Earnings Call Transcript - WELL Q2 2020

Operator, Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Q2 2020 Welltower Inc. Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. Operator instructions were provided. I’d now like to hand the conference over to your speaker today, Mr. Matt McQueen, General Counsel. Thank you. Please go ahead, sir.

Matt McQueen, General Counsel

Thank you and good morning. As a reminder, certain statements made during this call may be deemed forward-looking statements within the meaning of the Private Securities Litigation Reform Act. Although Welltower believes any forward-looking statements are based on reasonable assumptions, the company can give no assurances that its projected results will be attained. Factors that could cause results to differ materially from those in the forward-looking statements are detailed in the company’s filings with the SEC. And with that, I’ll hand the call over to Tom for his remarks. Tom?

Tom DeRosa, Chief Executive Officer

Thanks, Matt. First and foremost, I hope that all of you and your families are safe and healthy during these difficult times. When we last spoke with you in early May, Welltower was in the midst of the most challenging period in the company’s history. Many of our senior housing and post-acute care operators had implemented admissions bans to prevent or control the spread of COVID within their communities. Critical personal protective equipment and testing kits were difficult to procure and labor challenges left many of our operators short-staffed. However, I am pleased to report that significant progress has been made on all of these fronts, and that most of our properties have reopened with appropriate staffing levels and requisite PPE and testing kits. This was accomplished through careful planning and precautionary measures taken by our operators. In fact, in just a few months, 95% of our senior housing operating communities are now accepting new residents. This is significant, because our communities are a critical component to the care continuum. It is imperative that seniors have access to residential settings in which professional care is offered to meet their everyday needs, including safety, nutrition, hygiene, and medication management. It is important to remember that this is a need-driven asset class. Welltower’s traditional assisted living portfolio is skewed toward higher acuity settings, which are built for seniors who have exhausted the ability to be cared for in a conventional home setting. We continue to owe a debt of gratitude to the frontline workers in all of our properties, who braved extraordinary obstacles to put the care of their residents above all else. While I’m encouraged by our progress, by no means are we signaling the all clear. We are acutely aware of the heightened level of risk that continues to exist, particularly as the number of COVID cases in the U.S. continues to rise. As Shankh and Tim will describe in greater detail, the toll from COVID-19 on our business has been and will continue to be pronounced. However, the decisions we have made since the beginning of the pandemic and the steps we have taken over the past five years to strengthen our enterprise have put us in a position to weather this storm. These decisions, while often difficult, are rooted in data and always executed with the long-term interest of our shareholders in mind. This management team has earned a reputation for taking on both opportunities and issues in a proactive manner, and COVID-19 has not changed that. One of the strongest examples of this approach relates to our recent efforts to further strengthen our balance sheet. As financial conditions began to deteriorate at the outset of the pandemic, our team did not panic. Instead, through a thoughtful and deliberate process, we obtained a $1 billion term loan providing us with ample flexibility in the event of a prolonged market downturn. As conditions improved in subsequent months, our team waited for an opportune time at which to return to the public market. In June, we issued $600 million of unsecured debt at just 2.75%, the lowest coupon on 10-year notes in Welltower’s history. These actions are a reflection of Tim McHugh and his team’s responsible stewardship of our balance sheet and the confidence from investors and our banking partners in the Welltower platform. Another major achievement was the disposition of two large portfolios of seniors housing and outpatient medical assets with a combined total value of $1.3 billion. These sales were executed during a time in which few real estate assets traded and when the ability for senior housing to withstand the impact of COVID was called into question. Most notably, our $1 billion transaction with Kayne Anderson provided significant and immediate liquidity to Welltower in a period of under 45 days and was executed at valuation levels that were only modestly below pre-COVID pricing. Again, we were not backed into a corner to complete these deals. The valuation we achieved demonstrated the appreciation for the long-term growth prospects for healthcare real estate by astute investors and the strong liquidity that exists for our asset class. I applaud our investment teams for their perseverance in completing these deals under the most extenuating circumstances. As the year progresses, you should expect to see more of this. Following the completion of our capital markets activity and portfolio dispositions, our near-term liquidity stands at $4.3 billion. The company is extremely well-positioned to address all near-term capital obligations and has ample capacity to execute on accretive opportunities as they arise. Our team will continue to explore all avenues through which to create value for our shareholders. Regardless of how strong our liquidity position is today, our underwriting discipline will not be compromised. Many questions remain unanswered about the duration and ultimate impact of COVID-19. However, what we can say with great certainty is that the long-term drivers of our business remain firmly intact. The population is growing older, the need for value-based healthcare is as important as ever, and addressing social determinants of health will only grow in relevance. While it’s often difficult to see past the next week or next quarter, rest assured that Welltower’s long-term value proposition has not changed. There will be challenging times ahead, but we are confident that the company is positioned to navigate through these choppy waters and emerge as the continued leader in delivering the real estate that will enable more efficient and cost-effective healthcare and wellness. With that, I’ll turn the mic to Tim.

