The SeniorCare Investor: The Skilled Nursing Market Rides Again

During much of 2005, investors, lenders and operators, as well as market commentators, have been watching as portfolio after portfolio of assisted and independent living properties have come onto the market with higher and higher expected prices, and lower and lower expected cap rates. Sure, occupancies are rising from the over-built late 1990s, and combined with healthy unit rate increases, operating margins have been expanding (for most). With institutional investors in search of yields above the 5% to 6% level, seniors housing has now become a new found love, and the sales approach most commonly used, with two bidding rounds, has been put to good use to help drive the feeding frenzy.

Other than the auction of Beverly Enterprises (NYSE: BEV) this year, not much has been heard from the skilled nursing facility sector, at least in the acquisition market, until now. Most institutional investors have not wanted to get involved with an overly regulated industry that relies on at-times erratic government funding for 70% to 80% of its residents and with an average physical plant age of 25 to 30 years. If this is too depressing, stay with retirement housing. The flip side, however, is that the expected returns are much higher, to compensate for the higher risk, of course, and given where cap rates have gone for some assisted and independent living deals, the return may be almost twice as high in some cases.

We are sure this is what attracted Canadian company Onex Corporation (TSX: OCX.SV) to the largest acquisition of a private nursing facility chain we have seen in years, if ever. Through its Onex Partners, a $1.8 billion private equity fund, Onex is investing approximately $225 million of equity to buy California-based Skilled Healthcare Group (SHG) for close to $640 million (C$750 million). SHG is expected to have total revenues in 2005 of about $470 million, increasing to well over $500 million in 2006. Of the total revenues, approximately $80 million is derived from its therapy business, Hallmark Rehabilitation, which has nearly 60 internal contracts and 110 third party contracts.

The company owns 51 facilities, leases 17 and manages one with a total of 7,849 units. The property mix includes 57 skilled nursing facilities with 7,080 beds and 12 assisted living facilities with 769 units. Although the facilities are in four states, the overwhelming majority are in California (3,724 beds) and Texas (3,173 beds), with the rest in Kansas and Nevada. Overall occupancy at the company is about 87%, but in California it is thought to have about the highest Medicare/managed care census (over 23%) of any major chain in the state. That may have been the driving factor in what is considered a relatively high multiple of 1.36x 2005 revenues. The therapy business and assisted living component also helped push the multiple above the 0.8x to 1.0x revenues range that has been more common in the skilled nursing market over the years. The cap rate is harder to determine, partly because of the leased facilities and partly because of a healthy increase in the MediCal rate this year. Before the impact of that rate increase, the cap rate may have been between 11.0% and 11.5%, but this is just an estimate.

SHG filed for bankruptcy protection in October 2001 when it was known as Fountain View, and the filing was primarily due to a professional liability judgment against the company that basically tied its financial hands in trying to appeal the judgment. The company emerged from bankruptcy less than two years later, with creditors getting paid in full and all equity holders maintaining their stakes in the SHG. The controlling shareholder was Heritage Partners, which invested in the company in 1997, and then the seven-year itch came a year late. Not wanting to invest more funds in SHG’s growth, it was time to cash out, and Onex has plenty of experience in the U.S. health care market. In 2003 it bought a controlling interest in Magellan Health Services (OTCBB: MGLN) for about $285 million, and last year it purchased a 30% interest in ResCare (NASDAQ: RSCR) for close to $83.4 million. SHG’s management team will be making a significant equity investment in the transaction as well.

Although little financial detail has been provided, the price was probably pushed up as a result of a more stable Medicare environment and a significant increase in California’s MediCal reimbursement rate this year. CSFB represented SHG in the sale.