The top healthcare real estate stands to disproportionately benefit from the Affordable Care Act. There is an increased focus on higher-quality care in lower-cost settings. The best owners and operators in the industry, which can provide better outcomes while driving greater efficiencies, should see demand funneled to them from the best healthcare systems. Additionally, the baby boomer generation is starting to enter its senior years and the 80-and-older population, which spends more than 4 times on healthcare per capita than the national average, should almost double over the next 10 years. Long-term, the best healthcare companies are well-positioned to take advantage of these industry tailwinds.

In our view, Welltower will benefit from these industry tailwinds because of its portfolio of high-quality assets connected to top operators in the senior housing, skilled nursing facilities, and medical office buildings segments. The company has also spent years forming and developing relationships with many of the top operators in each segment. These relationships allow Welltower to push revenue enhancing initiatives and cost-control efficiencies at the property level, creating net operating income growth above the industry average, and provide a natural pipeline of acquisition and development opportunities to meet the needs of its growing operating partners. Welltower's management team is forward-thinking and should be able to produce strong internal growth and accretive external growth.

The coronavirus was a major challenge to Welltower over the past few years. The senior population was one of the worst hit from the virus, and a few cases led to quarantines of entire facilities, which dramatically impacted occupancy. However, month-over-month occupancy improved through 2021 and 2022 as vaccination rates went up, and we remain optimistic about the sector’s longer-term prospects given that the industry should eventually recover from the impact of the virus, supply growth has fallen below the historical average and will remain low for several years, and the demographic boon will create a massive spike in demand for senior housing.

We are maintaining our no-moat rating for Welltower. Senior housing is one of Welltower’s largest segments. We believe that there are limited barriers to entry for senior housing, so it is too susceptible to supply growth that restricts excess economic returns. While Welltower is in sectors that use a triple-net lease structure that can have long contracts with annual rent increases, there are precedents that show these contracts are renegotiated if the underlying tenant operations are under pressure. Therefore, we don’t view the triple-net structure as inherently conferring a moat to those assets. Medical office buildings have qualities that would lend themselves to supporting a moat for the highest- quality assets, but the initial rents and rent increases from the high-quality properties compared with the initial capital investment produce returns that are well below WACC, leading us to conclude that they do not quantitatively support a moat for Welltower. Welltower has historically shown an ability to drive higher internal operating income growth than peers, but we see this as more an attribute of its management team working with the best operators than qualities inherent in the properties themselves. For these reasons, we believe that Welltower has no moat.

In the operating senior housing sector, we believe that Welltower’s ability to select the top partners and work with those partners to spread best practices across the portfolio are signs of Welltower’s Exemplary stewardship and are not inherent attributes of the assets that would indicate the presence of a moat. While a competitor could build a portfolio of urban, high-quality properties with the geographic diversification to match Welltower’s portfolio through a combination of acquisitions and development, it would be difficult to build the necessary relationships with the top operators and the expertise to push operational efficiencies throughout the portfolio that Welltower’s management has spent years accumulating. Welltower’s management is forward-thinking in terms of portfolio construction and relationship building, allowing it to invest in growing properties and partners and divest struggling properties and partners. There have been several recent large senior housing operators that have run into financial and operational issues and the ability to pick the right partner for a given senior housing property is an attribute of high-quality management rather than something inherent to the property itself. We believe that Welltower’s historical above-average internal growth is more attributable to the quality of its management than the quality of its properties or markets, leading us to conclude that the company has no inherent moat in the sector.

Welltower’s senior housing and skilled nursing triple-net leased portfolios have qualities that could lend it to a narrow moat but we think recent events undercut these qualities, leading us to think they have no moat. The portfolio’s triple-net leases are generally long-term, with initial terms of 12-15 years or more and often include extension options, place all responsibility for property operating expenses on the tenant, and include other tenant credit enhancements such as corporate guarantees or letters of credit. Furthermore, Welltower generally rents its properties under master leases, which group individual properties together under one lease. These master leases generally prevent tenants from dropping poorer-performing properties, as lease renewals are “all or none,” and promotes strong partnerships between Welltower and its various operators, making triple-net business relatively sticky. However, many of Welltower’s triple-net leases grow only at inflationary levels as they are frequently tied to the Consumer Price Index (though often have floors of 2% and ceilings of 3%). Additionally, if the underlying properties can’t maintain the rent bumps throughout the lease term then eventually the leases will need to be broken and new, lower terms will be forced on the landlord.

