Leading healthcare REIT Welltower (NYSE:WELL) decided to move its second-quarter earnings report up by a week and reported its results on Friday, July 27. Despite slightly beating expectations for revenue and earnings, Welltower's stock fell by nearly 4% on the day of the earnings announcement.
With that in mind, here are three positive takeaways from Welltower's second-quarter earnings and accompanying presentation, along with two that would make me hesitant to invest.
Welltower increased its 2018 guidance
When it comes to REIT earnings, funds from operations, or FFO, guidance is extremely important. Since REITs tend to pay out most of their funds from operations in the form of dividends, investors want to know that there will be enough to cover the payout and hopefully to raise it.
One of the most positive items in the second-quarter earnings report is an increase in Welltower's full-year guidance. The company now expects full-year normalized FFO in the range of $3.99 to $4.06, up from a range of $3.95 to $4.05.
Still a massive growth opportunity
Despite being one of the largest REITs of any kind in the market, Welltower still has lots of potential to grow. The aging U.S., U.K., and Canadian populations should keep healthcare demand steadily rising for decades to come.
What's more, Welltower sees a massive opportunity to grow in the current market. Specifically, the company sees tremendous room for consolidation and further partnerships with the existing outpatient medical real estate market.
The outpatient medical real estate market is $394 billion in size, and to date, just 11% of properties in this category are owned by REITs. This leaves about $350 billion in properties owned by other entities. Welltower is especially excited about the 65% of existing properties (about $256 billion worth) that are owned by health systems or physicians.
The point is that just because the company is quite large doesn't mean it's done growing. In fact, being the largest and one of the most financially flexible healthcare REITs gives Welltower an advantage when it comes to pursuing opportunities to expand.
A challenging environment right now
While Welltower's long-term growth thesis is solid, the current environment is somewhat challenging. Oversupply in the senior housing industry is causing vacancies to climb and profits to drop, and many operators aren't in the best financial shape (like Brookdale).
This is impacting Welltower's earnings numbers. Rental income from Welltower's portfolio has declined by more than 6% year over year, interest expense has increased, and property operating expenses are up substantially.
Because of the challenging environment, Welltower's normalized FFO has declined nearly 6% year over year. Of interest to dividend investors: This has raised the company's FFO payout ratio from 82% to 87%, meaning that more of the company's earnings are now being used to cover the dividend. Some of the FFO decline is due to a significant amount of dispositions (Welltower expects to strategically unload $2.4 billion in properties this year), but it's still not the direction investors want to see the payout ratio go.
Welltower's latest acquisition seems to be a step in the wrong direction
This isn't a completely negative item, and I admittedly have mixed feelings about Welltower's just-completed acquisition of Quality Care Properties in a joint venture with healthcare system ProMedica. The short version of the arrangement is that Welltower is acquiring QCP's real estate, while ProMedica is acquiring the operating businesses that ran the properties, particularly HCR ManorCare.
For background, QCP was spun off from fellow healthcare REIT HCP (NYSE:HCP) in October 2016. At the time, the HCR ManorCare properties were becoming a big drag on the company's earnings -- rent payments were late and HCR ManorCare just wasn't doing too well. So HCP decided to spin off those and a few other properties and exit the skilled nursing business.
In full disclosure, I own shares of HCP and have for several years. I received shares of QCP in the spin-off and held them until the Welltower acquisition was announced a few months ago.
To be clear, I think HCR ManorCare has a lot of long-term potential. It just seems like the move will take Welltower in the opposite direction to where it's been heading. Specifically, skilled nursing properties generally are more reliant on government-backed revenue (such as Medicare reimbursements) than the properties Welltower has been targeting. In fact, over the past eight years, Welltower has built up its private-pay revenue mix from 69% of the portfolio to 95%. With the addition of QCP, this is dropping to 93%. Not a big drop -- just a reversal of its previous trend.
The bottom line: It's not that I don't like the skilled nursing business or QCP specifically -- it's that I don't particularly like this acquisition for Welltower. It seems to add an element of uncertainty to the portfolio after the company's done such a good job of focusing on stable, private-pay-dependent properties for such a long time.
A great long-term play, but...
I'm still a fan of Welltower as a long-term investment in the aging U.S. population, but this quarter's earnings report shows the effects of the challenging senior housing environment. And, as Welltower has the highest concentration of senior housing among the leading healthcare REITs, its earnings could come under serious pressure until the senior housing market becomes healthier. Between this and the company's making a major acquisition that I'm not sure is the best fit for its strategy, now could be a good time to be cautious, at least for the near term.