The SeniorCare Investor: Reset Looms, Ventas Still Buys -

The Clock Is Ticking, But Ventas Is Not Distracted

The appraisals for the Kindred Healthcare (NYSE: KND) rent-reset with Ventas (NYSE: VTR) are due to both parties on October 7, which just happens to be a Saturday, so they may have to wait until Monday. But that is a holiday (for some), so will it be Tuesday? It probably won’t matter to those of us following the negotiations and gossip, because we assume both sides will want to study the results for each of the four Master Leases before disclosing what the results are and what they want to do. On the surface, both sides appear to be very confident that the valuations will go their way, but with a $111 million difference in opinion, the gulf is fairly wide, to say the least. But neither side is commenting publicly, other than their respective party lines.

Other than Kindred, there are few people who think the new lease rates will come in unchanged. But the range is still wide, from a low of a $20 million increase to a high of $75 million (excluding VTR’s $111 million belief). Apparently, there is even a betting pool with winner take all, but we were not told what the entrance fee was. If the new rent is at the high end, no one believes that Kindred would just accept it, as there would be challenges, both legal and otherwise, to the methodology and assumptions, and the possibility of tying things up in court for a year or more is something that neither side really wants, especially their shareholders.

We assume that if the result is lower than VTR’s most pessimistic assumptions, they would do the same thing, but those 3.5% annual rent escalators in place look awfully good. Without a major fight at the end, Ventas is the one that has the right to agree to the rent reset or not, having the ability to accept or reject the new rents for any or all of the four leases, and they will do what is best for their shareholders. And, Ventas has 30 days to decide what it wants to do.

Despite all the work being done by the appraisers, and regardless of the end result, the majority opinion is that something will still be negotiated when the dust settles and the new "market value" rents will be ignored. The reason why this has not occurred yet is because, obviously, they are so far apart and neither side presumably wanted to show its hand. But after the numbers come in this weekend, neither side will be able to hide behind its own analysis, and they will both then have a known basis around which they can negotiate, or at least talk, other than zero or $111 million. This should be enough to get both sides off the dime.

In the meantime, Ventas’ lawyers have been busy, winning a mini-victory in the Supreme Court of the State of New York, with the court once again ordering Kindred to produce sufficient information to determine inter-company pharmacy profits at the Ventas-owned facilities. According to Ventas, Kindred has stated that it just did not have the information requested, but the court apparently rejected that line of reasoning. We assume this is a bit of a shallow victory, since the information will arrive too late to be of any help to the appraisers. Perhaps it could be used in later negotiations, but we doubt it because we assume it will take Kindred some time to find the information it does not have.

The acquisition team at Ventas has not been sitting on its hands either during this rent reset process. Four months ago we reported that instead of going public as a Canadian REIT, Senior Care, Inc. was negotiating to sell the vast majority of its assets to Ventas where, presumably, it would get a better valuation than in the Canadian REIT public equity market. Senior Care is controlled by the Reichmann family of Canada and is headed up by Pat Mulloy as CEO and Tim Wesley as CFO, who worked together at LifeTrust America, as well as Gary Smith, who is the former CEO of Kentucky-based Elmcroft Assisted Living and will be the company’s COO.

Senior Care is really a group of acquired portfolios, combined with a group of facilities already controlled by the Reichmann family. When everything closes, and there have been a lot of moving pieces (which is one reason why it took so long to disclose), the company will own, lease or operate 74 facilities, including three rehab hospitals, 18 skilled nursing facilities, 46 assisted living facilities, two dementia facilities and five CCRCs.

The bulk of the assisted living facilities are the former Balanced Care properties that the Reichmanns took control of after the "time of troubles," and there are also the ALFs that were owned by Elmcroft Assisted Living. The skilled nursing and rehab hospitals come by way of Kentucky-based United Rehab, while the five CCRCs and two dementia facilities were recently purchased by Senior Care from San Diego-based Health Care Group (HCG) in a deal that closed at the end of August.

The Health Care Group transaction is interesting because five of its CCRCs (all but one have a SNF component) with 1,170 units/beds and the two dementia facilities with 112 units have been sold to Senior Care, which will then be sold to Ventas when that larger deal closes, and leased back to Senior Care. Ventas made a bridge loan to Senior Care in the amount of $156.8 million to buy the properties, but we don’t know the amount paid above that loan, and the loan will be repaid when the assets are then sold to Ventas later in the fourth quarter.

HCG, and not Senior Care, will operate these communities under a 10-year management agreement, with any cash flow above the lease payments to VTR and management fee paid to HCG to be retained by Senior Care. All of these seven facilities are in California, and six of the seven are in San Diego County, so it is a nice little cluster. HCG kept two communities, in Alabama and California, which were being reconfigured and may be sold to Senior Care or Ventas at a later date, and HCG will also have the right to develop a few properties. For them, it is really the best of all worlds: they have realized their gains, they have a partner with whom to move forward and they have ongoing management of their properties.

Getting back to the transaction with Ventas, the REIT will acquire 67 of Senior Care’s 74 properties for approximately $649 million, or just under $111,000 per unit/bed. These include the seven HCG properties, which probably drove the average price of the transaction up, 17 SNFs and two rehab hospitals that were part of United Rehab, the eight Elmcroft Assisted Living facilities and 33 other assisted living facilities under the Outlook Pointe umbrella (mostly the Balanced Care properties).
The annualized EBITDAR of this group is about $57.5 million, after a 3% management fee on the rehab hospitals and a 4% fee on the rest of the facilities. The initial lease rate is $50 million, or a relatively low 7.75%, but the annual escalators will have a floor of 3% and a cap of 5%, which are considered high in today’s market.

Ventas has estimated that over the 15-year base lease term, with an assumed average escalation of 4%, the unlevered lease yield will be 10.6%, which will provide some healthy accretion to the REIT.

When Ventas closes this transaction, revenues from Kindred Healthcare will represent just 46% of VTR’s total revenue run rate, a diversification goal that Ventas embarked upon a few years ago. Even though the 7.75% initial lease rate was the lowest we had seen, it is balanced out by the high annual escalators, and as long as Ventas maintains that positive spread between its cost of capital and income, the deal remains accretive. Now, the only question is, with more than $250 million of revenues and $15 million of expected EBITDA in 2007, when is Senior Care going to think about a public offering, if ever?