The stock prices of healthcare real estate investment trusts HCP, Inc. (NYSE: HCP) and Welltower Inc. (NYSE: WELL) have been hit hard since peaking in 2014 and early 2015, falling 50% and 33%, respectively. Bargain-hunting investors, however, should see potential opportunity in these stock declines. These are both large REITs in an industry niche with long-term demographic tailwinds that offer robust over-6.5% yields. But is one stock a better choice than the other?
A little background
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The United States is getting older, demographically speaking. The baby boom generation is hitting retirement, with the leading wave now starting to reach the age of 75. These are important milestones because they mark the point at which medical expenses and the use of medical facilities start to materially increase. And this demographic trend has a long way to go, with the 75-and-over age group expected to be one of the fastest-growing in the country over the next 20 years. Within just the next 10 years, medical expenses in the U.S. are expected to rise from $3.2 trillion to $5.5 trillion.
This is the very real tailwind behind Welltower and HCP, which own the facilities in which medical services and daily living support are provided. HCP's property portfolio is comprised of two broad groups: medical offices and life science facilities (around 50% of net operating income) and senior housing (40%, while the remainder falls into "other"). Welltower's portfolio is more heavily weighted toward senior housing (roughly 72% of net operating income), with outpatient medical (17%) and long-term care (11%) making up the rest.
There is one additional issue to note here, however. The deeper decline in HCP's stock over the past couple of years was driven by the struggling nursing home industry. Its exposure to that segment of the healthcare sector has decreased at this point, but was much larger a few years ago just as nursing homes were starting to struggle. By comparison, Ventas, Inc. (NYSE: VTR), another large healthcare REIT, spun off its nursing home business before the segment started to hit the skids. HCP's management clearly missed the early signs of weakness. Although the portfolio has been repositioned, that misstep is a concern as management aggressively shifts its portfolio in a new direction.
Which portfolio is better?
Stepping back, the big question when you look at these two healthcare REITs is which segment of the market you want to highlight: senior housing or medical office and research facilities. The biggest opportunity today appears to be in the office and research space, HCP's current focus. Note that industry peer Ventas is also shifting toward this space, though it has a more diversified portfolio than either HCP or Welltower.
That said, HCP's push into office and research is notable. In fact, of the roughly $800 million in planned development spending between 2018 and 2020, roughly 80% of HCP's cash will go to medical research facilities, with another 13% going to medical office space. Demand for new construction here does indeed appear strong, with HCP's development projects already fully or materially leased out. So the next couple of years look like they could be solid ones for HCP.
That's not a bad thing, considering that there is currently an oversupply in the senior living space on which Welltower is focused. However, Welltower's portfolio of senior housing is well positioned in high-barrier markets and it tends to work very closely with its partners to ensure mutual success. Over time this has led to solid financial results, including a decade-long streak of revenue growth and a steadily rising dividend, even if short-term performance hasn't always been robust. And while that near-term outlook for Welltower's portfolio may not be as rosy because of overbuilding, the long-term picture remains on solid ground because of the demographic situation that is unfolding in this country.
This is where HCP's misstep in the nursing home market comes into play. The changing fortunes of that business resulted in a $1.45 billion asset impairment in 2015 and the eventual sale and or spin off of the company's nursing home assets. Those divestitures pulled revenue earnings assets out of the portfolio and forced the REIT to make a 35% dividend cut in 2016 -- not something a dividend-focused REIT investor wants to see. To be fair, it has repositioned its portfolio since that point, but the current push into the medical office and research space is a big one. If it doesn't pan out as well as expected, HCP could be getting itself into another jam as it focuses on a smaller number of healthcare property niches. That may seem like an overblown worry based on the construction pipeline being largely leased out, but it's hard to get it out of my mind when there are other options in the healthcare REIT space.
Similar but different
So, from a big-picture view, both HCP and Welltower have roughly similar dividend yields. They have basically similar valuations as well, with each sporting a price-to-projected FFO ratio in the 13-14 range (FFO is a key performance metric for REITs). But when you look more closely at the businesses, there's a significant difference in their portfolios because each is highlighting a different area of the healthcare market.
Although the office/research space is hot today, HCP's notable stumble in the nursing home niche and current plans for heavy spending in office/research don't sit well with me. For my taste, I'd err on the side of slow and steady with Welltower. It has a long history of slow and steady revenue growth and the oversupply in the senior housing space, while worrisome in the short term, doesn't change the long-term need for these assets. In fact the REIT is still projecting modest net operating income growth across its portfolio in 2018. This year might not be a great one, but Welltower has proven over time it knows how to survive the healthcare property cycle's inevitable ups and downs.
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