The SeniorCare Investor: Brookdale Snags Sunrise Deal

 
In Competitive Process, Price Goes Higher Than Expected
 

After an approximately three-month marketing period, Brookdale Senior Living (NYSE: BKD) ended up being the surprise winning bidder for the 21-property portfolio owned and managed by Sunrise Senior Living (NYSE: SRZ). We say "surprise" winner because it seemed as if Emeritus Senior Living (NYSE: ESC) was so intent on capturing this portfolio, partnering with Health Care REIT (NYSE: HCN), or so we heard, that we assumed they would prevail. Whether it was because they didn’t want to go above the $200 million mark, or they realized they would have their hands full with their Sunwest Management transaction, we may never know. The other surprise, at least for us, was that we thought Brookdale had already dropped out of the bidding.

The purchase price is $204.0 million, or nearly $147,000 per unit, for the portfolio, which includes 876 assisted living, 421 Alzheimer’s and 92 independent living units in 11 states. Of the total, 11 properties are located in the Midwest, with six in Ohio, four in Indiana and one in Michigan. The rest are a bit scattered from California to Georgia. From a geographic perspective, this acquisition makes more sense for Brookdale than it did for Emeritus, not just because of the states, but also because 80% of the units are in markets that can be immediately served by BKD’s therapy business, and 55% with home health. The acquisition is expected to close in November and will be accretive for Brookdale starting in 2010. The level of accretion will depend on many factors, and it could be very favorable.

Although financial data for the 21 properties has not been disclosed, we have extrapolated estimates based on what was the original portfolio of 22 owned properties; one property, with a large mortgage due this past September, was removed from the offering after the first round of bidding. So keeping that in mind, we have calculated that for the remaining 21 properties revenues and EBITDA in 2008 were approximately $83.0 million and $17.7 million, respectively, with an average occupancy rate of 93.9%. Average occupancy for 2009 was projected to drop by more than 300 basis points to 90.5%, and we assume that this forecast was based, in part, on actual data for the first five or six months of 2009. With a projected 1.9% average rate increase in 2009 (down from a 4.8% increase in 2008 and 6.6% in 2007), revenues were forecast to decrease to about $81.5 million, with a small drop in EBITDA, to perhaps $17.2 million. Using these numbers, the in-place cap rate was about 8.4%, but this is before capital expenditures, which had averaged about $2.0 million per year for the past three years. What we don’t know is the extent to which occupancy may have rebounded in the summer months, and perhaps beyond, as it seemed to do across the industry. If so, then the revenue and EBITDA numbers for the full year would edge higher, as would the cap rate.

While that cap rate appears to be low for the current market environment, and our original pricing estimate of $185 million was based on a cap rate closer to 9.5%, it can’t be looked at in a vacuum. In this transaction, Brookdale will be assuming about $134 million of mortgage debt with an average interest rate and maturity of 2.9% and November 2013, respectively. That represents a little more than 65% of the purchase price, and as buyers know, that rate would be impossible to beat in this market. Brookdale will be using its cash on hand for the remaining $70 million of the purchase price. Just on in-place cash flow after interest expense and assuming $2.0 million of capital expenditures, this would represent a 16% annual return on cash invested. Although this may be the base-case forecast, we believe Brookdale will be setting its sights much higher.

This portfolio has been operating with a below-average margin, especially when the relatively strong occupancy rate is taken into consideration. The forecast for 2009 was for a 21.0% margin, and this compares to about 31% for Brookdale. Admittedly, Brookdale has a wider mix of unit types, some with operating margins well in excess of 30%, but we have to assume that the company will get these Sunrise assets up to at least a 25% operating margin by 2013, and that is before they start to bring in their ancillary services and the extra revenue and cash flow that comes with it. On a conservative basis, we think occupancy should grow by 50 basis points per year, rates should start to increase by 2.0% in 2010 and up to 3.5% in 2013, and the operating margin should expand by 100 basis points each year starting in 2010. That would put the portfolio at 92.5% occupancy with a 25% margin and EBITDA of $23.2 million by 2013, which is the average maturity of the assumed debt. Assuming a similar cap rate environment, that would result in a 35% increase in value, and a doubling of the equity investment. The reality is that the performance could, and perhaps should, be even better, unless management gets distracted with a much bigger acquisition in the future. Therefore, from a financial perspective, this acquisition should work out very well for Brookdale.