Tim McHugh, Chief Financial Officer

Thank you, Tom. My comments today will focus on our second quarter 2020 results: the impact of COVID-19 on our business observed this quarter, our capital activity in the quarter, and finally, a balance sheet and liquidity update. In the second quarter, Welltower reported normalized FFO of $0.86 per diluted share. These results include a total of $37 million, or approximately $0.09 per share, of property-level costs in our senior housing operating portfolio associated with the COVID-19 pandemic. As we indicated last quarter, Welltower elected not to normalize these COVID-related expenses in normalized FFO and same-store results. Now, turning to our individual portfolio components. First, our Triple-Net portfolios. As a reminder, our Triple-Net lease portfolio coverage and occupancy stats are reported quarterly in arrears. These statistics reflect the trailing 12 months ending 3/31/2020 and therefore only reflect a partial impact of COVID-19. In the quarter, we collected 98% of cash rents due on these portfolios, and as of last night’s release, we’ve collected 97% of cash rents due in July, which is in line with previous months’ collections at this time. Our Senior Housing Triple-Net portfolio delivered 1.4% positive year-over-year same-store growth, and the difficult comp combined with an increased bad debt drove growth below original expectations. Occupancy was down 50 basis points sequentially and EBITDAR coverage increased 0.01 turns on a sequential basis in this portfolio. Our Senior Housing Triple-Net operators have experienced similar headwinds as other operators during the second quarter and we expect these coverages and occupancy stats to reflect that going forward. Next, our long-term post-acute portfolio generated positive 2.1% year-over-year same-store growth and EBITDAR coverage declined 0.04 times sequentially. And lastly, health systems, which is comprised of our HCR ManorCare joint venture with ProMedica, had NOI growth at positive 1.375% year-over-year and EBITDAR coverage declined one basis point sequentially to 2.13 times. Turning to medical office, our outpatient medical portfolio delivered positive 1.8% same-store growth. A significant year-over-year decrease in parking revenue caused by national shelter-in-place orders during the quarter, along with an increase in bad debt accrual, was slightly offset by better-than-expected tenant retention. New leasing remains uneven as a result of COVID. The second quarter ran behind pre-COVID budget by 104,000 square feet, but the gap narrowed in June and July with new leasing exceeding budget by 44,000 square feet in July. During the quarter, our outpatient medical tenants paid approximately 87% of cash rents, while we approved two-month deferral plans for approximately 12% of rents. The slower-than-expected reopening of certain regions in our portfolio caused more deferrals in the May-June period, as we anticipated when we reported our first quarter numbers. We are encouraged by the momentum in the rebounding tenant openings; they accelerated in the back half of June and July, driving cash rent collections to 95% in July. We’ve also had strong deferred rent collections in June and July as our two-month deferral plans began repayment. We collected 96% of what was due over this period. We’re extremely proud of the Welltower outpatient medical employees, both onsite and working from home, who have kept our platform running smoothly during these extraordinary times. Before viewing this quarter’s senior housing operating portfolio results, I want to briefly summarize the outlook we provided back in May when it certainly was at its peak. At that time, our expectations were that occupancy would be down between 500 and 600 basis points from April 1 through June 30, that RevPAR would be flat on a year-over-year basis, and that expenses would increase by 5% sequentially driven primarily by labor costs. Before turning to how things actually turned out in the quarter, I’d like to first point out that our same-store pool now represents 91% of our total senior housing operating NOI; this will continue to increase into year-end. In the quarter, occupancy declined in our same-store portfolio by 490 basis points from April 1 to June 30. Our same-store expenses declined 10 basis points sequentially and our same-store RevPAR declined 20 basis points year-over-year. The net result of the second quarter was same-store NOI declining 24.5% from the previous year and 23.3% from the previous quarter. These results were a collection of widespread admissions bans that were in place for most of the quarter, the limited move-ins as well as extraordinary COVID-related expenses totaling $34.2 million in the same-store portfolio, resulting in significant margin compression in the quarter. As a reminder, we’re not normalizing any of these COVID-related costs for same-store. Looking forward to the third quarter and starting with the July data we’ve already observed, we experienced 70 basis point declines in