Better Buy Now: CareTrust vs. Welltower

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Real estate investment trusts (REITs) specializing in healthcare properties are trading rather cheaply right now. To take advantage of the great long-term opportunity offered by healthcare real estate, are investors better off buying a smaller up-and-comer like CareTrust (CTRE +0.00%), or a sector heavyweight like Welltower (HCN 1.86%)?

Welltower and CareTrust: The 1-minute version

Welltower is a massive REIT with 1,490 properties in the U.S., U.K., and Canada. The bulk of the portfolio (64%) consists of senior housing, and there are also substantial holdings in long-term and post-acute care, as well as outpatient medical facilities. The company was founded in 1970 and has a 45-year history of consistent market-beating performance and dividend increases.

On the other hand, CareTrust is a relative newcomer to the healthcare REIT market, and was formed from a 2014 spinoff from the Ensign Group, an operator of skilled-nursing and assisted living facilities. Because of this, although diversification has improved since the spinoff, Ensign is by far CareTrust's largest tenant in its portfolio of 148 properties. 67% of the properties are skilled nursing, with smaller holdings in assisted and independent living properties.

Why healthcare real estate?

Aside from the cheap valuation, which I'll discuss more later, healthcare real estate is a highly attractive market right now, with favorable demographic and economic trends. Healthcare costs have been rising significantly faster than the overall rate of inflation, and the population of senior citizens is expected to grow by more than 70% over the next 25 years, leading to much greater demand for healthcare properties.

Image source: CareTrust investor presentation. 

So, more healthcare properties will be needed to meet this demand, and properties will be able to generate more revenue, which means REITs that own these properties can charge more rent. Since the value of commercial real estate is mainly derived from the ability to produce rental income, this is great for healthcare property values.

Growth strategy and diversification

Both companies grow through acquisitions, but their portfolios and acquisition behavior look rather different from one another. Welltower loves to invest in properties alongside operators with whom the company has established partnerships with. In fact, Welltower has invested an average of $1.1 billion per quarter over the past four years, and 70% was with existing operating partners, which include some of the best-known operators in the business, such as Sunrise Senior Living and Genesis HealthCare. No tenant makes up more than 15% of the portfolio, and the top five combine to make up 45%.

CareTrust isn't too diversified -- at least not yet. I mentioned that it was spun off from The Ensign Group, so naturally that company is the largest tenant. However, CareTrust has done a good job of adding non-Ensign properties, and is beginning to establish ongoing relationships with some operators.

It's also worth mentioning that there are some advantages to CareTrust's significantly smaller size. Specifically, the company can go after smaller deals and off-market opportunities that the bigger players like Welltower simply won't do. In fact, the initial cash yield on the 50 properties CareTrust has acquired post-spinoff has averaged 9.34%. In contrast, the $204 million in acquisitions Welltower completed during the first quarter have a blended yield of 7.2%.

Dividends and performance history

Since CareTrust is so new, it should come as no surprise that Welltower is the clear winner in this category. Both companies pay comparable dividends in the 4.8% to 4.9% range, as of this writing.

Welltower has a 45-year history of dividend growth. Although it hasn't increased its payout every single year, it has done a great job of growing shareholders' income by an average rate of 5.7% per year. Even more impressively, Welltower has produced an average total return of 15.6% since its inception -- a remarkable level of performance to sustain for more than four decades.

Image source: Welltower company presentation. 

In fairness, Welltower's history doesn't guarantee its future performance, but it does make a compelling case in terms of stability and consistency. Also, CareTrust could deliver performance and dividend raises that are just as good or better. However, the company's potential is simply unproven at this point.

Valuation

On paper, Welltower is clearly the more stable company. It is also more diversified, has a better credit rating, and has a proven history of creating value for its shareholders. However, that doesn't necessarily mean that it's a better investment than CareTrust right now. To determine that, we need to take a look at the companies' valuation.

To do this, we need to look at the price relative to the companies' funds from operations, or FFO, which is the best way to evaluate the earnings of REITs. Here is a more detailed explanation on FFO, but for now, let's just say that it gives the most accurate picture of a REIT's available cash to pay dividends and reinvest in the business.

Data source: Company press releases.

As you can see, CareTrust trades for a significantly cheaper valuation, which helps to compensate for the uncertainty that comes with being a recently established REIT and the risks that come with the high concentration of a single tenant in the portfolio.

Which is the better buy now?

Now, I'm a big fan of Welltower, and own shares of the company in my personal retirement account. And, for investors who want a more established company, it's not a bad choice by any means, even at the higher valuation.

However, for those with a bit more risk tolerance and a long investment time frame, an up-and-comer like CareTrust could pay off tremendously. With a significantly cheaper valuation, I feel that CareTrust adequately compensates shareholders for any additional risk, and shareholders who get in early could be handsomely rewarded over the coming years and decades.