In the last 20 years, there has been what we will call a crisis of capital three times: In the 1999-2001 period for skilled nursing, the 2000-2002 period for assisted living, and the 2008-2010 period for the entire sector. In the first period, five of the seven largest skilled nursing companies in the country filed for Chapter 11 bankruptcy protection. They were all publicly traded and represented more than 10% of all the skilled beds in the country. The other two eventually went private, and one of them, HCR ManorCare, recently went through its own liquidity problems and was eventually taken over by its landlord.
The change in Medicare reimbursement in the late 1990s to a prospective payment system was blamed for the SNF bankruptcies, and while it was a part of the reason, the real reason was the capital structure and high leverage of those companies. They were buying with abandon to fuel Wall Street’s expected growth targets, and even though they were publicly traded, the acquisitions were financed mostly with debt and sale/leaseback arrangements. Everything was looking up, and at the time, some of these skilled nursing companies were viewing themselves as the “super provider,” the little SNF that could take on the world of health care and at a much lower cost. Sound familiar? It was also in the 1990s that the term “subacute care” was introduced for what they were trying to do. While that has stuck, “transitional care” seems to be used more often these days.
At about the same time, the newcomer assisted living model was highly successful and, with every company wanting their own stake in the ground, growth by development made the current situation look like child’s play. One company, long since swallowed up by Brookdale Senior Living (NYSE: BKD), was proud of the fact they had one new community opening every week, for an entire year. As most people would agree, especially now, that is just not feasible, and it wasn’t then.
The hyper-development period in the late 1990s to 2000 was fueled by debt, sale/leasebacks and some equity, but not nearly enough of the equity.
Then came the “black-box” financing technique, followed by the “grey-box”. As these companies saw their leverage increasing, they wanted to get as much of their financing obligations as they could off-balance sheet. There were many bankers willing to help them set up these structures to give the appearance of lower leverage than what was actually there. But like anything that is not as transparent as it should be, most of these blew up, other lenders began to shy away from new commitments, new developments did not fill up as planned, staffing was hard to find, turnover increased, and the entire assisted living development market came to a grinding halt. Sound familiar, except for the grinding halt?
One exception was Sunrise Senior Living, which continued on until it ran into its own problems a few years later. And like the skilled nursing provider back then, the assisted living provider became the “super” provider, but from a consumer-friendly perspective, and not so much from a health care perspective.
In both of these situations, the capital crisis resulted in many bankruptcies or distressed corporate sales. At one point in the late 1990s, there were about 18 publicly traded assisted living-oriented companies. By the end of 2000, half of them had share prices worth less than $1.00 each prior to filing for bankruptcy protection or being sold, and only a few of the others were considered to be viable for the long term.
Today, there are just three publicly traded seniors housing companies. It was a similar story in the skilled nursing sector.
For the entire seniors housing and care sector, capital dried up, acquisition activity plunged so low that we recorded just 52 publicly announced transactions by 2001, and some of us were wondering if we had picked the wrong industry. Patience and longevity usually pay off.
Unlike the previous two periods, the third period of capital crisis was really an externally-influenced one, having little to do with problems in the seniors housing and care industry itself. Yes, acquisition pricing had peaked just before the Great Recession hit. Some of you may not remember, but before the market peak of 2007 there were investors talking about all those five-and seven-year loans that were made in the years leading up to the peak for what were then considered high-priced acquisitions. They wanted to swoop in and either buy the debt or the underlying real estate when the expected market crash occurred. What crashed was the stock market and the residential real estate market. Seniors housing and care? Not so much, as those bargains didn’t appear too many places, with the exception of the CCRC market. And there were not that many debt defaults.
But, capital practically evaporated from mid-2008 to the beginning of 2010. People just stopped buying and financing seniors housing and care as the dollar value of publicly announced transactions plunged from a high of $22.6 billon in 2006 to just $1.8 billion in 2008. In the private pay seniors housing market, according to our statistics, average prices per unit plunged for three straight years, from $164,500 per unit in 2007 (a market peak at the time) to $112,400 per unit in 2010, just before the sharp rebound in pricing. Part of the reason was the lack of capital, but equally contributing (if not more so) was the lack of quality properties that came on the market as a result of the economic and capital crisis. Why sell when cap rates are rising and prices are dropping if you don’t have to? They didn’t.