occupancy in July from start to finish, and we expect to finish the third quarter approximately 125 to 175 basis points lower than we ended the second quarter. We expect overall same-store expenses to remain relatively flat sequentially as continued reductions in COVID-related spend will be offset by increased costs relating to reopening of communities, seasonal utility costs and an increase in insurance costs. Now, on capital markets activity. In June, we issued a $600 million unsecured bond with a ten-and-a-half year tenor at 2.75%, the lowest tenured coupon in the company’s history as Tom mentioned. We were able to tender for $425 million of our two outstanding 2023 bonds, increasing the weighted average years to maturity to 9.2 years for our unsecured bond borrowings and further de-risking maturities through 2023. Following these tender activities, which closed in July, we have approximately $1.3 billion in cash and cash equivalents and the full capacity of our undrawn $3 billion unsecured revolving credit facility, totaling $4.3 billion of near-term liquidity as of July 31. Moving to investment activity, in the second quarter we invested $124 million, almost entirely in our development pipeline. On the disposition front, we completed $949 million of pro rata dispositions at a 5.7% cap rate. Post quarter-end, we closed the second tranche of the MOB portfolio sale we announced earlier, with proceeds of $173 million at a 5.4% yield. We expect the third and final tranche to close in the third quarter for $89 million of additional proceeds at a 5.3% yield. Shankh will speak to you later; we feel very good about liquidity for all property types in our high-quality portfolio and view our private cost of capital as significantly better priced than our public costs at this current time. As a result of these successful dispositions in the quarter, we ended the quarter at 6.36 times net debt-to-adjusted EBITDA, a 43 basis point increase from last quarter despite an approximately 13.5% sequential decline in EBITDA. COVID has substantially increased variance in our near-term EBITDA, and consequently, we’ve done everything in our control to counter that and maintain a strong cash flow-based leverage profile despite our currently depressed property-level cash flows. We’ve also been acutely focused on managing what is in our control to maximize retention of cash through this pandemic. This has been focused on three main areas: G&A, CapEx and the dividend. On G&A, we expect to finish the year between $125 million and $130 million of corporate G&A, implying a run rate of a little over $30 million a quarter for the remainder of the year and representing a $10 million-plus decrease from what we’d initially guided for the year. For CapEx, we reduced CapEx spend by $12 million, or 18% sequentially. With our growing liquidity profile and our buildings opening back up, we expect CapEx to increase over the next two quarters, but still expect to finish the year approximately 16% below 2019 levels. And as we announced last quarter, our dividend reduction has created approximately $110 million of annual cash flow savings. The results of these actions, along with many others, are that we were able to retain significant cash flow before investment activity despite the substantial negative impact COVID-19 had on our second quarter results. While these decisions, particularly the dividend decision, were difficult, we felt strongly that they gave us greater control as we navigate through the pandemic. Retaining cash flow is by design different than reconstruction. So, when analyzing the near-term impact of COVID-19 on our cash flows, it was not just analysis of when we might return to breakeven levels of cash flow. There’s a question of how long that deficit would last and the time it would take for retained cash flow to reach a level that allows for the accumulation of that deficit to be repaid — i.e., today’s dividends would need to be paid with tomorrow’s cash flows. As the duration of the deficit period increases, its compounding impact on the deficit repayment needed to return the balance sheet to pre-COVID levels increases. Ultimately, this has a dual impact of not only amplifying business strains caused by the pandemic, but also destabilizing the balance sheet. Disposing of assets or selling equity to offset this increased leverage can increase the payout deficit by either eliminating any cash flow from disposed assets or adding dividend-paying shares to our share count. Our asset sales this quarter demonstrated that reducing the dividend to a level below current cash flows was made by our management team so that we could make decisions to sell assets based solely upon the value received and the stabilizing effect these retained proceeds have had on our balance sheet. We believe these decisions are not dependent on a quick recovery, allowing us to decrease downside risk. We continue to make capital allocation decisions with a long-term focus. And with that, I’ll hand the call over to Shankh.

