A Real Estate Investment Trust (REIT) is a type of investment structure that allows investors to add exposure to real estate in their portfolio. REITs receive preferential tax treatment at the company level, where virtually all taxation is passed on to the investors, if they pay out at least 90% of net income as dividends. Because of this, REITs are generally some of the highest yielding investments. The dividend income received is taxed at ordinary income rates for investors though (unless it is considered return of capital) so it’s usually more efficient to own REITs in tax deferred accounts like IRAs.
The two most important factors for REITs are stable/growing rental income and stable/growing property values. REITs generally own the real estate but simply charge rent to other companies that use the property. Also, like most real estate transactions, nearly every REIT uses debt when acquiring properties. This added leverage means that falling real estate values can create magnified losses.
There are many different types of REITs out there – everything from hotels, apartment buildings, office buildings, industrial buildings, retail locations, and gas stations. But given the demographic changes occurring in the western world with aging populations, I think that healthcare REITs are perhaps the safest type when it comes to increasing property values and high demand to support stable/increasing rents. The 85+ age group is set to double over the next 20 years, providing a constant increase in demand for healthcare services.
Welltower
I recently purchased stock in Welltower (HCN) for my clients as an income investment. Welltower is the largest healthcare REIT in the US with arguably the best management team in the industry. Size means scale and favorable pricing, meaning a low cost of capital and very favorable returns on invested capital.
To reduce risk and support rental income growth, Welltower has been transitioning their target properties to private-payer care instead of government reimbursement, with a strong focus on senior housing which includes memory care, assisted living and independent living facilities. Additionally, a key value proposition of the company is the location of their properties. They have built what they call a “Class A” health care portfolio by focusing on properties in high income, densely populated areas (i.e. big cities like Boston, Manhattan, DC, Toronto, San Fransisco, etc.) where land is scarce and rents are higher. This reduces the risk of competition and allows Welltower to receive a higher rent per square foot.
Welltower also owns properties in Canada and the UK. Both of which have similar demographic trends as the US.
Financial Strength
Over the last 5 years, management has reduced debt and increased interest coverage, all while continuing to increase operating cash flows. They now hold a relatively balanced debt maturity profile over the next decade with investment grade credit ratings.
Dividend
When it comes to REIT investing, perhaps the most important metric for investors to analyze is the dividend sustainability. Net Income is not a great metric to track since real estate generally has a lot of depreciation deductions associated with it. For REITs, what investors want to track are Funds From Operations (“FFO” which is basically cash flow) and Adjusted Funds From Operations (“AFFO” which is basically free cash flow). AFFO is also referred to as Funds Available for Distribution (“FAD”). This is the actual amount of cash available for the REIT to distribute as a dividend. If a company is able to grow FAD then they should be able to continually boost the dividend payment.
HCN has paid a dividend each year since its founding in 1970 and increased it at a compound annual rate of 5.6% per year. At a current FFO payout rate of 83%, Welltower should be able to continue its impressive streak of increasing the dividend in future years.
Summary
REITs are tightly tied to interest rates so if rates rise in the near future and knock down the stock, I would be thrilled to add to the position at lower prices. Welltower is a company operating in an industry that is expected to experience robust economic tailwinds for the next 20+ years. It is perhaps the best managed REIT in the industry and the company has been going through a multi-year transformation that has reduced risk by focusing on prime locations with low competition, decreasing the percentage of business coming from government reimbursements, and reducing debt. The stock is currently trading around its historical average valuation so I wouldn’t consider it a bargain but with a 4.75% dividend yield and the ability to grow cash flow around 3%-5% per year, this is a classic Warren Buffett style investment of buying a great company at a fair price and allowing compounding to work in your favor for years to come.
Thanks for following!
-Nick
*All slides are from HCN’s most recent investor presentation