The SeniorCare Investor: Senior Care M&A Still Asleep

Demand Will Return, But It Will Not Be The Same

Day in and day out for the past several months (too many months for our liking), all we have heard is that the merger and acquisition market is quiet, too quiet. The real pessimists say it is dead, but our guess is that those who are saying that are not being creative, and perhaps what it really means is that the "easy" deals are gone. Or is it the easy days? Companies still want to grow, investors still want to invest, and in a sign that the real estate market really is not dead, Morgan Stanley just raised $2.5 billion of equity for a new global property fund that will invest part of its assets in…the U.S. mortgage debt market. Imagine that, finding opportunity in the most maligned, all over the world, investment market in the U.S. While it is unlikely that this new fund will be investing in the seniors housing and care market, partly because that is not where the bargains are today (more on that later), just the fact that there is $2.5 billion of fresh equity capital for real estate investments (and this is just one fund) is indicative of what we will refer to as the hidden pool of capital, and a pool that is growing, that will need to find an outlet during the rest of 2008 and into 2009. The senior care market will get its share, but it may have to wait.

One of the aspects of the current market that is a little baffling, however, is the absence of foreign buyers in the seniors housing market right now. The last major publicly announced deal completed by a non-U.S. investor was last fall’s purchase of Principal Senior Living Group’s portfolio by Australian-based FKP Property Group (ASX: FKP). Since that time, the U.S. dollar has weakened against practically every other currency (other than during the past five weeks), making investments in this country look even cheaper from the perspective of the foreign buyer’s currency. Most likely, these foreign buyers have been spooked by the residential housing meltdown, the subprime mortgage meltdown, the looming economic meltdown (even though technically we have still not entered into a recession), and that is just plain too many meltdowns for most investors to stomach, especially those several thousand miles away who may not have invested in the U.S. seniors housing market in the past.

While it may be surprising that more foreign buyers are not jumping into the seniors housing market right now, there is no surprise that private equity firms have taken a breather. Their absence is a combination of a lack of debt capital at a reasonable cost to finance a large transaction, and the simple fact that there have been no large transactions to finance. Large today is defined as over $100 million, whereas a year ago it would have included deals in excess of $250 million, if not $500 million. And don’t forget, most of these private equity buyers are only looking at the higher-quality end of the market, and these portfolios have been in short supply for almost a year. From the middle of 2005 until the summer of 2007, there was an unprecedented number of high- quality properties and portfolios that came to market, and we suspect that for some of them, it was a once-in-a-lifetime opportunity to cash in on the strongest bull market this industry has ever seen, far surpassing the 1990s market, and we know how that party ended. That, however, is the problem.

For the few years prior to last summer, we were living in a fantasy land, much like the subprime home-buyer who put less than 5% down, saw the value of his home go up by 20% and then took out a home equity line-of-credit to add a patio and buy a few flat screen TVs without thinking about what the monthly payment would be two years later. The value would keep going up, right? Just like cap rates would keep going down, right? Well, most everything in this world today goes through a cycle or two, and very few things continue in the same direction forever. While few people predicted the subprime mortgage meltdown and its severe consequences, there were also few people who really believed that the seniors housing acquisition market could continue on its recent path of the last several years without a jolt of reality. No one knew what that jolt would be, but the most popular bet at the time was that a major industry bankruptcy would be the catalyst for the market to take a breather. That didn’t happen, and that is fortunate for the industry as a whole.

The fact of the matter, however, is that there is a dearth of "A" quality properties and portfolios coming onto the market (but you knew that). There are a few here and there, to be sure, but nowhere near the volume that occurred in 2005 and 2006. The glib reason is that most of them already have been sold, but that would be too harsh a response for those private companies, with great assets, that just didn’t have a reason to sell a few years ago. Let’s just say that if someone had an itch to sell during the best market in 100 years, they would have sold. The funny thing is that we have yet to hear of anyone crying over spilled milk (meaning, upset that they did not pull the trigger to sell).

So we have gone from a miserable period that started this decade, to an incredibly robust market, to a very quiet market, but at least a market where the players are not in financial distress like at the turn of the millennium. Investors who purchased in the last downturn and sold in the rising bull market made out very well. CLW Health Care Services Group recently sent out a little analysis on seven independent/ assisted living properties that have been sold twice this decade, and the average annual rate of increase in value was 25%. Four of the seven more than doubled in value between sales, and that is just simply an uncommon return that should be the exception but one that came to be expected by some. This is a fundamentally strong industry, and will be for a long time barring governmental interference, but let’s at least admit that while there will always be spurts and market anomalies to take advantage of, it’s just not that easy to make a 25% annual return, year in and year out.

So, getting back to the market today, we are still seeing mostly single-property sales, we are seeing some properties and portfolios back on the market, most likely because of a financing problem since last summer, but we are not seeing many first-time portfolios, at least not that have publicly surfaced. Despite everyone calling it a buyer’s market (including us), it is not a buyer’s market in the sense that they can get bargains in the market. No one is going to sell an A-quality portfolio or property at a "bargain" price, because the buyers will end up bidding it up to a reasonable level. The only real bargains that may be present are the B and C properties, where demand is much less.

One brokerage firm, despite the "quiet" in the market, is apparently signing up one to two new listings per week, and with most of these the sellers have reasonable expectations (like 13% and 14% cap rates for skilled nursing facilities, but not necessarily bargains). These are not the A-quality portfolios of the past, but they are serious sellers who will find buyers in this market. And the funny thing is, this sounds kind of normal. Not sexy, perhaps not as fun as the 2005 to 2007 period, but a perfectly acceptable market, and one that we may have to get used to for a while. And the 2005 to 2007 period was definitely not normal. Obviously, the juicy portfolio will pop up from time to time, and the bidding will be very competitive, and there may be a run on one of the publicly traded companies, but we may be in for a plain vanilla year or two, if not longer. And what we believe will happen is that buyers who have not been buyers for several years will be back in the market, not with splashy acquisitions, but with solid strategic transactions in markets that they know or where they think there is strong potential.

A case in point of a buyer back in the market, and which we highlighted three months ago, is Five Star Quality Care (AMEX: FVE), which in April announced the acquisition of Somerford Corporation’s 13 assisted living and Alzheimer’s facilities. Somerford was founded in 1998 by three former Manor Care executives (Lew Price, Don Feltman and Ed Kubis) and backed by the Bainum family (founders of the original Manor Care). They started off in the Maryland and Delaware market, and then in 1999 purchased a small Alzheimer’s and assisted living company with three facilities in California. They then bought a fourth facility in California and built a fifth. Meanwhile, the Maryland/Delaware portfolio grew to eight facilities, of which six are on three campuses.

At the time of sale, the company had 13 facilities with 658 units. The actual purchase was made by Senior Housing Properties Trust (NYSE: SNH), which will lease the properties to Five Star. The price, excluding working capital, came to approximately $135.0 million, or $205,000 per unit. We have not seen any of these properties, but we believe they were built in the past 10 years and are all purpose-built, and with the Bainum family backing, we assume they are of high quality, and no lower than "A-." As far as we know, this is the largest transaction so far this year. By this time last year, there were several transactions above $100 million, one of which was close to $2.0 billion. Bill Mulligan of Ziegler Capital Markets represented Somerford in the transaction.