Senior Housing Headwinds Increase Uncertainty for Welltower's Dividend

On April 10, we published a note reviewing Welltower's (WELL) dividend safety and exposure to the coronavirus pandemic.

More information about the state of the senior housing market has trickled in since then, and it's been worse than expected.

As a result of these headwinds, we believe Welltower's cash flow may no longer cover its dividend for at least a couple of quarters.

The company has the balance sheet and liquidity to maintain its dividend during this period, but management may choose not to without more clarity on the depth and duration of these coronavirus-related headwinds.

In light of these mounting challenges and the uncertainty they create for the payout, we are downgrading Welltower's Dividend Safety Score to Borderline Safe.

LTC Properties (LTC), a healthcare REIT, reported earnings on May 4, providing the first glimpse at how the pandemic is impacting various parts of the industry.

Around half of LTC's properties are senior living communities. Occupancy at these properties declined sharply from 83% on March 31 to 80% by April 23.

Healthpeak Properties (PEAK) reported similar results on May 5. The REIT saw its senior housing occupancy fall 3% to reach 82.2% at the end of April, driven by a 73% decline in move-ins and a 22% increase in move-outs last month.

For context, occupancy rarely changes by more than 1% to 2% annually for many healthcare REITs. Going forward, some tenants believe occupancy will continue falling by 1% to 2% per month through the summer.

Rising expenses create further challenges. LTC's management said that while supplies of personal protective equipment (PPE) and sanitizers have become less scarce, "the costs have increased beyond anyone's estimation."

LTC also stated that employee costs (around 60% of Welltower's total operating expenses) have increased to "an almost unbelievable level, but what do you pay someone to try to fight an invisible enemy?"

LTC predicted that labor costs will remain higher going forward, noting that "it's very hard to take back money after it's been given for a while."

Omega Healthcare (OHI), another REIT that reported earnings on May 5, also predicted that higher PPE and labor costs will persist for its tenants going forward.

The second quarter is expected to be even more challenging for LTC's operators due to the larger impact of costs tied to PPE, cleaning, and payroll, coupled with the revenue hit from reduced move-ins and falling occupancy.

About 7% of LTC's rent collections were deferred in April, with most requests coming from senior housing operators. It's too soon to say how future months will play out.

As of its earnings call on Monday, approximately 55% of LTC's rent had been collected for May, not far off from historical trends (more payments come due on the 15th).

But management said it was possible that LTC would need to begin accounting for rent on a cash basis for numerous tenants in the future. Depending on the depth and breadth of the COVID-19 crisis, some tenants will struggle to keep paying.

Government aid could help. The $2-plus trillion CARES Act has provided some financial assistance to LTC's tenants, mostly in the skilled nursing industry.

The government has yet to disburse the remaining $100 billion earmarked for the healthcare industry, and LTC said a portion of that could benefit skilled nursing and senior housing. It's too soon to say.

As for Welltower, its business mix is different than LTC's. The majority of Welltower's senior housing exposure comes from properties it runs directly by partnering with an operator rather than leasing the space to a tenant.

This business, which accounted for 43% of Welltower's net operating income (NOI) in 2019, will feel immediate pain from lower occupancy and higher costs.

On April 17, Welltower provided a business update. The company said occupancy within its senior housing operating portfolio fell from 85.4% on March 27 to 84.2% on April 10.

Based on LTC's report, it wouldn't be surprising if occupancy has fallen another 1% to 2% since then, reaching a level with no precedent for the company.

It's worth noting that Welltower's largest markets are New York (7.9% of NOI), Los Angeles (6.3%), and London (5.2%). Given their population density and struggles to contain the virus, these cities could be slower to ease restrictions on property tours and move-ins.

Welltower also said that portfolio operating expenses during the pandemic are expected to rise by about 5% compared to the firm's original budget. This estimate hopefully captures most of the headwinds LTC has seen.

Another 20% of Welltower's NOI is generated from triple-net leases in the senior housing industry. LTC already experienced some struggles collecting all of its rent from senior housing tenants.

Welltower could struggle as well since its tenants' rent coverage ratio was low heading into the crisis.

If higher PPE and labor costs represent the new norm as LTC and Omega Healthcare suspect, financially weaker tenants may need to renegotiate their leases.

One of Welltower's non-top 10 tenants, Chelsea Senior Living, already said it is negotiating rent relief from the REIT.

Welltower will survive these challenges and continue generating cash flow. The company also has $3.5 billion of near-term available liquidity, no material unsecured debt maturities until 2023, and a BBB+ credit rating from Standard & Poor's.

But the REIT's commitment to its dividend will be tested. Prior the pandemic, Welltower's adjusted funds from operations (similar to free cash flow for REITs but excludes growth capex) was projected to be about $1.5 billion this year, covering the company's $1.4 billion dividend.

Analysts no longer expect the dividend to be covered this year, and it wouldn't be surprising to see Welltower's payout ratio get worse before it gets better based on these latest developments.

A dividend cut would be surprising at this stage of the crisis given the firm's history of paying uninterrupted dividends since 1971.

Management would likely need to believe that the crisis will have longer-lasting consequences on Welltower's cash flow, which may not be out of the question if the pandemic persists through the rest of the year.

Welltower reports earnings after the market closes on May 6 and will begin answering some of these questions.

As we said in April, income investors should make sure they remain comfortable with their investment in Welltower given the widening range of outcomes facing the industry for the foreseeable future. We will continue monitoring the situation.