Welltower (HCN): A High-Yield Medical REIT Blue Chip

A great way of building long-term wealth is to ride secular mega-trends. One of the largest of these is the aging of America’s population, which is expected to see the population of those of 75 years of age double over the next two decades.

 

Source: Welltower Investor Presentation

 

Thanks to improvements in medical care, people are not just living longer, but consuming more and more medical resources as they age. In fact, as you can see, the amount of annual per capita healthcare spending rises exponentially the older you become.

 

 

This means that investing in certain companies involved with healthcare can be a great way to profit over time from this major economic shift. One way of doing this is with high-quality, dividend growth blue chips such as Welltower (HCN), America’s largest medical Real Estate Investment Trust, or REIT. Investors can learn more about REITs and how to evaluate them here.

 

Let’s take an in-depth look at how this venerable company has enriched long-term dividend lovers for decades and, more importantly, why that impressive track record is likely to continue in the coming years.

 

Business Description

As you can see below, Welltower is extremely well diversified, owning a total of 1,486 properties located primarily in major cities across the US, Canada, and the UK.

 

The company is involved in every aspect of patient care, from hospitals and long-term skilled nursing facilities to senior assisted living communities and medical office buildings, or MOBs. As health care continues to move to lower cost settings, many of Welltower’s properties should benefit.

 

 

Here is a look at Welltower’s Net Operating Income (NOI) by business segment. Seniors housing is the biggest contributor:

 

 

The way Welltower makes money is by owning a high-quality portfolio of medical properties and renting them out, under long-term contracts, to a diverse group of partners, such as Brookdale Senior Living (BKD) and Genesis Healthcare (GEN), who are the ones actually caring for patients.

 

Here is a look at some of Welltower’s biggest tenants:

 

 

This diversified tenant base is key to Welltower’s ability to generate secure cash flows, which is what has allowed the consistent growth of Welltower’s generous dividend over the past half century.

 

 

Business Analysis

As America’s largest medical REIT, you might expect Welltower’s growth to be rather slow. However, thanks to its world class management team, led by Thomas Derosa, who has extensive experience in: healthcare, real estate, and capital markets, the company has been able to continue recording far better growth than its major rivals, such as fellow medical REIT titan Ventas (VTR).

 

In fact, in the first half of 2016, the company was able to achieve extremely strong growth in revenue and funds available for distributions, or FAD per share. The growth was driven by strong results from all business segments, but especially senior housing.

 

Source: Welltower Earnings Release

 

FAD is arguably the most important metric for Welltower investors to track because it’s the equivalent of the company’s free cash flow, and thus the source of its dividend’s security and growth.

 

Welltower has been able to earn higher profits from the same properties over time primarily because of the contracts management is able to strike with its partners. Not only are they usually very long in duration, but they also include annual rent escalators to offset inflation.

 

In addition, management is extremely skilled at allocating shareholder capital. For example, management continues to find attractive investment opportunities, not just in new properties that offer attractive cash yields, but also by working with numerous partners via joint ventures to remodel its existing assets and construct brand new buildings from the ground up.

 

Some of these investments can result in cash flow yields in excess of 8%, which is extremely high for real estate returns, especially in today’s market where property prices have risen, driving down overall profitability.

 

And lest you think that these past two quarters have been a fluke, Welltower actually has a long track record of generating some of the best same store growth in the industry.

 

 

Better yet, that is likely to continue thanks to management’s recent $1.15 billion acquisition of 19 senior, assisted living, and memory care facilities in California. This is a classic move by Welltower, which has spent over 50 years consolidating the fast growing, but highly fragmented medical property market.

 

And thanks to management recently increasing the size of its short-term credit facility, Welltower has a total of $2.77 billion in available liquidity to continue growing in the years to come. Even more impressive, thanks to the strong balance sheet and its economies of scale, Welltower has some of the lowest costs of capital of any medical REIT. For example, $2.3 billion of its liquidity is from its revolving credit facility at rates of LIBOR +0.9%, or about 2.5% today.

 

With Welltower’s share price sitting near all-time highs, the company is able to also sell additional shares, a natural part of the REIT business model, at extremely favorable rates.