Capital practically evaporated from mid-2008 to the beginning of 2010.
Back in late 2000, several healthcare REITs began to experience the same liquidity problems that their tenants had been facing for the previous 18 months. Many of them started shedding properties, and distressed tenants, and some were aligning themselves with companies that in better times they may have avoided (e.g., moving properties from a distressed tenant to another operator that may end up getting overwhelmed).
There are certainly parallels today with tenants suffering through a similar liquidity crisis and REITs shedding properties and tenants, except the REITs have not suffered from their own liquidity crisis yet. Given the evolution, size and sophistication of the REIT market in the 17 years since, we don’t expect that to happen, unless the situation with SNFs continues to worsen, and census on the seniors housing side of the business continues to slide. Both of which are possible.
We are not yet at a crisis point like the three other periods, but there are more companies in financial pain today than we have seen in quite a while. And we have never seen the REITs forced to sell off properties or change out tenants to the extent that is currently going on, and it is certainly not over. The problem is that not all of these stress fractures are public yet, and some may never get disclosed. But we have been hearing that more shoes will drop.
Recently, we detailed what happened between Ventas (NYSE: VTR) and its tenant Elmcroft Senior Living, which had leased 77 of its 83 communities from Ventas with an investment value of $1.1 billion and $75 million of annual rent. Those 77 properties were transferred to a new operating company and will be owned by Ventas and a new joint venture partner which, presumably, will be funding the new operating company as well. The rather aggressive move by Ventas certainly had some heads shaking, and tongues wagging, and perhaps it was necessary to try to turn things around if existing management had not been able to in a certain time period.
Ventas has not been alone. Omega Healthcare Investors (NYSE: OHI) is transitioning skilled nursing facilities away from its fifth largest tenant, Orianna Health Systems. OHI is expecting its annual rent from the Orianna properties to decline from $46 million to a range of $32 million to $38 million when all the transitioning is done. MedEquities Realty Trust (NYSE: MRT) disclosed that its tenant, Gruene-Pointe Holdings, representing about 24% of revenues, has seen a slip in operations and is not in compliance with two financial covenants.
Rent coverage had slipped to 1.06x and total fixed charge coverage to 0.90x. This is after management fees, which are subordinate to the lease payments, so when they are added back the situation from MRT’s perspective looks better. GruenePointe is current with rent, but the overall occupancy for its 10 Texas skilled nursing facilities leased from MRT had fallen to 78.1% in the second quarter. Based on preliminary data, it appears that census has increased to 79.6%, and may be reaching higher. The company was experiencing staffing and quality problems, but also appears to have made the necessary corrections to stem the decline. As we have always said, this is a very management-intensive business.
National Health Investors (NYSE: NHI) decided to transition a seniors housing portfolio of four smaller buildings in Minnesota to Bickford Senior Living. This will be the third tenant for this portfolio, and the new rents have been reduced from $2.1 million to $1.5 million, with two months of free rent. One big difference is that Bickford is financially much stronger than the previous tenant.
This is a very management-intensive business.
NHI did receive all the contractual rent from this Minnesota portfolio before operations were transferred. In addition, Bickford has an option to purchase this portfolio at a cap rate over 8.0%. There is another seniors housing portfolio that represents less than 4% of NHI’s total rent that is technically not in compliance with certain covenants but is current on rent payments and is expected to stay current, but will be watched closely. Many of the questions on last year’s third quarter earnings call focused on these tenant issues and lease coverage ratios, even though the Minnesota situation was quite small and the other tenant is still paying rent. Given the operating environment, investors are nervous.
