Despite senior housing net operating income approaching pre-Covid levels in the second quarter of 2022, Welltower (NYSE: WELL) CEO Shankh Mitra sees those results as “mediocre at best.”
But that is not because he believes the company’s senior housing partners did especially poorly during the quarter. Instead, he sees a much longer runway for unlocking value ahead, and believes that the company’s senior housing holdings are capable of delivering much higher returns for the company’s investors.
Mitra noted during the call that the Toledo, Ohio-based real estate investment trust (REIT) has about 120 properties in its senior housing operating (SHO) portfolio that are currently generating negative cash flow. In fact, he said that if Welltower trimmed those properties today, it would significantly boost its overall earnings.
But through community improvements and transitioning certain parts of the portfolio to new operators, the REIT’s leaders believe the portfolio will be humming in the long-term despite short-term distress.
“As frustrating as near-term challenges of operating transition might be for reported earnings — and trust me, I share those frustrations with you — we have to do what’s right for the long-term interests of our owners,” Mitra said.
And good things are coming in the long-term, Mitra said as he teased an “exciting set of initiatives that will transform the business as we know today.”
In the second quarter of 2022, Welltower reported normalized funds from operations (FFO) of 86 cents per diluted share, beating analysts’ expectations by about one cent.
As of the end of the second quarter, Welltower had 904 properties in its SHO portfolio, with another 312 under triple-net management agreements.
Welltower’s stock finished at $83.31, up 0.79% on the day.
Short-term pain for long-term gain
Welltower management takes the view that, although the company’s recent community transitions are disruptive to operations, they are necessary for achieving long-term success.
Last month, the REIT transitioned 12 former Vintage Senior Living properties to operating partners Oakmont Senior Living, Kisco Senior Living and Cogir Management USA. Mitra also noted the company’s move last year to transition its Gracewell senior living assets in the UK to another operator, CareUK.
“Despite some of the most coveted locations and CapEx plans, these assets did not live up to our expectations,” Mitra said.
But both moves exemplify the company’s grand strategy at work, he noted.
In all, Welltower currently has 59 senior housing assets in transition showing that “management is willing to take short-term earnings pain for improved performance in the future,” COO John Burkart said.
“If we have not removed transition assets from the same-store portfolio, our year-over-year NOI growth for 2Q2022 would have been 14.9%,” he said. “Bottom line, strategic transitions are undoubtedly worth it, and they can drive significant value despite creating near-term noise.”
Indeed, those transitions are already bearing fruit, with occupancy already up 13% in the properties handed off to Oakmont, Mitra said. He sees stabilization in reach for those properties sometime in 2023.
Welltower management reported that revenue for its senior housing operating (SHO) portfolio grew 11.5% in the second quarter of 2022 compared with the same period a year prior, driven primarily by occupancy and rate growth in those communities.,
Same-store average occupancy for the REIT’s SHO segment ticked up to 78.8% in the second quarter of 2022, up from 73.8% a year ago. The portfolio’s same-store NOI also grew by 15.4% during the quarter compared with 2Q21.
As occupancy grew, so too did expenses. Costs for the SHO portfolio grew 10.5% in the second quarter. Agency labor expenses were 6% of the REIT’s total compensation expense in 2Q2022, down from a peak of 7.3% in 4Q2021.
But Welltower management also expects that trend to “moderate” in the second half of the year as operators cut down on agency labor use.
Giving Mitra confidence is the fact that the company’s operating partners reported net hiring at levels equal to or exceeding those seen in the previous six months combined.
“We’re taking two steps forward and one step back in terms of occupancy and labor costs, and it appears from the July trends that we’re making that one extra step forward very quickly,” he said.
He also sees the Covid challenges abating, and that the “impacts are becoming less pronounced, and rebounds are getting quicker.” And while the REIT’s operating partners encountered stiff challenges related to move-ins as Covid cases shot up in June, they still were able to make up lost ground toward the end of July.
Thankfully, the health impact of Covid has been getting more mild and the psyche of the population has significantly improved,” he said.”
Industry in its ‘infancy’
Earlier this year, Burkart noted that he saw senior living in 2022 as analogous to the multifamily industry in the ‘70s. And he continued that theme during the second-quarter earnings call by noting he saw the industry still in its earliest stages of evolution.
“I would place the senior housing business in the infancy phase, but rapidly transitioning into the growth phase,” Burkart said. “This is very similar to the multifamily business years ago whose transformation I witnessed firsthand.”
Given that they see the industry at a crossroads, Burkart and other leaders at Welltower are implementing strategic initiatives meant to prepare it for the industry’s next evolution.
Specifically, Burkart mentioned a real need to revise how the industry approaches incentives and management agreements, something other industry leaders have noted in recent years. And he believes that current fee-based management structures “limit the economic incentive to fully invest in optimizing the business as an owner-operator would.”
“For example, if a fee manager is paid 5% of revenues, the most they would logically spend to collect $1 of revenue is five cents, whereas owner-operators would theoretically invest 99 cents to collect the dollar,” Burkart said.
Welltower has sought to address these structural issues through its RIDEA management structure, which the company’s leadership has bolstered over the years. And now, Burkart said the company is working on the “next generation of contracts” that better address the challenges specific to senior living operators.
“In the two reviews we performed, we identified that care revenue was underbilled by 25% or more, meaning that the necessary quality care was provided to the resident, however they were underbilled,” he said. “Other challenges are much greater, including keeping up with modern consumer expectations.”
Helping to propel those efforts is a years-long data effort spearheaded by Welltower called Alpha, and the company expects to roll out more data-sharing pilots in the coming months. Management also noted that the company is undertaking a sales force automation plan, with expectations to launch a new pilot in early 2023.
Alpha, which has been developed over the past six years, will improve the customer and employee experience, according to Burkart.
Other initiatives aimed at improving operations include the formation of an “interdisciplinary team of experts” and the hiring of a chief technology officer.
“What the company has done from an investment side is untouchable,” Burkart said. “But from the operating perspective, there are some more opportunities that I’m going after that should help us [on] an asset management level.”