The Largest Deal In 18 Months Sets The Stage For More
As everyone knows, Sunwest Management, together with its various Canyon Creek Development affiliates, has been under mounting financial pressure from mortgage lenders, unsecured creditors and TIC investors, not to mention various state licensing authorities. Part of the reason was a result of management’s own doing, but also because of the current credit market crisis, certain lenders have a need to recapture their own capital. The former cause included growing too fast, a common mistake in the seniors housing industry. But there have been very few companies that tried to do what Sunwest did, which was to buy well over 225 properties in a four- to five-year period, in more than 100 transactions, covering more than 30 states across the country, and live to brag about it. If Sunwest had stuck to its knitting, which was developing seniors housing communities in the West, and mostly Northwest, supplemented by an acquisition here and there, we would not be writing this story. But with that rapid growth by acquisition, as a result of being the winning bidder more often than not in a rising market with cap rates cascading downward, operations never had a chance to catch up with the deal-mongers, and the rest, as they say, is history.
Sunwest Management in this decade is similar to the former Alterra Healthcare in the 1990s, an assisted living company that believed in its ability to engage in a building spree unmatched in industry history (to our knowledge) that ended with them trying to open a new community each and every week for over a year. Not only is that pace trying on the operations staff, but eventually the overwhelming amount of capital needed to accomplish this turns into an avalanche of monthly payments that eventually buries a company. It is at that cross-over point, when management shifts its focus from growth and, we hope, operations, to the financial side of the business and fighting for its survival, that we know the beginning of the end is near. Some would say it is way before that.
There were whispers in the market two years ago questioning the sustainability of the Sunwest model, just as there were whispers in the 1990s when Alterra’s founder and then CEO, Bill Lasky, was publicly defying the naysayers about his ability to manage his way out of his self-created demise. His company ended up in bankruptcy court, and was eventually absorbed by Brookdale Living Communities (NYSE: BKD). Sunwest’s founder, Jon Harder, has already filed for personal bankruptcy protection (see last month’s story), but a bankruptcy filing by Sunwest Management itself seems unlikely since it is a management company with all the properties held in various LLCs with different investors and lenders. And, to muddy the waters further, the noise you would hear from bankruptcy filings by all the various Canyon Creek affiliates would be a great sucking sound as any excess cash held by the combined entities would disappear into the morass of enormous legal and consulting fees associated with those filings. A cheery thought, eh?
Getting back to the second problem facing Sunwest Management—its creditors—it has been well-known that GE Healthcare Finance was not happy with its mortgage loans extended to various Sunwest affiliates as the credit crisis deepened last year, and GE’s exposure grew by more than one-third with its acquisition of the Merrill Lynch Capital mortgage portfolio a year ago. Our understanding is that while there were some technical defaults on the portfolio, by and large the GE portfolio was cash flow positive and covered its debt payments. That said, it was apparent at the time that Sunwest as a whole was under increasing financial stress, and whether GE wanted to get out before the proverbial house of cards came tumbling down or it just wanted its money back for its own internal capital needs is of little matter at this point. Six months ago we heard they were camped out in Sunwest’s offices, and Mr. Harder was scrambling for a financial lifeline at what ended up being the worst possible time in 70 years to be looking for capital. That is known as bad timing, and at least he can’t be blamed for the current financial mess in the capital markets.
Sunwest Management was founded in 1991 and by the middle of 2008 it had under its control nearly 300 properties with more than 25,000 units, becoming in the last five years one of the largest players in the market. As occupancy and financial pressures started to unravel the company, it was clear (at least to some) that it was time to start shedding some assets. Unfortunately, from what we hear there was not a lot of agreement as to how that should be done, how quickly and which assets. In the last few months, the company has shed a few properties in one-off sales, and in December what was known as the “Carolina portfolio” was sold to Five Star Quality Care (NYSE: FVE) for $44.0 million, or about $73,200 per unit. These seven properties with about 600 units had filed for bankruptcy protection earlier in 2008, and the sales price did not cover the debt outstanding. We assume this was part of the original 150 or so properties that had been slated for possible sale, but our guess is that practically the entire company was “put out there,” so to speak, to see what might stick. The reality, however, was that pressure from GE seemed to be driving the sales process, at least for the first stage, and it was the sale of a 45-community portfolio with GE debt that was just completed in mid-January.
Although the buyer has not been publicly disclosed, it became somewhat common knowledge late last year that Texas-based Lone Star Funds was the buyer who ended up paying approximately $364.0 million, or just over $102,000 per unit, for 45 of the Sunwest properties with 3,554 units located in 11 states, including Alabama, Arizona, California, Colorado, North Carolina, Oregon, South Carolina, Tennessee, Texas, Washington and Wyoming. While these 45 communities offer independent living, assisted living and dementia care services, the majority of the units are traditional assisted living, and the overall occupancy of this portfolio is about 85%. Dave Rothschild, Matt Whitlock and Mary Christian of CB Richard Ellis represented the seller in what we believe to be the largest announced transaction in the seniors housing and care market in nearly 18 months.
That is about all the financial details that have been released, so the rest of our analysis will be based on some market assumptions as well as small details we have heard from other market participants who have had a look at the deal. We understand that this group of 45 properties included some of the best-performing communities managed by Sunwest, and as a portfolio was fairly good overall. This is why we believe Sunwest’s management was reluctant to give up this group of properties, because they were cash flow positive and could help, in theory, the company keep its head above water, even though funds in the various LLCs were not supposed to be commingled.
