The SeniorCare Investor: Of Erickson, Sunwest & CCRCs--
Notes From The Underground At The NIC Conference
When industry executives, capital providers and others descended on the NIC Conference in Chicago
in 2008, the mood was quite somber. Not that the industry was suffering, and in fact it has weathered
this financial storm better than any other "real estate" asset class (and some institutional investors
still don’t get it), but many were keenly aware what the collapse of the capital markets would do to
the growth of the seniors housing and care industry, even if there was a little underestimation of what
the ultimate impact of the housing market collapse would be on seniors housing.
This year, the mood was vastly different, but there were not smiles all around. Seniors housing providers were the most optimistic of the crowd, as occupancy problems appeared to have bottomed out in the second quarter and most of the companies we spoke with were seeing occupancy increases throughout the summer, with a few even experiencing record increases during the summer months. At least one equity analyst, however, returned from the conference and lowered his earnings estimates for 2010 for the public companies based on lower rate growth assumptions. Based on his conversations with executives, rate growth for next year was reduced by about 100 basis points. Our take was that the industry was more optimistic than that, and it is possible they want to be conservative so that there are no earnings surprises next year, or if there is a surprise, it’s a positive one. And as they say, first comes occupancy increases, then rate increases. In addition, the private companies seem to be performing better than the public ones, with at least one company expecting rate increases of 6% to 7%. The public companies estimated that rate increases in 2010 will range between 1.4% to 3.6%.
If there was any negativity, however, it emanated from many of the capital providers. Their outlook on the industry was quite positive; it was their predictions, or lack of them, about when the capital markets would start to thaw and when loans would begin to come from the banks and finance companies in any meaningful volume. One common phrase we heard was, "At least we still have Fannie Mae and Freddie Mac." But under their breath came, "at least for now." The finance company and bank executives want to lend money, and they understand that the industry is in better shape than others may think, but everyone is trying to strengthen their balance sheets, and anything to do with real estate usually is not welcome at their credit committee meetings. Will capital free up next year? We didn’t hear many people making that prediction, and most were hopeful that the environment would improve by 2011 or 2012, but they just didn’t know.
We had the same reaction on our annual mid-year audio conference that takes a look at the acquisition market half way through the year (CDs still available). Attendees were a little surprised that the panelists were not more upbeat. It turns out that the three providers were quite optimistic about the future and the operating environment in general; it was the two panelists who deal more with the capital markets who, while not negative, were certainly cautious about the future availability of capital, especially for large transactions. They have their hand on the pulse of the market, so to speak, and it is a faint one at that. No one knows exactly how the next wave of commercial property defaults will impact capital availability, but it won’t be pretty. With valuation declines of 25% to 50% in other real estate sectors, write-downs will be huge and vulture funds are already set up to take advantage of distressed selling. And unfortunately for seniors housing and care, that is where a lot of the equity capital will be going, because even though the risk is higher, the potential returns are higher as well (economics 101). Our values may be down, but not across the board and not anywhere to that extent.
Another hot topic at the NIC Conference, at least for some of us, was the anticipated appearance of The Wall Street Journal article on the CCRC industry. We heard it was supposed to come out three weeks ago in the Wednesday real estate section, so Wednesday morning there were many eager eyes scanning the pages to see if it was there. It was not…again. It is our understanding that the focus of the article is the inherent risk of entrance-fee CCRCs for both the residents and the lenders. In most states (if not all), in the event of a bankruptcy, the residents of a CCRC with a refundable entrance fee become unsecured creditors and often lose their right to the entrance fee when a buyer steps in and if all contracts are canceled in bankruptcy court. Ahead of them in the creditors’ line are the secured lenders or often the bondholders for not-for-profit CCRCs. Sometimes buyers do honor those refundable entrance fees to maintain good relations with the existing residents as well as the local community, but very carefully. The other aspect of CCRCs that we believe the article will be addressing involves the thin capitalization of the sponsor in many cases and whether this is made clear to both the buyers of the bonds as well as to the residents. The news of a recently started GAO investigation into the CCRC industry may have prompted the upcoming article. There is one CCRC in Pennsylvania that has been in bankruptcy that may be discussed, where the entrance-fee refunds may be canceled, as well as a new high-end, high-rise CCRC in Chicago that lost many depositors because of the housing market. Discussion of the current troubles affecting one of the largest CCRC companies in the country is also expected to be in the article.
