The SeniorCare Investor: 2008: A Year Best Forgotten

 
It May Be Bad, But The Industry Is Still In Good Shape

While we have turned a page in the calendar and entered a new year, there are not many people who believe business in 2009 will be any better than in 2008, at least not until late in 2009, and since no one wants a repeat of 2008, that is not very cheery news. If there is one word that can best describe last year for the seniors housing and care industry, it would be "disappearance." Yes, nasty, ugly, horrible and depressing, among others, are all appropriate adjectives for what happened and how we felt last year, but "disappearance" seems to fit better and have more meaning.

What, exactly, are we talking about? For starters, we are referring to the disappearance of lenders in the market and their capital, the disappearance of private equity investors and other financial buyers and the disappearance of the CMBS market. How about the disappearance of large M&A transactions—and last year "large" was anything over $50 million—and the disappearance of an M&A market in general, the disappearance of high-end properties on the market, the disappearance of the IPO market, the disappearance (or drastic shrinkage) of seniors housing stock values and the disappearance of some companies that were liquidated, with perhaps more to come in 2009? About the only thing that was going up were cap rates, even though there are still some people in the market who continue to live in the past and won’t agree with that statement because they haven’t seen enough deals to convince them. But come on, that’s a no-brainer to us.

When Sunrise Senior Living (NYSE: SRZ) dropped to a low of $0.27 per share in November, we thought that SRZ might be joining the "disappearance club," as unthinkable as that may have been just a few short months ago. While it is still touch and go, investors did push the share price well above $1.00 in December, where it has stayed. To put what happened in 2008 in perspective, the six publicly traded seniors housing stocks plunged by a combined total of 78% in value from their peaks during last year to their end-of-year closing prices, losing a total of $5.1 billion in value. The loss was even greater before the December rally, although that is not much comfort to investors who purchased any of the stocks in the first half of the year or earlier. The economic loss is not quite as bad as what happened 10 years ago, with the one major difference being that we have not had any public company bankruptcy filings yet, and if any occur, it may be limited to just one or two as opposed to most of the sector the last go round.

Let’s start with the stock market. It is obvious that this was the worst year ever for investors in seniors housing stocks (the worst year for skilled nursing stocks was 1999), where the best performer, Assisted Living Concepts (NYSE: ALC), was down "only" 45%. The other five lost between 60% and 95% of their value during the year when the overall market dropped by a mere 38.5%. These companies were not lining up to get a piece of the federal bail-out pie (okay, one private company was), although investors were treating them as if they were. And while there are some debt maturity issues in 2009 (obviously, Sunrise), even those companies with no looming need for capital were hammered by investors. And how did our $50,000 portfolio of seniors housing stocks, created on October 28 when we thought the market had bottomed out, perform? It jumped by 24% in December but ended the year down 17.2% from its inception. The good news is that in the opening days of 2009 it has continued to increase in value.

The overall stock market collapse was magnified in the seniors housing sector because of the weak residential housing market, outsized fears regarding occupancy declines and the industry’s over-reliance on leverage, which is a dirty word these days. A more realistic concern is what the stock market plunge has done to the financial health of the elderly, combined with the lowest returns ever on fixed-income portfolios, which most of them rely on to pay the bills, including their rents in retirement communities. Everyone used to talk about how wealthy the 65+ age cohort was, and while we haven’t seen any numbers on the decline in their income and assets values (investments and homes), we have to assume that their spending habits will change in the absence of a decent rebound in the next year or two, and that may include spending on retirement housing. With trillion-dollar annual federal deficits now looming for the next several years, there is a growing fear that the current economic malaise will be with us for quite a while and everything—house values, stock values—will be stagnant, at best. Nevertheless, the sector still appears to be oversold despite all the other macro problems it is facing.

The skilled nursing market more closely mirrored the overall market in 2008, with the average stock declining by 33%. Only one company, The Ensign Group (NASDAQ: ENSG), posted a price increase, while National HealthCare (AMEX: NHC) was essentially flat for the year; the rest of the pack had dismal performances. The sector was spared a Medicare cut in 2008, and Medicare is still what drives earnings and growth potential at most of the companies. But with trillion-dollar federal deficits, not to mention what will be happening at the state level, reimbursement increases will be far and few between for the next few years, and everyone knows that cuts will be on the agenda for many politicians, as impractical as that may be when all they talk about is increasing quality of care. Our best guess is that skilled nursing stocks will muddle through 2009, impacted more by earnings hits and misses than real economic performance and their preparation for the next several years.

Bankruptcies
After a four-year period of growth, rising values and unprecedented access to capital, the bankruptcy front had been relatively quiet until 2008. Not that there has been a surge in Chapter 11 filings, but two Connecticut-based skilled nursing companies filed in the last year or so, and one California-based assisted living company that had grown by acquisition with some dubious leadership has been in the process of liquidation. Several individual properties managed by Sunwest Management have filed for bankruptcy protection, and we suspect that more will follow. We are sure there are a few other small bankruptcy filings that we have missed or just not reported on, as well as the various one-off CCRC bankruptcies that are individual situations and not part of a major trend (yet), but there has been nothing close to what happened in 1999 and 2000. And we don’t think we will see a repeat of that in the coming year or two unless, of course, we really do enter into another depression with unemployment hitting 15% to 20%. Cheap labor will not count for much in that event.

