The SeniorCare Investor: Erickson Retirement In Ch. 11
CCRC Industry Pioneer Succumbs To Bankruptcy
When Erickson Retirement Communities opened its first CCRC in Maryland in 1983, we are not sure they really knew how successful the company would end up being 15 years later. That community, in Catonsville, celebrated its 25th anniversary last year, and it now has about 1,500 units with more than 2,000 residents and has a strong occupancy level (95% plus) and a hefty wait list despite the recent economic woes.
Erickson followed the entrance-fee model, and the company has usually targeted more of the middle market or, as management used to say, the retired teachers and accountants who wanted an attractive, safe and affordable place to retire with great amenities. Today, of Erickson’s 20 CCRCs, eight are completed and have been sold to not-for-profit entities and 11 are in various stages of build-out with a combined total of about 23,000 residents. One additional property in Ohio, which had yet to have any resident move-ins, has been shut down and foreclosed upon. In addition, there are a few other sites that are probably not far along the development path.
Although we are sure that 25 years ago the entrance fees were lower, today they average in the range of $250,000 to $350,000 at Erickson communities, but they can certainly be higher for some units. The entrance fees are 100% refundable upon resale of the unit, with the only caveat being that if the resale price was less than the entrance fee paid, the resident’s estate received the lower number. That was never really an issue while the housing market rose and rose during the past 25 years, and new demand was not much of an issue either. As we all know, things started to change dramatically about 18 months ago.
In early 2008, Erickson Retirement Communities embarked on a plan to raise about $400 million of fresh equity, most of which was going to pay off the corporate revolving credit facility, with the remainder for future growth and a nice dividend to the Erickson family. At the time, there were no takers, at least not on the terms being offered, and whether investors saw the writing on the wall with the housing and capital markets is anyone’s guess. If they had tried to raise the equity a year earlier, there may not have been much of a story to tell today. But there is a story, and on October 19, Erickson Retirement Communities filed for Chapter 11 bankruptcy protection, claiming more than $1.0 billion in both assets and liabilities, representing the largest retirement housing bankruptcy filing ever. Unfortunately, it never should have happened.
As many readers know, we have always liked the CCRC model, whether straight rental or entrance fee, and while the model is not for everyone, there is certainly a significant market demand for it. When Erickson’s first community opened 26 years ago, it was quite successful, so they expanded the campus, and kept on expanding it over a 10-year period. Thereafter, this became the model, but the next community didn’t open until 11 years later in Michigan. While the financing of these communities changed over the years, the model of building a series of "neighborhoods" over five to 10 years has not. Usually there are three to four neighborhoods on each campus, with each neighborhood having three to four buildings of independent living units and one neighborhood housing the assisted living and skilled nursing component. The neighborhoods usually have between 350 and 400 units each, and when completely built out, the campuses average between 1,500 and 1,600 units, although some are even larger and others are closer to 1,200 units.
It took 15 years for Erickson to open its first five communities, and an additional eight years to complete them and bring the census to stabilization (23 years in total). Compare this to the company’s recent activity. In the last six years, from 2003 through 2008, Erickson has opened 10 additional communities and most, if not all of them, have not finished their full build-outs. In addition, the company started venturing out of its comfort zone geographically in its efforts to expand, sometimes picking locations that just did not seem to make sense. One of the most recent developments, in Ohio, has not yet taken any new residents and construction was stopped. It has been described as being in the middle of a soybean field, in the middle of nowhere, and someone has now learned the lesson that just because you build it, it doesn’t always mean they will come (unless you are in Hollywood). We would enjoy reading the feasibility study on that one, and the lenders who foreclosed on it are probably doing that right now.
The point is that after the company’s initial success during its first 20 years, and it was very successful, Erickson seemed to get way ahead of itself. Building out one 1,600-unit campus, and filling it, is not an easy task for anyone, but doing this simultaneously with 11 to 12 campuses, with more than 16,000 units in nine states, is extremely difficult, even for Erickson and its home-grown expertise. Difficult became impossible when the housing market crashed, and the tightening of the credit markets gave Erickson no financial means to ride out the storm.
There had been whispers over the past year about an imminent financial collapse at Erickson, and that the company was trying to restructure its various agreements with creditors without any success. Everyone knew that the situation was tenuous when they announced the massive layoff at corporate headquarters late last year. But when you have a dozen campuses that will house upwards of 20,000 residents all in various stages of development, you may need a large corporate staff. When that development comes to a grinding halt, however, they become superfluous and it was a move that Erickson had to make. With Erickson’s creditors unwilling to compromise, or so we have heard, and payment defaults beginning to occur, the company had no choice but to file for Chapter 11 bankruptcy protection. As part of the filing, there is a stalking horse bidder, Redwood Capital Investments LLC, which is controlled by Baltimore businessman and friend of John Erickson, Jim Davis.
