The SeniorCare Investor: Capital Senior Living Expands--

Buying Signature Senior Living’s Leases With No Cash

 What is it about two old friends and previous partners from  Wichita, Kansas, who just keep on doing it over and over again?  In one corner you have Tim Buchanan and his Legend Senior Living company, cherry-picking new development sites and setting at least one record on filling up an assisted living facility in Oklahoma in a matter of weeks.  His company-wide occupancy, at last count, was 98% and certainly the envy of his larger competitors.  And then you have Steven Vick and his Signature Senior Living, also cherry-picking new development sites, but all in Texas and all, we believe, within three hours of his company’s office.  

 The average occupancy for his 12 assisted living and memory care facilities is 91%, and this includes two properties opened in the last 90 days. Did we mention that we are still in a major recession and that industry occupancy rates have yet to rise in any meaningful way?  Or that several of these properties have had to fill up during this recession?  Mr. Vick obviously knows how to pick his markets, and obviously knows how to run assisted living communities.  As it turns out, this will now all be to the benefit of Capital Senior Living (NYSE: CSU), which announced an agreement to effectively buy the Signature portfolio.

 All 12 properties are leased from Health Care REIT (NYSE: HCN), and include 532 assisted living units and 145 memory care units for a total of 677 units.  There is a 45-day due diligence period to allow CSU to “kick the tires,” but with an average age of three years for the portfolio, it would appear that the treads have hardly been worn, so the kicking won’t take long.  Signature built 11 of the 12, and the one they didn’t build, they did an addition, and from what we hear, the properties are in tip-top shape.  Consequently, we don’t expect any stumbling blocks from due diligence.

 Since these are all leased from HCN, Capital Senior Living is essentially buying the leased operations, but we don’t know what sort of purchase option may be involved for the real property 15 years down the road.  Signature’s current lease rate is $7.9 million annually, but that will increase to $8.9 million for CSU.  Why?  Because the REIT is financing the $25 million purchase price and adding that amount to the lease (sort of).  An extra million dollars per year in lease payments for a $25 million investment looks pretty good, but you have to understand the nature of Health Care REIT’s construction leases to understand what may be going on (and you would if you had listened to our audio conference last January when Chuck Herman spelled it out). 

 For new construction, unlike other REITs, Health Care REIT does what it calls a construction lease.  This means that the construction draw-downs start as a lease as opposed to secured debt financing that would turn into a sale-leaseback upon certificate of occupancy.  We have to believe that these construction leases come with a higher lease payment rate than a standard lease for a stabilized portfolio because of the higher risk and uncertainty, so now that they are stabilized, a new tenant should, in theory, have a lower lease rate.  In addition, being a much larger company, Capital Senior Living should also command a pricing discount to the much smaller Signature, and CSU and HCN established a new relationship earlier this year. 

 Third, we are sure that Health Care REIT wanted to keep these high-performing assets in its portfolio, so there must have been an additional degree of pricing flexibility.  If the $7.9 million pre-sale lease payment was 10% to 15% higher than what it would have been for a stabilized portfolio, then the new $8.9 million lease payment is really a $1.8 to $2.0 million increase over a “market” lease rate, which would theoretically be a 7.5% to 8.0% yield on the fully funded $25 million acquisition cost.  Capital Senior Living’s initial lease rate with HCN on another portfolio from earlier this year was 8.25%, and the new lease rate on the 12 properties plus the acquisition cost is 8.50%, according to a report from Rob Mains of Morgan Keegan.  And we’re not at the good part yet.

 The only financial data we have is the month of May annualized, which produces annualized EBITDARM of $13.8 million, which we have to assume is representative of the portfolio’s performance and is not simply a great month.  With the corresponding revenues of $30.3 million, that translates into a 45% operating margin before a management fee.  That’s what the industry was promising 10 to 15 years ago and not many providers are turning in that kind of financial performance today.  The incremental management expense for the buyer is about $300,000 annually, compared with the $1.8 million, or 6% of revenues, that a typical buyer would use when analyzing this as an acquisition. 

 Consequently, Capital Senior Living is looking at a $5.6 million incremental EBITDA before capex (and after Signature’s $7.9 million lease payment), which implies a 4.46x purchase multiple.  Using a market rate management fee, the multiple rises to 6.1x, which is at the high end of the market.  From a general valuation perspective, after an implied 6% management fee, the annualized EBITDAR is $12.0 million, and using a cap rate of 9.5% produces a value of $126.3 million, or about $186,500 per unit.  Obviously, if you think the cap rate should be lower because of the higher quality and a portfolio premium, the value goes up. 

 But that’s all right, because what Capital Senior Living has done, assuming this transaction goes through, is purchase the operations of a high-performing portfolio of new properties concentrated in one state where it already operates 17 other communities, and which also happens to be the state where its headquarters is located. 

 According to how CSU analyzes it, they are also getting $2.3 million of additional adjusted cash flow annually (after an assumed tax rate), or about $0.09 per share, with no cash investment for the acquisition.  And Mr. Vick and his partner, Linda Martin, are being taken out for $25 million in cash, not to mention that Health Care REIT gets to expand its relationship with a New York Stock Exchange company and keep a top portfolio on its books.  This seems to work for all sides, so we expect it go through later in the third quarter.

 This portfolio is a higher acuity model than the majority of Capital Senior Living’s existing assets, and there is always the risk that they will not be able to manage it as well or as efficiently as the Vick team.  But given the location and that there don’t appear to be any problem assets, we think the risk is somewhat low.  The risk is also partly offset by the upside potential to increase the occupancy of the buildings that are below 90%, especially the new ones that are in lease-up, and maybe achieve a portfolio-wide occupancy of 92% to 93%.  Although we expected some sort of a jump in Capital Senior Living’s share price as a result of the transaction and the accretive earnings, it was muted by the down market in June.  Still, CSU was the only assisted/independent living stock to not decline in June, which was an accomplishment given the performance of the other companies. As for Mr. Vick and his team, they have a five-year non-compete within 10 miles of any Signature building and within five miles from any existing Capital Senior Living property, but that leaves a large part of Texas available if he wants to start over again (or in another state).  He also has a software company with a product used by senior living companies called Right Click that he will focus on, at least in the near term.  So we assume we will continue to see Mr. Vick walking the corridors of the industry conferences, perhaps chatting with Larry Cohen, CSU’s CEO, who we hope will have a smile on his face.