We know the portfolio was 85% occupied, and since the quality was apparently good, we are going to assume that the average revenue per occupied unit was between $2,800 and $3,200 per month. The dementia care units would be higher, and the independent living would be lower, but the assisted living units would probably have a very wide range depending on location and level of care, but we will assume close to $3,000 may be appropriate. The operating margin on a portfolio with 85% occupancy could be as low as 25%, but the dementia care and independent living units would drive it higher, most likely near 30% for the group. So, using these assumptions, we derive annual revenues of about $109 million and EBITDA of $32.7 million, yielding a theoretical cap rate of about 9.0%. Could it have been as high as 10% in this market and under these circumstances? Yes, but we don’t believe it would have been as low as 8%, primarily because there are not enough bidders in this market for a portfolio of this size to drive the price up and cap rate down.
The one caveat to this is that in almost any other case, a discount would have been applied to a portfolio of this size by most buyers because of the illiquidity in the debt markets. However, because we believe that the buyer was basically assuming the existing GE debt and putting in an unknown amount of equity to make up the difference in “value,” the actual pricing may have been closer to true market value without the debt market overhang complicating things. Also, we don’t know whether the GE debt was re-priced for the buyer or the basic terms were left in place with, perhaps, some of the maturities extended. If our analysis is reasonably close to accurate, Lone Star probably got a pretty fair deal and, despite the characterization as a good portfolio, we assume there is significant upside, and that is where management comes into play.
It is apparent that Sunwest Management devoted its time and energy to growing the company by acquisition, and we had often heard that operations were kind of left behind. Even if the operations staff had been the best in the industry with more than enough resources to do its job, it is doubtful they could have handled the explosive growth of the past five years, especially during the past 12 months as management’s focus changed amid the mounting financial pressure. Lone Star has hired an affiliate of California-based Senior Resource Group (SRG), called LaVida Communities, to manage their new seniors housing portfolio. When we first caught wind of this a month ago, we thought it was a mistake and a complete mismatch. After all, SRG is known for developing and managing very high-end retirement communities, currently in three western states and Florida, and not middle market assisted living facilities in secondary and tertiary locations. We just don’t think Sunwest has a Maravilla of Santa Barbara in its portfolio. And, the company has just 13 communities under management, plus two more under construction. So, SRG is effectively quadrupling the number of properties under management and going from four states to 12 states at the stroke of a pen. Our initial reaction was, are they nuts? Do they have a clue what they are getting themselves into?
Of course they do, but while it may be without financial risks, there could be a stress toll. No one will talk, but our guess is that the top brass at SRG is not taking on this portfolio for a measly 5% management fee. Even though that would gross the company in excess of $5 million annually before out-of-pocket expenses, we assume there is a potent incentive piece as part of the contract, and there should be. There are approximately 530 empty units in the portfolio, and while they will not all get filled, they represent an additional $20 million of potential annual revenue. Since the profit margin on incremental occupancy is quite high, the incremental EBITDA should be at least $10 million, which means at least $100 million of potential additional value at 100% occupancy. Usually, we would assume an incremental profit margin closer to 75%, but we are assuming that Sunwest’s expenses have been a bit on the low side and that there will be a need to bring some of the properties up to operational snuff, so to speak.
This is not the first time the company has been brought in to manage a turnaround situation for an outside investor, having done some management work for REITs and private equity firms in the past. We assume in those cases the assignments were relatively short term, probably less than two years. With the Sunwest portfolio, we assume it will be longer term and will coincide with Lone Star’s eventual sale of the portfolio when the market is in better shape, and when the properties have reached their full potential value. SRG has a very strong reputation in the market, and with its high-end communities, we know that they know how to take care of their residents. What we are going to assume is that they will bring this approach to the former Sunwest communities, but in a somewhat less glamorous, scaled down way. In addition, we also assume that the SRG people will bring in a sophisticated financial and reporting system with strong controls, which is probably needed at this point in time. The bottom line is that SRG is more of a careful, plodding operator that wants to do it right the first time, and is willing to put the time and money into a project to make sure it is right the first time. After all, there is a reason they have just 15 communities in their portfolio after all these years. So, after our initial surprise since the two companies, Sunwest and SRG, are so different, we conclude that it is perhaps that difference that is best about what SRG will bring to this portfolio, to the benefit of Lone Star, GE and, most importantly, the residents. We hope to be able to write about the sale of this 45-property portfolio in three to four years, when occupancy is 95%, revenues are $150 million, EBITDA is approaching $50 million and the price is well over $500 million.
Finally, this transaction is important for Sunwest as well as the seniors housing industry for a variety of reasons. First of all, with no deals in 2008 crossing the $300 million threshold, it starts 2009 with quite a bang, and maybe injects a little bit of much-needed confidence in the market and tells us that, yes, there are still equity investors out there who believe in the industry and recognize value. Second, with the Carolina deal complete and now this larger transaction, the logjam at Sunwest may now finally be broken. We know that the company’s restructuring advisors, Hamstreet & Company, still want to preserve as much of Sunwest as possible, but unless the courts intervene to prevent it, this deal shows that there is a market for Sunwest’s properties, and our guess is that other lenders will be more open to ride with credible purchasers much as GE has done with Lone Star.
Sunwest has stopped making mortgage payments even on properties with debt service coverage ratios in excess of 1.5x, so lenders are not in a very good mood with regard to the current Sunwest management team and will do everything they can to remove them or force the sale of their properties. If the current disarray at Sunwest continues for much longer, with reduced attention on operations and certainly no money being reinvested in the properties, the headlines on resident care will only proliferate, and that will be a black eye for the industry, especially with labor issues moving to the forefront with the Obama administration and a Democratic-controlled congress. We understand that hearings were held in late January in an attempt by Sunwest to obtain a stay to prevent future foreclosures, and we haven’t heard whether the judge has made a ruling. This story, unfortunately, is not over.