The SeniorCare Investor: Holiday: Beneath The Veil--
New Owner Dealing With Large Drop In Census
When he was just 22 years old, Bill Colson asked his father to go into the construction business with him, saying “These guys here aren’t any heck of a lot smarter than we are. I think we can do what I see being done by these other guys as well or better, let’s try that.” And he wasn’t even talking about retirement housing. The rest, as they say, is history, as the two of them went on to create what eventually became the largest retirement housing company in the world, with help from plenty of other people, including investors, lenders, colleagues and those resident managers who believed in what Bill Colson was doing.
Shortly before his death in 2007, he sold the company that he loved, Holiday Retirement Corporation, for a record price in the seniors housing industry (somewhere between $6.6 billion and $6.8 billion, but we have used the lower number) and for a record multiple (to the best of our knowledge, close to 17x in-place cash flow, but that was never publicly disclosed). The market was hitting its peak in late 2006 and early 2007, and the timing could not have been better with investors flush with cash and lenders beating themselves up to get the next deal. But Holiday was a somewhat unique creature, especially given its huge size. The sale included approximately 300 retirement communities with more than 35,000 units in the U.S. and Canada (European operations were not included), plus a development pipeline that had been averaging 10 to 12 new openings per year. Despite the large size, it still felt like a family company, largely because of the always-present figure of Bill Colson, who very quietly gained a reputation as someone who would help anyone in need. And there definitely was a “Holiday” culture, and while it may have been difficult to define, it was strong. Unfortunately, with new ownership it is often impossible to maintain that type of culture, and sometimes new owners think they can do as well or better than “these other guys.” It doesn’t always work out that way.
Timing is everything, and when an affiliate of Fortress Investment Group (NYSE: FIG) purchased Holiday in early 2007, they most likely never knew what was going to hit them. Within 18 months, the capital markets froze, the housing market plunged and the economy went into its worse decline in a generation or two. FIG obtained two mortgage loans from Goldman Sachs (NYSE: GS) totaling about $4.3 billion with five-year and seven-year terms, and used cash from their funds for the remainder of the purchase. Apparently, within a few months Goldman sold the loans to Fannie Mae, perhaps after an in-house meeting about the future of the mortgage market (couldn’t resist). What could go wrong? You had the largest retirement housing company spread across the country with occupancy above 90% and a built-in development pipeline. As it turns out, a lot.
When the sale of Holiday closed, the average occupancy rate at communities open for at least 18 months was about 92% (overall occupancy was 89% because of yet-to-be stabilized properties), and nearly 50 of the communities were at 100% occupancy—tops for the industry. The stabilized occupancy level was a little higher than the industry as a whole. A year later, we have learned, occupancy had dropped by 200 to 300 basis points, which was before the real problems in the housing market had surfaced and was a larger decline than the rest of the industry had experienced in the same time period. Eighteen months later, in early October 2009, however, census had plunged to about 80%, with fewer than 10 communities at 100% occupancy. Just six months later, according to our information, it had dropped still further, dipping well below 80% for the portfolio (but almost 200 basis points higher when the newer properties are removed). These declines are much more severe than anything the rest of the industry has suffered. According to the NIC MAP data, in the top 100 MSAs, freestanding independent living communities had an average occupancy rate of 91.0% in the first quarter of 2007, very close to the Holiday census at the time of the sale. The industry as a whole (in these 100 MSAs) declined by 615 basis points to 84.8% by the first quarter of 2010, but that is a lot higher than the Holiday occupancy levels. And from the fourth quarter of 2009 to the first quarter of 2010, the IL sector’s occupancy dropped by just 20 basis points, much less than the decline at Holiday. If we assume that most of the Holiday census numbers are included in the NIC MAP data, then the industry as a whole excluding Holiday has actually performed better than these numbers, with Holiday’s size bringing the total industry average down further than it has actually fallen. Because NIC’s data is confidential, it is impossible to determine what the industry looks like without the Holiday census results, but it has to be better.
Two months ago, after hearing about census problems from various sources, we reported that senior management at Holiday declined to confirm what current occupancy levels were, only that 2009 revenues were flat with 2008, and that there was a dramatic increase in move-ins in the first two months of 2010. If our occupancy numbers are accurate (and we believe they are), there must have been a lot of move-outs as well. But how could revenues be flat with such a dramatic decline in occupancy?
While there is no easy answer, the one that makes sense is that monthly rental rates have been increasing by amounts unheard of prior to 2007. Holiday was known as the “Wal-Mart” of the industry, or as the Chevy. It built quality retirement communities with few bells and whistles for the middle income elderly who used much of their Social Security income to make their monthly rent payments. We were always told that rent increases were benignly tied to Social Security increases. Holiday, through its Colson & Colson construction company, not to mention its lumber mills, prefabricated frames and trusses, and everything else to keep the construction costs down, knew how to watch costs. Food costs were most likely the lowest in the industry because of the way they bought food and were able to squeeze vendors (size matters), so rents and rent increases did not have to be as high as some competitors, and the residents were happy and well fed, and the communities were basically full.
