The SeniorCare Investor: Getting Back To Basics With The Ownership of Real Estate

On the recent 20th anniversary of a biotech-oriented newsletter, the editors titled the issue, "Learning from the Past, Investing in the Future." We couldn’t help but notice how appropriate that sounded for the senior care industry today. Looking back to the years prior to the early 1990s, owning the real estate was a natural part of the senior care business, whether skilled nursing facilities, retirement communities or properties in the nascent assisted living field.

By owning the primary asset of the business, an operator believed he controlled his financial destiny: if cash flow increased, he could refinance at a higher level and re-deploy the original equity investment. Or, over time, the debt could be paid down (or off), producing an investment with significant cash flow that could be used for expansion or other needs, and an unencumbered asset that would be important for future financial flexibility. Financial flexibility, perhaps, is the key phrase.
Now, all of this is certainly not new, nor is it high finance. But sometimes it seems as if it is forgotten amidst the various financial games that have been played in recent years, including the various black box concepts with all their shades of gray.

The key argument against owning the real estate is the huge amount of capital required, especially for a growing company, and the high cost of the equity component of that capital. This limits growth opportunities for those so inclined, as well as the ability to spread risk among an expanding group of assets. The second argument is the depreciation hit to earnings, which lowers valuations for public equities, but has little impact on private companies. The third argument, though a much weaker one, is the old stand-by statement that "we are a senior care operating company, not a real estate company."

All of these arguments are reasonable, but an equally persuasive argument can be made that they are missing the point. There were many factors that caused the worst financial meltdown in the history of the senior care market just a few short years ago, but the problem was worsened, and lengthened, by the absence of any significant ownership of the assets operated by some of the bankrupt companies. Highly leveraged leases on questionable properties operated by companies growing too quickly, combined with high levels of corporate debt with minimal assets to support it, are often the ingredients to create the perfect financial storm, and they did. Skilled nursing facility operators will claim it was the Medicare changes that did them in. True, the lower reimbursement, which certainly was known in advance, was a significant factor, but we would argue that it merely hastened the disaster that was already on the way.

So why, at the end of 2004, are we talking about real estate ownership again? Hasn’t Sunrise Senior Living (NYSE: SRZ) dispelled us of the notion that real estate ownership is important, or perhaps necessary, for long-term financial stability? Our answer, rather simplistically, is to follow the money, and the acquisition of Mariner Health Care (OTCBB: MHCA) is a case in point. Anyone whom we have talked with who had been interested in acquiring Mariner had never arrived at a value of $30 per share for the company. The range was usually in the $24 to $27 per share area, and when the stock was trading in the mid to high teens, this seemed to be quite a reasonable premium.

Although these other potential buyers knew that Mariner owned 70% of its nursing facilities, they were not building into their pricing structures the value that could be achieved with that ownership, primarily by the combination of selling and refinancing any number of the assets. National Senior Care and its financial backers did see that opportunity, and although it could ultimately backfire on them, the current low interest rate environment combined with the relative liquidity in the market are favoring a successful outcome for the acquisition. Even though Mariner’s shares still trade at an almost 10% discount to the $30 offer price, there has been little news to indicate a deal not getting done. In fact, we have heard that financing commitments have been issued by Credit Suisse First Boston, but for some unknown reason this has not been publicly disclosed.

Mariner is not the only publicly traded company with a majority of its assets owned, and it is not the only one seeing its market value hit a new high. Genesis Healthcare (NASDAQ: GHCI), which saw a quick jump in its share price on the news of the Mariner deal two months ago, recently hit a 52-week high $31.68 per share, which is more than double its low since being spun out of its predecessor company last December 1 and 16% higher than at the end of July.

It is easy to see what is attracting investors. Of a total of 26,500 beds operated by Genesis, 62% are owned by the company with the rest managed or leased. When the 2,773 beds that are jointly owned by Genesis and independent third parties are added to the ownership total, the percentage increases to over 72%. Of the large chains, Genesis is the only one that is truly a regional company. Just under 90% of the beds are located in the Northeast, and all but two of the facilities (in Wisconsin) are in contiguous states. The concentration is so high that 90% of the 26,500 beds are in just seven states. All of these factors have contributed to Genesis being viewed by some as the next potential takeover candidate.

Speaking of takeover candidates, bankers representing the board of Assisted Living Concepts (NASDAQ: ASLC) are already in the market seeking interested buyers. The company’s share price jumped this summer when it was announced that a special committee of the board would be looking into "maximizing shareholder value," and in August the price hit a 52-week high of $11.30 per share, which is also the highest since ASLC emerged from bankruptcy protection in January 2002.

So why this level of investor interest in ASLC, other than it has returned to consistent profitability? Once again, we believe that real estate ownership is having an impact. The company operates about 175 assisted living facilities with 6,838 units, but nearly 70% of these are owned. The overall occupancy of the portfolio as of December 31, 2003 was 89.1%, but that was dragged down by the average 70% occupancy of the 20 facilities in Indiana. Excluding Indiana, the overall occupancy jumps to over 92%, which is quite good even in this improving market. And at the end of last year, more than 25% of the facilities in the overall portfolio were 100% occupied.

One could say that it is easier to fill a portfolio of facilities where the average size is less than 40 units, but by the same token flu season can result in a 15% to 20% drop in occupancy with the loss of six to seven residents. While current management, which inherited the small size prototype, has done an admirable job in filling the units and controlling costs to return the company to profitability, the small facility size will have a limiting effect on valuation, as will the wide geographic dispersion of the assets from the west coast into the Midwest, the south central states and finally the Northeast. The company breaks them up into three regions, and although it may be unrealistic from a sales perspective, selling the facilities on a regional basis, or better yet state by state, could yield the maximum shareholder value they are looking for. But since that strategy is too time-consuming and risky, it won’t happen.

At $11.30 per share, the stock may be topping out with respect to value, which is one reason why it may be difficult for the board to attract many buyers. In addition, even though ASLC owns the majority of its assets, the financing of these facilities, which may generate just $1.0 to $1.3 million in revenue each, will be more limiting than larger skilled or assisted living facilities. Nevertheless, the 70% ownership factor is certainly impacting value.

Finally, we would be remiss if we did not mention the ownership granddaddy of them all, Manor Care (NYSE: HCR). The largest company in the senior care market by any yardstick, HCR owns a whopping 94.5% of the 363 facilities it operates (it does lease its corporate headquarters, however). Even though the facilities are spread across 32 states, 74% of the beds are located in just seven states (but not regionally clustered). Manor Care has been the most consistently operated company in the senior care sector over the years, with the most consistent profits. While management might claim it has been their operating expertise that has been the key driver to their success, which certainly has some validity, the high ownership level has to be a contributing factor to the long-term stability and success of the company.

There is no right or wrong answer to the question of real estate ownership in the senior care market, but it will influence some choices for companies, such as going public or not, as well as their rate of growth. Sunrise Senior Living has chosen its path to be a management company and compares itself to the leading hotel chains, something that will not work for everyone. And there are some flaws in their model that may come back to haunt them, such as the costs associated with having a landlord, a tenant and a management company (Sunrise) in some of their structures, and who will ultimately bear those costs.

The current sentiment seems to be against the public equity market for senior care operators, and that is beneficial to the concept of real estate ownership. The late 1990s into the new century was a difficult period for the senior care industry, and as that biotech newsletter stated, perhaps we can learn from the past while we invest in the future.