Welltower: Great Dividend, Risky Price

Summary

• Welltower is a strong healthcare REIT with ties to excellent demographic trends and considerable net operating income expansion.
• The REIT's investment-grade credit ratings and strong portfolio offer continued support to its dividend. Shares yield ~7%.
• Rising interest rates may pose trouble for Welltower's equity as investors shift toward vehicles with more promising risk-reward yields.
• Our fair value estimate implies modest upside to shares on a valuation basis, but investors should watch its technicals very closely at present levels.

Image shown: A long-term chart showing the critical nature of current price levels for Welltower's (NYSE:WELL) equity.

By The Valuentum Team

Shares of Welltower have faced an onslaught of selling pressure during the past few months as income-oriented investors start to worry about the impact that rising interests may have on REIT equity values, particularly as yield-seekers look for higher income-oriented vehicles outside of equities. Though Welltower has not been spared the selling pressure, shares are still holding the line around what we believe to be critical levels on a technical basis. We think paying attention to where Welltower goes next in coming months may be telling of where its share price ends up in coming years.

Welltower used to be called Health Care REIT, and the entity has been at the forefront of seniors housing and health care real estate since the company was founded in 1970. Its portfolio spans the full spectrum of health care real estate, including senior living communities, medical office buildings, inpatient and outpatient medical centers and life science facilities. By enterprise value, Welltower is the largest health-care REIT and trails only Simon Property Group (SPG), Prologis (PLD), and Public Storage (PSA) as the largest publicly-traded real estate company overall. It's in some great company.

Image Source: Welltower, February 2018

Portfolio Composition A Plus

We like Welltower’s portfolio concentration in affluent, high-barrier-to-entry markets and affiliation with market-dominant operators and health systems. Its pipeline across the US, UK and Canada is robust. Major, high growth metro markets in the US, Canada and the UK will continue to provide opportunities. As a percentage of net operating income (NOI), Los Angeles, Boston and New York, for example, are key markets for the REIT, and surveys have indicated that those that currently live in the city tend to want to stay there, with estimates as high as 70%+ of seniors desiring to "age in place." We don't expect this preference to change in time.

As with its other health care REITs, Welltower will benefit from strong demographic tailwinds. The number of individuals in the 85-years-and-older group, for example, is expected to double over the next 20 years as people are living longer and fuller lives, and by definition, this age group spends significantly more on health care than others. Based on estimates from Centers for Medicare and Medicaid Services (CMS), seniors 85 years and up spend as much as ~$35,000 per year on personal healthcare per-capita compared to less than ~$16,000 in the 65-84 age group, and much less for younger cohorts.

Since the first quarter of 2010, Welltower has increased its in-place NOI from senior housing to 72%, as of the fourth-quarter 2017 on an adjusted basis, from 40%. Private pay now accounts for 94% of its facility revenue mix, up from 69% in 2010. We think the focus on this niche of the healthcare arena makes strategic sense and will offer material support to the REIT's growth trajectory over the long haul. People are living better and longer than ever before, and Welltower is at the heart of this trend. The CMS expects national healthcare expenditures to rise to ~$3.7 trillion in 2018, to account for nearly 19% of gross domestic product.

An Investment-Grade Balance Sheet

Image Source: Welltower, February 2018

Welltower’s relationship-investment philosophy continues to create opportunities for remarkable growth, and while a focus on senior housing dominates its equity analysis given the portfolio mix, the REIT has opportunities in outpatient medical and long-term/post-acute care, too. The credit agencies rate its debt Baa1/BBB+/BBB+, and given the capital-market dependent nature of REITs, what the credit agencies say and how much the market believes them will be important to ongoing capital-market access and the health of the dividend.