Another unique aspect of the Holiday retirement community were the live-in managers, one couple as the “senior manager,” and another, less experienced couple in a smaller apartment unit, as the assistant manager (in training). Most executives in the industry would not dream of running their communities this way, but even though it was very difficult with high turnover, Bill Colson could not imagine doing it any other way. An emergency in the middle of the night? You get the manager on the phone who lives a few units away and not some recently hired night aide who has no idea who you are and may or may not speak much English. Despite the inherent difficulties of the two-couple live-in managers concept, it worked for Holiday, partly because of the Holiday culture. It doesn’t work for everyone, however.
Getting back to the flat revenues amid declining occupancy, there is only one way for that to happen, and that is by raising rents, on both new residents and on renewals, by amounts that had not been done before at the company. At the time of the sale three years ago, we understand that average rents were in the $1,850 to $1,950 range (some people believe they were a little lower), with the average kept slightly lower because of the Holiday practice of keeping in long-time residents who might be a few hundred dollars short of the market rent. As Bill Colson liked to say, 20% of his residents were below the poverty line (with family members often helping with the rent), 20% were very wealthy but didn’t want to pay for the bells and whistles, and the 60% core were the ones who had always been there. With the new owners and their debt structure (which was almost twice the debt that Holiday had on its books), and their return expectations, there was obvious pressure to increase cash flow. Raising rents was one way, but cutting costs was another, and both may have impacted the occupancy decline above and beyond the economic and housing crisis.
No one ever accused Holiday of having a bloated home office structure—they were never accused of having a bloated anything, and proud of it—but we have heard that the headquarters staff has been reduced significantly by both voluntary and involuntary attrition, and apparently there is an atmosphere of not knowing if they will still have their job when they return to work in the morning. This can’t be helpful in trying to turn around a large ship in unsettled waters. Holiday had organized its community operations on a regional basis, with the community managers reporting to one of 22 regional managers who reported to four division heads. Prior to the sale to Fortress, Holiday tried to promote from within, with the better community managers sometimes becoming regional managers. They would have a much better understanding of how hard it was to be a live-in manager, the sometimes 14 to 21 days in a row with no time off, especially if the assistant manager quit or was fired. We have heard that most (if not all) of the 22 regional managers in place at the time of the acquisition are now gone, and we are not sure if they have been replaced.
In addition, we understand that Fortress has been tinkering with the live-in manager model, which is actually somewhat logical since no other major company operates this way. Turnover of these resident managers has always been high (up to 40% annually prior to the sale, usually from burn out), and while turnover may be higher under the new regime, it has always been an issue. Turnover for live-out executive directors for the rest of the industry is not exactly low either. One change has been to have just one resident manager reporting to a general manager who does not live there. This may work, but we are not sure if there has been any commitment to one model or another yet. One thing is certain, they don’t want to hire any more “blue light specials” from K-Mart. In addition, the former resident managers appeared to have more autonomy under the old regime, and we hear things are much more centralized. This may be a better way to manage a large enterprise, but it is also a change, and change can be difficult.
So costs have been cut and rents have been raised. We have heard that the average now may be inching closer to $2,300 to $2,400 per month, which admittedly seems high, with many new residents at much higher rates. And remember that the typical Holiday community is made up of 40% studios, 50% one-bedrooms and perhaps 10% two-bedrooms, so we are not talking about properties with a lot of spacious units. The old Holiday knew its target market well and didn’t try to be anything else; the new Holiday appears to be trying to compete at a different price point, but that changes the targeted customer, and it is a customer who has more options. Consequently, we believe that the occupancy problems in the past 18 months have been caused partly by the general economic problems, but have been compounded by declining morale, higher turnover and rents that are becoming too high for the typical “Holiday” market. So, what happens next?
The good news is that despite the drop in census, we believe cash flow is still relatively strong, helped by the cost cuts as well as the low interest rate on the mortgage debt. We learned that last month Fannie Mae extended the term on the five-year debt to match the other tranche with a 2014 maturity, and also cross-collateralized the two portfolios. We don’t know if the interest rate increased, but it should have. This is important because it gives Fortress four years to increase the value of the portfolio, instead of two, because right now, the Holiday portfolio, at best, is worth about the total debt outstanding, which means that Fortress’ $2 billion-plus equity investment has little, if any value. Actually, it is the outside investors in the funds who made the investment, and we have heard that CalSTRS was a major investor. Fortunately, they are not trying to sell the company (that we know of). It also means that no one would be able to refinance the portfolio today given the 75% loan-to-value parameters in today’s debt markets, if not 70%. As long as there is some excess cash being thrown off, and according to our calculations we believe there is, no worries, right?
