The SeniorCare Investor: Assisted Living Prices Slump; Skilled Nursing Prices Flat - April 2003

Even though there was little doubt about the outcome, management at Sunrise Assisted Living (NYSE: SRZ), not to mention at Marriott International (NYSE: MAR), must have breathed a big sigh of relief last weekend when the assets of Marriott Senior Living Services (MSLS) were finally sold to SRZ. The combination has created the largest senior living provider in the country, with 340 communities and a resident capacity of nearly 40,000, and the company will soon be known as Sunrise Senior Living. And it may change how some people look at the industry as well.

In a recent National Investment Center "SelectExec Poll," 61% of the owners/operators who responded thought that SRZ’s decision to go down the path of becoming a management company, with real estate not on the balance sheet, was undesirable. On the other hand, 76% of the lenders and investors who responded thought that it was the right way for SRZ to go. The latter group has a bit of a built-in bias, since REITs have long been a proponent of asset-free operators, and some lenders prefer the predictability of an income stream associated with management contracts, even though this precludes them from any asset-based lending.

The providers that still believe in the merits of asset ownership may be looking at what happened over the past few years to companies that had sold off most of their hard assets and then had little flexibility when they ran into financial difficulties. In addition, managers and their landlords do have squabbles from time to time, such as the well-publicized disputes between Marriott International (the manager) and the owners of several of the hotels. Less than satisfactory operating results, leadership changes or conflicts of interest can all tarnish the relationship between a manager and the real estate owner.

Sunrise has the benefit of the support of many owners of the former MSLS properties, most of whom are looking forward to the change. But the honeymoon may be short-lived if the execution produces less than desirable results. Integration of that large an acquisition, whatever the industry, is never easy, and it is expected that management’s time will be heavily weighted toward a successful integration. In theory, the potential losers could be the investors in the Sunrise prototype properties that have already been sold, since the focus will be on merging the MSLS facilities, and time away is usually not a good thing. The reality, however, is that most of these properties were the cream of the crop and should be running on autopilot, not requiring much oversight from headquarters.

So how dominant will the new Sunrise Senior Living be? The company will operate more than 20 communities in each of four states, California (37), Virginia (27), New Jersey (26) and Ohio (24). In addition, there will be eight other states with more than 11 communities each. With nine more communities under construction in California, that state will soon represent close to 13% of the entire portfolio. But approximately 50% of the properties are along the eastern seaboard, which is SRZ’s traditional stronghold.

The MSLS deal brings Sunrise into 10 new states, all of which have five or fewer properties, with the exception of Texas (9). One weak spot in SRZ’s portfolio had been Florida, with just one community, but that jumps to 18 with the MSLS deal. Some may say that is an unfortunate development, given Florida’s liability problems. But if you are going to be a national senior housing provider (which has its own problems), Florida is a critical state.

The transition is not going to be easy, especially because the cultures are quite different, not to mention the types of properties. The short-sellers are already looking for problems, including a new FASB interpretation, called FASB Interpretation No. 46 ("FIN 46"), which came out in January of this year. Under FIN 46, companies will be required to determine if they are the primary beneficiary of a "variable interest entity," and if they are, that entity will have to be consolidated on its balance sheet.

Based on management’s preliminary review of the interpretation, SRZ believes that its joint ventures will be considered to be variable interest entities, but it does not know if the company will be considered the primary beneficiary. The company’s sale/manageback transactions, where SRZ retains a minority equity interest, are considered to be variable interest entities. These are one of three different types of joint ventures the company is a party to. But with just a 20% to 25% ownership interest in these sale/managebacks, they should not be considered the primary beneficiary.

The shorts are getting excited (prematurely, perhaps?) because they are looking at the $1.0 billion of debt associated with various unconsolidated entities, some of which may go on the balance sheet depending on whether SRZ is deemed to be the primary beneficiary. More debt would make the balance sheet of a "management" company look over-leveraged, which may scare some investors, or so the shorts want to believe. It is too early to tell what will happen, including perhaps nothing at all, but the cash flow of the company would not be impacted. It is, however, a development to watch, and the impact, if any, will most likely not be seen until the third quarter balance sheet.

While management was closing the MSLS deal, CNL Retirement Properties closed on the previously announced acquisition of nine MSLS properties for $166 million, which will now be managed by Sunrise. And on the last day of the quarter, Sunrise announced the completion of another sale/long-term manageback of 10 assisted living facilities in Minnesota for $19.2 million. These are all small cottage-style communities that came with the acquisition of Karrington Health in 1999, and although we do not have the number of units, the price was close to $65,750 per resident (based on capacity). Sunrise will record a $10 million gain from the sale, 50% of which will be recorded in the first quarter 2003, and the remainder will be recognized as the buyer repays a $5 million note. The gains are already included in the company’s previously disclosed earnings forecast for 2003.

Although the shorts will say SRZ sold a 100% interest in this transaction to avoid any FIN 46 problems, the reality is, they probably had no interest in keeping any minority position and were fortunate to sell them since they are so different from the SRZ or MSLS prototypes. The buyer is a subsidiary of the Wedum Foundation, a nonprofit family foundation in Minnesota that supports the elderly, higher education and struggling youth.