The Role of Capital
The Changing Face of the Senior Care Acquisition Market

Exactly 30 months ago, in the February 2004 issue, we wrote about CNL Retirement Properties (CNL) and the changing role of capital in the senior care acquisition market. We basically made the case that there was developing a new acquisition standard in the market, with a different metric for financial buyers (such as CNL) compared with operator buyers, who were seen to be a dying breed for the large transactions, at least in terms of an ability, and willingness, to match the higher prices paid by financial buyers. People began to refer to this transformation as the “bifurcation” of the senior care acquisition market.

Although the timing of when this change began can be debated, looking at CNL’s four major acquisitions in 2003 is a good starting point. Acknowledging that each transaction was unique with its own set of circumstances, variables and asset quality, chronologically, the per-unit prices escalated with each deal, as did the price to revenue multiples, while the cap rate dropped with each acquisition. For example, the first transaction was at $86,600 per unit, followed by $115,100 per unit, $150,000 per unit and $156,000 per unit. Similarly, the cap rate started at 10.2% for the first one, followed by 8.4%, 7.8% and 6.0%. Those last two cap rates certainly raised a few eyebrows at the time, and while CNL did not view those transactions as having sub-8% cap rates, the “market” was shocked. But what CNL was doing was paying a “forward price,” with certain stop-loss guarantees from the sellers in several cases until the facilities reached stabilized occupancy and cash flow, resulting in a higher ultimate cap rate in CNL’s mind. While some of us were laughing, CNL shareholders had the last laugh when the company sold to Health Care Property Investors (NYSE: HCP) earlier this year for $5.2 billion in one of the most aggressive deals of the decade. And given today’s market, HCP may ultimately have the last laugh, but we will not know that for a few years.

A lot has occurred since CNL began its aggressive acquisition spree, including record low cap rates, record average per-unit prices paid and an unprecedented number of high quality assisted and independent living portfolios coming on the market, which had a lot to do with the direction of cap rates and per-unit prices in the past two years. Obviously, the direction of cap rates and values in the non-senior care segments of the real estate market had an impact on pricing for senior care assets. But the role of capital in our market has changed as well, influenced in part by the importance (or lack thereof) of real estate ownership by the operator.

When looking at transactions over the past few years, there have been more than two dozen financial buyers, or equity investors, involved in one or more seniors housing and care transactions, and this is not including the publicly traded health care REITs. What’s more, at least with the publicly traded assisted/independent living companies, operators have aligned themselves with capital providers. Sunrise Senior Living (NYSE:SRZ) has a strong relationship with the newly formed Sunrise Senior Living REIT (TSX: SZR.UN), “based” in Canada, as well as the largest stable of joint venture equity partners, enabling the company to buy or build most anything it wants. And although it is somewhat unrelated, the accounting difficulties at Sunrise have revealed that in their old partnership agreements with “preference returns,” the portfolios performed so well that the partners never had to receive a preference return. As a result, SRZ may have more investors lining up to get top returns in this stingy market, much like we expect is happening at Formation Capital.

Sunrise is not alone, however, in forming equity partnerships. Brookdale Senior Living (NYSE: BKD) has its relationship with Fortress Investment Group, which not only owns a controlling interest in BKD, but also has enough liquidity that it can commit the equity for BKD to cement a billion-dollar deal or two. Five Star Quality Care (AMEX: FVE) has gone the more traditional route with its ties to Senior Housing Properties Trust (NYSE: SNH) and the sale-leaseback model. That leaves Emeritus Assisted Living (AMEX: ESC), which uses REIT financing and the Dan Baty bank, and Capital Senior Living (NYSE: CSU), which has used Ventas (NYSE: VTR), GE Healthcare and Blackstone Real Estate Advisors, to name a few. While there is nothing wrong with these relationships, it does represent a fundamental shift in how public companies are raising the necessary capital for growth, as well as the increased acceptance of senior care assets by traditional real estate investors and private equity investors in general. It is also accelerating the shift away from real estate ownership for many operators.

Is it necessary to have a tight, strategic relationship with one capital provider to be active in the acquisition market? Common sense would tell us that the Sunrise or Capital Senior Living approach with a variety of “partners” makes the most sense because it limits any control a financial partner may have over your acquisition decision-making process. Also, capital providers change their investment parameters, and if your financial backer is “fully allocated” to senior care, you have to go elsewhere. In addition, different structures fit different deals, and equity players may prefer one structure over another, so a variety of partners provides some flexibility. What is happening in the market today is that operators are sometimes competing against some of their capital providers for deals, often without knowing it until they contact them about financing the transaction. While this can lead to some awkward conference calls, they can only hope it hasn’t resulted in the price being bid up.

Equity capital is fleeting, however; it goes where the return is the greatest relative to the risk, and can change its investment appetite very quickly. One good thing about seniors housing is that, despite some natural (and unnatural, if you know what I mean) cycles, these investors know that, unlike most industries, this market will be in a growth mode for the next 50 years, especially in 20 years or so when the baby boomers are hitting the age of 80. While these investors are obviously not looking out that far, it is comforting to know that time is on your side, at least in the long term.