The stalking horse bid was agreed to by Erickson’s board of directors on September 19, and on October 19, the terms of the purchase and sale agreement were also agreed upon. The basic outline of the sale includes $75 million of cash, a $25 million promissory note, the assumption of approximately $500 million of campus-level debt and a commitment of $50 million of new capital for future development. What they get is the Erickson management company, which has revenues of about $30 million (more on that later), the construction and development business, which is basically at a standstill, plus the real estate (land and buildings) of eight campuses in various stages of build-out. There are about 5,700 units fully constructed on these eight campuses with 770 of them still available. With an average build-out of 1,500 units, this would mean that they are 45% finished. Occupancy is actually lower than that because some residents have committed but not yet moved in.
The management company manages these campuses plus eight others that are completely built out but have already been sold to various not-for-profit entities. These mature campuses have about 11,100 units and are 95% occupied (closer to 98% if the Michigan property is excluded). So despite the financial problems, the mature campuses seem to be thriving. Also included is the management of three other campuses that, while not sold, the not-for-profits involved have already sold bonds ranging from $137 million to $178 million for a total of $471 million (perhaps the most troubling aspect of the whole thing). The stalking horse offer doesn’t seem to mention what happens to the approximately $200 million of project-level subordinated debt. In addition, at the corporate level there is $47.5 million of Subordinated Taxable Adjustable Mezzanine Put Securities (STAMPS) with an 11% interest rate as well as the corporate line of credit, which as of September 30 had $195.7 million outstanding.
Even the quantitatively challenged among us can figure out that the offer comes up short for the creditors, more than $350 million short by our calculations. Our guess is that with the bankruptcy filing the holders of the subordinated debt will get little to nothing, and the line of credit will be negotiated. The campus-level senior debt is secured by the real estate and while those lenders are in a reasonable position, we have to assume their debt will be restructured by any buyer, with some sort of haircut, because the alternative would be to take back the unfinished campuses, which few lenders would want to do in any market, but particularly not in this market. The good news is that even though these campuses are not finished, there are no half-completed buildings sitting with boarded up windows and a tarp-covered roof. Consequently, what has been built is good to go from an occupancy perspective.
Houlihan, Lokey, Howard & Zukin Capital was retained by Erickson last March to look into strategic alternatives and to assist in negotiations with the company’s lenders. As is typical in cases like this, the lenders do not want to negotiate until they have to (which is now), and no one really knows what they will accept because we have heard they have rejected any potential restructuring plan that has been put forward to date (prior to the bankruptcy filing). In the interim, Houlihan has had discussions with about 80 potential buyers, and while there are a handful who may take part in the auction process that may take place in coming weeks, there just aren’t that many buyers out there with 1) the financial wherewithal to do this transaction, 2) the development expertise to finish the build-out of the remaining campuses and 3) the national presence, let alone temerity, to take on something of this magnitude, in this market, with the future so uncertain. We are hard pressed to come up with even five names that meet the above criteria, and it may really be one or two. No one knows the motivations of the stalking horse bidder, but apparently he took a good look two years ago when Erickson was trying to raise equity capital, and he must have liked what he saw. Even though he is an FOJ (friend of John’s), he is apparently not doing this for the sake of a friendship.
So, how did this premier developer and operator of CCRCs get into this kind of financial trouble? The obvious answer is too much development in the past five years, in too many markets, with many of the new campuses opening up just as the housing market came crashing down in the worst economic environment in 70 years and one of the most illiquid capital markets ever. Simply put, it was the perfect storm of CCRC development, but on a massive scale. Way back when it all started, the model was fairly conservative: build 400 units, fill them up, build another 400 units, and fill them up and continue until you hit the maximum that both the market could take and that the land site could hold, usually 1,600 units on 80 to 100 acres. These were truly unique campuses because of their size, but the neighborhood concept kept the "feel" somewhat smaller. Founder John Erickson became something of a folk hero in the industry, even though some people were still scratching their heads wondering how it all really worked.
While we are not sure how it originated, sometime in the late 1990s someone came up with the idea of selling the completed and stabilized campuses to a not-for-profit that could raise the necessary funds in the tax-exempt bond market. This seemed like a reasonable way to cash out of the development but continue to manage the properties on behalf of the NFPs. This was not complicated and it was nothing new. We are under the impression, however, that the sales price was "below market," because presumably much of the construction debt had been paid off by the entrance fees from the first-time residents. Each of the campuses where this has happened is owned by a separate not-for-profit entity, but they are now all under sort of an umbrella arrangement with National Senior Campuses (NSC). Under the IRS Code, NSC is a "Supporting Organization," providing oversight, supervision, management and strategic planning for its supported organizations, which in this case are all the not-for-profit owned campuses managed by Erickson. While NSC and Erickson are independent of each other, NSC does not appear to offer these services to other CCRCs, and the management contracts at the campus level are not usually put out to bid. NSC, we are told, is happy with Erickson and their approach to the business and caring for the elderly, and does not want to see many changes.
