The pandemic had a devastating impact on older populations, and that had a trickle-down effect on the senior housing industry. Occupancy rates slumped as more people departed than moved into these communities while their costs increased as they spent money on testing and protective gear. Those issues put a lot of pressure on their net operating income (NOI).
While there's some concern that the pandemic could have a long-term impact on senior housing occupancy levels, that's not causing healthcare REIT (real estate investment trust) Welltower (NYSE: WELL) to shy away from the sector. Instead, it's making a bold bet on its recovery by purchasing a portfolio of senior housing properties.
Digging into the deal
Welltower has agreed to acquire Holiday Retirement's 86-property senior housing portfolio for $1.58 billion. That deal will enable Atria Senior Living to purchase Holiday Retirement's operating business.
The REIT is buying 80 nearly identical independent living facilities and six combination independent living/assisted living properties. This portfolio has about 10,400 units spread across 31 states. The transaction values the portfolio at $152,000 per unit. That's 30% below their replacement cost, which is what it would cost to build a similar property in today's market.
One factor driving that discounted price is the currently low occupancy level of around 76%. That's enabling Welltower to purchase the portfolio at an attractive initial cap rate of 6.2%. Because of that, the company estimates that the deal will be accretive to its normalized funds from operations (FFO) per share by $0.10 during the next 12 months. That's a modest increase for a company that currently expects to generate between $0.72 and $0.77 per share of normalized FFO during the second quarter (or about $2.98 per share annualized at the midpoint).
High upside as senior housing recovers
Welltower is making a solid investment based on the current state of the senior housing market. However, the main draw of this deal is its upside potential. Welltower believes that as occupancy improves, NOI at these properties will surge. That's already starting to happen as portfolio occupancy is up 2.7% since bottoming this past March.
In the company's view, the portfolio's occupancy level could eventually exceed its prior peak of 87.4% in December of 2019 to reach the low 90% range. Several factors drive that view, including:
- Favorable supply and demand dynamics in the senior housing industry.
- A plan to invest $1.5 million to $2 million per community to position them for success in a post-COVID-19 recovery.
- The benefit of Atria's successful operating model and technology platform.
- A highly aligned relationship with Atria that incentivizes the operator to grow NOI.
Even after factoring in the additional investment and potential incentive payments to Atria, Welltower estimates that it will eventually earn an 8% yield on its total investment in this portfolio.
One of the main drivers of its investment thesis is that demand for senior housing will improve in a post-pandemic world while the supply of new facilities will lag due to the recent increase in construction costs. Occupancy has already started recovering as vaccines reduce the risk for older demographics. While there are questions on how long it might take to get back to pre-pandemic levels, it's heading in the right direction after steadily declining over the past year.
Meanwhile, Welltower believes that current construction costs don't justify new senior housing development. That's because the rents required to support development would need to be more than 20% above the current rate at existing properties. Thus, as more of those in older demographics seek out senior housing, this portfolio should benefit from higher occupancy and rental rates since there will be less competition from new development.
A solid deal with compelling upside
Welltower is buying a large-scale senior housing portfolio at a huge discount to what it would cost to build a similar portfolio at today's construction rates. Because of that, it's getting a good deal even at the currently low occupancy rates.
However, what makes this transaction even more attractive is the upside potential as occupancy continues improving from the bottom. With the possibility that it could eventually exceed pre-pandemic levels because current construction costs are making new development uneconomical, this deal could pay huge dividends for Welltower as the senior housing sector recovers.