earn a fair return on and return of the capital they invest to build, operate, and maintain their distribution networks. In exchange for regulated utilities’ service territory monopolies, state and federal regulators set returns at levels that aim to minimize customer costs while offering fair returns for capital providers.

This implicit contract between regulators and capital providers should, on balance, allow regulated utilities to achieve at least their costs of capital, though observable returns might vary in the short run based on demand trends, investment cycles, operating costs, and access to financing. Intuitively, utilities should have an economic moat based on efficient scale, but in some cases regulation offsets this advantage, preventing excess returns on capital. The risk of adverse regulatory decisions precludes regulated utilities from earning wide economic moat ratings. However, the threat of material value destruction is low, and normalized returns exceed costs of capital in most cases, leaving us comfortable assigning narrow moats to many regulated utilities.

We believe Duke's international energy segments are no-moat businesses, as they lack long-term competitive advantages based on their exposure to commodity markets. We assign a narrow moat to Duke's commercial power unit, which is supported by long-term wind and solar power purchase agreements with creditworthy borrowers. Overall, given the relative size of the regulated and commercial power segments, we believe a narrow moat rating is appropriate for Duke.

Duke Energy is strengthening its narrow moat with the pending acquisition of Piedmont Natural Gas, a fully regulated domestic gas distribution company that benefits from the same advantages as Duke's regulated subsidiaries.

Duke Energy: Valuation 10/26/2015

We are lowering our fair value estimate for Duke Energy to $82 per share from $83 to incorporate a 75% chance of closing the proposed acquisition of Piedmont Natural Gas at the $60 per share cash offer. We assume $0.50 per share of value from estimated synergies. Partially offsetting the acquisition dilution is $1 per share of time value appreciation since our last update.

We estimate Duke will invest about $42 billion in capital expenditures through 2019, most of this at its regulated utilities, and continue to receive constructive regulatory recovery of those expenditures. This excludes incremental investment opportunities in 2017 and beyond if Duke closes its Piedmont acquisition in 2016. Based on this investment budget, we anticipate consolidated rate base could grow as much as 6% annually, on which the company is allowed to earn modest returns. We expect 4.5% long-term normalized earnings growth, as regulated earnings driven by rate base growth is partially offset by weakness at the company's international unit.

We forecast 1% average power demand growth for Duke's Carolina, Indiana, and Ohio subsidiaries and 1.5% for Florida from 2015 through 2019, alleviating the need for any near-term rate relief even with Duke's huge investment plan. We anticipate that Duke will increase its dividend 4% annually during the next few years, largely in line with management's projections and at the midpoint of management's targeted 65%-70% payout ratio.

We discount our cash flows using a 5.9% weighted average cost of capital, which is based on a 7.5% cost of equity, 2.25% inflation, and a 4.5% normalized risk-free rate.

Duke Energy: Risk 10/26/2015
Regulatory risk remains the key uncertainty for Duke Energy, particularly given its aggressive investment plans during the next several years. Much of the company's success hinges on the relationships it has built through years of low power prices and excellent customer service. Duke's regulatory exposure is diversified due to operations in six state jurisdictions and its federally regulated transmission projects. Duke should benefit from favorable regulation in the Carolinas, Florida, and Indiana, partially offset by a more challenging regulatory environment in Ohio. We don't forecast any major near-term rate cases. Duke might file for a rate increase in Florida in 2018.

Another potential risk for Duke shareholders is the decline in power prices due to decreasing electricity demand or falling natural gas prices. The company has a significant ongoing development program that is subject to potential cost overruns and political and regulatory risk. Tightening environmental compliance regulations could require significant capital investment or added operating costs that may have uncertain cost recovery through traditional regulated rates. Duke also faces potential integration challenges with the pending Piedmont Natural Gas acquisition.

As with all regulated utilities, Duke faces the risk of an inflationary environment that would raise borrowing costs and make other investments more attractive for income-seeking investors.

