Perhaps the two most powerful women in seniors housing, Debbie Cafaro of Ventas and Cindy Baier of Brookdale Senior Living, had to make some decisions with regard to Brookdale’s under water leases that have a maturity date in 2025. If there can be any silver lining with the current pandemic, it most likely pushed the two sides to come to an agreement to do something now before the leases drowned in more red ink. And while there are benefits to both companies, the newly revised lease agreements provide a cash-flow lifeline to Brookdale.
The triple-net leased portfolio now has 120 communities, but when the lease was last negotiated back in 2018, combining several leases into one master lease, there were 128 properties. Two years ago, it was billed as a win-win for both companies, but then national occupancy levels continued to decline and the pandemic hit earlier this year, with no end in sight. By the first half of 2020, the current lease with 120 properties had an approximately 0.75x EBITDAR coverage, but that does not take into account the worsening financial performance in the second quarter for Brookdale and the industry.
The 120 communities have 10,174 units and trailing 12-month EBITDAR was about $136 million as of the end of the first quarter, while the annual lease expense was $182 million. It is assumed that the $136 million figure has declined since then based on yet-to-be-released numbers for the trailing-12 months ended June 30. As part of the agreement, the annual lease payment, effective July 1, drops to $100 million, with 3% escalators beginning effective January 1, 2022. Based on March 31 trailing 12-month numbers, the new implied lease coverage is 1.36x, quite generous for seniors housing, where we typically see coverage ratios closer to 1.1x (a level we have argued, to deaf ears, that is too low).
Because the second quarter cash flow of these 120 communities most likely deteriorated, we assume that drop was baked into the new lease amount, and the current coverage is closer to 1.15x to 1.2x. And, the escalators don’t kick in for 18 months, presumably to give Brookdale time to turn the cash flow results around by the end of next year. The $82 million current annual saving on lease expense for the portfolio is huge for Brookdale, especially since the losses were only growing. To put it in perspective, the new lease amount comes to $819 per unit per month, while the old lease was $1,491 per unit per month.
As part of the overall agreement, Brookdale is selling five other communities to Ventas for the satisfaction of $78 million in debt (9% interest rate) that was due in September 2021. That “price” comes to just over $165,600 per unit, and with more than $5.0 million in EBITDAR, the implied cap rate is about 6.5%. It is unclear whether this can be considered a “market” transaction” since it may not have happened without the larger lease restructuring.
In addition, Brookdale agreed to forfeit to Ventas a $47 million security deposit, will make a $115 million cash payment to Ventas, and will give Ventas a 9% note that matures in December 31, 2025, the same date that the lease expires. When you add in the escalators on the old lease, Brookdale will be saving just under $500 million in total lease payments over the next five and one-half years, and giving up $207 million in cash and debt. Looks like a good deal, right?
It is, but there is more to it. In addition to the $207 million, Ventas is getting warrants to purchase 16.3 million shares of Brookdale for $3.00 per share anytime between now and the end of 2025. The shares have recently been trading just under this level. There are many investors who believe Brookdale will be worth more than $3.00 per share by the end of 2022, so there is plenty of time to improve operations, cash flow and its value in the three years after that.
Pick a number, say $10 per share, and that equates to a gain of $114 million. So, this is sort of like Ventas getting secure lease payments with annual escalators until the end of 2025, plus the benefits of a RIDEA structure, but on the whole company and not just one portfolio, because of the warrants. By the end of 2025, Ventas will be able to negotiate new lease terms, presumably at higher rates, whether with Brookdale or another operator, and we assume Brookdale if operations improve.
There is an additional benefit to Ventas, and that is having a financially healthier tenant in its stable. The value of that? Priceless. This lease restructuring was probably in the works when Ventas announced its significant dividend cut in June, since losing $82 million (and increasing) in annual lease payments would have made it impossible to maintain the existing dividend rate. While there will be pockets of improvement in census and cash flow for seniors housing, the financial impact of the pandemic will be with us well into next year.
While painful for Ventas in the short term, this agreement will be beneficial in the long term. For Brookdale, it is a win for the short term and the long term, especially if the board ever decides to sell the company in a year or two, or five. Not that Cindy Baier wants to do that, but at $15 or $20 per share, our bet is that she could be persuaded. It looks like sound business sense prevailed all around. Well done.