At some point, the financing model began to change, whereby a not-for-profit was set up very early in the process of a new campus development. Now, the NFP enters into a lease with an Erickson subsidiary, and prior to when construction on the first neighborhood begins, the NFP is the entity that takes the reservation deposits. When the first neighborhood is completed, the NFP then takes the initial entrance fees, which are then loaned to the Erickson subsidiary that owns the site which in turn uses the funds to pay down the initial construction debt and to start the next neighborhood phase of 400 units. At some point during the process, the NFP enters into a purchase option with the Erickson subsidiary, and raises the funds for the option by issuing municipal bonds, usually tax-exempt. The proceeds from this purchase option deposit are then used by the Erickson subsidiary to also pay off construction debt and for new construction and fees to Erickson the parent. We are not sure the size of these purchase option deposits when they first started doing this, but we assume they were in multiples of $10 million. Somehow, it just doesn’t seem appropriate to sell bonds to fund a purchase option on an unfinished campus development, with those proceeds going to pay off the construction debt of another "unrelated" entity or for more construction on the final build-out.
With a few of the later developments, in particular two in Illinois and one in Massachusetts, a large bond financing was completed prior to the completion of the campus. In Naperville, Illinois, there is $178 million in bond debt outstanding that is now in default, but the campus is less than 50% complete. The other Illinois campus, in Lincolnshire, with $137 million of bond debt, has a similar situation, as does a community in Hingham, Massachusetts, with $156 million of bond debt. This totals nearly $500 million of debt, and with some recent trades we have seen, these bonds are trading at 40 cents to 50 cents on the dollar.
As an example of some of the problems, the Lincolnshire, Illinois campus, known as Sedgebrook, commenced operations in 2005 and when finished was supposed to have 1,380 independent living units, 96 assisted living units and 132 skilled nursing beds for a total of 1,608, the basic Erickson prototype. In 2007, the not-for-profit entity formed as the "operator" of the campus sold $137.1 million of variable rate demand bonds, and used $125 million of the proceeds for the purchase option deposit with the Erickson subsidiary that owned the site. That subsidiary then used $60 million of the option deposit to pay off a construction revolver with Bank of America, and another $27 million to pay off subordinated debt. We’re not sure where the remaining $38 million went, but probably other fees or to pay off some of the financing provided by Erickson. Three years before this bond issue, a $15 million Special Tax Service Bond District Financing bond issue was closed.
As of August 2009, 469 IL units were open with 363 sold, for a 77.4% occupancy rate. Four out of 44 AL units and 11 out of 44 SNF beds were occupied. Now, being just 35% built out four years into a typical Erickson development is not unusual, as these can take six to 10 years to finish. One big problem is that to finish the campus, they are projecting that total costs will be about $550 million, or just over $340,000 per unit, which happens to be about $103 million over the original budget. Almost half of that represents hard construction cost overruns, with the next biggest culprit marketing costs, with an estimated cost of $41.6 million to completion compared with the original budget of $28.2 million. And to finish the campus, the cost is estimated to be $291 million, most of which would, in theory, be funded with the initial entrance fees of those units. If finished according to plan, there are potential entrance fees of about $300 million, if the pricing holds and, of course, if demand holds and current residents are kept happy. We are not sure who will do the construction work, as various subcontractors have already filed mechanics liens for more than $2.4 million this summer.
It is quite likely that the other two campuses mentioned above are experiencing similar problems, which is one of the reasons why we believe all three have been left out of the sale of the Erickson assets. The other, and maybe larger reason, is that the $125 million purchase option deposit for Sedgebrook is a liability on the books of the Erickson subsidiary. The way we believe this works is that if the not-for-profit "operator" decides not to exercise its purchase option, Erickson has to refund the deposit. Since the money has been spent, no buyer wants to enter into the situation with that exposure. In addition, Erickson is apparently on the hook to provide working capital financing, and that is not going to happen either. For these three campuses, their separate boards of directors have hired restructuring consultants and financial advisors to advise them on how to proceed. One of the things they have to discuss is whether to keep Erickson as the manager, especially given the conflicts of interest over financing and who owes what to whom. Right now, there appears to be a strong preference to stay with Erickson. As is typical in the cases where new not-for-profits are set up to own and/or borrow, there really is little backing them up financially, and that may be generous. This is basically what "project finance" is all about, where investors rely on the cash flow of the project and when it doesn’t materialize as planned, there is nowhere else to go. And this was not the plan.