Shankh Mitra, Chief Investment Officer

Thank you, Tim, and good morning, everyone. I’ll now provide additional color on the operating performance that Tim discussed and discuss our capital allocation strategy in these challenging yet rapidly evolving times. As we reflect back on the frenzied pace of activity over the last few months, our focus has been and will continue to be the safety of our residents and staff in our communities. The frontline heroes of these communities have done a tremendous job of improving the safety and quality of life for residents from the earliest days of this crisis. For example, in our senior housing operating portfolio, reported resident COVID cases over a trailing two-week period peaked at 510 cases in the first week of May. Since then, that number has declined to 98 cases, representing an 80% decline from the peak. This is despite the fact that our operators tested nearly 100,000 residents and employees so far. While COVID cases have spiked across the nation, the prevalence of cases across our portfolio has remained relatively flat so far. COVID-related deaths, which peaked during the last week of April, are down 92% since then and have so far remained relatively stable in July despite the spike in nationwide cases. This remarkable improvement, though far from complete, has allowed our operating partners to cautiously open doors to new prospects. In the last week of April, 42% of our communities had official admissions bans. That number today is 5%, including 3% partial events, moving down sequentially from the pre-COVID February peak to April when you had the first full month of COVID by almost 77%. Since then, admissions bans are down 174% from the April low to July. Move-outs peaked in March and are sequentially down 37% in July relative to March. However, we still have more move-outs than move-ins. As a result of this, occupancy loss in our senior housing operating business has narrowed from down 60 basis points during the last week of April and the first week of May to down 10 basis points in each of the last three weeks. Though this improvement is encouraging, we are cautious about the overall environment as spikes in COVID cases in our markets are real and can impact our communities at any time. We have been seeing a steady increase of leads, inquiries, and deposits due to the need-driven nature of our business. The total number of leads in the system, which declined 55% from February to the April trough, has since bounced back 60% in June from that trough and is approaching pre-COVID February numbers in July. However, move-ins are trailing those lead activities due to consumer hesitation; families are balancing the difficulty of taking care of elderly loved ones with fear related to national headlines about rising COVID cases. So far, we have been positively surprised by our operating partners’ ability to scale expenses to a rapidly declined occupancy. We saw rates held up slightly better than we thought in assisted living and memory care segments, where RevPAR was up 1.7%. The occupancy hit was much more pronounced there, down 6.2% year-over-year. While occupancy of our independent living segment held up relatively better, down 2% year-over-year, rate growth declined 10 basis points year-over-year. Additionally, the entrance of a lower price-point senior apartment portfolio into the same-store pool in Q2 impacted the reported same-store RevPAR growth by reducing it by 40 basis points for the quarter. Clearly, given how COVID has spread, the larger coastal markets were impacted significantly during the quarter more than other markets. Finally, we’re starting to see some differentiation in operator performance that can be explained by operator value-add, not just location, product type, or acuity. As I mentioned last quarter, correlation patterns completely broke down in March and April, and we are happy to see them improving through June and July. On capital allocation front, we discussed in last quarter’s earnings call two distinct mental models: short-term defense and long-term offense. We are glad to inform you that during the quarter we have largely completed our efforts on the defensive side and have now shifted our focus to the offense. We’re extraordinarily proud of our execution during the second quarter in both public and private markets. It is important to remember and understand these two are one interconnected set of decisions and not distinct actions. For example, our exceptional execution with Dave and his team at Kayne Anderson in record time with our senior housing and MOB portfolio disposition, along with our execution to secure a term loan with our banking partners, both took place during the dark days of March. This gave us the confidence to be patient in accessing public bond markets rather than issuing bonds when credit spreads were peaking. If we had issued bonds during those days, we would have been looking at coupons close to 5%, not the 2.75% that we issued later in the quarter — which would have come at a cost to shareholders of roughly $130 million over the life of the bond. We believe our execution in private markets speaks to the significant demand for stabilized assets, both in senior housing and medical office asset classes. We’re in the middle of other transactions that are premature to discuss at this point, but needless to say, we feel very strongly about the demand for our assets. More to come as we progress through the year. Notably, this robust interest and pricing is nowhere to be found in assets that are not in the middle of the fairway — e.g., deals with broken capital structures, suboptimal operators, development and lease-up assets, or generational handover of companies and assets, to name a few. Fundamentals determine cash flow and asset price is a multiple of that same cash flow. These variables are usually inversely correlated with opportunities to invest at the highest moments of uncertainty. In other words, when fundamentals are great, asset pricing is high and expected returns are low. When fundamentals are bad, asset pricing is low and expected returns are high. We’re seeing that play out in many parts of the senior housing sector today. We’re starting to see signs of distress across the spectrum of the issues I mentioned. These situations not only require capital, but they also require operators who are otherwise overwhelmed with the demands of their time given what’s happening within their communities — and that’s where we come in with our toolkit. At Welltower, we think our value proposition is three interrelated groups: capabilities, culture, and capital. We lead with our capability, we execute with our culture of partnership, and we get the ball across the finish line through our ability to write resolute checks with unmatched speed and structural creativity. When we introduced our ideas through our business model to achieve better alignment with our operators, many of you asked if Welltower would be able to retain its cultural partnership. We responded that the proof was in the pudding. We are seeing the proof today. We’re working with our operating partners very closely in identifying assets in their backyards through our data analytics platform and tailoring opportunities to their models based on size, acuity, vintage, demographics, and psychographic criteria. This algorithmic approach narrows the opportunity set to a manageable number, which is then filtered to succeed for our operating partners who dive in and help us underwrite. Our operators and deal teams connect with fellow operators and owners to run through our thoughts on pricing, our ability to close and execute on operator transfer agreements on an expedited basis. We are either getting a quick yes and jumping to execution, or getting a quick no and moving to the next opportunity. For example, one of our partners in the Midwest, StoryPoint, we identified 137 distinct communities in seven states that fit their criteria and we’re going through the list of opportunities with the StoryPoint team one asset at a time. There are more than 2,800 senior living properties, which are humanly impossible to hone in on on a practical basis. The job of the algorithm is to bring our partners and our deal teams to focus on the highest-probability, last-mile opportunities. We remain fundamental value investors. We’re focused on bottom-up underwriting, relative to replacement costs and structural protection. In another example, we are in the process of executing on three premium opportunities with our partner Brandywine in extraordinary locations, such as Princeton, New Jersey and Summit, New Jersey. In another example, we’re proud to be executing an opportunity in the Fishersville submarket of Brookline on an existing land and structure that used to be a college. The township and the people of Brookline have given us incredible support and zoning approval even during COVID-19 to create an iconic 160-unit senior living project. We are underwriting several more transactions with Balfour in the home markets of Colorado, as well as a new home in Boston. I can cite many other examples with other operators, but I will retain those for future calls. I hope you walk away from this call understanding that we have never been more excited about the opportunity to invest capital in the senior housing space because of the pricing we are seeing. We are buying communities in our core California and New Jersey markets for less than $200,000 per unit while replacement costs in these locations are in excess of $0.5 million per unit, targeting development or development-plus returns without the majority of the development risk during lease-up. We believe in this business long-term; we also understand the near-term is going to be uncertain and challenging. Please note that the uniqueness of this very challenge is what’s creating a once-in-a-generation opportunity, right before the market gets into the upturn in the demand cycle. At the same time, supply is coming to a screeching halt. Many of you who follow NIC data have seen starts are down to Q1 2009 levels and we’re likely to see this trend continue. Construction activity across all real estate asset classes is down significantly, which is creating softness in soft and hard costs. Land prices are starting to show cracks as well. In this environment, we’re standing by our operating partners, shoulder-to-shoulder when outside capital is fleeing the space. That is attracting more and more operator and development partners to Welltower, taking the proof in the relationship pudding. I am optimistic we’ll be able to create significant value for long-term shareholders in the next 18 to 24 months by allocating smart capital and leveraging our operating platform. With that, over to you, Tom.