The liquidity problems at Genesis Healthcare (NYSE: GEN) have been well documented on these pages, and while changes in reimbursement have certainly played their part (just like in the late 1990s), it is the company’s leverage and expensive leases that is also putting the squeeze on the largest skilled nursing facility operator in the country. Welltower (NYSE: HCN) has been able to sell a relatively small portion of its Genesis inventory, but has not been able to offload the larger number of remaining SNFs, even though they seem to be willing to sell them at a price that would assume a lower lease payment from Genesis (or another operator). GEN’s share price plunged to new lows in November 2017, hitting $0.60 per share, which may have had to do with whispers about not getting any rent relief soon enough with a buyer of Welltower’s properties.
Speaking of rent relief, Genesis has received some early concessions from landlord Sabra Health Care REIT (NASDAQ: SBRA) on the second group of SNFs that Sabra wants to sell, which includes 43 properties dubbed the Genesis Exodus portfolio. The remaining SNFs (35) have been on the market for sale, and four have already been sold. For the Exodus portfolio, Sabra has agreed to lower annual rent effective January 1, 2018 by $19.0 million, to $47 million. As an extra kicker, if that is not enough of a rent reduction to attract buyers at a reasonable price, and the rent has to be lowered further, the difference between the new rent and any further reductions will have to be made up by Genesis on a monthly basis over 4.286 years.
Genesis also has the right to defer a majority of its rent payments during a six-month period for up to a month from the applicable monthly due date, providing it with some extra temporary liquidity if it needs it. Meanwhile, Sabra reserves the right not to sell any facilities, which could prove beneficial if operations and cash flow should turn around. However, Sabra still expects the sale of the Exodus facilities to generate between $425 million and $475 million of aggregate value.
This is not all. The negotiations between Quality Care Properties (NYSE: QCP) and HCR ManorCare kept on getting extended and extended, until finally HCRMC filed a prepackaged bankruptcy petition which included an agreement to be taken over by QCP. Meanwhile, LTC Properties (NYSE: LTC) had its problems with memory care provider Anthem Memory Care, but that seems to be improving, with Anthem’s occupancy rates rising and Anthem paying LTC $1.2 million in rent for the fourth quarter, above what LTC had budgeted as they work through their problems. Eric Mendelsohn of National Health Investors even referred to Wendy Simpson and LTC as the gold standard on how to handle the disclosures, PR and negotiations with a troubled tenant. We don’t hear that too often among the REIT CEOs, but many if not most of them appear to be in the same boat.
So, even though we have an abundance of capital in the market right now, there exists a liquidity crisis among a growing number of providers. Most of it has to do with escalating lease payments at a time when daily rates are declining in skilled nursing facilities, the ability to raise rates high enough is getting more difficult for many senior living communities, and labor costs are rising at a faster pace than anyone’s rates. All of this when leverage is high, lease rates are based on high original acquisition values, and acquisition pricing has peaked. For now, there is plenty of debt capital, and it remains extremely cheap.
So, even though we have an abundance of capital in the market right now, there exists a liquidity crisis among a growing number of providers.
But the acquisition volume of REITs has definitely tapered off (with the exception of Sabra) as many of them sort through their own problems in their existing portfolios. The Chinese buyers are vacationing in Macao while they read the political tea leaves on the Mainland, and private equity, flush with cash and looking for high real estate returns they can’t find elsewhere, has been filling the void. But in some cases, PE firms are waiting for the other shoes to drop so they can buy at lower prices.
The case in point may be Brookdale Senior Living, which has been a cloud over the market for way too long. The stock price, which dropped below $7.00 per share and is still trading in the $6.50 to $7.00 range, may become attractive to that buyer that wants to take the plunge. The problem is that with all the operational and staffing problems, when “that” buyer takes the plunge, they may drown or sink in the quicksand regardless of the price. And that is just one reason why we think a deal has failed to emerge after all these months of talks.