The REIT's weighted average debt maturity stands at ~7 years, but while the next few years seem manageable, the largest debt coming due will occur in 2021, to the tune of over $2 billion. Given the strength of Welltower's end market and the quality of its portfolio, not to mention solid investment-grade marks, we have little concern that the REIT will not be able to roll forward the debt. The Dividend Cushion ratio we assign to Welltower is based on an assumption for continued access to capital markets, a critical dynamic unique to REITs and MLPs relative to corporates. At the end of last year, Welltower had ~$244 million in cash and cash equivalents and ~$2.3 billion in borrowing capacity on its credit facility.

Fundamental and Dividend Outlook Not Bad

Image Source: Valuentum

In late February, Welltower posted an in-line quarter but many thought it was a miss on the bottom line. We think things are fine. During the quarter ending December 31, 2017, same-store net operating income advanced by more than 2%, helping the full-year mark to 2.7%, almost entirely composed of expansion in its bread-and-butter senior housing operating division. During the year, it finished ~$1.5 billion of property sales and loan payoffs and worked to remove $1.4 billion of debt and preferred from its books. Improving net-debt to undepreciated book capitalization will help continue to support Welltower's credit rating.

Image Source: Welltower's 10-K, page 32

Welltower's guidance for 2018, however, came in a bit lighter than we would have liked. Normalized FFO per share is expected to be in a range of $3.95-$4.05 compared to $4.21 in 2017, and same-store NOI growth is expected to be 1%-2%, down from 2.7% in 2017. Though the REIT’s portfolio continues to generate nice same store NOI growth, and occupancy and retention rates remain solid, we're just had been expecting more in light of favorable demographic trends, even as we say "senior housing triple-net" will lead most of the same-store NOI growth for the year. Over the long haul, we think it is fair to say Welltower's portfolio should experience low-to-mid single-digit average same store NOI growth, even as annual results may ebb and flow a bit with the economy.

Welltower is quite the dividend "story," and we imagine most that are holding the stock are counting on its payout for sustainable income. The dividend payment in February 2018 marked the 187th consecutive quarterly cash dividend, and as long as same-store net operating income continues to remain healthy and its credit ratings are firmly investment grade, future dividend growth can only be expected. Our forecasts for Welltower's pace of dividend growth are in the table above, and we offer our opinion of the REIT's key strengths and potential weaknesses of its dividend below in our Dividend Report:

Key Strengths

Welltower benefits from a portfolio full of relatively new assets with low capex needs in markets with high barriers to entry. The firm maintains investment grade credit ratings, and it has delivered over 180 consecutive quarterly dividends. Funds from operations averaged nearly $1.4 billion from 2015-2017, slightly above annual run-rate cash dividend obligations of just over $1.3 billion, and the metric has been sufficient in covering dividend obligations in each individual year in the period. It expects to continue to benefit from attractive demographic tailwinds as the 75+ age group continues to outgrow the general population (more than two-thirds of its portfolio is senior housing).

Potential Weaknesses

Real estate investment trusts pay out 90% of annual taxable income and therefore are unable to meaningfully reinvest internally-generated funds, resulting in external capital-market dependence. The weak internal cash-flow retention of most REITs translates into poor raw, unadjusted Dividend Cushion ratios, which could become severe during the depths of the real estate cycle. Even though a REIT’s operating cash flow may be robust, the lack of cash accumulation on the balance sheet and the massive debt needed to purchase/develop new properties can become restrictive. The adjusted Dividend Cushion ratio, accounts for expectations of continued access to the capital markets, which while “normal,” cannot be guaranteed in times of tight credit.

Conclusion

Image Source: Valuentum

We're huge fans of Welltower's portfolio and think demographic trends are in its favor. We're also expecting dividend expansion to continue in coming years, but the rising interest rate environment may be too much for even the best REITs to drive equity performance higher. Those focused primarily on the dividend can point to a strong dividend track record, but they must also be aware of any REIT's capital market dependence. Even with high credit marks, during times of tight credit, the equity prices of REITs could face considerable pressure. Our fair value estimate of $56 per share, however, is slightly higher than where the company's equity is trading at the moment. Shares yield nearly 7% at the time of this writing.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.