National Grid ADR NGG
Investment Thesis 08/03/2015 | Travis Miller

National Grid has grown into one of the largest utilities in the world since since U.K. regulators unbundled energy distribution, transmission, and supply in the 1980s. National Grid began acquiring northeastern U.S. utilities in 2000, and made its biggest move buying New York-based Keyspan for $11.8 billion in August 2007. It now earns about 30% of its profits from the U.S., a share that continues to shrink as National Grid invests more heavily in the U.K., where the regulatory environment is more constructive.

With its U.K. rate structure set through 2021, National Grid offers transparent earnings and dividend growth. Even though the dividend likely won't grow at the 10% annual clip it did between 2005 and 2012, we still think it can grow in line with or faster than inflation. With a dividend yield that has been consistently above 5%, we think the stock offers attractive total returns given the stability of its business model.

The key for National Grid is delivering and optimizing its eight-year U.K. investment plan, which it recently cut back to GBP 16 billion-GBP 20 billion from GBP 26 billion based on delays in expected new generation interconnections. In the RIIO regulatory framework, National Grid can earn an average 4.4% real return on its transmission and distribution assets plus incentives that could add as much as 300 basis points or more on its earned return on equity. National Grid consistently has earned those incentives and we expect it will continue to do so during the RIIO rate cycle. The U.K.'s annual rate adjustments for inflation and interest costs also should help National Grid achieve consistent 10% nominal returns on equity.

In the U.S., National Grid must sustain the improving returns and keep costs in line. National Grid perpetually underearns its allowed returns. In fiscal 2015, National Grid earned just 8% returns on equity in the U.S. compared with its 9.8% allowed ROE and average 12.5% earned ROE in the U.K. Management has said it plans to invest $2 billion annually in the U.S., a level that will require more constructive regulatory support to be accretive for shareholders.

National Grid: Economic Moat 08/03/2015

Service territory monopolies and efficient-scale advantages are the primary moat sources for regulated utilities like National Grid. Regulators in the U.K. and northeastern U.S. grant National Grid exclusive rights to charge customers rates that allow it to earn a fair return on and return of the capital it invests to build, operate, and maintain its transmission and distribution electricity and gas networks. In exchange for its service territory monopoly, regulators set returns at levels that aim to minimize customer costs while offering fair returns for capital providers.

This implicit contract between regulators and capital providers should, on balance, allow National Grid to earn at least its cost of capital, though observable returns might vary in the short run based on demand trends, investment cycles, operating costs, and access to financing. The risk of adverse regulatory decisions precludes regulated utilities from earning wide economic moat ratings. However, the threat of material value destruction is low, and normalized returns exceed costs of capital in most cases, leaving us comfortable assigning National Grid a narrow moat.

National Grid: Valuation 08/03/2015
We are cutting our fair value estimate to $62 per ADR share from $63 after incorporating fiscal year-end 2015 results, updates to the RIIO rate plans, current exchange rates, and time-value appreciation.

From a fiscal 2015 base, we forecast 3% annual operating profit growth through 2019. Our new forecast assumes that National Grid invests GBP 9 billion in fiscal 2016-19, down from our previous estimate because of delays in the outlook for new generation interconnections. We continue to assume GBP 4.9 billion of investment in the U.S. during the same period.

Within the U.K. RIIO rate plan, we assume that National Grid earns GBP 170 million of incentives based in part on total expenditure savings after customer sharing. In the U.S., we assume projected rate increases total $300 million annually to compensate for 6% forecast rate base growth and higher operating costs. We expect the U.S. utilities to earn 10% returns on equity on a long-run, normalized basis.

We assume a long-term currency exchange rate of $1.60 per GBP 1 to drive our cash flow forecasts starting in fiscal 2017. In our discounted cash flow valuation, we use a 5.8% cost of capital and a 7.5% cost of equity. This is lower than the 9% rate of return we expect investors will demand of a diversified equity portfolio. Our pretax cost of debt is 5.5% as we incorporate a normalized long-term real rate environment and normalized credit spreads. A 2.25% long-term inflation outlook underpins our capital cost assumptions. We use a $1.56 per GBP 1 exchange rate as of Aug. 3 to value the ADR shares.