The timing for REITs to expand into the RIDEA structures turned out to be quite fortuitous. While we do not think this is the case, it could have been possible they viewed RIDEA as a hedge against the traditional sale/leaseback structure in the event of a market downturn, such as the one we are experiencing. The real reason is that the market was at the beginning of a significant surge coming out of the Great Recession, and they wanted to take advantage of that, not so much as a hedge but to balance and boost the “plodding” returns of leases with their “small” 2% to 3% annual escalators. In today’s market, while the REITs may not be too happy with the financial performance of some of their RIDEA customers, at least they are not having to go public with lease concessions or tenant removals.
This brings us back full circle to the concept of a capital crisis. What is missing in the capital markets today? First of all, there is no public equity market to speak of. When was the last seniors housing and care provider IPO? It was on November 8, 2007, when The Ensign Group (NASDAQ: ENSG) went public at $16.00 per share, six months after Skilled Healthcare Group priced its IPO (which subsequently completed a reverse merger with Genesis Healthcare on February 2, 2015). That is 10 years, one Great Recession and two market peaks ago.
In 1999, there were about 30 publicly traded seniors housing and care companies, compared with just seven today. In fact, the number of total publicly traded companies in the U.S has dropped by 50% from 1996. The number of IPOs each year has plunged by 85% in 20 years. And weirdly, The Wilshire 5000 hasn’t had 5000 stocks in it for more than a decade, and now has only about 3,600 stocks.
The REITs, however, are another story. In 1999, there were 14 publicly traded healthcare REITs with a primary focus on the senior care market. Today there are 12, and that range has been somewhat consistent over the years through mergers, a few IPOs and the past proliferation of the non-traded REITs that were always looking to go public as a possible exit strategy.
The number of IPOs each year has plunged by 85% in 20 years.
The consensus is that the seniors housing and care sector does not belong in the public equity arena. Why? Because they can’t show quarterly profit growth, and actually, can’t show any profits at all, at least as measured by Generally Accepted Accounting Principles. Why? Because of the capital structures that have become so common in this sector, with high leverage and escalating lease payments, not to mention a difficult operating model, excessive competition, intervening government authorities, litigious attorneys….have we forgotten something?
The story has always been that you can’t run a “real estate” business on a quarter-to-quarter basis and manage earnings for public shareholders. But providers could deal with most of the problems thrown at them if they had a more conservative capital structure based on more realistic prices paid for acquisitions. Just ask management at National HealthCare Corporation (NYSE: NHC), which always makes a nice GAAP profit with its conservative capital structure while operating skilled nursing facilities. You know, those skilled nursing facilities that can’t make any money.
And here is the kicker. Everyone wants values to rise, because that is how you make a profit, especially if you are an investor with a three- to seven-year time horizon. But with each incremental increase in price (or value), that means an incremental amount of cash flow has to support the cost of capital, as opposed to the cost of operations. And long term, it is the operations that will support the value.
So, we have been in a period where capital has been both abundant and cheap, yet too many companies are struggling. What happens if real estate prices continue to rise, and capital becomes more expensive? If you assume occupancy will rise because of the boomers and all will be merry, you better have a better business plan, because hope is not a plan. At some point, all those boomers will be on Medicaid and Medicare, and if you think we have problems with funding today, just wait. The silver tsunami may yield to the bankrupt economy, and then we will all be up that creek without a paddle.
…..with each incremental increase in price (or value), that means an incremental amount of cash flow has to support the cost of capital…..
The point is, with the capital markets having been so supportive to the sector, when that changes, a conservative capital structure will save the day. And if there is one thing we have learned over the past 30 years, it is that capital markets do change and there are always cycles.
Is the current problem the REITs are having with tenants the beginning of a cycle, or rather the end of the past one? It may be too early to tell, and it will all depend on whether operations, census and rates can improve enough to stave off another downturn. But it certainly does not seem to be the time to go on an acquisition binge at high prices. Unfortunately, history repeats itself all too often.
There is no doubt that we are in the middle of a shake-out in the skilled nursing sector. While it is painful for some, the sector will become stronger and healthier as a result. Weak providers will disappear, the strong will be better, poor quality SNFs will be closed, and by 2020 we may have a different situation, but still feeling the sting of today’s pain. However, the capital structures will have to change. Otherwise, history will repeat itself again and again.