(01/07/16) Welltower and Ventas: Healthy REITs

Over the years, REITs have added a lot of value to our strategy. Even in today’s trying circumstances, our picks continue to deliver the handsome income and growth of income we expect, explains Josh Peters, editor of Morningstar DividendInvestor.

For now, we’re living through the volatility that comes with sensitivity to interest rates, credit market conditions, and trends in the industries.

It’s not hard to imagine sentiment toward this sector getting worse before it gets better. But I’m a part owner of these businesses for the long haul.

As long as our REIT holdings deliver the cash distribution and dividend growth we expect—and those payouts remain properly supported by healthy cash flows and capital structures—I’m prepared to endure periods where the stock market doesn’t properly appreciate these virtues.

Welltower (HCN), a senior housing REIT, makes a point of announcing a new dividend rate each autumn for the upcoming year; the firm intends to pay $3.44 a share next year.

The 4.2% enhancement edges out my forecast of $3.42 and reflects a modest pickup in dividend growth from the mid- to high 3% range of recent years.

Meanwhile, Welltower’s funds available for distribution (the best metric of the REIT’s earning power) have been growing at a roughly 6% average pace over the past five years, including a 9% year-over-year gain in the third quarter of 2015.

Yet with a 13.9% loss, Welltower was our worst performer last month and rival Ventas (VTR)—another senior housing REIT—wasn’t far behind, down 12.3%.

REITs are out of favor in general because of their interest rate sensitivity; for these two firms in particular, there is also some concern about excess supply in the senior housing industry.

This property type generates 63% of Welltower’s net operating income and 54% of Ventas’, though in both cases nearly half of the rent is secured with triple net leases).

Both stocks have behaved in a way that is wildly disproportionate to the risks, creating what I believe are two highly appealing bargains.

Meanwhile, demographic trends suggest that any oversupply in senior housing nationwide should be short-lived and Ventas and Welltower hold portfolios concentrated in regions with higher barriers to entry and better long-term pricing power.

I don’t know where the stocks are headed in the short-term; I know better than to call a bottom on any falling stock. Still, I am confident in my conclusion that Welltower and Ventas are very cheap for their risk and return profiles.

Ventas’ lower valuation gives it an edge for my next add-on purchase, but I like the dollop of company-specific diversification provided by holding both.