The SeniorCare Investor: Do Beverly, Sunrise Deals Imply Renewed Market Strength?

In last month’s issue, we stated, "Beverly Enterprises (NYSE: BEV) is taking so long to divest its Florida nursing facilities that in time the environment may improve enough to cause management to pull the facilities off the market."

Just two weeks later, when Beverly announced the signing of a definitive agreement to sell the facilities, one equity analyst (to remain anonymous) could not resist a lighthearted ribbing of our editorial content and wanted kudos for predicting an imminent sale. As the saying goes, "It ain’t over ‘til the fat lady sings," but she may be tuning up.

On July 16, BEV announced that it reached a deal to sell the 49 Florida facilities with 6,129 beds to newly formed NMC of Florida, LLC (NMC) for $165 million in cash. That price equates to about $27,000 per bed, which is almost 40% below the five-year historical average price per bed in Florida of $44,000.

Consequently, the price appears to be relatively cheap, especially since the price to revenue multiple is just 0.62x, and for the past dozen years the national average has been between 1.0x and 1.1x, with the lone exception of last year when it plunged to 0.84x. The cap rate (after a 5% management fee) of 14.5% is the only value indicator that is close to today’s market.

The buyer is an "affiliate" of Vantage Medical, Inc. (aka Bill Smith) and Formation Capital LLC (aka Arnold Whitman). The initials NMC are not too coincidentally close to New Millenium Care, which is Neil Chur’s management company that (together with several predecessor companies) has been run in close association with Bill Smith. Messrs. Chur and Smith have completed several large transactions with Beverly over the past decade and this ability to close increased Beverly’s confidence in signing the deal, even though Mr. Chur is not taking a role this time (at least not directly).

It is very difficult to gauge whether NMC is getting a good deal or not because there are so many variables involved. The first one is what assumption NMC made for the cost of liability insurance. Revenues last year for the properties were $267 million and they produced EBITDARM of approximately $40 million, using a theoretical $2,000 per bed for liability insurance. After deducting a 5% management fee and about $2.5 million of rent, EBITDA is just over $24 million. As Florida nursing home owners know, the cost of liability insurance can be up to $10,000 per bed. Just doubling the theoretical cost to $4,000 per bed would therefore cut EBITDA by 50%, changing the economics of the transaction quite dramatically. Even though the liability insurance crisis may be bottoming out, low-cost policies are not going to be in abundance any time soon.

The second cost issue is the new Florida staffing requirements. Effective January 1, 2002, nursing homes must increase their certified nurse’s aide (CNA) hours from 1.7 to 2.3 per patient day, which ultimately rises to 2.9 hours in two years. In addition, licensed nursing hours must increase from 0.6 to 1.0 hours per patient day. The Florida legislature has approved increased funding for Medicaid, but when everything kicks in, the estimate is that there will be a $100 million shortfall that will have to be made up by increased private pay and Medicare rates (don’t count on it). The state funding for the increase in CNA hours implies an all-in cost of about $12 per hour, which may be fine during a major recession, but not when the industry needs to hire another 11,000 CNAs in one state. If agencies must be tapped to deal with the shortfall, margins for everyone will be cut.

Because there are so many underwriting issues and moving parts, there have been few people who think this deal will actually close. One of the parts, of course, is financing. The buyer has received a commitment for senior debt in the amount of $125 million from UBS Warburg and Heller Healthcare Finance, subject to completion of due diligence. That leaves $40 million to $50 million of equity necessary to close, which includes closing costs. NMC received proposals from four different institutions, and according to market sources, Blackacre Capital Management, a large hedge fund with $1.4 billion in real estate-related investments, will be providing $45 million of equity and the buyer $5 million. Working capital financing, which will be substantial, is up to the actual operator, which brings us to another important hurdle.

The buyer (or any buyer) had to submit an acceptable application for a change of ownership to the state by the end of August in order to receive the state’s change of ownership step-up in Medicaid reimbursement, something that disappears from the reimbursement regs at the end of this month. The step-up for this deal is worth about $7 million annually, which is quite valuable to a purchaser. How much value is disputable, however, because the entire state will be re-based for patient care effective January 1, 2002, so many of these properties would be receiving a step-up in reimbursement anyway.

The application has already been filed (faster than most people expected), and the new operator for the facilities will be an affiliate of Centennial HealthCare. Centennial had been the leading bidder for the Beverly homes, with an apparent offer of $160 million in cash and $20 million in notes. Why it was not accepted a few months ago is unknown. Now, the company (really its newly created affiliate) will be leasing the properties from NMC. While most of the lease terms have apparently been worked out, there are still some details yet to be determined.

With issues relating to liability insurance, new staffing requirements, Medicaid reimbursement, equity for the purchase and nailing down the lease terms for the tenant, it is easy to understand why there are few people who think that this deal will ever close. As one spectator put it, however, if anyone can do it, it is "Arnie."

If there are no glitches with the debt and Centennial falls into place, with lease terms that make sense for NMC, five years from now the $27,000 per bed price may look cheap. The big caveat is liability insurance, but since the new company will be starting with a clean slate, and will most likely form a captive for some part of the liability, in two or three years the cost may be manageable. There are a lot of ifs, but the buyer has passed many of the hurdles so far. Unfortunately, one missing piece could throw the entire deal off course. Stay tuned.

All eyes will be on Blackacre Capital as the new institutional investor entering the senior care market, because the track record of large institutional equity investors in the senior care market has not been stellar, to say the least. But if more "sophisticated" money starts to come into the industry at this juncture, it could be the catalyst to lift the senior care market out of its investment doldrums. It will also get them to the podium at industry conferences like NIC.

One new entrant in the field, The California Public Employees Retirement System (CalPERS), has made its first investment. CalPERS, advised by AEW Capital Management, and Sunrise Assisted Living (NYSE: SRZ) have formed a joint venture to own and operate a portfolio of seven assisted living facilities with 562 units in six states. The "value" of the transaction was approximately $115.5 million, or $205,500 per unit, a price that should make every assisted living facility owner or investor envious. Most of us continue to say these high prices will come to an end, but not quite yet.

The seller was a joint venture that was 9% owned by Sunrise, and all seven facilities were Sunrise prototypes. As part of its agreement with the majority owner of the original venture, SRZ participated in any upside in the value of the facilities that they built and managed. Consequently, SRZ decided to keep its equity interest, which will increase to 20% in the new joint venture, and the company will continue to manage the facilities on behalf of the new joint venture.

The value mentioned above is derived from the $81 million of first mortgage financing provided by Fannie Mae, the $29 million equity investment from CalPERS for its 80% ownership interest and the remainder from Sunrise’s retained 20% interest (the numbers do not exactly add up, but this has been a problem before). The proceeds from the new debt, which is a seven-year loan at 7.05% with a 25-year amortization, and CalPERS investment will pay off the original construction debt, an $18 million SRZ note receivable and a return on investment to the majority joint venture partner in the original deal.

Because these facilities were off-balance sheet for SRZ, there is no gain on sale to boost reported earnings. By keeping the management fee income and receiving $18 million from the note pay-off, the company has nothing to complain about. CalPERS, however, is paying top dollar in a bad market, but the attractive financing combined with top-notch properties may make it palatable.