Tom DeRosa, Chief Executive Officer

Thanks, Shankh. Before we begin the Q&A session, I wanted to call your attention to a press release from last week announcing the appointment of Diana Reid to our board of directors. Diana is an accomplished and highly respected executive with 38 years of experience across the financial services and commercial real estate industries. She most recently served as Executive Vice President of the PNC Financial Services Group and head of the bank’s commercial real estate business. She’s also held leadership positions in many prominent organizations, including the Mortgage Bankers Association, Commercial Real Estate Finance Council, the Urban Land Institute and Real Estate Roundtable. All of Welltower’s stakeholders will benefit from Diana’s extensive experience and insights and we are extremely fortunate to have someone of her caliber join our board. I’m also pleased by the fact that with Diana’s appointment, 88% of our independent directors are women and minorities. As I’ve said in the past, the diversity of our employee base, our leadership team and our board continue to be a priority at Welltower. This is not only a key component of good governance, but it is a proven driver of higher returns to shareholders. And with that, I will turn the mic back to Galen to open up the line for your questions.

Operator, Operator

Thank you, sir. Operator instructions were provided. I show our first question comes from the line of Steve Sakwa from Evercore ISI. Please go ahead.

Steve Sakwa, Analyst, Evercore ISI

Thanks. Good morning. I guess both Tom and Shankh, you guys spent a fair amount of time talking about the investment opportunities and Tom, it sounds like you alluded to some other potential sales coming down the pike. I guess how do we sort of think about or weigh the sale of assets that may be stabilized and Shankh, it sounds like you’re looking at buying some broken assets and sort of the dilution short-term versus kind of the long-term gain and the high IRR potential? Is there a sort of amount of short-term dilution you’re willing to take to get long-term growth out of these transactions?

Shankh Mitra, Chief Investment Officer

Steve, that’s a very good question. If you think through at least the mental model that we have, we are fundamentally looking to sell at this point assets that we think achieve pre-COVID pricing or pre-COVID IRR if we had sold those days. Our need for liquidity that we had, or what we wanted to achieve in March, is all now achieved at this point. So, we are looking to release capital from assets that we think are a testament to long-term value. With that, we’re looking to buy assets or deploy capital, whether that’s assets or other inevitable opportunities such as our stock, unless we think there’s a substantially higher IRR that can be achieved. So that’s how we’re thinking about it. We are long-term value investors and we are not focused on quarter-to-quarter dilution. As you might have noted, the sale that we executed in the quarter had $0.02 of dilution in the quarter, but we still think that achieved extraordinary pricing as well as value for the shareholders.

Tom DeRosa, Chief Executive Officer

But Steve, I’d add that we’re not sellers underdressed. There are many quality sources of capital — institutional investors that see the long-term value of this space and are very interested if there’s an opportunity to buy high-quality assets from us or partner in a joint venture structure with us. So, there are very active dialogues going on and that’s why I mentioned you should expect more of this as the year progresses. I can’t say that definitively, but we’re pretty optimistic at this point.

Operator, Operator

I show our next question comes from the line of Nicholas Joseph from Citi. Please go ahead.

Michael Bilerman, Analyst, Citi

Thanks. It’s Michael Bilerman here with Nick. Maybe spend a little bit of time talking about the senior housing operating environment and whether you’re seeing any differences among operators in their pricing strategies — whether some are using concessions versus some are holding rates. Just how different operators, like different healthcare REITs, are approaching the market. If you can go through that, that would be helpful. Thank you.

Shankh Mitra, Chief Investment Officer

Yes. As I mentioned in my prepared remarks, we are seeing different strategies, but I would describe that more as a tweaking of pricing strategies than wholesale changes. We believe that we provide exceptional value to customers and for that we need to attract a certain level of staffing for which you need pricing. So, we’re not interested in compromising on staffing or on pricing in a way that undermines care. If you look at our assisted living and memory care portfolio, RevPAR was up 1.7% even during this quarter. Now, if you think about it, as you lose occupancy and you are not building occupancy, you lose community fees. That obviously impacts that number in a meaningful way. However, we’re not seeing like-for-like pricing decreases in our communities. The reported number was impacted by bringing the lower price-point senior apartment product into the pool. If you exclude that, we would have reported a RevPAR increase of 20 basis points relative to flat, which Tim described on the last call.

Tim McHugh, Chief Financial Officer

I would just add to that: who you’re seeing move in today tends to be your most needs-based resident. So, the value proposition from high-quality care and reputation, which is where our operators sit within these markets, has probably never been higher. There could be a point when things actually start to pick up and you see incremental demand come back, where pricing becomes a more significant factor. Just given how suboptimal occupancy is across most markets, pricing is not what's driving the incremental customer at this point — it’s truly a needs-based client that’s coming in.

Operator, Operator

I show our next question comes from the line of Rich Anderson from SMBC. Please go ahead.

Rich Anderson, Analyst, SMBC

Hey, thanks. Good morning. So, obviously you’ve got a commitment to senior housing long term. I wonder, Shankh, I understand you’re not a seller unless you can get reasonable price and pre-COVID value in IRR and all the rest, but how would you characterize the future from an asset allocation perspective for Welltower in light of skilled nursing and post-acute assets and medical office? If you had your way and got the pricing you wanted, would senior housing be almost the entire story here five or ten years from now, or is it more a growth in senior housing while you continue to maintain exposure to other asset classes?

