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Welltower Fixes the Broken Capital Structure - Part 2

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By Steve Moran

Yesterday, we published Part 1 of "Welltower Fixes the Broken Capital Structure Problem." In Part 1, I offered my perhaps somewhat cynical view of how we got here. Now I want to address what Welltower is doing to fix the problem. This article is based on the Welltower Earnings Transcript, dated July 27, 2018.

A Bit More on the Problem

The traditional REIT lease model is mostly broken and the Welltower Leadership points this out. The most interesting example of this is Brandywine Senior Living, a great organization that operates in really good marketplaces. They have great cash flow, and yet, for all of that, they found themselves in a position where they were at a 1.0 lease payment coverage ratio.  

(In case you don’t know, that means that essentially 100% of the net operating income was going to lease payments.)

At the most fundamental level, the problem is that when cash flow is this tight, there is little room to maneuver, which has the potential to cause several bad things to happen:

  1. Cutting expenses where they really should not be cut.

  2. Making decisions primarily for economic reasons, rather than doing the right thing.

  3. Not generally being as effective in making the best decisions.

  4. Putting great emotional stress on leaders.

Fixing a “Broken Capital Structure”

The reason “broken capital structure” is in quotes is that that description comes from Tom DeRosa, which has always been my view of REIT financing.

Welltower is doing three things to fix the “over-leveraged” “Triple Net Lease” problem:

  1. Selling some assets.

  2. Transitioning a bunch of assets to new operators -- a large number of Brookdale buildings -- at what are presumably more favorable terms, believing that these new operators can substantially enhance value.

  3. Converting some triple net leases into RIDEA contracts. For Brandywine it looks like this:

    1. Welltower owns 99.3% of the property company

    2. The same for the operating company

    3. Finally, Welltower owns 34.9% of the management and development company.

They have also done similar conversions with Sagora and Legend.

This is fundamentally the right thing to do for everyone. All interests are more closely aligned to create great experiences for seniors and teams. We know for sure two things:

  1. That great cultures result in low turnover and high occupancy

  2. That great profits flow out of great cultures

While it is true that Brandywine -- and presumably the other senior living organizations -- have had to give up significant amounts of ownership, they end up in a much healthier position that allows them to continue to excel in caring for residents and providing jobs for their team members. Moreover, in addition to being relieved of escalating lease payments and debt, we understand that there are significant amounts of upside built into the deal for Brandywine's owners on the current portfolio -- as well as the opportunity to capitalize on future growth.

So, I end this two-part series where I started . . . while fixing "broken capital structures" might be hard, it is necessary for the future health of both the REITs and the good operators in our industry.

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