I first began writing for Seeking Alpha in Q4-2016 back when I was absorbing as much information as possible in order to learn how to invest. At the time, I personally found REITs to be interesting and extremely undervalued but it wouldn’t be until two years later that I would develop portfolios for my clients’ John and Jane that have a handful of REITs as the core holdings of their retirement and taxable portfolios.
Welltower (WELL) is a medical-based REIT that was added to my clients' portfolio (and then sold when it became too-highly valued) that has started to become attractive again. I felt compelled to review its finances and trends after my last article which was published approximately three years ago. One reason that I haven’t bothered with reviewing WELL is that it has continued to push sky-high valuations which includes reaching a P/FFO of nearly 22.4x at the end of October when the share price reached an all-time high of $93.17.
Even when we consider WELL’s strength in the healthcare REIT sector, this level of valuation is unrealistic and exceeds historical peaks of 18-19x P/FFO. The question isn’t whether WELL deserves a premium but rather how much premium is justifiable in the current market.
How WELL Drives Value
Before I begin delving into my analysis of the supplemental information, I think it is important for prospective investors to understand how WELL continues to drive value which includes steady occupancy rates and growing net operating income (NOI) during times when their competition has not. First, let’s consider the reasoning for building a company that is primarily focused on senior housing.
In the image above, I find the social benefits quadrant to be the most interesting because it is something that I don’t feel is emphasized enough by other companies that have heavy operations in senior housing. It’s true that medical advances have improved the human condition substantially but there has been increased research looking into social determinants of health (SDOH) which includes “the social, economic, and environmental factors that can affect individuals’ health and quality of life.” The most commonly mentioned factors include:
- Food and nutrition
- Gainful employment/steady income
- Safe and affordable housing
- Safe neighborhoods
- Reliable transportation
When all five of these factors are satisfied individuals are more likely to remain in good health and they will likely continue to maintain it over the long-term.
So how do WELL properties satisfy these needs? It doesn’t take more than one stop on an operator’s page to see that the level of service provided is superb. The goal of these communities is to create an environment for residents that include practically all the amenities a person could possibly need. What I find most interesting about the reviews is that nearly every testimonial left is from the family members of the person who is living in one of WELL’s facilities.
WELL has found its niche by creating a community-based environment and providing top-notch service. Even better, WELL has found a way to change the negative image associated with long-term care facilities which makes them more attractive to their target market.
Senior Housing Operations
WELL operates in a difficult landscape which includes a portfolio of senior housing facilities that make up 63.1% of net operating income. If you haven’t noticed, companies like WELL and Ventas (VTR) have taken a large hit in their stock price in part because there are major questions about the sustainability of senior housing and the ability to drive NOI growth from the segment. Let me be clear, WELL is leaps and bounds above VTR because it has been able to drive NOI growth whereas VTR has not.
SeekingAlpha’s Trapping Value pointed out that WELL was defying this trend back in their article Welltower: Defying The Senior Housing Cycle and suggested that one reason for this was likely due to the amount of revenue generated by private pay residents and extremely low dependence on government sources. At the same time, Trapping Value also notes that private pay alone cannot be what is driving WELL’s success because New Senior Investment Group (SNR) would be thriving on its 100% private pay model if that were the case.
I appreciate WELL’s strategic approach in growing its senior housing operations because they are focused on owning properties where there are high barriers to entry. Based on the results that WELL has achieved, their market analysis looks spot on when it comes to selecting properties that will experience minimal impact from the addition of new supply. The markets that WELL focuses on are making it much more feasible to drive NOI growth because it is targeting populations with above-average income and 75+ population growth.
WELL has a relatively well-balanced lease maturity schedule with approximately 54.5% of total revenues coming due over the next 10 years. With the exception of lease maturities and 2026, most years account for no more than 6.6% of total revenues.
