The SeniorCare Investor: Five Star: Strategic Buying

After A Dry Stretch, Five Star Quality Care Finds Deals

Everyone enjoyed the bull market in seniors housing and care we have experienced for the past four years except, perhaps, those who sold four years ago before the market really took off. For those early birds, we can only hope they reinvested their proceeds wisely. As we have repeatedly stated, the recent bull market was fueled by abundant capital that grew cheaper by the year, an industry reinvigorated after the 2000 to 2002 debacle, and private equity and other financial buyers who saw higher "real estate" returns than they could achieve in any other real estate market.

From the end of 2005 through mid-summer of last year, financial buyers really dictated what the "market" was for seniors housing real estate. Operators, or what are referred to as "strategic buyers," were often closed out of the acquisition market unless they were bidding as the operating partner of one of the financial buyers. This sometimes caused a few awkward moments, as some operators teamed up with more than one financial buyer and found themselves competing against one another at times, much to the seller’s delight.

All of this changed after last summer’s market meltdown, when financial buyers, other than REITs, mostly disappeared from the market. The void left by their sudden departure meant that no one really knew how to price an acquisition and what their cost of capital might be. Most of the acquisitions that closed in the fourth quarter last year had already been agreed to before the capital markets changed, and this is still true with many deals so far in 2008. Almost everyone has agreed that cap rates have theoretically increased, but there has been little agreement as to how much. The most common number put forth has been a 50 basis point increase, but an increase from what? From the 6.5% cap rate paid by a financial buyer for a large portfolio? Or the 7.5% to 8% cap rate paid by a strategic buyer? Who knows, but we do know that 2008 will be marked by the return of the strategic buyer, and this should be healthy for the industry, although not quite as good for the wallets of the sellers.

The return of the strategic buyer may be best exemplified by Five Star Quality Care (AMEX: FVE), a company that had been largely blocked out of the acquisition market despite a decent cash horde waiting to be invested. In fact, during the past 18 months, the company was able to close on only one facility acquisition, having been frustrated in many bids where at best they came in second. That frustration, however, has turned to exuberance, as the company expects to close on more than 25 property acquisitions in 2008, and may come close to that total by the end of March or April.

In the first transaction that closed in early January, Five Star has acquired, through Senior Housing Properties Trust (NYSE: SNH), which will own the real estate and lease the facilities to FVE, a portfolio of five facilities in Wisconsin that include a mix of assisted and independent living units as well as a skilled nursing facility on one of the campuses. There are 430 "assisted living" units (under the two different licenses used in Wisconsin), 65 independent living units and 74 skilled nursing beds for a total of 569 units/beds. The one campus with skilled beds has about 40% of the total units and beds in the portfolio. All of the properties have been built since 2000 with the exception of one campus that incorporates an historic building into the new building. We understand that the purchase price paid was between $67 million and $68 million, or close to $118,000 per unit/bed.

Overall occupancy in 2006 was about 90%, and was expected to increase to 93% in 2007 as some newly constructed units were stabilized. Most of the existing properties experience occupancy between 93% and 98%. Based on actual performance for part of the year combined with pro forma numbers, revenues and EBITDA in 2007 were expected to be about $22 million and $6 million, respectively. This compares with $20.1 million and $4.9 million in 2006 as some of the new units were just beginning to fill up. The cap rate and revenue multiple on 2007 estimates are close to 9% and 3.1x, respectively, and the cap rate heads above 10% when using 2008 forecasts. This looks to be a solid acquisition at a reasonable price given the age and condition of the properties, the relatively high occupancy, the geographic concentration within the state and the growing cash flow.

According to management, it is questionable whether they would have been the winning bidder a year ago. They believe cap rates have increased by 100 basis points since last summer, and this has made them much more competitive in the market. Bidding without any financing contingencies didn’t hurt either. Dave Rothschild and Mary Christian of CB Richard Ellis represented the seller in this transaction.

Five Star is not done, however. The company has four transactions with six properties that are expected to close between the end of this month and the end of March. One of those transactions involves a large assisted living and Alzheimer’s facility with about 220 units. The campus is made up of one large, five-story assisted living building that is connected to several other buildings with Alzheimer’s units by underground walkways. Management is very excited about the prospects for this campus. In addition, Five Star expects to close on the purchase of a 13-facility portfolio which includes eight mostly Alzheimer’s facilities in Maryland and five others in California. All of the properties in these transactions are expected to be purchased by Senior Housing Properties Trust and leased back to Five Star.

So, after a dismal acquisition market that saw one deal in 18 months, Five Star, which has annualized revenues in excess of $1 billion, will have its busiest year ever. That is probably providing some satisfaction for Evrett Benton, the company’s CEO who just announced his resignation after responding to a call from the Mormon Church to lead a mission in an undisclosed region. He will, however, be around for the next three months to ensure a smooth transition, and the board has tapped Bruce Mackey, who has served as the company’s Treasurer and CFO since the company went public in 2001, to succeed Mr. Benton as CEO effective May 1. According to a Stifel Nicolaus report, Bruce Mackey is knowledgeable and solid on finance and operations, but "will have his work cut out replacing Benton’s motivational, marketing and deal making skills." The securities firm has maintained its Buy recommendation based on valuation and growth prospects.