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Welltower (WELL)

Founded in 1970, Welltower has grown to become America’s largest medical REIT. The company owns more than 1,300 properties across the U.S., Canada, and the U.K., but approximately 75% of its real estate investments are in the U.S.

The company's properties serve approximately 200,000 residents and are essentially involved in every aspect of patient care, from hospitals and long-term skilled nursing facilities to senior assisted living communities and medical office buildings.
Welltower organizes its business into three kinds of medical properties:

  • Senior Housing (i.e. retirement homes): 70% of operating income
  • Post-Acute Long-Term Care (i.e. skilled nursing facilities): 13% of operating income
  • Outpatient Medical Office Buildings: 17% of operating income

Over the past decade, management has been steadily reducing the company’s reliance on government funding (i.e. Medicare/Medicaid), and today more than 90% of the company’s revenue comes from private payer insurance sources (compared to less than 70% in 2010).

Business Analysis

The key to any reliable high-yield investment, especially REITs, is a highly secure and consistent source of cash flow. In the case of Welltower, this cash flow security comes from very well staggered and diversified rental lease agreements, with an average remaining length of 9.7 years. 

In addition to only having to renegotiate 1.5% to 2.5% of leases in any given year, Welltower’s tenant base is similarly diversified across some of the industry’s strongest names, such as Sunrise Senior Living and Brookdale. This helps ensure that the company’s portfolio of tenants can collectively continue making their rent payments in full and on time.

Though Welltower is America’s largest medical REIT, it only owns about 3% of the $1 trillion U.S. healthcare real estate market, meaning there is still plenty of room to grow in this highly fragmented industry. Welltower has historically been a large-scale property acquirer, buying more than $28 billion in new properties since 2010 to nearly quintuple the size of its portfolio. 

However, management recently made a wise long-term decision to temporarily slow the pace of new property purchases in order to adapt to challenging market conditions and focus on strengthening the quality of the company's portfolio and balance sheet.

This has been done in three ways to further lower the company’s fundamental risk.

First, the company's leverage metrics have improved across the board over the last five years. As a result, Moody's, S&P, and Fitch have all given the company an investment grade credit rating with a stable outlook, providing Welltower with easier access to low cost capital. 

Second, Welltower is selling off many of its struggling skilled nursing facility (SNF) properties, especially those owned by distressed SNF operator Genesis Healthcare (GEN).

In 2016 and 2017, Welltower sold approximately $4.1 billion worth of SNF facilities, which will result in slower cash flow growth over the short term; however, this is a smart move in the long run for a highly conservative REIT.

That’s because the skilled nursing facility industry is currently experiencing major challenges due to a number of factors.

First, the Center for Medicare & Medicaid Services (CMS) has been instituting a number of reforms to how Medicare and Medicaid reimburse healthcare providers, including shorter-stays and lower reimbursement rates.

Combined with higher regulatory compliance costs and rising labor costs in the medical industry as a whole, many SNF operators are struggling with thin margins and having difficulty covering their full rental costs.

Senior housing that’s operated under a triple net lease model, meaning the tenant pays all maintenance, insurance, and taxes, is similarly struggling, with several of Welltower’s leases currently underwater.

This is why management has been so focused on selling off financially weaker properties and investing in senior housing that it operates itself. That appears to be a prudent strategy because Welltower’s senior assisted living properties are actually much higher quality and better run than most of its industry rivals.

For example, Welltower’s company-run senior housing facilities are not only younger than the industry average, resulting in lower maintenance costs, but they are also located in faster-growing and far more affluent urban locations, which has helped result in higher occupancy (90% vs 82% industry average).
In fact, Welltower’s overall portfolio of medical properties is very high quality, with below average property ages, above average affluence, strong occupancy, and solid same store revenue and net operating income (NOI) growth.
Welltower’s increased focus on building and refurbishing its own facilities rather than acquiring new properties is also appealing because the cash yields on these investments are higher than those it can obtain from simply acquiring new properties.

For example, new properties can be bought for cash yields of 6% to 7%, but by taking its time and constructing its own assets, Welltower can obtain 7% to 9% cash yields.

This extra profitability is important because the REIT business model is unique in that the vast majority of cash flows must be paid as dividends (so that the REIT doesn’t pay corporate taxes). However, this means that growth is funded mainly by external debt and equity (i.e. selling new shares).