There is another side to the story, however. These facilities are relatively small, with an average size of just 66 units, with three having fewer than 50 units (the smallest is 37 units). Many of these properties were developed as Sunrise mansion knock-offs by the former Karrington Health, which was purchased by Sunrise in 1999. Think of them as the assisted living version of "mini-me," and they had a little less of everything that the Sunrise properties did. Age is another issue, and even though Sunrise has been spending an average of more than $1,400 per unit annually on the properties, the average age is about 12 years, and all but three of the facilities are more than 10 years old. So even though this is probably the highest quality portfolio on the market this year (at least with a signed purchase agreement), some have questioned whether Brookdale would have been better off concentrating on improving its existing portfolio and using its cash for a better portfolio or the new, high-end CCRCs that investors believe will be coming on the market next year and into 2011 that just couldn’t fill up because of the housing market and the economy in general. While we understand these concerns and are sympathetic to them, we still believe that this was a portfolio that Brookdale could not have walked away from, and it is a portfolio that should generate above-market returns for the company.

This sale also has a dramatic impact on the seller, Sunrise. The immediate impact was on the stock price, which had been steadily creeping up in the days before the announcement. On top of that increase, when the announcement came, SRZ’s shares jumped by 60% with nearly half the company’s shares outstanding trading hands. Even though it lost more than half that gain the next day, in the subsequent two weeks it made most of it back again. The main reason for investor euphoria was that the cash the sale will bring in, $70 million before transaction expenses, provides the liquidity needed to keep the lenders at bay. Ten days later, Sunrise announced it entered into the 13th amendment to its credit agreement with banks, extending the maturity another year to December 2, 2010. With the sale proceeds and cash on hand, the company is reducing that credit line by $28.7 million and will deposit $20 million into a "collateral account" pledged to the bank group. An additional $30 million will go toward repaying other mortgage debt. Clearly, Sunrise’s viability as a going concern will be enhanced when the deal with Brookdale closes, but despite some of the yahoos on Yahoo who think Sunrise will climb back to more than $20 per share, the company still has a long way to go.

The other little noticed aspect of this sale is that for Sunrise, these properties were a very profitable component of the business, especially with the 2.9% average cost of the debt.

In fact, based on the second quarter results for Sunrise, it looks as if these 21 properties contributed to about one-half the EBITDA for the quarter after an assumed $0.5 million of capital expenditures (which should be capitalized but we are assuming are written off). Excluding write-offs, restructuring and restatement charges, but after rent payments, SRZ had a quarterly EBITDA of about $7.5 million, and this portfolio had an estimated quarterly EBITDA of $4.3 million before capex. Consequently, it looks as if a sizable chunk of cash flow will disappear after the sale. The good news is that interest expense will also decrease, but that benefit is not so great because of the low 2.9% average rate on the portfolio. The company’s quarterly interest expense of $3.2 million will drop by about $1.0 million before the excess proceeds are applied to other indebtedness. This is a transaction that Sunrise really had to do since there were no other places to raise this amount of needed cash, but it does come at a price. Also, now that Sunrise appears to be in better financial shape, other creditors may take a tougher negotiating stance.

About 10 days after the transaction with Brookdale was announced, Sunrise had some more good news. It has now reached a restructuring agreement with its lenders, Capmark Finance and Natixix, owning about 77.5% of the debt outstanding on the company’s assisted living facilities in Germany, which totals $121.6 million. Those lenders that participate in the agreement will receive a pro rata share of 5 million new Sunrise shares (worth between $20 million and $25 million based on recent prices), plus a minimum of $58.3 million of the sales proceeds of a group of properties. As part of the agreement, Sunrise will try to sell the German properties and cover all operating costs until the earlier of either their sale or December 31, 2010. Separately, HSH Nordbank and Sunrise’s joint venture partner in the troubled Fountains portfolio have agreed to release Sunrise from all past and future funding commitments, as well as from all other liabilities prior to the date of the agreements arising out of the Fountains joint venture, including deficit and income support obligations. In exchange, Sunrise will transfer its 20% ownership interest in the Fountains joint venture to its soon to be former joint venture partner, will contribute vacant land that SRZ owns that is adjacent to six of the Fountains properties to the J/V partner (current book value of $12.9 million), and has agreed to transition management of these 16 communities as soon as practical, but probably during the course of 2010. These have been two major obstacles in the way of a successful Sunrise recapitalization, which now makes the prospect more likely.

Assuming the sale of the 21 properties to Brookdale closes, it is an important statement for the acquisition market, and bodes well for 2010. Although the statement would have been stronger if Brookdale had to raise 75% of the purchase price in the debt markets, a successful sale will give the market a bit of a boost that it definitely needs. Combined with the pending Blackstone Real Estate Advisors acquisition of the much larger Sunwest Management portfolio, the sector will be entering next year from a reasonable position of strength, at least stronger than five months ago.