Shankh Mitra, Chief Investment Officer

Rich, as we have mentioned in nearly every call, our asset allocation, or really our capital allocation strategy, is driven by price. In the scenario you described where every asset class we play in remains perfectly overpriced for the next 10 years and senior housing remains perfectly underpriced for the next 10 years, then yes, the allocation could shift heavily toward senior housing. That is rarely how things happen. Moments of opportunity occur when capital comes in and out of a sector for various reasons, and that’s what we believe we’re seeing now. Near-term capital allocation will obviously show a significant increase in senior housing, but we love all our asset classes. We remain interested in playing all of them. Our incremental capital allocation strategy is a function of price, not a function of love for one asset versus another. Right now, we have never seen a better opportunity to invest in senior housing as an asset class.

Operator, Operator

I show our next question comes from Jonathan Hughes from Raymond James. Please go ahead.

Jonathan Hughes, Analyst, Raymond James

Hey, good morning. My question is on the rate outlook and you did touch on it a bit earlier, but I was hoping you’d share some thoughts on the trajectory or reception of rate increases in a world where amenities have been taken away from residents. Of course, those amenities have been removed for safety, but the social interaction aspect is what attracts a lot of residents to these properties and that might not be back to normal for some time. So, how does this removal of the social aspect impact the rates your operators are able to achieve today for both new residents and existing resident rate increases? Thanks.

Shankh Mitra, Chief Investment Officer

Jonathan, that is a great question. You are seeing the lower-acuity models, where the need for healthcare and social determinants of health is lower, be impacted differently. We saw a slight decrease in rate in some areas. On the other hand, where the social aspect is less important and care is more critical, those rates have been more resilient. It’s an interplay between the services provided. For more needs-driven residents, the impact on rates is less pronounced in this environment; for lifestyle-driven residents, you will likely see more impact, given the lack of social programming.

Tom DeRosa, Chief Executive Officer

Right. Jonathan, as I said earlier, our portfolio is skewed toward higher acuity. These are people who have exhausted other options. The social part of the senior housing model is less important to them; they need daily care that cannot be provided in many families today, particularly for residents with dementia. So, while the social aspect is important, the primary driver for these residents is safety and care. As things return to normal, the social component will regain importance, but today it’s really all about safety and care.

Operator, Operator

I show our next question comes from Michael Carroll from RBC Capital Markets. Please go ahead.

Michael Carroll, Analyst, RBC Capital Markets

Yes, thanks. Shankh or Tom, can you talk a little bit about how the second COVID wave or maybe the continuation of that first COVID wave has impacted your operators — particularly in California? Have they been forced to re-shut or delay reopening some facilities, or what’s the thought process behind that?

Shankh Mitra, Chief Investment Officer

That’s a really good question. Frankly, I’m extremely encouraged and positively surprised by the example you brought up. California is probably the place where you can see what looks like a true second wave. I’m happy to tell you — and this is why I was so encouraged by the performance of the last three weeks — we haven’t seen significant admissions bans or lack of performance in California in the last three weeks, which really surprised me. We reported roughly a 10 basis point occupancy decline in the last three weeks; if you follow the real numbers, they were down 14 basis points, down 10 basis points, and last week down 7 basis points. Given Southern California is our largest market and it has been impacted, you might have expected much worse numbers, not an improving trend. So this is an encouraging datapoint for us.

Tom DeRosa, Chief Executive Officer

Michael, I’ll add that one operator in particular was very quick to shut the door during the first wave in California. In the second wave, they are now taking new residents because they adjusted to this COVID environment. They have the right protocols and procedures in place that enable them to safely admit new residents. This helps explain why the number of cases are not spiking in our portfolio like they did in April and May when several operators were blindsided. Again, this could change, but California is an interesting and encouraging data point for us.

Operator, Operator

Our next question comes from Jordan Sadler from KeyBanc Capital Markets. Please go ahead.

Jordan Sadler, Analyst, KeyBanc Capital Markets

Thanks. Good morning. I wanted to follow up on the investment cadence. Within the context of what’s going on with cash flows and leverage, are you guys better to buy or to sell right now? In other words, will sales and purchases be more balanced going forward and offset one another in terms of volume?

Shankh Mitra, Chief Investment Officer

No, I cannot tell you with certainty right now. It will depend on price and expected return. If we find opportunities to deploy capital at an extraordinary basis and expected returns, we’ll buy more. If we think we’re better off selling because the market is providing great value for our assets, we’ll sell. Practically, there will be a combination of both as debt gets re-priced and stress moves through capital structures. It takes time, but we’re very encouraged by what we’re seeing today. Ultimately, it’s purely price dependent.

Operator, Operator

I show our next question comes from the line of Vikram Malhotra from Morgan Stanley. Please go ahead.

Vikram Malhotra, Analyst, Morgan Stanley

Thanks for taking the question. Maybe for both Tom and Shankh, you’ve obviously talked a lot about exciting acquisition opportunities across the spectrum, more so in senior housing. I’m just wondering senior housing specific, can you talk about those opportunities in the context of geographies — meaning the U.S., the U.K., and Canada as well — product type, IL, AL and then maybe even affordable product. What are you looking at in terms of potentially getting a little bit more aggressive in building the portfolio from here?

Tom DeRosa, Chief Executive Officer

Vikram, we’re looking at opportunities across the board in all three countries. Given the population and number of product types, we’re seeing more opportunities in the U.S. so far. We see opportunities across product types, but more in higher acuity and assisted living/memory care where occupancy fell the most. We’re seeing opportunities on both coasts, in the Midwest and in Texas. Our deal teams, legal teams, investment teams, and supporting teams have never been busier. Execution will be a function of price and the environment we find ourselves in today.

