The news for the skilled nursing sector just does not seem to be getting any better. Perhaps the best news is that the persistent dysfunction in Congress means that dealing with an unsustainable Medicaid budget will get kicked down the road, again. But that is not going to be a long-term solution, and it will most likely get kicked back up to the front of the road sooner than providers want. As long as Republicans are in control, the push for Medicaid block grants or per capita caps will be constantly pushed forward for consideration.
In the middle of July, Fortis Management Group reached an agreement with its landlords to turn over operations to a receiver until the owners can transfer operations to new providers. Fortis operates mostly skilled nursing facilities, with a handful of assisted and independent living communities, for a total of about 65 properties. Nearly half are located in Wisconsin, with the remainder in Michigan, Minnesota, Oregon, Idaho and Washington. They were part of a larger transaction completed two years ago when a group led by Formation Capital and Safanad Inc. purchased more than 150 skilled nursing facilities for $870 million from Extendicare (TSX: EXE), which wanted to exit the U.S. market.
The buyers leased other parts of the portfolio to additional operators. The entire portfolio had revenues and normalized EBITDA of $1.155 billion and $99.0 million, respectively, resulting in an 11.4% cap rate and an 8.6% operating margin. The receiver, Michael Polsky of Beck, Chaet, Bamberger & Polsky based in Milwaukee, Wisconsin, plans to hire Florida-based Focus Management Group to advise on operations during the receivership.
We do not know what went wrong at Fortis, especially since the price per bed paid ($56,500) was below average in the market, so the lease payments could not have started too high, and time was too short (two years) for the annual escalators to have done too much damage. Not all of the facilities were owned outright in the full portfolio purchased from Extendicare, however.
We have to assume that rising costs, declining Medicare lengths of stay and declining average daily Medicare reimbursement all contributed to the problems. There also could have been plain, old-fashioned management problems, because it usually takes longer than two years for a significant transaction to blow up. Management is increasingly crucial as the skilled nursing facility sector becomes more complex.
In another bad news story, a few months earlier a jury in Florida turned in a verdict in a False Claims Act trial against several entities in Florida, including Formation Capital affiliate Consulate Health Care, which, with treble damages, totaled $347 million. At least the judge decided to stay that amount because even he knew it would put the various entities out of business if forced to pay it. And then where would the patients go? But the whistleblower case was based on alleged up-coding for therapy services, a somewhat common allegation these days as financial pressures mount on the sector. This may be one reason why, under proposed rules that may take effect in October 2018, ultra-high therapy will be sharply curtailed, cutting into the bottom line of several of the top skilled nursing facility chains. It won’t be pretty.
Bank of America Merrill Lynch, which has been negative on the prospects for the skilled nursing sector, recently issued a report ranking REITs with significant skilled nursing exposure based on their percentage of ultra-high and very-high rehab beneficiaries and patient days of their respective tenants (note that the analysis is based on data that is three years old). The skilled nursing facility portfolios of Quality Care Properties (NYSE: QCP), Welltower (NYSE: HCN) and Omega Healthcare Investors (NYSE: OHI) were among the highest in these categories, topping 70% in some cases for ultra-high therapy.
Since 94% of QCP’s portfolio is operated by HCR ManorCare, that is where those cases are derived from. For Welltower, it is Genesis Healthcare (NYSE: GEN), and for Omega it is a combination of providers. This would make sense since the top, larger chains are the ones taking on more of the higher acuity patients, and they are well-positioned to do so. However, this also means they are most at risk for decreased reimbursement under the proposed reimbursement changes.
If this change goes through as proposed, combined with Medicare Advantage LOS and rate pressures, not to mention overall census numbers in a funk and the ever-present 600-pound Medicaid gorilla, the last half of 2017 and all of 2018 are going to present some major challenges to a very leveraged industry.
QCP v. HCRMC. There are two major battles going on right now involving two REITs. Well, one is a battle and the other is what we will call a short-term skirmish. The first, wellreported on these pages, is the fate of HCR ManorCare as it negotiates with its landlord, Quality Care Properties, over leases that HCR claims it can’t afford to pay. Given what may happen with reimbursement, their ability to pay those rents will not be improving anytime soon. The problem is even if there is not an agreement to merge HCRMC into QCP, which makes the most sense right now, a rent reduction today would quite likely lead to more rent reductions in the future. That is a path former landlord HCP, Inc. (NYSE: HCP) already went down in a futile attempt to give HCR some breathing room.