National Grid: Risk 08/03/2015
Regulatory risk is the primary factor in our low fair value uncertainty rating. Regulators seek to keep customer bills low, while the company tries to increase profits. Investor returns depend on the rates regulators set. In the U.K., regulators prefer incentive-based rates that require certain investments and efficiency standards. Current U.K. regulation also allows for annual inflation adjustment, protecting National Grid from falling earned returns as costs rise. The current U.K. regulatory framework is in place at least through 2021.

U.S. regulators typically offer no inflation protection or rate incentives, subjecting the utilities to risks from inflation and rising interest rates. In addition, regulators could punish the company if costs--and, thus, rates--rise too fast. In 2013, New York regulators granted multiyear rate plans that will help guide National Grid's investment plans, but they kept allowed returns well below the national averages. This demonstrates the uncertainty of utility regulation. Some of those plans are coming up for renewal.

Ventas VTR
Investment Thesis 08/18/2015 | Stephen Ellis

With the advent of the Affordable Care Act, change is under way in the health-care industry. The reforms bring a renewed focus on constraining growth in health-care costs, while potentially introducing tens of millions of new insureds to the health-care system. Despite the uncertainty over current and potential changes to the industry, the bulk of health-care spending is nondiscretionary and often requires physical space--that is, real estate--for its delivery, leading to favorable conditions for health-care landlords. We think Ventas will continue to benefit from in-place long-term leases, well-located senior housing properties, and future opportunities for profitable external growth via expansion of partners' operations and via consolidating its industry.

In recent years, Ventas has added senior housing operating assets to its diversified portfolio. Given the direct impact of these assets' operating variances on Ventas' financials, we believe that they could introduce more variability to Ventas' results than its legacy (mainly triple-net-leased) assets. However, Ventas is also immediately exposed to operating improvements at these properties, which could drive faster growth in strong markets. The firm's strategy in this area is sound; it attempts to limit downside risk by owning high-quality assets in markets with favorable demographics, with the expectation that these assets will enjoy expanding demand over time. Early results of this effort are promising, as these assets have been some of Ventas' best performers of late.

Having spun off the majority of its skilled nursing facilities as a separate REIT (Care Capital Properties), Ventas is concentrating its portfolio among more-desirable assets, including its senior housing operating assets, other triple-net-leased health-care properties, and medical office buildings.

Overall, Ventas' business remains exposed to favorable tailwinds, such as a growing and aging population, along with increased health-care coverage because of ACA. We expect inflation-plus internal growth from legacy assets. In addition, its fragmented industry should provide further consolidation opportunities to drive external growth.

Ventas: Economic Moat 08/18/2015

We think Ventas has a narrow moat, sourced from efficient scale benefits associated with owning quality assets in markets with strong demand characteristics, particularly in its senior housing operating and medical office building portfolios, as well as customer switching costs stemming from its triple-net lease portfolio.

Ventas' senior housing operating portfolio (an estimated 32% of net operating income, or NOI, following its spin-off of Care Capital Properties) is concentrated in top metropolitan areas with higher average household incomes and higher average home values than the country in general. Moreover, Ventas' properties in these markets are in more-affluent areas that exhibit higher average household incomes and home values than their broader metropolitan areas. We expect these favorable characteristics, combined with the aging population and the general desirability of living in population centers, to drive above-average demand for Ventas' senior housing operating portfolio over time, resulting in pricing power for Ventas.

Similarly, we think Ventas' medical office building, or MOB, portfolio (20% of NOI following the CCP spin-off) also enjoys benefits of efficient scale associated with owning quality properties in desirable areas. Specifically, 96% of Ventas' MOB portfolio is located directly on a hospital campus or is affiliated with a hospital campus. We believe that there is an upcoming tailwind for demand for health-system services, given the combination of an aging population, the Affordable Care Act's potential ability to bring tens of millions of incremental Americans to the ranks of the insured, and an industry trend toward serving patients in lower-cost settings. In our view, Ventas' well-located on-campus and affiliated MOB properties are positioned to benefit from this expected increase in demand.