 

A relatively low cost of capital means that the 7% to 8% cash yields management is getting on its invested projects and acquisitions is resulting in high levels of NOI and FAD per share growth. This bodes very well for the future growth prospects of one of the safest payouts in the entire REIT industry.

 

With the U.S. health care real estate market being an estimated $1 trillion in size, Welltower’s market share is just 2.6%. While the company has invested $28 billion since 2010 to nearly quintuple in size, there should be plenty of opportunities for continued growth.

 

Welltower’s quality real estate in quality markets, access to low-cost capital, and strong focus on private pay sources (89.2% of facility revenue mix) should continue to serve it well for many years as the healthcare market grows.

 

Key Risks

There are four main risks that I’m watching for, although only two are specific to the company.

 

The first company-specific risk is Welltower’s exposure to the UK in a post-Brexit world. Fortunately that risk is small and at most threatens only the dividend growth rate, and even then only if the UK is plunged into a worst case, deep recession once it exits Europe in 2019.

 

As you can see, the short-term effects of Brexit, which are mainly from a far weaker Pound, will likely mean an insignificant increase in Welltower’s payout ratio for 2016.

 

Sources: Earnings Release, 10-Q

 

In addition, remember that Welltower is very selective about what properties it owns, meaning its UK assets are generally much newer, in higher demand, and command higher rents.

 

 

The second specific risk is the relatively high concentration of cash flow Welltower derives from its largest partners, such as Genesis Healthcare. Don’t get me wrong, I’m not saying that getting up to 14.7% of NOI from a single healthcare provider means the dividend is at risk.

 

However, be aware that the industries in which Welltower’s tenants operate are low margin, and this means that some companies, such as Genesis, can occasionally fall on hard times.

 

For example, the Department of Justice recently fined the company $52.7 million over improper billing practices. In addition, Genesis’ high debt load means that it faces steep refinancing costs, which, should interest rates rise, might threaten its ability to service its liabilities.

 

However, Welltower and Omega Healthcare (OHI) recently did a joint refinancing of some of Genesis’ debt giving it some breathing room, and buying time to get its financial house in order.

 

The reason I point out this risk is tied into two additional risks. First, understand that, while most of Welltower’s cash flow base is derived from private payers, 75.3% of the funding to its long-term/post-acute care tenants is from Medicare and Medicaid. This means there is always the risk that changes in government healthcare policy will hit Welltower’s partners hard, as occurred in 2002.

 

Specifically, in 1997 Congress, in an attempt to control rising medical costs, changed its pay structure for Medicare to a fixed-fee reimbursement system. To give the various medical industries, such as skilled nursing facilities, or SNFs, time to adjust Congress added a five year add on payment.

 

However, by 2002 when the payment expired, SNF operators had been seeing their margins compressed by years of ongoing cost increases. So when the payment expired it effectively resulted in a massive decrease in reimbursement that brought the SNF industry to the brink of ruin. Many operators declared bankruptcy.

 

Investors can read more about the events that happened in 2002 in my analysis of Omega Healthcare here (read the dividend safety section).

 

The government’s changes in healthcare reimbursement decimated the largest SNF chains, and now again the government is trying to head off a tsunami of rising medical costs by changing the way it approaches medical reimbursement.

 

Now understand that the policies that the Department of Health and Human Services, or HHS, is proposing are not anywhere near as potentially destructive as what occurred in 2002.

 

However, the government is trying to shift spending away from a fixed-cost model, and more towards one where hospitals and healthcare workers are compensated based on patient outcome.

 

As seen below, the mix of traditional fee-for-service Medicare enrollment is projected to shrink, and the proportion of value-based purchasing is expected to increase meaningfully through 2020.

 

Source: Omega Healthcare Investor Presentation

 

Theoretically, this will mean that the healthcare industry will have an incentive to work together more closely to ensure that all of a patient’s doctors and caregivers are coordinating care to prevent things like hospital readmissions after surgeries or heart attacks.

 

Of course, it could also mean that certain extremely sick patients might be shunned as “too sick to treat,” and/or result in more variable pay to the healthcare industry.