Operator, Operator

Our next question comes from Tayo Okusanya from Mizuho. Please go ahead.

Tayo Okusanya, Analyst, Mizuho

Yes, good morning everyone. I just wanted to focus a little bit on the comments around the improvement in the rate of decline as it pertains to occupancy in senior housing. It’s clear that most of your facilities are open. It sounds like virtual tours and things are happening, but can you talk a bit more about why that slowdown is actually occurring — the ability of directors of these buildings to still get move-in traffic despite COVID?

Tom DeRosa, Chief Executive Officer

So, as we touched on earlier, our portfolio — primarily U.S. and U.K. — is higher acuity and need-driven. There is a limit to how much families can push off the need. That’s why we’re seeing leads recover: a 55% decline to the trough and then a 60% bounce; in July leads approached pre-COVID February numbers. But move-ins lag leads because families are hesitant. The absolute number of COVID cases in our portfolio (we referenced 98 cases) relative to the size of our portfolio is a testament to the quality of care provided by our operators, and that reputation matters and attracts new residents.

Shankh Mitra, Chief Investment Officer

One thing to add: the decision chain today is about whether a building has COVID, whether they can take my mother or father and protect them, and whether they can meet their needs. Many people have exhausted their ability to care for relatives at home; in many markets they have no options. For many incoming residents, their lifestyle hasn’t changed dramatically — they might be in a room at home or in an apartment — but the security and consistency around care in a community is much higher and that matters, especially for individuals needing consistent care.

Operator, Operator

Our next question comes from the line of John Kim from BMO Capital Markets. Please go ahead.

John Kim, Analyst, BMO Capital Markets

Thanks. Good morning. Your operating diversification is a positive for company performance, but when you look at some of the larger tenants and the sequential declines — looking at Sunrise or Riverview — they’re pretty significant underperformers within your portfolio. Can you comment on these operators specifically or, if not, overall, the ability for some of your private-pay senior housing operators to handle this kind of performance in the absence of government assistance?

Tom DeRosa, Chief Executive Officer

Before Shankh answers, a point of perspective: the sequential decline is being annualized for the quarter, which amplifies changes. Sequential changes are more pronounced when you annualize them.

Shankh Mitra, Chief Investment Officer

John, you make a good point. Some of our higher-acuity operators have underperformed, and coastal locations compounded that in some cases. Without getting into specific names, if you follow coastal markets and add high acuity where declines were greatest, you can identify operators that performed relatively worse. That’s why having a diversified portfolio matters. Also, remember that one quarter with a 25% NOI decline should not be extrapolated without context; annualizing it will produce very different results.

Operator, Operator

Our next question comes from the line of Nick Yulico from Scotiabank. Please go ahead.

Nick Yulico, Analyst, Scotiabank

Thanks. I wanted to turn back to the move-in issue. Move-ins have improved, but they’re still down 45% in July versus last year. Do you have any data on why customers are delaying move-ins — for example, are people saying they’ll wait three months, a year, or until there’s a vaccine? Do you have any feel for the timeframe of that delay, or any backlog of deposits you can point to?

Shankh Mitra, Chief Investment Officer

First, deposit activity is extraordinarily strong. Move-ins have improved materially but are not matching deposit activity because people are spreading out their moving dates — that’s what you’re asking about. We’ve seen lead activity improve, but move-ins remain down year-over-year. Sequence gives you what’s happening tomorrow; year-over-year gives you a view of what happened. We won’t speculate on exact run-rate timing, but deposits are strong while move-ins are delayed.

Tom DeRosa, Chief Executive Officer

Nick, to add: many people secure a place with a deposit but delay the move until conditions meet their needs better. Reasons include visitation policies — families want open, safe visitation before moving someone in — and testing protocols, which some families view as invasive. If the situation is not desperate, families will delay; if it’s urgent, they move immediately. It’s individual and specific to each family.

Operator, Operator

Our next question comes from the line of Joshua Dennerlein from Bank of America. Please go ahead.

Joshua Dennerlein, Analyst, Bank of America

Yes, thanks. Good morning everyone. I’m curious on operator expenses going forward. There obviously were a lot of extra COVID costs. What should we look for in 3Q and what’s the ability for labor to flex as occupancy has come down and marketing budgets shrink?

Tom DeRosa, Chief Executive Officer

Josh, think about COVID-related costs this way: the biggest piece is PPE and cleaning, which may make up roughly 20% of the COVID-related costs and will likely remain until a vaccine or a substantial decline in prevalence. PPE costs have come down from March/April peaks but are still elevated relative to pre-COVID. There are also dietary and meal-delivery changes when communal dining is limited that will come down as internal activities resume. The labor piece makes up the largest portion of costs. Labor costs were tied to COVID prevalence; they peaked around early May and came down considerably into June and will continue to burn off depending on the pandemic and prevalence in facilities. Going forward, PPE and cleaning costs will be a dominant force and labor will be dependent on the actual prevalence of the virus.

Operator, Operator

Our next question comes from the line of Steve Valiquette from Barclays. Please go ahead.

