The SeniorCare Investor: CNL Retirement Is Sold

With prices at record highs and cap rates at record lows in the seniors housing market, it has been said that almost everything could be available for sale in an environment not really seen before, and one that we may not ever see again (although this bull market still has plenty of steam).  There is a certain amount of sentiment in the market that cap rates have further to go on their downward trend, and when this is combined with rumblings that the cost of new construction just does not “pencil out” in several markets because of soaring land and construction costs, we have a situation where existing properties will just continue to increase in value.  That just may have been on the minds of the limited number of prospective buyers who were given the opportunity to take a look at the CNL Retirement Properties (CNL) portfolio over the past 45 to 60 days in what was a well-kept secret in the market, at least until the last two weeks of March.

CNL was organized as a REIT in December 1997, but was relatively quiet in the market until 2003.  At the end of 2001, its real estate investment properties totaled just $35.2 million, but jumped to $1.5 billion by the end of 2003 and $3.5 billion by the end of last year.  In 2003, just four transactions accounted for more than $700 million of investments, and its largest acquisition to date, the $562 million Horizon Bay Senior Communities portfolio, came in early 2004.  As of the end of last year, CNL owned 184 senior housing facilities with 21,857 units with an investment of just under $2.9 billion and 73 medical office buildings with an investment of $665 million.  In addition, there are more than 260 million shares outstanding with 91,280 shareholders who paid $10 per share, usually in increments of $10,000.

As CNL’s buying spree took off in 2003, there were many people in the market chuckling over the prices that were being paid.  Cap rates of 10.2%, 8.4%, 7.8% and 5.4% on annualized operating income for four large deals in 2003 just did not seem to make sense at the time, with CNL’s pricing dependant on occupancy increasing in order for cash flow to catch up with the stated lease rates in some of the deals.  In some cases sellers were required to post deposits or guarantees to fund the differential between cash flow and lease rates, leaving the market to shake its collective head at the high level of risk of the deals.  Well, shake no more.

According to its corporate structure, CNL had to either go public or dispose of its assets and remit the proceeds to shareholders by the end of 2008.  After the disaster of one of its sister REITs under the CNL umbrella a year or two ago in an attempt to go public, the board obviously decided a sale of the entire company would make more sense, especially in this extremely bullish seniors housing market environment.  We also heard there may have been a little difference of opinion between the outside board and the REIT’s “external” advisor, CNL Retirement Corp., a relationship that is somewhat of a relic in the health care REIT market (more on this later).

So we estimate that sometime in early March between seven and 10 prospective buyers were approached, which probably included Ventas (NYSE: VTR), The Blackstone Group, Fortress Investment Group/Brookdale Senior Living (NYSE: BKD) and Health Care Property Investors (NYSE: HCP), among others.  By the last week of March, we had heard in the rumor mill that HCP was the winning bidder, paying between $15.00 and $16.00 per share and assuming just over $1.5 billion of debt for a grand total of $5.4 billion (just above the actual price).  This is the largest health care REIT transaction ever done and the single largest senior care-oriented acquisition ever to be contemplated.  Although we do not cover the general REIT market, this would certainly qualify as one of the largest acquisitions in the overall REIT industry as well.

Just as we were finishing up this story, HCP made the formal announcement that it was paying approximately $13.50 per share for CNL, with 82% in cash and 18% in stock, and assuming (or refinancing) about $1.6 billion of CNL’s debt for a total price of $5.2 billion.  On top of this, it is paying approximately $120 million for the “external” advisor, CNL Retirement Corp.  Although the press release states that the advisor was sold as a result of a separate process, each transaction is conditioned on the consummation of the other and you would be hard pressed to convince us that the advisor was worth anywhere near that amount.  When asked on the conference call by an equity analyst as to how HCP valued the advisor, the response was weak, at best, noting the high quality people at the advisor, the non-compete and the pipeline as somewhat of a weak rationale for the high cost.  As far as we are concerned, it is just part of the price for CNL and that may be where the higher per share value came into play in the March rumor mill.  The other little contradiction is that if the valuation for the REIT was based, in part, on removing the G&A expense of the advisor from the equation, the implied “value” of the advisor is already calculated in the pricing of the deal, so is the $120 million price for the advisor double counting?  But what do we know?  HCP was represented by Cohen & Steers Capital Advisors and UBS Investment Bank, while CNL (the REIT) was represented by Banc of America Securities.