Since HCRMC has not paid its full rent for two months, the company is now in default and technically owes all the current rent plus deferred rent that is now an additional $265 million. Let’s just say, they are not going to pay it. Instead, they have apparently borrowed $550 million from Centerbridge Partners to perhaps clean up the balance sheet, paying off a $375 million term loan. But will it also fund a few executive deferred compensation unfunded liabilities? We don’t think Centerbridge is that stupid. In the meantime, QCP has also talked to lenders to put together a loan package that would be used to fund a purchase of HCRMC.
Although the two sides are supposedly continuing their talks, we don’t know what has changed since three months ago, other than the lack of rent payments. Oh, and apparently HCRMC’s financial condition continues to deteriorate, one of the reasons given for not making full rent payments. Because of the reduced rent payments, Moody’s has downgraded QCP’s various debt obligations from B3 to Caa1 and from Caa1 to Caa2, citing the continued disruption in cash flows from HCR that could lead to a “material deterioration in QCP’s operating profits and liquidity as well as the high likelihood of a covenant breach under the REIT’s secured credit facility.” We are sure QCP’s CEO, Mark Ordan, has seen all of this before in his other workout roles. He has never appeared to be a worrier.
The Carlyle Group (NYSE: CG), which still owns HCRMC, has been noticeably silent about the situation. As the owner, the decision is ultimately theirs to make, and let’s just say that one piece of their leverage, HCRMC’s very large home health and hospice business, has just dropped a notch in value with the recent proposed reimbursement cuts to home health.
The news sent Kindred Healthcare’s (NYSE: KND) stock plunging 15% in one day, and they are the largest home health provider in the country. Various “experts” have opined about the likelihood of an HCRMC bankruptcy filing or receivership, which we don’t see happening unless the financial performance has really deteriorated to an extent making it too difficult to recover from with the leases in place.
We still believe that staying the course as a single-tenant REIT is a non-starter and that combining the two entities would provide the needed financial flexibility to fix whatever operating problems HCRMC has. The problem, however, is who would run the show. No one believes that CEO Paul Ormond would be allowed to stay on, and we doubt he would want to anyway, especially if he receives his deferred compensation package. It is truly unfortunate to be a bystander and watch the former gold standard of the skilled nursing business flounder like this. A decision needs to be made soon, because the financial environment six months from now is not going to be better than today. It could really start to get messy by December.
Sabra and Care Capital Properties. Two shareholders of Sabra Health Care REIT (NASDAQ: SBRA) came forward in the past several weeks against the proposed merger with Care Capital Properties (NYSE: CCP), citing a decrease in Sabra’s value as a result of the announcement, and the relative vulnerability of CCP’s portfolio due to the current turmoil in the skilled nursing facility reimbursement environment. While both of these concerns have some merit on the face of it, let’s just say we doubt either of these investors want to be in the stock for the long term.
Hudson Bay Capital Management, which owns 3.4% of Sabra, and Eminence Capital (3.9%), have aligned to try to stop the merger, believing that a cancellation would potentially put Sabra’s price back to where it was before the announcement. And then what? There are other factors putting pressure on REITs with heavy skilled nursing facility exposures, so the forecasted bounce-back is not a sure thing. They are trying to rally the other investors for a no vote on August 15, but it may be a hard sell. The reality is that three funds control nearly 45% of Sabra, including Vanguard Group, Blackrock and Fidelity. We believe they are long-term holders and may have a little more faith in Sabra CEO Rick Matros than the newcomers. But then proxy advisory firm Institutional Shareholder Services (ISS) came out against the merger, while the other advisory firm, Glass, Lewis & Co., came out in favor. While a “split decision” gives investors more leeway to ignore the dissident shareholders, the ISS decision was not good news for Sabra.
The arguments against the merger include CCP’s heavy skilled nursing portfolio, the purchase price and relatively low “cap rate,” which we believe is the wrong way to look at a REIT acquisition anyway, and the financial frailty of some of CCP’s tenants. The one most frequently mentioned is Kentucky-based Signature HealthCARE. It leases 49 properties from CCP and represents 13.7% of CCP’s revenues.
