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3 Reasons Welltower Stock Could Fall

I've written before about why healthcare real estate could be a fantastic long-term investment, and why industry-leading healthcare REIT Welltower (NYSE: HCN) is an excellent way to invest. However, no stock that is capable of average total returns over 15% is without risk, and Welltower is certainly not an exception. With that in mind, here are three reasons why Welltower stock could fall.

Image source: Getty Images.

Slower-than-expected healthcare demand growth

One of the biggest potential positive catalysts for Welltower over the coming decades is the aging population of its three markets -- the U.S., U.K., and Canada. In these markets, the elderly population is growing much faster than other age groups, and the 65-and-over population is expected to roughly double by 2050. Older age groups are growing even faster. For instance, the population older than 75 is expected to double in just 20 years.

Image source: Welltower.

While these projections should be pretty accurate, there is still a potential supply and demand issue. Specifically, in response to the expected elderly population growth, an influx of senior housing facilities is coming into the market. It's completely possible that inventory will grow faster than supply, which not only would lead to vacancies, but would reduce the operators' pricing power.

Just as one example, the latest projections call for demand for an additional 50,500 senior housing units during the five-year period from 2020-2024. It's entirely possible that this figure could be off by a few thousand, and could lead to too much new construction.

Welltower has taken steps to mitigate this risk, by creating a geographically diverse portfolio of properties located in mainly affluent, high-barrier markets, but this is still a very real risk.

Tenant/partner issues

Welltower has a lot of joint ventures in its portfolio, and is highly reliant of a select group of tenants. In fact, the company's top five operating partners account for 41% of the portfolio's total income. Sunrise Senior Living (15.7%), Brookdale Senior Living (7.6%), and Genesis HealthCare (7.1%) are the largest, and if any of these companies ran into significant financial difficulties, it could send Welltower shares lower.

Image source: Welltower.

Interest rates

Finally, and most likely, is the effect of rising interest rates of REITs in general. Since the Federal Reserve is anticipating three rate hikes in 2017 and several more in 2018 and 2019, this is a risk all REIT investors should keep in mind.

For starters, it makes it more expensive for REITs to borrow money. I wouldn't call Welltower a "high debt" REIT by any definition of the term, but the company does rely on its borrowing ability for growth. Rising interest rates lead to higher borrowing costs, which in turn generally lead to smaller profit margins.

In addition, when rates rise, income-seeking investors tend to flee "riskier" assets like REITs, in favor of more stable income-generating options like Treasury bonds. Think of it like this: When the 30-year Treasury yield is 3%, a 5% yield from a high-quality REIT like Welltower may entice income-seekers to take the additional risk. However, if the Treasury yield spikes to 5%, it may not seem so appealing. So, REIT share prices tend to fall when rates rise to compensate investors for taking on the added risk.

You can see this concept in action in this chart of Welltower's stock price and the 30-year Treasury yield over the last seven months or so. Notice how they move almost exactly opposite one another.

HCN data by YCharts

The lower stock price further hurts the REIT by increasing its cost of capital when issuing new equity. REITs have two main methods of raising capital -- borrowing money or issuing new shares. Let's say that Welltower is trading at $70 per share and wants to buy a $10 million property. From an equity-issuance standpoint, it needs to issue about 143,000 new shares to raise the money. If the stock price falls to $50, it needs to issue 200,000 shares to make the exact same acquisition.

Are any of these likely to happen?

All three of these reasons are certainly possible. In fact, it was issues with an operating partner that caused fellow healthcare REIT HCP to plunge in early 2016, and interest rates were the main cause of the dismal REIT performance during the latter half of the year. Also, several other factors could contribute to falling demand. For instance, if Medicare and Medicaid reforms are passed, even though it makes up a small fraction of Welltower's income, it could do significant damage to the company's profits.

However, while any of these could make Welltower's stock price go down, I suspect that any weakness (especially if caused by interest rate fluctuations) will be temporary. Over the long term, Welltower has a rock-solid business model that should produce strong returns.

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Matthew Frankel owns shares of HCP and Welltower. The Motley Fool recommends Welltower. The Motley Fool has a disclosure policy.