But too much capital is not always a good thing, as counterintuitive as that may sound. It drives up demand, and consequently prices, when the supply of acquisition properties is somewhat fixed. And private equity firms today have more cash to invest than at any time ever. For example, the most recent fund raised by The Blackstone Group exceeded $15 billion, which when leveraged with debt, can be used to buy well over $50 billion of assets or companies. In fact, nine of the 10 largest acquisitions ever announced by private equity firms have occurred in the past 15 months, whether adjusted for inflation or not. The largest, on an absolute dollar basis, and the only health care transaction, is the pending acquisition of hospital giant HCA (NYSE: HCA) by three private equity firms joining forces to pay $33.0 billion, a trend that is expected to continue as deals get larger.

Does the current leveraged buyout for HCA have implications for the seniors housing and care industry? You bet it does. These private equity funds are flush with capital and searching for businesses with a high level of relatively consistent cash flow with assets that can be easily recapitalized or spun out. That seems to be a perfect match with seniors housing. The problem, however, is that stock prices for most of the publicly traded senior care firms are at fairly high multiples, with real estate ownership declining in recent years. And the 8.1x EBITDA multiple for HCA seems low for a hospital company, and won’t get any seniors housing sellers excited.

Imagine if Sunrise Senior Living was having its current accounting disclosure issues and the related drop in its stock price, but still owned the majority of its facilities. The private equity funds would have already crunched the numbers by now. Our guess is that all of the senior care companies have already been valued, with buyers waiting for the most likely candidates to suffer a price decline.

One potential target that keeps on popping up, partly because of the noise made several times this year by Mercury Real Estate Advisors, is Capital Senior Living because it still owns a large portion of its assets and would be a very clean acquisition, especially since it has just refinanced, and fixed the rate, on almost all of its debt. A few months ago (May issue) we did the math using CSU’s fourth quarter EBITDA annualized and, after deducting the debt, came out with an equity value close to its actual trading range at the time. Since we are hearing more buzz about CSU this summer as potentially “the next one” to go, we thought we would do the math once gain.

Using updated numbers (first quarter 2006 annualized), a cap rate of 6% on EBITDA of $26.8 million would yield an equity value of almost $8.00 per share, compared with the current market value of just over $10.00 per share (not too appetizing no matter how much money the funds have). But, the naysayers say, the company’s G&A expense is too high, so after adjusting it downward from almost 9% of revenues to 5%, and once again using a 6% cap rate, we derive an equity value of almost $11.00 per share (not much wiggle room there). This analysis assumes that a 6% cap rate is the right number, which is questionable. Only by dropping the cap rate further, or removing the G&A expense entirely, does the equity value get up to a reasonable premium for current shareholders (30% or so, or a price of $13.00 or more).

There may come a time when Capital Senior Living becomes an attractive acquisition candidate, but not now. Unless, of course, cap rates do decline to 5% or the company’s cash flow increases significantly. We think the latter will come first, especially as its current properties improve and with new acquisitions added to the mix. If the stock price does not begin to move with the cash flow, then some of these firms may start to sharpen their pencils.

In the skilled nursing side of the business, potential buyers need a sizable drop in the market prices for any of the public companies to be attractive. Three of the skilled nursing stocks hit 52-week highs last month, and most are trading near their highs. Genesis Healthcare (NASDAQ: GHCI) had been the one company mentioned the most, because of its regional concentration and percentage of assets owned, but its stock price is up more than 30% this year. Management at Manor Care (NYSE: HCR) made a short-lived attempt to take the company private last year, but at the current price, LBO firms will be looking elsewhere.

While most nursing facility providers don’t like to admit it, the operating environment is not so bad these days, with profitable Medicare reimbursement, increasing occupancy rates with basically no new beds, and with almost every state operating in the black which, while not using the surplus to improve Medicaid reimbursement in most states, means that there will not be pressure to reduce Medicaid payments or rates. These may have been some of the reasons why GE paid the healthy price it did for the Formation Capital skilled nursing portfolios last month.

The recent (past few years) influx of institutional capital into the senior care market has certainly put the industry on the investment map, which is good for the long term because of the huge amount of capital that will be required to fund the next development boom. But as the old Chinese proverb warns, be careful what you wish for. In the current market, it has driven up prices, which has made many people very wealthy.

But many of these transactions are financial deals, not strategic ones, and when (if) the next industry recession hits, these equity providers may become very fickle, which could result in some disruptions that no one wants to see. In other words, the industry fundamentals are very strong right now, but they are not driving the acquisition market; it is the financial markets, flush with cash looking for a decent return, that are steering our industry’s ship right now. For now, capital is providing a level of liquidity that has never before been seen, and a high degree of financial flexibility for operating companies, both of which are certainly welcome. But cap rates won’t drop forever, and interest rates won’t stay low forever, and capital won’t be this available forever. So here is the $64,000 question: Is the market hitting a peak, temporary or not, and if it is, what can you do about it? For some possible answers, tune in to our fourth annual audio conference on the senior care investment market (click here for details).