Look Past Near Term for Healthcare REITs' Value

We have lowered our economic moat ratings for the healthcare real estate investment trusts we cover--

After transferring coverage, we have lowered our fair value estimates for Ventas to $65 per share from $67 and for HCP to $25 per share from $26. We are maintaining our $74 fair value estimate for Welltower. These changes are the net result of some offsetting changes in our near- and long-term assumptions. While we had previously recognized that 2018 would be a down year for senior housing fundamentals and the next two years would also see slower growth in net operating income, we’ve lowered our near-term expectations further based on how the situation has developed.

Additionally, we are modeling more detailed dispositions in 2018, given what the companies have announced to date. HCP is estimated to dispose of $2 billion more in assets than we had expected in 2018, and it is disposing assets at a higher cap rate or lower price than we had previously anticipated. Partially offsetting these negative adjustments, after reassessing longer-term demographic trends, we now include several years of above-average NOI growth starting in 2021 as supply growth slows and the baby boomers start to move into these properties.

Slowing senior housing fundamentals have weighed on the sector. The big three healthcare REITs derive 20%-45% of their EBITDA from operating senior housing. Supply growth caused occupancy to trend negatively in 2017, and construction as a percentage of supply is now at an 11-year high, suggesting that 2018 will be worse. Additionally, the flu season has been the worst in over a decade, leading to further occupancy declines in the first half of 2018. The companies confirmed as much in their guidance, saying that they expected occupancy to drop 100-200 basis points and net operating income could fall as much as 4% in 2018.

However, we think this concern about near-term headwinds is shortsighted and overblown. The severe flu season is a one-time event that should correct next year. Furthermore, construction starts as a percentage of total inventory have flattened out and even dipped a bit from the high point four quarters ago, suggesting we are at peak supply now. As interest rates rise and construction costs get more expensive, supply is likely to decline in the coming years. The first baby boomers will turn 75 in three years, and the 80-plus population (which spends more than 4 times on healthcare per capita than the national average) will double over the next decade, so we should see a significant increase in demand when they start to move into these properties. For patient investors, we think short-term supply issues are more than offset by the long-term demand wave that is going to hit the space.

Healthcare REITs have also declined since mid-December because of rising rates on U.S. Treasuries. Rising interest rates negatively affect REITs because the high dividends provided by REITs become relatively less attractive compared with risk-free options. They have an even larger impact on healthcare REITs, whose external growth is affected. For the past decade, healthcare REITs have benefited from the large spread between the high-yielding assets they were acquiring and the low cost of debt and equity they could use to fund the acquisitions. Rising interest rates and falling equity prices means these companies can no longer accretively grow through external opportunities.

However, we think the sell-off on the news of rising interest rates is an overreaction and misses the long-term value that the healthcare REITs have spent years cultivating. They are all trading below our estimate of their net asset values, indicating that the public market is pricing these companies below where the private market values the underlying real estate. Our fair value estimates for Ventas and Welltower are above our NAVs because we believe these companies’ exemplary stewardship will create value through leveraging relationships and operational expertise to drive higher internal growth. While we have viewed acquisitions as an unsustainable source of growth due to interest rates inevitably rising, we still trust these management teams to make smart investment and capital-allocation decisions.

If investors are willing to overlook some short-term supply disruption in the senior housing space, we believe these companies are well positioned to benefit from long-term demand for their assets.