We believe the company ran into trouble when it started to grow too quickly, meaning too many campuses started and under expansion at one time, in too many markets, including some that they may not have had as strong a knowledge about as their earlier communities on the East Coast. Or, the location may not have been as good as the earlier campuses. Two of Erickson’s Midwest communities may be part of The Wall Street Journal article. And, when the housing market crash is combined with this many new developments which count on seniors selling their homes, fill-up just wasn’t what the pro formas had projected. So part of the buzz at the NIC Conference was the fate of Erickson, and that a preliminary offering memorandum had just hit the market from, rumor has it, Houlihan Lokey.
Erickson manages 19 retirement communities with about 23,000 residents, eight of which are fully developed and have been sold to a not-for-profit that in turn hired Erickson to manage them (no surprise there). We believe that the other 11 communities are open and operating but at various stages of their build-outs, some close to the finish line, others not. Since we haven’t seen the official offering documents, it is difficult to determine exactly what is included in the sale and what’s not. That said, we are fairly certain that the management company is included in the sale, as well as the development and construction "business." We put that last word in quotes because we don’t believe that there will be much of a development and construction business in 2010, at least from a revenue perspective, compared with perhaps up to $40 million a year or two ago. We also hear that the management company revenues are approximately $30 million and should be relatively steady going forward.
We were caught by surprise with the offer, and the only one caught more off guard may have been Jon Harder himself. The rumor mill had him and his family vacationing somewhere in the Bahamas, perhaps relaxing and celebrating his "victory" with the reorganization plan where he and the other insiders could have, in theory, regained up to 25% ownership of the future Sunwest if all went well. One phone call had him back on the plane to try to head off disaster, or so the rumors went. If the Blackstone/Baty transaction goes through, he would get nothing but legal bills, and perhaps something else.
We had to chuckle when we read about the Blackstone/Baty offer, which has been preliminarily agreed to by Sunwest and its chief restructuring officer, Clyde Hamstreet, and the federal receiver, Michael Grassmueck. It is quite ingenious, actually, because Mr. Baty, through his various entities, owns about $265 million of Sunwest’s secured debt, loans he purchased in two batches from Credit Suisse going back to late last year. We had heard that he was very upset with how the secured creditors were being treated by Judge Hogan in the reorganization plan, especially the planned restructuring of the $975 million or so of debt in the future Sunwest. As it stands now, that debt for the reorganized company will have a term of three to five years, an interest rate between 5% and 5.5%, interest only for the first year and then a 25-year amortization after that. So, even though Mr. Baty bought his debt for what we hear may be around 80 cents on the dollar, while being Hoganized as a secured creditor, he will benefit as the Sunwest owner when he assumes the debt with the favorable terms, 30% of which he already owns. It is absolutely beautiful, because his effective rate as a debt holder will be closer to 7%, but as the future debtor (assuming the deal with Blackstone goes through), he will benefit from having a low interest rate and no amortization for the first year, giving them some breathing room on the capital costs side while they try to improve census and cash flow. And, because the deal won’t go through until the end of the year or by late January, in theory the occupancy rate and cash flow will continue their upward trend, acting like an option on what should be a continuingly improving asset. Pure genius.
Who will own how much is still up in the air, but Blackstone will probably own 50% to 60%, with Emeritus owning at least 10% and the Baty entities 10% to 30%. So, with a $27 million minimum investment (at least cash investment), Emeritus will reap about $22 million in annual management fee revenue, which is not a bad return on investment, and one that will only increase as census rises. As it now stands, the total purchase price is about $1.245 billion, or about $102,000 per unit. Remember, the properties being purchased may be a moving target, and the limited financial data we have is for a set group of properties, not all of which will end up being included. Consequently, we are using the best proxies we can to try to determine the valuation and upside.
