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Healthcare REIT giant Welltower (NYSE: HCN) has performed exceptionally well in 2016. In fact, the stock has risen a remarkable 44% over the past six months or so since its February low. While this is certainly impressive, I wouldn't call Welltower "expensive" just yet. In fact, any of these three scenarios could catapult Welltower shares even higher.
Demand and/or healthcare costs could drive income higher
This is actually two reasons, but both would result in Welltower's properties producing more income, so I'll discuss them together.
First, it's no big secret that the American population is aging. The massive baby boomer generation is retiring, and people are living longer lives in general. In fact, the 75-and-over population in the U.S., Canada, and the U.K. -- Welltower's markets -- is expected to double over the next 20 years.
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Image source: Welltower presentation.
In addition, healthcare costs have been rising at a faster rate than the overall rate of inflation. If this trend continues, that means even without an increase in demand, people would pay more for the same medical services, including senior housing and the other forms of healthcare Welltower's properties provide.
The point is that since commercial properties derive most of their value from their ability to generate rental income, more lucrative healthcare facilities will be able to produce more rental income, and therefore the values of the properties themselves would rise. So, if some combination of growing demand and healthcare cost inflation translates to higher income at Welltower's properties, it could easily push the stock higher -- especially if the demand/cost growth is greater than expected.
Interest rates could stay low for a while
It's safe to say that the current low-interest environment has stuck around for much longer than most experts had expected. To get a sense of just how low interest rates are in a historical context, just take a look at the 10-year Treasury rates of the last few years compared to previous yields.
Low interest rates are one of the main reasons REITs have performed so well recently. In fact, there are a couple of major ways record-low interest rates benefit REITs.
First, low interest rates obviously make it cheaper to borrow money. Most REITs (including Welltower) use borrowed money to finance acquisitions and development, and low interest rates generally translate to higher initial profit margins.
In addition, high REIT dividends become much more attractive to investors in a low-interest rate environment. Most REITs offer dividend yields of 4% or more and the potential for share price growth over time. When compared with 10-year Treasuries that pay 1.5% or AAA-rated corporate bonds that pay 2.4%, both with no potential for principal appreciation, it's no wonder REITs are the more appealing option. This increased demand can create significant upside pressure on REIT shares.
Acquisition opportunities could heat up
Welltower is currently projecting FFO of $4.50-$4.60 per diluted share for the entire year of 2016, which gives the company a relatively low valuation of 16.9 times FFO, using the midpoint of that range. Many leading REITs that specialize in other forms of real estate trade for significantly higher multiples -- for example, retail giant Realty Income (NYSE: O) trades for 23.8 times this year's expected FFO, and apartment REIT Equity Residential (NYSE: EQR) trades for a P/FFO of 22.1.
When looking at the company's guidance, keep in mind that Welltower specifically says in its press release: "Our guidance does not include any additional investments, dispositions, or capital transactions beyond what we have announced."
Therefore, if Welltower encounters an abundance of acquirable properties at attractive initial spreads, there's a significant chance the company's actual FFO could be at the high end of the range, or even higher. Other REITs have seen higher-than-expected volumes of attractive opportunities -- in fact, the aforementioned Realty Income just raised its 2016 acquisition guidance by 39% and specifically cited an "ample pipeline" of opportunities. The same scenario could play out for Welltower going forward, and the recently announced acquisition of a $1.15 billion portfolio is certainly a good sign of an attractive marketplace.
Will any of these happen?
Any of these events are entirely possible, and I'd even go so far as to call them likely. Other REITs have already said the acquisition market is more attractive than expected, demand for senior housing could easily grow faster than expected in a strong economy, and interest rates have remained at rock-bottom levels for longer than most experts predicted -- and they could easily remain low for a while.
Regardless of whether any of these three positive catalysts happen, Welltower is a rock-solid dividend powerhouse that could be a great addition to any long-term investment strategy.
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Matthew Frankel owns shares of Realty Income and Welltower. The Motley Fool recommends Welltower. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.