Occupancy
Starting late in the second quarter of 2008, there was growing concern over sliding occupancy rates in assisted and independent living communities, with the latter property type (especially CCRCs) perceived to be the most vulnerable to the housing downturn. It didn’t really happen as the playbook expected, as many "need-driven" assisted living facilities suffered from a mid-year decline in census, while many independent living communities did not experience any weakness in demand or census. What this tells us is that census issues may have more to do with geography (where the housing market is really bad), price-point and local reputation than with the general housing market. Although some communities experienced an above-average number of move-outs (sometimes with no clear reasons), move-in rates in general appeared to decline, prompting an increase in price discounting, free rent and other giveaways to entice residents to make the move.

Many of the public companies reported a turn-around in census during the third quarter last year, but we still don’t know how durable that has been and how much was the result of discounting, which will eventually show up in the bottom line, or just plain back to basics in their marketing methods. What we do know is that new development has slowed dramatically, and while those late 2007 and first half 2008 property starts will be opening in 2009, by the third quarter of this year there will be very little nationwide to lure potential residents away from the existing seniors housing stock. While this decrease in development will help existing providers over time, there is a trade-off between having a built-up demand and losing potential customers (who deferred a move) permanently either through death or the need for higher acuity care after deferring the decision. As fourth quarter earnings results begin to come in later in February we may have a clearer picture, but not if the companies don’t come clean on the pervasiveness of discounting.

Now versus then
When looking at the last industry downturn that began about 10 years ago, there are plenty of similarities and perhaps an equal number of differences between what is happening today compared to the end of the 1990s. The big difference, of course, is that the current problems have been mostly caused by external factors (the capital markets crisis), while 10 years ago it was mostly industry caused problems—reckless overbuilding and leverage in seniors housing and reckless acquisitions and leverage in skilled nursing (although changes in Medicare reimbursement are blamed, they knew it was coming and ignored the consequences). In both periods, lenders dropped out of the market, but 10 years ago it was because of increasing defaults and bankruptcies, while today it is because they need to preserve their capital even though their seniors housing and care portfolios are probably their best performing real estate asset class, and perhaps their best of all industry types.

Acquisition values increased significantly in the 1990s leading up to the collapse, and while they were capital markets driven to an extent, it was the huge increase in publicly traded companies, with their new-found acquisition currency, that had the primary impact. In this recent bull market, values rose to an even greater height than in the previous decade, but the far fewer publicly traded companies were not the ones pushing the envelope. This time around, price expectations rose as a result of an unprecedented amount of private equity capital streaming into the sector, pushing cap rates to historical lows and every seller’s price expectation through the roof. In both time periods, deals were done more and more based on aggressive forecasts that never had the "what if" scenario built into them. For many acquisitions it didn’t matter; for others, it was catastrophic.

From 2000 through 2003, it became a buyer’s market with regional companies and sub-regionals doing most of the buying after being shut out of the market for several years because they couldn’t compete on price. But the quality of assets available for sale to these buyers was not quite at the high-end, to say the least, with foreclosed properties, including too many empty ones, seeming to proliferate in the market. Starting in late 2007 it became a buyer’s market again (similar buyers who had again been shut out because of pricing), but just like the last time, most of the properties available for sale have been of average or below-average quality, and with many of the traditional lenders in hibernation, the buyers have often been tapping smaller, lesser-known lenders for the small conventional mortgage financing. In both time periods, the average deal size declined significantly, the number of transactions declined and the average price paid per unit/bed decreased (remember, it’s all in the quality). The fact that interest rates in this cycle are at their lowest point ever is largely irrelevant since the spreads have widened and there is little lending being done anyway.

The one big difference compared with 10 years ago is that today there is more operational stability despite last summer’s occupancy concerns, and while leverage does remain a concern, many providers spent 2007 refinancing their debt, fixing their floating-rate debt and buying back some of their properties to provide some financial flexibility going forward. Most providers we speak with are performing at or near expectations and do not expect a financial problem or liquidity crisis (for them) in 2009.

Opportunities and the future
Despite all the issues confronting the seniors housing and care industry, we still believe that it is a land of opportunity, especially for anyone with access to capital. When looking at "real estate," would you rather invest in office buildings, retail shopping centers, industrial buildings, hotels....or seniors housing in this economy? For investors, one of the best opportunities today is to purchase outstanding debt on properties, probably at a discount to par, which can provide a very attractive yield, whether levered or not. And if it is a relatively new property in a good market, foreclosing could even provide a better yield. Although we don’t know the dollar value of seniors housing loans coming due this year, we have heard that there is $400 billion of real estate loans in general maturing in 2009, and more than $1.0 trillion over the next three years. All of that can’t get refinanced in this capital markets environment, so there is going to be a lot of financial maneuvering, and that spells opportunity.