Based on the properties that we believe will be in the purchase (at least most of them), the annualized EBITDA for the group, based on the first six months of 2009, is approximately $96 million (Sunwest’s number). Using a cap rate of 9.5%, that produces a value of $1.01 billion, or a little more than the assumed debt. The current cash flow, however, is higher than this because operations have certainly improved since the first quarter, and we know that current occupancy is just about 80%. It is quite possible that annualized cash flow today is well over $100 million, and increasing. Each 100 basis point increase in occupancy should result in an increase in EBITDA of about $3.0 million, and perhaps more. At 90% occupancy, EBITDA could be between $125 million and $130 million. We would assume that when stabilized and with a more normal capital market environment, the cap rate could decline to 8.5%, which would produce a future value of about $1.5 billion. So, in theory, that would be a $255 million return on a $270 million investment in what we assume to be a three-to five-year period. The ballpark annual return would then be about 20%, and this also assumes no debt pay-downs and no annual cash distributions.
But remember, the cost of that assumed debt is just 5.5% or lower, with interest only the first year. So the real cost of capital for the deal would be closer to 8.5%, which assumes a 20% cost for the equity. And with just $50 million or so of interest payments the first year, there will be over $50 million of excess cash flow available for equity returns, debt principal payments and capital expenditures. The last one is the most crucial, because you have to assume there is at least $1,000 per unit of deferred maintenance, and probably more, so that could mean a higher equity investment than just the $270 million of cash, unless they want to spread it out over the first 12 to 18 months and use the internally generated cash flow. At $1,000 per unit, that would mean $12 million, but we suspect that they will want to spend a lot more than that on an ongoing basis for market competition reasons as well as for future value reasons. We obviously have not seen the buildings, but more than half of them are less than 10 years old, and almost all of the rest were built in the 1990s, so this is not a particularly old portfolio, especially given its size.
The bottom line is that Blackstone/Baty is not getting a bargain price and the potential value will be based on future performance. However, we don’t believe there is significant downside risk at the current price either, especially with the excess cash flow that will be generated. The risk, therefore, is one of execution. The risk is also that taking on 148 properties so overwhelms the management team at Emeritus that the great progress Granger Cobb has made since coming on board either stalls or, worse yet, goes into reverse for a year or two. That would truly be unfortunate. Our suggestion would be to mimic in some way what Senior Resource Group (SRG) did when it took over management of the 45-facility portfolio that Lone Star Funds purchased from Sunwest last January (coincidentally, or not, at the same price of $102,000 per unit). SRG created a separate management company to deal with the Sunwest assets, partly because the Sunwest assets were so different from the SRG product, and partly because they needed more attention and a different kind of attention.
We know that Mr. Baty wants to get as large as a foothold as he can in the market right now, probably because with so little new development projected over the next several years, those with "boots on the ground" will be the winners. This may be true, but more often than not there is a breaking point in terms of size where economies of scale begin to work in reverse in the seniors housing and care sector. After all is said and done, however, our bet is still on Baty.
Since all of this happened, Judge Hogan approved the distribution plan and Sunwest filed its Chapter 11 bankruptcy reorganization plan on October 2. In connection with this, Sunwest has hired the investment bank Moelis who will work with the chief restructuring officer to solicit public bids for the core HoldCo property group and hold an auction to ensure that creditors and the TIC investors get the highest value. We assume this is partly in response to criticism that the Blackstone/Baty bid was not tested in the market and just accepted as a "money-in-the-bank" today deal, since they had their own execution risk of reaching a significant premium to the debt outstanding. And remember, the $270 million in cash will be on top of any third party claims that Sunwest is working through, which could bring in some significant sums. In today’s market, no one is buying large portfolios and most people are using cap rates between 8.5% and 10.5% on in-place cash flow or trailing 12 months. When looked at it this way, Sunwest is receiving a premium bid and gets rid of its execution risk. We don’t think they will receive a higher offer.