 

This basically means that companies like Genesis and Brookdale Senior Living may face a few lean years as they attempt to adapt to yet another new payment paradigm.

 

Fortunately for Welltower, government funding makes up just 10.8% of its cash flow, meaning that even in another doomsday scenario, such as 2002, the dividend would likely remain secure and covered by unaffected private payer supplied cash flow.

 

However, the company’s dividend growth would almost certainly take a deep hit, potentially resulting in several years of little to no growth and weak stock performance.

 

Speaking of poor performance, let’s examine the last risk, rising interest rates, of which Welltower investors could be harmed in two ways.

 

First, like all REITs, Welltower has a lot of debt on an absolute basis. This is a natural component of the REIT business model, in which, by law, 90% of taxable profits must be paid as dividends.

 

Thus, in order to fund growth, Welltower must resort to selling new shares and taking on debt. While Welltower’s conservative corporate culture has proved masterful at avoiding excess leverage, nonetheless the company has benefited immensely from the lowest interest rates in human history.

 

I am not saying that rising interest rates will cause Welltower’s long-term dividend growth thesis to collapse. After all, the company was founded in 1970 and has been growing its dividend at a compound annual growth rate (CAGR) of 5.8% for the past 45 years, including during times when interest rates hit an all-time high of 14.1% in 1980.

 

That’s because rising interest rates can temporarily depress property prices. That in turn makes the cash yield on new investments, including the loans that make up a portion of Welltower’s asset portfolio, potentially more, or at least as profitable as its current opportunities.

 

However, there is one aspect of higher interest rates that can’t help but hurt Welltower’s, as well as all REITs. As interest rates rise, the risk free rate of return (i.e. the yield on US Treasuries), also rises. This means that there is less pressure from yield-starved investors to go into high-quality bond alternatives such as blue chip REITs.

 

In other words, a big reason that Welltower’s current 5.0% yield looks so good to so many investors is largely because the 10- and 30-year Treasury yield is a pathetic 1.7%, and 2.5%, respectively.

 

If rates meaningfully rise, it’s reasonable to expect some investors to rotate out of bond-like stocks, many of which have been bid up strongly in recent years, and go into less volatile investments. As a result, the dividend yield across all REITs would presumably rise.

 

And since yield and share price are inversely proportional Welltower’s shares would need to decline, potentially hurting investors who are counting on selling shares in the next few years to fund obligations such as retirement living expenses.

 

I’m not saying that the threat of rising rates should scare anyone away from high-quality REITs. Especially since the futures markets are predicting a far slower pace of rate increases than the Fed is projecting.

 

Their dividends should largely remain safe, and rising rates would most likely be a signal of an improving economy, which means rising rental rates and solid occupancy rates.

 

In addition, anyone with a long enough time horizon should be thrilled at the prospect of being able to buy Welltower at a yield of 6% or higher, which would result in superior long-term total returns.

 

However, with Welltower trading near all-time highs and many bond-like stocks trading at premium valuation multiples relative to history, short-term, more risk averse investors need to keep in mind the risk of a short to medium-term correction if rates do begin to rise and cause capital outflows for bond-like stocks.

 

Dividend Safety Analysis: Welltower

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. Welltower’s dividend and fundamental data charts can all be seen by clicking here.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.

 

Welltower has a Dividend Safety Score of 84, suggesting that the company’s dividend is extremely safe. Welltower has never cut its dividend since it began paying one in the early 1970s, and the dividend has been raised almost every calendar year. This is due to several positive factors.

 

First, the medical industry is generally insensitive to economic downturns, especially with the secular tailwinds of a fast aging population in the US, Canada, and England. As seen below, Welltower’s revenue grew each year during the financial crisis.

 

 

Second, the long-term rental agreements that underpin Welltower’s business model make for extremely secure and predictable cash flow.

 

Next, management has shown a long-term dedication to consistent and moderate dividend growth, while maintaining a sustainable and secure payout ratio.

 

With a year-to-date and 2016 full year guidance FAD payout ratio of 83.9%, and 86.0%, respectively, Welltower’s current payout is well covered by its funds available for distribution.

