A lot of mom and pop investors have been encouraged to purchase shares in Welltower stock (WELL) over the past few years on the basis that it is “safe” real estate investment and source of regular income. If you have never encountered Welltower, it’s basically a giant collection of properties that are rented out by senior centers, assisted living facilities, and a broad array of geriatric healthcare providers.
The investment thesis for a company like Welltower tends to go like this: “This company didn’t cut its dividend during the financial crisis, the stock has increased from $6 per share in the 1970s to the $80s today, and America has an aging population so it owns the type of real estate that will benefit from an uptrend over time.”
While those appeals sound superficially enticing, there are some real issues with paying mid-$80s per share for Welltower stock today.
The first issue is valuation. Welltower is a stock that has historically traded at 12-15x its funds from operations. Right now, its P/FFO ratio is 18.5. That is tied for the most expensive valuation for Welltower in the same past twenty-five years.
But here is the catch. The funds from operations are only growing at a mid-single digit rate. The company likes to brag during conference calls about how its funds from operations have increased from $500 million to over $1.5 billion over the past eight years. But there is a catch. Welltower had to issue 200 million new shares in equity to achieve that growth in rental income (the share count of 192 million eight years ago is now nearly 400 million today). As a result, funds from operations have only increased from $3.41 to $4.20 over the past eight years. That is a compound annual growth rate of 2.64%.
Next, even while Welltower has achieved this 2.64% growth, it has benefited from a very attractive rental market as iit has been raising its rents 4% compared to its twenty-year average of 2.8%. It has loaded up on $13 billion in debt as well, compared to $6 billion eight years ago.
In short, I look at the company and see a firm that has had the double benefit of low interest rates and a strong rental income environment and has still only managed to grow funds from operations at a 2.64%. With over $10 billion of its debt due in the next years, a cooler economy and/or higher borrowing costs will lead to negligible funds from operations growth and also P/FFO compression.
There is historical precedent for this. In 1993, Welltower was trading at 16x P/FFO and had recently raised its rents by 4% annualized during the 1988-1993 stretch. Its borrowing costs were 4.9%. Over the coming decade, the P/FFO fell to 12, rent increases were less than 2% annualized, and borrowing costs rose to a little over 6%. The consequences? An investor could have bought the stock for $22 in both 1993 and 2003. A decade went by with no capital appreciation to show for it, and worst of all, the lack of price appreciation was justified based on the fundamentals and wasn’t the result of 2003 being an awful recession year like 1974 or 2009.
When I run the numbers, I think Welltower in 2019 is trading at 2024 prices. If the P/FFO ratio falls to 15, and funds from operations grow from $4.21 to $5.25 for 4.5% growth in available funds, the stock will trade at $78 per share. You are going to be collecting the 4.1% dividend, but you are not going to have any capital appreciation to show for five years of delayed gratification.
In good economies, people become lazy with valuation. They forget that Welltower rising from $25 in 2009 to $83 is partially a product of the P/FFO switching from an unusual low (10x funds from operations) to an unnusual high (18x funds from operations). The investors of the past decade benefited had their account values rise from valuation expansion. The investor who pays $83 will be forfeiting the effects of future growth to account for valuation compression. High valuations and moderate growth rates are almost always a formula for subpar returns, and I think the typical Welltower investor will be lucky to get 5-6% annual returns over the next 5-7 years. There are heavy debt, valuation, and cyclical forces weighing against any return in excess of that.
