The SeniorCare Investor: The Best of Times…For Now

During 2004, almost everything in the senior care market seemed to be moving with all four cylinders churning away. Stock prices were rising, cap rates were declining, the acquisition market heated up in the second half of the year, higher quality properties finally appeared on the market just as the inventory of distressed properties began to dwindle, and both debt and equity capital were attracted (again) to the fundamentals of the sector.

Combined with the Medicare rate increase that finally had a financial impact in 2004, the Medicaid cuts that never materialized, with some states actually approving large increases, and the improving occupancy rates in assisted living facilities, one might say that we have the perfect storm in reverse.

The stock market is often said to be one of the best predictors of future performance, and public equity investors jumped on the senior care bandwagon in mid-2003, producing returns of 131% to 616% for the top eight performers, while almost all the others had double-digit gains ranging up to 86%. It is true that the universe of publicly traded senior care stocks has dwindled over the past five years, and many companies were starting at a low base price, but that kind of price performance is unusual, and very difficult to replicate. It is also often followed by a down year, or at best, a mediocre one.

But this did not happen in 2004. In fact, it was almost as good as 2003 and one of the best years ever for senior care stocks. Three companies more than doubled in value, with Advocat (OTCBB: AVCA), one of the oldest publicly traded senior care stocks, returning from the depths of financial despair to jump in price by 1,880%, after starting the year at just $0.25 per share. Most of the other stocks had double-digit gains, with six companies increasing in price by 25% to 92%. Other than Sun Healthcare (NASDAQ: SUNH), all skilled nursing companies posted positive returns, with Five Star Quality Care (AMEX: FVE), which is really a hybrid company with significant assisted living assets, nearly doubling in value, followed by National HealthCare Corp. (AMEX: NHC), up 77%, and Genesis Healthcare Corp. (NASDAQ: GHCI), up 54%.

The assisted and independent living segment was led by American Retirement Corp. (NYSE: ACR) with a 268% price increase, followed by Assisted Living Concepts (OTCBB: ASLC), which more than doubled in value as the auction process, featured in last month’s issue, took the share price higher and higher. Readers will remember that ACR traded as low as $1.00 per share a few years ago, as pressure mounted on management to file for bankruptcy protection as a large convertible bond issue was coming due. Management held firm, and those shareholders that stayed with the company certainly have reason to celebrate. Emeritus Assisted Living (AMEX: ESC), which jumped 52% in 2003, tacked on another 57% increase last year to reach its highest level in five years. And speaking of highs, Sunrise Senior Living (NYSE: SRZ) is zeroing in on its all-time high of $53.13 per share, with a 20% share price increase in 2004 after jumping by more than 50% the previous year.

The average gain in 2004 of 177% (55% if Advocat is removed from the calculation) compares favorably with the 152% average gain in 2003. But is there any room to move even higher? And are the factors that are driving stock prices the same ones that are causing a drop in cap rates, resulting in the most aggressive buying we have seen since the late 1990s? At the risk of disappointment, and without sounding too indecisive, it is difficult to say. The "scarcity" factor is relevant for both markets, since there are the fewest alternatives in the senior care public equity market in over 10 years, and the acquisition market, until recently, has been dominated by distressed property sales.

Consequently, there is a pent-up demand for profitable, stable and high quality facilities—whether skilled nursing, assisted living or independent living—and when they come onto the market, their prices get bid up to levels that are causing some industry veterans to shake their heads with that "watch out" look on their faces. And investors have realized that the public equity market hit bottom two years ago, and figured that there was only one way to go, but it is doubtful they thought we would see the returns that eventually materialized.

Despite the scarcity factor, we believe that the public equity values, by and large, have gotten ahead of earnings growth. In the skilled nursing market, all we need is for Congress or the President to act on MedPAC’s annual recommendation to decrease Medicare reimbursement for SNFs, and share prices, as well as per-bed values, would plummet. While unlikely to happen this year, when looking for ways to decrease the federal budget deficit, Congressional friends of the nursing home industry seem to disappear faster than a private paying patient.

In the assisted/independent living segment, in a few months we will be left with just four alternatives, three of which have already seen substantial price increases, and two of those still lose money or are at best breakeven. Did we really say getting ahead of earnings growth? So after two unprecedented years, senior care stock prices should underperform the market in 2005.

The acquisition market is a different story, and may lag the public equity market by 12 to 18 months. Our annual acquisition market statistics for 2004 will not be available for two months, but given the surge in the last half of the year, we would be surprised if average bed and unit prices across the board did not increase, perhaps substantially so, from 2003’s relatively low levels. Some of the highlights of the year include our first billion-dollar deal in six years, representing one of two publicly traded companies being sold, the sale of Centennial Healthcare out of bankruptcy and the $520 million purchase of Horizon Bay Senior Communities’ properties by CNL Retirement Properties in the largest private deal of the year. Other than the sale of a few private companies, the year was dominated by smaller, single-facility sales, but that began to change by the fourth quarter.

The most significant news in the acquisition market in 2004 was what happened to cap rates, and whether it is a temporary phenomenon, driven by a shortage over several years of quality facilities on the market, or whether it represents a fundamental shift in investment parameters, especially as more non-traditional real estate investors enter the senior care market. It is still too early to tell, especially since interest rates remain near historic lows. But at least in today’s market, compared with that of the late 1990s, buyers are purchasing existing facilities with real cash flow, and in some cases the leverage is quite reasonable. It is just a matter of time before they know if their return expectations are met at these low cap rates and high prices. One contradictory factor is that cap rates seem to be declining just as interest rates are increasing. How that relationship continues will be interesting to watch, especially as many of those buyers in the past few years closed deals with low cost floating rate debt. They won’t look as attractive with another 200 to 300 basis points added on. HUD refinancing would make a lot of sense at this point in time.

But the aggressive buying that seemed to characterize the market in the second half of the year did accomplish one thing that we had been waiting for—the appearance of the high quality properties and portfolios for sale that required a stronger market to make their availability known. Unless there is little intention to sell, an investor would be foolish not to take advantage of this market shift and cash out while buyers and capital are plentiful, and interest rates are low. An opportunity like this may not reappear for a while.

The stars are in alignment, but it will not last forever, with any of a number of factors capable of derailing the current bull market in senior care. At a loss at how buyers are paying such high prices in the seniors housing market, one financial intermediary recently quipped, "So what’s the exit strategy, $200,000 per unit?" As they always say, buyer beware.

In the month of December, there were certainly a lot of buyers in the hunt, and there was a good spread of activity among the various property types. Almost all of the deals were single-facility transactions, but the largest in terms of dollar size was in the assisted living market. And let’s not forget that the sale of Mariner Health (OTCBB: MHCA) finally closed in December, despite all the hand-wringing about the buyer being able to get the financing done. We assume that Mariner management continues to run the facilities, but how long that will last is anyone’s guess.

Before moving on to last month’s acquisition activity, we were saddened to hear that Neil Chur, co-founder of Park Associates and one of the major buyers and operators in the skilled nursing market during the past two decades, died suddenly at the end of the year. Although he had slowed down in recent years, he completed some of the largest, and most profitable, deals of the 1990s and added a certain element of intrigue and excitement to the market. He will be missed by those who knew him.