CNL has used a strategy of leasing many of its properties to thinly capitalized companies who in turn hire operating companies to manage the facilities.  As an example, about 22% of CNL’s revenues are derived from affiliates or subsidiaries of Harbor Retirement Associates (HRA), but HRA does not manage most of them.  When asked on the conference call what they knew about HRA, HCP management basically punted, responding that they didn’t have any information about them available.  Really, the company (and its affiliates) from which 22% of CNL’s revenues are derived?  Our guess is that the timing was just not right to open that Pandora’s Box.

From a management perspective, Sunrise Senior Living (NYSE: SRZ) is the largest operator in this group, with 107 facilities on the books at $1.5 billion and contributing just over $152 million in rental income, but SRZ is not the entity making most of those lease payments.  In fact, Sunrise’s total lease payments to all landlords in 2005 were just $48 million.  It was surprising that the analysts did not  pick up on this not too insignificant detail, focusing instead on the operators and not the actual tenants/lessees.  Sunrise is followed by Horizon Bay Management with 27 facilities managed on the books for $768.8 million and annual rent of $82.9 million (guess who the lessee is on many of these), and Encore Senior Living, American Retirement Corp. (NYSE: ACR) and Erickson Retirement Communities.  The facilities managed by these five companies combined accounted for about $288 million of CNL’s rental stream last year.  As of the end of last year, seniors housing assets accounted for almost $303 million of annualized rent and medical office buildings about $66.7 million.

Most of what we heard in the market before the announcement regarding pricing multiples had been rumors, with some people saying the price represented a cap rate of just over 6% using the rental income as the proxy for cash flow to the buyer.  Based on publicly available information, on a simple math basis, dividing the annualized rental income by the proposed purchase price yields a cap rate of 7.0%.  Another way of looking at the deal is to remove the MOBs, assuming a value of $200 per square foot or almost $750 million, and you get a price of about $210,000 per unit for the seniors housing assets (HCP came up with $180,000 per unit, which may be based on more units than were disclosed at the end of 2005).  HCP management indicated that the cap rate at the property level for the entire CNL portfolio was 6.8% on 2007 net operating income after a management fee.  There are many ways to look at it, but however you choose to do so, it is an expensive deal for the buyer, especially since we hear that some of the portfolios that were not stabilized when CNL purchased them are still struggling to reach optimal occupancy and pricing.  Apparently, just 50% of CNL’s seniors housing assets are operating at a 1.0x or better coverage ratio after management fee, despite a portfolio that has an overall occupancy rate of 90%.

So what does HCP see that the rest of us are not seeing in our crystal balls?  With a market cap of about $3.6 billion, the REIT just edges out Ventas as the largest health care REIT, but this acquisition will put HCP in a class of its own in terms of assets, depending on how the deal is ultimately structured.  But HCP intends to off-load up to $3.0 billion of assets, most of which will come from joint ventures as well as some sales of existing HCP properties.  But more importantly, given the price and the income stream, it seems that HCP is making a bet that cap rates will continue to decline and property values will keep on rising with limited risk to the acquired portfolio from new construction.

In addition, it may try to restructure some of the leases so that the actual operators have more of an incentive to increase cash flow than simply collecting their management fees.  This is all conjecture, of course, because there will be a lot of moving parts over the next 12 months.  One thing is clear, and that is, HCP views the CNL assets as a move to the future with younger assets, compared with some of its older hospitals and its original skilled nursing portfolio with an average age of at least 30 years.

This is a monumental deal that will go down as the most significant transaction of the decade for seniors housing, if not the past four decades.  In three years, management at HCP may be viewed as geniuses with their market timing, or we may all be laughing (and crying) at the foolishness of such a rich deal at the “peak” of a market cycle.  In our February 2004 issue, which had a lengthy description of CNL’s activities, we stated, “three years from now we may be looking at some of CNL’s deals and talking about what a deal they were.”  And this was when everyone was snickering about CNL’s aggressive acquisition pricing.  In the same issue, we also stated “there very well could be a fundamental downward shift in cap rates, for both independent living communities and higher-end assisted living facilities, but with the impact being felt first with the former property type.  Single digit cap rates will become more common, as opposed to currently being the exception to the rule, and asset ‘values’ will rise.”  The market moved faster—and to more aggressive levels—than we ever imagined.

As for now, who knows who will have the last laugh, but those 91,000 CNL shareholders are laughing all the way to the bank with a 35% premium that few thought would ever materialize.  Everyone wants HCP to succeed with the acquisition, because if it stumbles, it will certainly be a problem for the industry.