 

Looking at Welltower’s balance sheet, the REIT’s high absolute debt load may appear alarming. However, remember that this industry is monstrously capital intensive, so high debt loads are to be expected.

 

Rather, we need to view Welltower’s debt levels in the context of the industry in which it operates. For example, its leverage ratio (Debt/EBITDA) is 8% lower than the industry average, while its current ratio is nearly 3x that of its average peer.

 

In addition, the company is highly free cash flow positive, and its interest coverage ratio indicates it has no trouble servicing its debt obligations.

 

Furthermore, as you can see, not only is Welltower’s debt considered investment grade by all three credit rating agencies, but its debt ratios are all strong and getting stronger.

 

Source: Welltower Investor Presentation

 

That positive trend has been going on for the last few years, as Welltower’s exemplary management team has proven itself able to grow the REIT’s funds from operation (operating cash flow) per share at a brisk pace while reducing its debt as a percentage of overall capital (debt + equity).

 

Source: Welltower Investor Presentation

 

This shows both the kind of conservative management team and enduring corporate culture in place at Welltower. Specifically, since management recognizes that interest rates are likely to rise over time, the company is deleveraging now to ensure maximum financial flexibility in the future. This well help Welltower continue growing both in a higher rate environment, as well as during the next economic downturn.

 

Overall, Welltower’s dividend is very safe because of the company’s reasonable payout ratios, recession-resistant business, conservative management style, and proven commitment to the dividend.

 

Dividend Growth Analysis

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Welltower’s Dividend Growth Score is 26, which indicates that the company’s dividend growth potential is somewhat weaker than average.

 

As seen below, Welltower’s dividend has compounded by just 2.3% per year over the last 20 years and by 3.8% annually over the last five years.

 

 

Welltower’s rate of dividend growth isn’t eye-popping, the company has paid uninterrupted dividends since 1971 while increasing its dividend for more than 10 consecutive years, making it a Dividend Achiever (see all Dividend Achievers here).

 

Management raised the dividend by 4.2% at the beginning of this year, and low- to mid-single digit dividend increases will likely continue, matching underlying growth in FAD.

 

Based on the company’s impressive growth this year, a time when Welltower’s property acquisition has been slower than normal (due to management believing attractive deals are hard to come by), and the recent California mega-deal, I think that 4% to 5% is a reasonable growth rate that investors can expect.

 

That’s especially true given that management’s deleveraging over the past five years sets Welltower up for a potential major acquisition in the future.

 

Even if management doesn’t choose to pursue a big purchase, in a rising interest rate environment, it’s likely that Welltower will be able to find more attractively priced growth prospects upon which to unleash its nearly $3 billion of liquidity.

 

Welltower’s dividend has been paid for 181 consecutive quarters, and income investors should continue to be rewarded by the company.

 

Valuation

Due to the way REITs are structured for tax purposes, the P/E ratio is less useful. This is due to depreciation and amortization expenses lowering earnings when in reality properties generally appreciate over time.

 

Thus P/AFFO, or adjusted funds from operations (aka FAD), is a more useful valuation metric since it compares the price to the REIT’s free cash flow.

 

In this case, Welltower is trading at a P/AFFO of 17.4, a slight discount to its historical 18.1. The current 5.0% dividend yield is somewhat higher than the stock’s five-year average yield of 4.8%, too.

 

From a quick glance, Welltower’s current trading multiples look reasonable relative to the company’s history. Going forward, Welltower will likely continue delivering low- to mid-single digit cash flow growth, which is also in line with management’s FAD growth guidance for 2016.

 

Should this pace of growth continue, Welltower could be expected to deliver annual total returns of 8-10% (5% dividend yield plus 3-5% annual earnings growth) over the long term.

 

Conclusion

When it comes to blue chip medical REITs, Welltower has to be near the top of the list. With a nearly 50-year track record of creating value for shareholders, a conservative management, steadily rising dividends, and a highly recession-resistant business model (see seven other recession-resistant businesses here), Welltower deserves consideration to be a core holding in every diversified dividend portfolio.

 

We currently hold Omega Healthcare (OHI), which offers a yield north of 7%, in our Conservative Retirees dividend portfolio. Investors can read our analysis of Omega Healthcare here.