The problem is that Signature has been rumored as the tenant that may need to file for bankruptcy protection. If true, it may not be such a bad thing for either CCP or Sabra. It would help clean up the company’s balance sheet, giving Sabra (assuming the merger goes through) added financial flexibility to restructure Signature’s portfolio as needed. Signature would then represent less than 10% of the combined company’s rental revenues with a stronger balance sheet. The losers, of course, would be the lenders, and there are some big name lenders involved with Signature who have little interest in a bankruptcy filing.
The heavy skilled nursing facility concentration is certainly a concern, but CCP has 38 providers in its portfolio, and it is much easier to work with smaller companies when problems occur, and they have a much smaller impact when they do. Getting rid of one bad property in a tenant’s portfolio can move the needle, but it doesn’t help much with someone the size of HCR ManorCare. They unloaded 50 properties and financial performance still declined.
Speaking of “one” property problems, Sabra had its own problem with a tenant with just five skilled nursing facilities, but which represented 12% of revenues (they came with a very high price tag, but did very high-end care). One facility was forced to close last month and move all the patients out. The other four still covered the lease obligations of the five (with room to spare), and Sabra moved one of its smaller tenants not only into the closed facility to lease it up again, but also had them take over management of the other four because of problems the previous owner had with the state. And they worked quickly. If the merger goes through, and both managements expect it to, the concentration of tenants across the board will decrease, which provides more stability to both REITs, and perhaps most to Sabra because of its current exposure to Genesis HealthCare properties at 32% of revenues. Future GEN divestitures will also help that decline even more.
So, for both REITs the deal represents a spreading of the risk among more tenants, even though Sabra is picking up more skilled nursing facility risk after spending a few years diversifying away from its once 100% skilled nursing facility exposure when it was split off as the PropCo from the former Sun Healthcare. The combined entity will eventually have a lower cost of capital, and there will be overhead synergies as well. There are certainly reasons to be positive.
Everyone has been dumping on the skilled nursing business, but there have always been risks in this sector, and there have always been cycles of turbulence when it comes to reimbursement. It must always be remembered, however, that skilled nursing facilities are still the lowestcost producer in post-acute healthcare delivery.
As of today, we really don’t see any workable alternatives. Yes, there has been some gaming of the reimbursement system, but if you want to see gaming, why not focus on hospitals where the real abuse occurs.
The current problem today for the sector is that it has become increasingly difficult to grow the top-line revenues when the major growth factor (Medicare) of the past several years is pushing down on length of stay and rates. If a skilled nursing facility already has an above average Medicare census in a market, it is difficult, if not impossible, to keep on expanding that. If revenues don’t grow, and costs always go up, then there is the squeeze. Add to that the annual escalator factor with leases, and the squeeze gets tighter. In the original days of the healthcare REITs, the lease escalators were tied to increases in revenues at each facility, not an automatic amount.
Along the way, that changed to the CPI or somewhere between 2.5% and 3.0%, which penalizes a skilled nursing facility that isn’t growing revenues, but as a result can’t grow EBITDAR to pay the increasing rent. A facility with a small Medicare census taken over by a proven operator can often improve that census, but that improvement usually runs its course. It appears to have run its course with some of the big players, at least at many of their properties.
The problem with skilled nursing facilities today is not so much operationally, but with their capital structure. Skilled nursing facilities around the country are doing very innovative things and taking care of patients that 10 years ago many inpatient rehab and LTAC providers would have thought impossible. But their success, and the increased profits from that success, resulted in payers thinking they could squeeze more out of them, not to mention that the supply of dollars is going to shrink as well.
With 80% leverage (or higher), that results in the situation we are facing now. It also didn’t help that gearing up for all the post-surgical orthopedic rehab is ending up as abust as more and more people are either going directly home or for a very short skilled nursing facility stay.
When the baby boomers hit their 80s, the demand will certainly grow, but that is not for a while. In the meantime, the next 18 months will be very turbulent for some REITs and some operating companies.
But for Sabra and CCP, we believe that the ability to deal with it will come from size, and we never underestimate Rick Matros and his ability as a problem solver. The one problem that even he can’t solve is the labor shortage and costs, and that worries us more than reimbursement in the long term.
(Sabra and CCP did close their merger in August despite the activist shareholders trying to prevent it from happening. Within a month of that closing, Sabra announced a $794 million investment (inclusive of assumed debt) in a portfolio of private-pay senior living properties operated by Enlivant, a portfolio company of TPG.)