Fortunately, due to its large size, Welltower has plenty of access to relatively low cost capital (close to $3 billion in currently available liquidity), which means that it can invest profitably and grow cash flow per share and its dividend over time.

Another competitive advantage Welltower has is that, because of its size (it’s the number one medical property operator in nearly all of its core markets), it has very good and long-lasting relationships with customers.

Specifically, 95% of its outpatient medical properties are rented to major healthcare systems, including those run by states, national governments, or health maintenance organizations. This means that the REIT enjoys high switching costs that help it to enjoy stronger pricing power and above-average margins and returns on capital.

While there are certainly challenges facing different parts of the medical REIT industry, it’s also important to acknowledge the immense growth opportunity in this space, courtesy of the rapid aging of the U.S., Canadian, and U.K. populations.

In fact, the population of those 85+ years of age is growing four to nine times faster than the overall population in Welltower’s markets.
As a result, a substantial increase in demand for both medical resources (such as operations and treatments) is expected, but especially higher demand for assisted senior living.
The bottom line is that Welltower’s management has an excellent track record in steadily growing both its business and its dividend over decades, in extremely challenging and fast-changing medical environments.

Given the significant demographic trends coming over the next few years and management’s moves over the past decade to improve the company’s portfolio quality while reducing reimbursement risk, Welltower appears to be positioned to take advantage of strong growth in overall medical spending.

Key Risks

While there is a lot to like above Welltower, there are nonetheless several major risk factors to be aware of.

The biggest long-term concern is arguably with the major growth that’s projected in U.S. medical spending. While this creates a large opportunity for Welltower, it also serves as a double-edged sword.

That’s because U.S. medical costs have been rising far faster than inflation for so long that medical spending per capita in America is by far the largest in the world.
Since the vast majority of medical spending per American occurs at the end of life, governments and insurance companies are desperate to squeeze every last drop of savings from the current medical system before the onslaught of aging citizens fully strikes.
As a result, this naturally creates a large deal of uncertainty regarding how health care spending will be managed in the coming decades.

While it’s true that 93% of Welltower’s revenue is from private payer (i.e. non government) sources, that doesn’t mean the company might not face margin-compressing price pressure at some point.

After all, health insurance companies are just as eager as governments to minimize costs. In addition, there is always the risk that, should the U.S. move to a single payer (i.e. government run) healthcare system, private insurers currently paying Welltower could be squeezed out.

Next, consider that no company operates in a vacuum. For example, while demand for all manner of medical properties seems likely to rise in the coming decades, this is something the entire industry is aware of.

In other words, there’s a risk that medical property developers could get ahead of themselves and overbuild in the short-term, resulting in too much competition, lower occupancy rates, and lower profitability across the medical REIT industry.

In the meantime, the demographic shift that is expected to raise all healthcare REIT ships is still about 5 to 10 years away, while the regulatory and financial challenges are here now.
Source: Hoya Capital Management

Fortunately, Welltower’s quality management team has an excellent track record of adapting to a fast-changing medical market environment, and the company’s industry-leading scale means that it will almost certainly be a survivor of any major medical REIT shakeout that may occur in the coming decades.

That being said, if too drastic of changes happen to America’s medical system, than Welltower’s growth could be severely impacted, resulting in far slower dividend increases and lower total returns then investors may have come to expect in recent decades.

Next, Welltower’s international properties, while great from a diversification standpoint, also exposes it to currency risk. Particularly, rising U.S. interest rates could cause the dollar to strengthen, which would decrease the reported growth from its Canadian and U.K. properties.

The good news is that Welltower, unlike some other REITs, doesn’t appear to face much of a long-term growth threat from rising interest rates because the company is very good at matching funding costs (debt and equity raises) over time with its investment plans.

In other words, Welltower generally fixes its net cash spread (i.e. cash yield on new investments minus cost of capital), helping to ensure predictable profitability and steady cash flow per share growth.

Closing Thoughts on Welltower

Welltower operates in challenging, price-sensitive markets that face a number of uncontrollable risk factors. However, management's conservatism and recent moves to further improve the company's portfolio quality and balance sheet have positioned Welltower to remain a force in the industry as it waits for one of the largest demographic trends to play out in the years ahead.

As the biggest and one of the best-managed players in this industry, plus with a history of paying uninterrupted dividends since 1971, Welltower seems to be a sensible candidate for conservative income investors who are comfortable with the uncertainties faced by the medical real estate sector. 

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