When Bill Colson ran the company, we believe that the prototype for new developments was to have a 50% EBITDAM margin at the community level at stabilization (45% EBITDA at the corporate level). Depending on what your assumptions are for average rents at the time of the sale in 2007, the best case scenario was an in-place EBITDA of about $380 million to $400 million, which is where the 5.75% cap rate comes from. Fortress was probably looking at it from the perspective of the 12 to 15 new developments each year that it expected to grow by, which after year five would have produced an additional $75 million of potential stabilized EBITDA, worth an additional $1.0 billion or so with some cap rate assumptions at the time. But that didn’t pan out, because as the housing market and economy deteriorated, they decided to stop taking the option on new buildings, so growth came to a virtual halt by early 2009, or less than two years into the acquisition.
At today’s occupancy levels, and assuming an average rent of $2,500 per month (which we assume is high, so it is just for illustrative purposes to give a best case), we derive an estimated EBITDA of about $350 million based on a 45% margin after a management fee. This excludes, however, a capex assumption, which should be between $500 and $750 per unit, at least. In theory, that margin should have declined with the drop in census, but with cost cuts and higher rents, they may have been able to maintain it. If not, the numbers would just be worse, and anyone can plug in their own numbers with similar results. If you think the Holiday portfolio would sell at an 8% cap rate on in-place cash flow today, the value would be about $4.37 billion, or close to the existing debt, given our assumptions. Because independent living is not in high demand in today’s acquisition market, especially for an underperforming large portfolio where the majority of the properties were built more than 10 years ago, most people believe the cap rate would be higher, reducing the current value below the existing debt. And, if average rents are actually below the $2,500 we used in our example above (and we believe they are), the valuation woes will be even worse. In addition, we have heard that in several markets Holiday is using the same discounts and free rents to attract new residents that most everyone else is using, and we did not adjust for that.
By our calculations, the Holiday portfolio would have to reach 90% occupancy with even higher rents to begin to approach the original purchase price, assuming an 8% cap rate. If the new management can stabilize operations, and staffing, and then increase the census by 50 basis points each quarter through 2014 and increase average rents by 3% each year, by the time the Fannie Mae debt matures, the debt would be about 75% of the higher value (we started at the higher $2,500 average rent per month to get there, which we admit is aggressive). Even though the Fortress funds would still be in a losing position relative to the original purchase, if they dividend out the excess cash flow it might not be so bad. However, while in theory it should be easier for a company that had been at 90%-plus occupancy to start to regain census momentum at the 50 basis points per quarter we used in our assumptions, that would be considered a tall order for anyone, especially with the housing market still years from a full recovery. And that is important because we believe that at the time of the sale three years ago, close to 75% of Holiday’s customers sold their homes before moving. With low prices, a smaller number of potential residents will sell their homes, and a smaller number will move in. There has already been strong pressure on the management at the community level to increase census, and additional pressure may result in more turnover, something that the company really can’t afford.
All of the assumptions we have made have been favorable to Holiday regarding current rents and the ability to increase rents and occupancy. This was done on purpose to present sort of a best-case scenario to see what could happen. Now, what happens to interest rates between now and 2014 will be important, and there is a bit of a Catch-22. If the economy surges ahead, which will help the housing market, then interest rates will rise, making the refinancing more difficult, or at least more expensive. If the economy continues to stagnate, or it double-dips, then the housing market will take even longer to recover and the Holiday customers who postponed their move will then be moving into assisted living facilities by the time the debt matures. Interest rates are currently near historic lows, and not many people are predicting they will decline. If in 2014 Fortress can refinance the debt with a 30-year 6.5% fixed rate, Holiday would have an estimated 1.3x coverage based on our simple assumptions and calculations above. As rates go up, the coverage goes down, and we would assume the value would decline as well, as the higher interest rates filter into cap rates.
There has been some criticism that the new senior management has come from the multifamily and hospitality areas of real estate, and that they don’t understand seniors housing. We are unable to express an opinion on that, and while “thinking outside the box” may help, it doesn’t appear to have helped yet. Perhaps they haven’t had enough time to really solve the problem at hand. With the Fannie Mae extension, Fortress has bought some time, but it is hard to imagine recovering that much lost census in just four years over a portfolio of more than 300 hundred properties. However, we don’t believe this is reflective of the rest of the industry, because even with a 400 or 500 basis point drop in occupancy over three years, with rate increases and cost controls, other acquisitions from three years ago would have fared better. And remember, not many came with a sub-6% cap rate, which is a problem that can’t be overcome even in the best of circumstances. In addition, an acquisition completed at a certain cap rate can basically maintain its value over a five-year period even if cap rates increase by 200 to 250 basis points, as long as cash flow can be increased by 5% each year. So Holiday can make a comeback, as difficult as that may be. But then Fortress will have to worry about those non-competes which start expiring at the end of the year…