I consider almost all of the lease maturity schedule to be positive but it should be noted that rental income that comes from outpatient medical is the only category with a weighted average maturity less than 10 years and therefore poses the most risk to revenues going forward (highlighted in red).
WELL offers a well-balanced debt maturity schedule with the average weighted maturity coming in at 7.8 years and with the next significant maturity not occurring until 2023.
Source: Welltower Q3-2019 Presentation
It will be interesting to see how WELL approaches its debt over the next year now that interest rates have fallen considerably. WELL issued $1.2 billion of notes back in August which can be broken down into the following tranches:
- $450 million of notes issued at 3.625% due in 2024.
- $750 million of notes issued at 3.10% due in 2030.
These issuances were quite favorable as they were used to replace $450 million of notes which had a yield of 4.95% and to retire $600 million of notes that carried a yield of 5.25%.
One of the major reasons why I am waiting for the share price to come down is that WELL has failed to produce any dividend growth in 2018 and 2019. When we originally purchased shares of WELL back in late February 2018, I wasn’t as concerned with dividend growth because the company had continued with its history of dividend increases for quite some time. Additionally, we were able to pick up 100 shares at the cost of $53.16/share which resulted in a yield of 6.5%.
Determining What Is A Fair Valuation
From the table in the section on dividend yield, it becomes even more clear how much premium WELL is currently trading for and it is worth noting that the yield at its 52-week-high of $93.17 was approximately 3.74%. When trying to come up with a fair value for WELL I place a lot of emphasis on the ability to grow its dividend, or at the least, look for the stock to be paying an above-average (but sustainable) yield. At this point in time, WELL is offering neither of these things; however, it’s recent decline in price gives hope that we will be able to pick up shares again in a range that I consider to be attractive.
FastGraphs is one of the best tools I have purchased that can help give me a complete picture as to whether a stock is currently under or overvalued. The image below shows the high and low valuations over the last 10 years which gives us a better idea of how the market has valued WELL from a historical perspective. Historical perspective is important but it is important to remember that you must consider how the company was performing during that frame of time before you can truly say whether it was trading at a fair value.
- If shares are trading below a P/FFO ratio of 14.5x then shares should be considered a Strong Buy because the chart demonstrates that historically there is very little downside below this point. Based on earnings of $4.16/share for FY-2019 shares would need to be trading at approximately $60/share in order to be trading at a P/FFO of 14.5x.
- The peaks in WELL’s P/FFO are significantly more scattered, however, we can determine that the first peak resulted in a stock price of $74.97/share. The second peak in early 2015 resulted in a share price of $81.95/share. The share price peaked at $79.33/share at the third peak in the middle of 2016. Most recently, shares peaked at $93.17/share in the last few weeks which was well above any of the previously recorded highs.
Using these figures, I believe that it would make sense to establish a position in WELL again if the share price were to drop below $80/share which would result in a P/FFO ratio of 19.2x. Even if we consider the projected FFO in 2020 and 2021 we can see that shares are already fully valued for the type of growth WELL is expected to generate over the next two years.
If the share price moderates to a P/FFO of 19.5x, we would expect the stock price appreciation and dividend to generate a total annual rate of return of 3.81% if we were to pick up shares at the current valuation of $84.87/share.
After considering the data available on WELL, I feel comfortable in saying that I need to see the share price drop further before I can consider starting an entry position for myself or my clients. Although WELL is trading at a higher premium than it currently deserves, it would also be fair to say that the company does deserve an overall premium to its competitors because it continues to deliver results that its competitors have not.
Companies with senior housing operations have felt the impact over the last week, with many of them losing double-digits in share value. Much of the data shows that senior housing will continue to be an important component of the medical economy going forward, but it is definitely true that this traditionally safe investment group has hit a rough patch. Overall, investors that are interested in this asset class should consider WELL to be superior and best-of-breed when compared with other senior housing REITs.
My clients' are currently long VTR.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in VTR, WELL over 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.