Ventas' tenants face high switching costs, due to the company's triple-net leases with operators of its senior housing, skilled nursing, and hospital properties (44% of NOI following the CCP spin-off). The triple-net structure makes the tenants responsible for all costs associated with the operation of the properties, including repairs, maintenance, real estate taxes, insurance, and utilities, in addition to paying rent, which generally escalates annually at rates that keep up with--or exceed--inflation. These leases are long term, with initial terms of 12 to 15 years or more, followed by one or more renewal options. Furthermore, Ventas generally rents its properties under master leases, which group individual properties together under one lease. These master leases generally prevent tenants from dropping poorer-performing properties, as renewals are all-or-none. Other tenant credit enhancements may include corporate guarantees or letters of credit.

Overall, Ventas' different property types and leasing models afford it competitive advantages, which should result in a steady stream of rental income that can grow organically at rates approximating inflation or more over time. Furthermore, we don't think its CCP spin-off diminishes its moat in any way. And we like the fact that the spin-off largely rids Ventas of a property type (skilled nursing facilities) which we generally view as less attractive than the remaining areas of Ventas' portfolio.

Ventas: Valuation 08/18/2015
We are decreasing our fair value estimate for Ventas to $81 per share, down from $90 previously. This decrease reflects the estimated value that Ventas has spun out to shareholders as a separate REIT, Care Capital Properties, offset slightly by the time value of money since our last update. Our overall expectations for Ventas and its industry are unchanged, although we think Ventas is left with a relatively more attractive portfolio following the spin-off, as we like the skilled nursing facilities that CCP owns less than Ventas' remaining portfolio.

Our $81 fair value estimate implies a mid-5% cap rate on our 2016 NOI forecast, a 20 times multiple on our 2016 normalized AFFO estimate, and a 3.7% dividend yield, based on a $2.98 annualized payout, which we think Ventas can hit by year's end 2016, without any contribution from its CCP spin-off.

The major assumptions in our valuation model drive annual same-store NOI growth averaging 2.6% across our 10-year forecast. We also expect Ventas to continue winning its share of acquisitions, with a projection of $1 billion annually at an average cap rate of 7%. We plan to incorporate potential large acquisitions, similar to its recent $1.75 billion Ardent deal, if and when they are announced. We expect Ventas to also invest roughly $300 million annually in developments at an 8% average yield. We estimate that maintenance capital expenditures will range between $120 million and $210 million per year, higher than historical levels because of the increased impact of senior housing operating assets.

Outside of our cash flow forecasts, we give Ventas credit for its loan book, joint ventures, current debt-funding costs that are well below our long-term expectation, and other minor assets, which add nearly $3 billion to our valuation, or $8 per share to our fair value estimate.

In addition to our base case, we also contemplate upside and downside forecasts which translate into upside and downside fair value estimates of $125 and $53, respectively, both of which now reflect the value transferred to the CCP spin-off.

Ventas: Risk 08/18/2015

Ventas roughly tripled in size in 2011, changing its property and business mix, and expanding its business to include assets it also operates. However, Ventas has exposed itself to the upside potential in its best assets (that is, operating assets) through the RIDEA, or operating, structure, while protecting itself somewhat from the potential fluctuations in results at its lesser properties by leasing them to operators on a triple-net basis. This strategy makes sense, but relative to its historical triple-net-heavy model, which resulted in historically stable and growing cash flow, Ventas has introduced a greater degree of potential future variability into its own results, in our opinion.

Ventas has significant customer concentrations relative to other REITs. Following its spin-off of CCP, other companies operate or manage large chunks of Ventas' properties, including Atria Senior Living (20% of Ventas' NOI), Kindred Healthcare (10%), Sunrise Senior Living (10%), and Brookdale Senior Living (10%). Ventas' competitor Health Care REIT is a partial owner of Sunrise.

Prior to its CCP spin-off, roughly 20% of Ventas' NOI was attributable to facilities where its tenants receive reimbursement under government health-care programs Medicare and Medicaid, indirectly subjecting Ventas to pressure on Medicare and Medicaid reimbursement levels. Most of this exposure will be transferred to CCP with its spin-off.

Health-care inflation has run roughly 2.5 times the overall inflation rate historically, which can't continue indefinitely. When rates of health-care inflation normalize, the entire health-care industry will re-evaluate spending. Health-care landlords such as Ventas, which have historically enjoyed a strong tailwind from outsized growth in health-care spending, may suffer.


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