The Sunrise Portfolio. The final bit of gossip from the conference involves the sale of what is known as the "Blackjack" portfolio, or the now 21 properties owned by Sunrise Senior Living (NYSE: SRZ) that are being sold by Goldman, Sachs. Even though the original portfolio was larger and included some leased assets, do you think that the name Blackjack was derived from the 21 owned properties? Hmmm. We understand that Dan Baty and at least one other bidder are neck and neck with their prices and terms, with a price near $185 million, which is well within the range we valued the portfolio at last month. The market must think something is up as well, as SRZ’s share price increased by more than 30% in September. The proceeds from the sale will be used to pay down SRZ’s bank debt, the maturity of which has been extended a few times and is now due in December. With a sale, Sunrise’s viability is certainly enhanced. Stay tuned.
Although asking prices are not usually associated with this sort of sales process, the number we heard was about $150 million of cash plus the assumption of nearly $250 million of debt. What we have not determined is whether the real estate associated with the 11 campuses that are open and still being built out is included in the purchase. If that real estate is included, and if many of the campuses are far along the development schedule, then the price would be a relative bargain. That alone tells us that no real estate is included in the sale. But remember, with refundable entrance-fee communities the "value" of the real estate is diminished because as long as those contracts are in force, any sale is subject to them so you don’t capture the full value of the real estate.
Depending on the actual assumed debt number, the "price" would come to about 13 times gross management fee revenues, or about 20 times net revenues. That seems a bit rich to us, but we don’t understand what happens to the 11 properties that have yet to be sold to the not-for-profit entity and who would own the real estate. The other question that came up was, Who would buy it? We have heard there is a stalking horse bidder for $100 million who is an FOJ (friend of John). We’re not sure if that would be a purchase price or a figure to recapitalize the company and satisfy the creditors. Traditional names such as Life Care Services and Chartwell/Horizon Bay were mentioned, but we just don’t see either one of them taking this on in this market environment. And we don’t see the private equity firms doing this either. But we said the same thing about another troubled company.
Erickson Retirement Communities. It has been common knowledge that Erickson Retirement Communities has been under financial pressure for more than a year. The first public hint came when the company laid off nearly 50% of its corporate staff at the beginning of 2009. Erickson has been a very successful and unique model in the CCRC industry. With its large campuses, starting at perhaps 400 entrance-fee units and then expanding in stages to 1,000 and up to 2,000 units or more, it has succeeded in the mid-tier market better than most and knew its customer very well. Its super-sized campuses, however, were unique, and in some ways the model works best when it gets to that size. This is because of the high upfront costs of a planned 1,000 to 2,000-unit community as well as the lower-than-average monthly rental rates upon which the management fee revenues are based.
Sunwest Management. At last year’s NIC Conference, many people were surprised that Sunwest founder Jon Harder showed up, and some creditors, if given a chance, might have been tempted to slip a mickey into his Kool Aid. He didn’t show up this year, but a few Sunwest executives were there, we assume partly to keep some industry contacts and, we hear, trying to see if they could drum up a bid to top that of Blackstone Real Estate Advisors. Within weeks of the proposed reorganization and distribution plan being filed by Sunwest, Blackstone, in partnership with Emeritus Senior Living (NYSE: ESC) and Columbia Pacific Management, Inc., an entity controlled by Dan Baty, the Chairman of Emeritus, made an offer for what was to be the new Sunwest, known as HoldCo in the reorganization plan. Although there has been no "official" word on the terms, we understand the price to be about $270 million of cash plus the assumption of the debt associated with the approximately 148 properties to be sold. The debt number is a moving target, as are the properties, but we are going to use the number of $975 million, which is as close as we can get from the Sunwest documents we have reviewed. It may end up as low as $950 million.