Steve Valiquette, Analyst, Barclays

Great. Thanks. Good morning, Tom and Shankh and Tim. A couple of questions here. One, you touched on Slide 17 that a recent rise in COVID cases may result in near-term increases in admission bans, but it sounds like your operators generally want to be on the offensive on move-ins. If there are potential new admission bans, those sound like they would be more mandated by state government as opposed to voluntary bans. I want to make sure we’re interpreting this the right way. And then the bigger question: are you expecting that in calendar 2020 Welltower will cross the threshold where move-ins exceed move-outs so that occupancy will start to increase at some point this year, or is that still up in the air?

Tim McHugh, Chief Financial Officer

Thanks Steve. I’ll start with admission bans. I’d recharacterize your comment: I think our operators are being very smart about the way they admit residents. Outright admissions bans will generally be driven by state and local governments, and the building itself will enact stricter protocols when there is an actual case of COVID. Operators are being cautious with admissions protocols, which partly explains why consumers may delay moving in. We’ve seen cases within our facilities move up and then be controlled and come back down over the last two weeks, which suggests the protocols are working well. So yes, bans will be driven more by governing bodies, while operators are exercising caution in how they admit residents.

Shankh Mitra, Chief Investment Officer

Steve, regarding whether move-ins will exceed move-outs this year, we will not predict the future given the uncertainty. We’re encouraged by recent trends but are cautious; things can change at any time. We’re not providing a definitive forecast on when those two will cross — we want to observe how consumer behavior plays out over the next several months before projecting that.

Tom DeRosa, Chief Executive Officer

And the one thing we do know is that operators now know how to manage COVID better than they did in March and April. They have protocols and procedures in place. That’s a positive, but it doesn’t remove the uncertainty that things can change rapidly.

Operator, Operator

Our next question comes from Lukas Hartwich from Green Street Advisors. Please go ahead.

Lukas Hartwich, Analyst, Green Street Advisors

Thanks. There’s a lot of focus on the potential for government support for senior housing in the U.S. I was hoping you could provide some color on discussions regarding government support in Canada and the U.K.

Tom DeRosa, Chief Executive Officer

In the U.K., it’s a very different story. There is more government support for the senior housing industry than in the U.S. In the U.K., frontline workers in senior care have been regarded as heroes similar to hospital staff. In the U.S., that recognition hasn’t been as consistent, which is a shame because those working in senior living face many of the same challenges as hospital workers. In Canada, remember our business there is more focused on independent living; higher-acuity models in Canada are often government-provided. I can’t comment on additional government support specifically for independent living in Canada today. Both the U.K. and Canada have different healthcare systems than the U.S., and the level and type of government support varies accordingly.

Operator, Operator

Our next question comes from the line of Daniel Bernstein from Capital One. Please go ahead.

Daniel Bernstein, Analyst, Capital One

Good morning. Quick question: when we look back at 2009, average entrance fees changed, acuity went up, margins went down, and length of stay went down. When you’re looking at the opportunities that sound generational, how are you thinking about underwriting the long-term fundamentals of the business? Are you concerned that the long-term upside of NOI in the business will be lower going forward than it has been in the past?

Shankh Mitra, Chief Investment Officer

Dan, we are indeed focused on those risks. We’re paranoid about changes that can alter investment returns — that’s why price needs to reflect uncertainty. We do think the industry is reaching a point where you can underwrite different scenarios and price them. If cash flow characteristics are depressed long term, that will naturally depress returns and reduce future development. That is true for any capital-intensive business. We are applying a combination of top-down data analytics and bottom-up value investing to assess these risks and price opportunities appropriately.

Operator, Operator

Our next question comes from Sarah Tan from JPMorgan. Please go ahead.

Sarah Tan, Analyst, JPMorgan

Hi, this is Sarah on for Mike Muller. One question: how much of your Triple-Net revenues are at risk of a rent reset? Could you comment on that?

Tim McHugh, Chief Financial Officer

Sarah, as I said in my prepared remarks, the Triple-Net business and senior housing operating businesses have different structures, and the impacts have been felt differently. The long-term economics have to support rents, and we’ve been proactive with restructurings where they make sense. Rent collection in the Triple-Net space remains strong. While there will be conversations about economics and potential rent adjustments, the thought of a broad rent reset simply based on current economics is somewhat misplaced. Operators generally see long-term value in these assets and want to remain in control of them. We will continue to observe rent collections and report to the market.

Shankh Mitra, Chief Investment Officer

And Sarah, as you think through our reported numbers, remember our reported results still include a very large tenant that we have already restructured and announced to the market — Capital Senior — and that remains in those numbers for the next two quarters. That restructuring has already taken place.

Operator, Operator

Our last question comes from the line of Tayo Okusanya from Mizuho. Please go ahead.

Tayo Okusanya, Analyst, Mizuho

Hi, just a quick follow-up on the health systems platform. There’s a lot going on in skilled nursing and government funding. Can you help us understand what you’d expect to happen next from a government funding perspective? What are you hearing from states about Medicaid funding given their stretched budgets because of COVID?

Shankh Mitra, Chief Investment Officer

Tayo, we’re reading the same things you are. It would be inappropriate for us to speculate on what additional government funding might or might not come to this space, so we’ll leave that for future discussions. We are encouraged by the support the post-acute industry has seen so far, but we won’t speculate on future state government actions during this call.

Operator, Operator

Thank you. I show no further questions in the queue at this time. This concludes our Q&A session. Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may all disconnect.