The situation with Genesis, one of its premier skilled nursing operating partners, provides a great example of how high-rent bumps can become unfeasible despite all of the protections put in place for the triple-net lease structure. Welltower acquired Genesis and their portfolio of high-quality skilled nursing assets in 2011. The lease was set at an 8.25% initial yield at a 1.5 times EBITDAR coverage ratio (above the industry standard of 1.4 times), had a lease term of 15 years with a 15-year option and had contractual rent increases of 3.5% in the first five years and 3.0% thereafter. However, shortly after the lease commenced, the Federal government began to make cuts to Medicare and Medicaid reimbursement increases, reducing revenue growth and reducing profits to an even greater degree due to the thin margins for the industry. Cash flow coverage dropped quarter after quarter until Welltower had to sell a large portion of the portfolio and reduce rents on the remaining portfolio in 2016 and then dispose of another portion and make an even greater rent reduction in 2018. Despite all of the protections and guarantees in place in the original triple-net lease term, on multiple occasions Welltower was forced to sell underperforming assets and make concessions to the operator to keep them financially solvent. Therefore, we conclude that, despite the positive attributes, a triple-net lease structure does not create a moat if the underlying assets don’t support rent payments above the industry average.

Moats for a medical office portfolio could hypothetically come from their proximity and connections to top health systems. Given the Affordable Care Act’s mandate, which incentivizes coordinated, value-based care between healthcare providers and a shift of patients to the types of lower-cost, consolidated settings that MOBs can provide, we believe there will be increasing demand for these types of assets from customers and healthcare partners. Premier MOB assets are usually located on-campus or are campus adjacent to a hospital, the hospital system is considered one of the top 2-3 in the region and is one of the top 100 in the U.S. and the location is in a large MSA with strong population and income growth. Demand for these types of assets will remain strong as patients seek the best treatments from the top health systems, driving consistent patient volumes to their affiliated assets and thus increasing the rents that can be charged to doctor’s groups that want to service these patients. Additionally, the top health systems often seek to work with stable, long-term, well-capitalized partners, creating an opportunity for a landlord to build a long-term relationship with the health system that benefits both parties. Welltower has established itself as a desirable partner with some of the top hospitals as 95% of Welltower’s MOB assets are affiliated with a health system. However, the average quality of Welltower’s assets is not high enough to generate an intrinsic moat and the assets haven’t generated an internal growth rate high enough to exceed the company’s WACC. Thus, Welltower’s MOB portfolio neither has an inherent moat from having better locations nor from extracting excess returns from the relationships it has built.

We use an adjusted ROIC calculation to determine if a company historically has shown or is forecast to have the characteristics of an economic moat. After adjusting the ROIC calculation to use maintenance capital expenditures instead of accounting depreciation, we calculate that over the past few years Welltower has averaged an adjusted ROIC approximately 110 basis points below our 7.2% WACC. While, the adjusted ROIC rises over our forecast horizon as the assets stabilize from recent transactions and developments, it does not exceed our WACC estimate for the company. This affirms our view that Welltower’s portfolio should be assigned a no-moat rating.

We are maintaining our fair value estimate of $97 after incorporating third-quarter results into our model. Our fair value estimate implies a 4.9% cap rate on our forward four-quarter net operating income forecast, 25 times multiple on our forward four-quarter funds from operations estimate, and 2.5% dividend yield, based on a $2.44 annualized payout.

The rent, occupancy, and margin assumptions for each sector drive total company annual same-store NOI growth averaging 6.0% across our 10-year forecast. We expect continued acquisition and disposition activity as Welltower repositions its portfolio and improves the overall quality of its assets; we project $400 million-$500 million in acquisitions annually at an average cap rate of about 6.1% and $120 million of dispositions at 6.7% cap rates as the company looks to recycle lower-quality assets to partially fund the acquisition of higher-quality assets. Additionally, we expect Welltower to invest roughly $360 million annually in new development and redevelopment projects at a 7.5% average yield.

We estimate Welltower’s net asset value to be approximately $63 per share. We use NAV as an assessment of the firm’s potential private-market value, essentially viewing the firm as a portfolio of assets. To calculate the NAV, we utilize recent asset transactions to assign a cap rate to each segment of the portfolio, apply the cap rates to arrive at gross asset value for the company’s real estate, put a multiple on the company’s non real estate assets, add the non-income producing tangible assets, then net out the company’s liabilities (excluding corporate overhead considerations). We find NAV to be a useful data point in gauging the underlying value of the firm, especially as the likelihood for realizing this value through potential asset sales, recapitalization, or mergers and acquisitions activity.

