Leading healthcare real estate investment trust Welltower (NYSE:HCN), along with most other REITs, has not performed particularly well in 2017. As of mid-November, the stock is up by just 2.2%, and although the total return including dividends is a more respectable 7.5%, it is roughly half of the company's long-term average. This is also less than half of the S&P's total return so far in 2017.
The key point for investors to know is that the main reason for the mediocre performance are headwinds that affect real estate stock prices, as opposed to anything wrong with Welltower's business itself. Here's a rundown of why REITs as a group haven't done so well in 2017, what's going on with Welltower as a company, and what could be in store for 2018.
Why real estate has underperformed in 2017
Generally speaking, REITs have underperformed the market this year. While there have been some outliers in the sector that have done exceptionally well, the Dow Jones Equity REIT Index has risen by 6.7% this year -- less than half of the S&P 500's gain.
There are a few reasons why REITs haven't performed as well as the rest of the market this year. For starters, growth hasn't been exceedingly strong. Don't get me wrong -- many REITs are growing earnings and continue to acquire new properties, including Welltower, but it's not enough to fuel a major rally.
Interest rates are another major factor, as the Federal Reserve has raised rates several times in the past year, and is expected to do a handful of further increases over the next few years. Rising interest rates and the expectation of rising rates are generally negative catalysts for high-dividend stocks such as REITs.
Consider this example. If a Treasury bond pays 3% and a certain REIT pays 6%, it might be worth taking on the additional risk to achieve the higher level of income. On the other hand, if the 10-year Treasury yield spikes to 5%, the small difference in income may not be worth the added risk. So, this would likely put downward pressure on the REIT's price, which would in turn drive the REIT's dividend yield higher.
Tax reform could be another reason, especially since Congress seems set on passing some form of tax reform by the end of the year. Many stocks that have fueled the S&P 500's rally have done so because of the prospect of a lower corporate tax rate. Well, REITs are generally not taxed on the corporate level, so this is of no benefit to the sector, and therefore REITs have not been a beneficiary of the "tax reform rally."
Welltower's business is doing fine
The key point to notice is that none of the previous section had to do with anything being wrong with the REIT business model or with Welltower's business. In fact, businesswise, Welltower is having a pretty good year.
To name some key highlights:
- Same-store NOI in the senior housing operating portfolio (Welltower's largest segment) is up 4.1% year over year.
- Through the first nine months of the year, Welltower's overall revenue is nearly flat (up slightly).
- Welltower recently increased its full-year normalized FFO guidance range due to better-than-expected performance, particularly in its senior housing operating portfolio.
- The company's net debt to capitalization has declined from 39.5% to 35.5% (400 basis points) over the past year.
In a nutshell, Welltower's business is doing fine. There's nothing investors should be worried about, but the company's results just haven't been stellar enough to fuel a massive rally in the midst of a rising rate environment.
What to expect in 2018
Welltower investors should be aware that this company is intended as a long-tailed play on the growing demand for senior housing and other healthcare facilities. Additionally, many of the factors that move REITs aren't related to the underlying business.
Having said that, I expect Welltower to continue doing what it's been doing: focus on steadily building a portfolio of above-average healthcare assets in desirable locations. Over time, this business model should produce strong results for investors, as it has done for more than 45 years. However, in any given year, it's impossible to predict what Welltower's stock price will do.
I would, however, view any weakness brought on by interest rates or general economic conditions as an opportunity to get into this rock-solid REIT at a discount.