There will be some comparisons made between what has happened at Erickson Retirement Communities and Sunrise Senior Living (NYSE: SRZ). Both companies were essentially development companies with a large management arm. But Sunrise did many acquisitions, some of which were disastrous, and expanded outside the country, with horrible results in Germany. Erickson basically stuck with its large campus, staged build-out CCRC model and didn’t vary much from it, other than perhaps doing too much at once. What is similar between the two companies is that the development arm fed the beast, so to speak, and when development was forced to stop, it exposed a weakness in the model that was not sustainable. Sunrise obviously had a wider range of problems to deal with than Erickson, which basically has the unfinished campuses and limited financing options.
Houlihan, Lokey is in active discussions with the buyers who have the highest probability of topping the stalking horse bid, as well as with the lenders who obviously have an important say in the ultimate outcome. With $30 million of management fee income, of which a high proportion may be considered profit, the current cash-on-cash return may not look too bad. What we don’t know is what kind of coverage there is on the campus-level debt from those unfinished campuses. Anyone coming in is going to either need deep pockets to deal with contingencies, or redesign operations for smaller scale campuses. The sale process will become quite active later in November, and if other offers come in, there may be an auction. One risk that we are not sure how buyers will handle is the timing and ability of any one of the not-for-profit entities to cancel its management agreement with Erickson or its successor entity. Right now, that seems to be where the cash flow is until development can be resumed at a profitable rate.
Erickson management has made it clear that its bankruptcy filing does not impact current residents and their 100% refundable entrance fees, because the entrance fees are the responsibility of the individual communities and their not-for-profit sponsors. Those initial entrance fees, however, were loaned to the Erickson subsidiary at the campus level and used to pay off debt or fund new construction. The ability to refund those entrance fees rests entirely on the shell not-for-profit and its ability to resell those units at the same price, something that unfortunately is no longer a given in this market, and not just for Erickson. Disaster would strike if a large number of residents at any one community decided to leave, because the residents filling those units would take the place of the necessary residents for the future build-outs of the unfinished campuses. We don’t anticipate this happening, and a lot will depend on what happens with the sale, whether a high quality of service is maintained and how soon the capital markets return to normal.
We have to say that John Erickson and his PR team have done a tremendous job in communicating with the residents and allaying any fears about the future of their homes. Erickson Retirement Communities, and now the not-for-profits that own about half the campuses, have never reneged on the refund of the entrance fees, and we hear that in the case of the Ohio project that was never occupied, all reservation deposits (up to 10% of the entrance fee) have been refunded in full as well. This is very different from what has been going on in Pennsylvania, where a new buyer of a not-for-profit sponsored CCRC in default has canceled all resident contracts and is not going to refund any of the previously paid entrance fees (see story on page 13).
The good news is that the eight oldest Erickson CCRCs may not be impacted by this disruption, other than we are sure that it has been more difficult to re-sell units during the housing market crisis, and the negative publicity won’t help either, even though they really are outside the bankruptcy filing. The eight campuses that are being sold out of bankruptcy have a long way to go and the timing of becoming cash flow positive may depend on the size of the lender haircuts and what happens with the build-outs. The bad news is that the timing of Erickson’s bankruptcy filing could not be worse. With the General Accountability Office just getting started on its investigation of CCRCs, in particular the regulations and the financial protections in place (or not) for the residents who put up large sums of money, we suspect the GAO staffers will be taking a hard look at how the financing was done with these communities, especially the two in Illinois and one in Massachusetts. In most, if not all states, when a CCRC files for bankruptcy protection, the residents and their entrance fees become unsecured creditors, and depending upon the severity of the situation, they can be left with nothing, as is the case in the recent Pennsylvania situation.
There are some who fear this may be the beginning of the end of the entrance-fee CCRC as we know it. Since we have always been in favor of the CCRC model for the people who really matter (the residents), whether straight rental or entrance fee, we don’t think the end is near. However, the financing of new CCRC developments may change, and sponsors may have to have more skin in the game, so to speak, and that will be a good thing because it should bring more stability to a model that has enjoyed a lot of success with its customer. The ability to somewhat freely use the initial entrance fees may come under new scrutiny, and this is one of the reasons that sponsors have been able to develop without much of their own funds. But since there doesn’t seem to be a lot of skin around these days for anyone, it may curtail the development of these projects just as the oldest baby-boomers are starting to think about retirement housing options. That will be unfortunate for all of us.