The pressures to increase quality of care at a lower cost does not favor all healthcare assets. Welltower’s performance is highly dependent on the future of the healthcare industry and regulation including the Affordable Care Act, the effects of which we are in the early stages of realizing. If future changes to the ACA cause healthcare subsectors that Welltower invests in to fall out of favor, then the performance and asset values of Welltower’s portfolio will suffer. Additionally, the performance and asset values of Welltower’s portfolio will suffer if Welltower’s operating partners fail to provide superior care or Welltower’s assets fail to retain the top tenants.

Welltower has significant tenant and operator concentrations throughout its portfolio, including Sunrise Senior Living (12%), ProMedica (8%), Genesis HealthCare (5%), and Revera (4%). Disruptions in the operations or financial positions of these companies potentially could affect the performance of Welltower. If the underlying business continues to underperform, Welltower may need to make further rent cuts or dispositions.

By owning a substantial senior housing operating portfolio, Welltower has unlocked value in its most favorable assets, but this also leads to more volatility and financial risk versus the traditional triple-net lease structure, which remains in place for weaker assets. High supply growth has significantly impacted the operations of senior housing. While we expect long-term demand to eventually absorb this incremental supply, persistent new supply will continue to pressure performance and asset values.

The company may face environmental, social, and governance risks that would negatively affect its portfolio or cash flows. These include properly maintaining the safety of the buildings across the portfolio, paying a competitive wage to employees, and accounting for the future impact of climate change.

We give Welltower an Exemplary capital allocation rating. In our opinion, the company’s balance sheet is sound, its capital investment decisions are fair, and its capital return strategy is appropriate.

We view Welltower's balance sheet as sound as the company operates with a reasonable level of leverage for the industry. While we project 2023 net debt/EBITDA to be roughly 6.0 times, which is slightly above the company's long-term target, we believe Welltower will return to average historical levels for the sector within a few years as the senior housing sector improves.

The company’s capital investment decisions are fair, with Welltower growing through a combination of internal growth, development, and acquisitions. While many acquisitions the company has made in recent years have been at a slight premium to the company average, they have provided Welltower new opportunities to generate further internal growth as they expand best practices to new locations.

We assess the company’s capital return strategy as appropriate, as Welltower has averaged a dividend payout ratio near 80% of funds from operations the past several years. We think this is an appropriate level for a REIT, and while we believe the payout ratio will be below that level in 2021 as the company is still hesitant to raise the dividend after cutting it in 2020 to preserve cash, we believe that Welltower will return to a 75% payout level once the senior housing recovery is underway.

Shank Mitra took over as CEO of Welltower in the fourth quarter of 2020. Mitra joined Welltower in 2016 and previously served as the company's senior vice president of both finance and investments and functioned as the company's COO before becoming CEO. He leads a deep management team that has emphasized the importance of developing relationships across healthcare sectors and demonstrated great foresight in the industry by forming creative real estate solutions to handle changing healthcare needs and preferences.

Welltower’s focus on fostering relationships has brought a diverse group of the best-in-class operators to manage their high-quality portfolio, a strategy that should continue to serve shareholders well in the long run. Its senior housing operating portfolio displays favorable demographic and economic characteristics relative to its public and private peers, driving stronger annual NOI growth than other areas of healthcare REITs' portfolios, boosting overall portfolio performance. While high supply caused a drag on this sector in in 2018, 2019, and into 2020, Welltower was the only healthcare REIT that produced positive NOI growth in the senior housing segment over that time frame before the outbreak of the coronavirus as it can leverage its relationships and operational expertise to maintain occupancies, drive higher rates, and contain costs better than its peers. Long term, we believe this structure best positions the company to financially benefit from the incoming demand wave of the aging baby boomer cohort.

We think Welltower’s portfolio strategy is also bolstered by management's successful capital strategies, which has included sensible use of leverage, equity issuance, joint ventures, and opportunistic and strategic noncore asset dispositions. Welltower’s fostering of industry relationships has resulted in a consistent source of new investment and development opportunities. The company also has a demonstrated history of working with both healthcare operators and nontraditional investors looking for well-capitalized, experienced real estate partner to devise new and creative ways to deliver better healthcare options to patients. The combination of flexible capital options, along with an in-place deal and capital-sourcing pipeline, should pay dividends well into the future, allow the firm better execution and scale, and ultimately benefit shareholders.