Long-term care on the mend in 2004
Raymond J. Lewis
The senior living industry experienced the beginning of a turnaround in 2003–particularly in the skilled nursing sector. But what can providers learn from their collective experience last year? And more importantly, what can the industry expect in 2004?
The seniors housing industry as a whole witnessed the beginnings of a recovery across all sectors last year. The upturn was led by the skilled nursing sector, which benefited from increased Medicare funding as a result of market basket rate adjustments and partial restoration of the “cliffs.” Furthermore, while many believed that the year would bring substantial cuts in Medicaid funding because of state budget shortfalls, the cuts never materialized in most states. Although liability insurance and litigation costs continued to pressure skilled nursing operators, we began to see real progress in tort reform with the passage of a $250,000 hard cap on noneconomic damages in Texas. The passage of real tort reform legislation in Texas and several other key states may signal the return to a more rational operating environment as other states follow their lead.
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Positive signs of recovery were witnessed in other industry sectors, as well. Sectors such as assisted living, for example, continued the theme of limited building and steady lease-up contributing to improved occupancy rates and financial performance.
2003: Setting the Stage for Consolidation
A number of events last year helped to set the stage for future consolidation. First, the industry continued to work out of its financial problems. Several companies such as Alterra Healthcare Corp. emerged from bankruptcy, creating platforms that will begin looking to acquisitions to grow as they return to financial strength, or become an attractive merger partner for other regional providers.
Second, there were several significant capital events in the skilled nursing industry. Trans Healthcare, Inc.’s acquisition of Integrated Health Services, Inc.’s facilities brought those facilities out of bankruptcy, creating overnight one of the top five largest nursing home companies. Fountain View, Inc., emerged from bankruptcy, and Centennial HealthCare Corp. filed for reorganization under Chapter 11. Genesis HealthCare Corp. spun off its nursing home operation from its pharmacy company to create a significantly capitalized and strong operating company that should be able to aggressively seek growth opportunities. These events will set the stage for the nursing home industry to accelerate its consolidation in 2004.
At the same time, we saw a sizable increase in the number of equity financing sources and the appetite for investment, particularly in financing property acquisitions or refinancing stabilized assets. An outgrowth of the more competitive financing environment was a modest relaxing of underwriting standards (capitalization rates and valuation multiples), as well as some compression in pricing. Interest rates compressed between 50 to 75 basis points on average, while lending multiples of EBITDA (earnings before interest, taxes, depreciation, and amortization), the approximate measure of a company’s operating cash flow, expanded by 0.5 to 1.0 times.
Key Financial Indicators Show Positive Trends
In reviewing last year’s Key Financial Indicators–industry-wide statistics compiled quarterly by the National Investment Center for the Seniors Housing & Care Industries (NIC)–there were even more reasons to feel optimistic about heading into 2004.
As 2003 came to a close, occupancy and move-in rates continued to show signs of improvement in the industry. In skilled nursing, average occupancies rose from 85% in the second quarter to 87% in the third quarter. For assisted living median occupancy rates were somewhat bleak at 83% in the first quarter of 2003 and 84% in the second. However, rates improved slightly to 85% in the third quarter. The average net move-in rate (for properties open less than 24 months) was also more positive, increasing to 4.8 from 4.3 in the previous quarter. In congregate care the median and average occupancy rates held steady in the third quarter at 89%. And for this sector, the average net move-in rate increased compared to the previous quarter, rising from 4.8 to 6.1.
Perhaps most encouraging was the overall drop in the delinquency rate for permanent debt, which went from 5.4 to 3.6% for the entire seniors housing and care industry. Decreases in permanent debt delinquencies in the assisted living and congregate care sectors were the leading contributors to the improved third quarter results. Permanent debt delinquencies dropped from 10.01 to 4.30% in assisted living and from 1.94 to 0.25% in congregate care. These drops signified that many of the troubled properties were continuing to work their way through the system for the remainder of last year. On the skilled nursing side, permanent debt delinquencies actually increased from 8.41 to 12.71% during this period, showing there is not a lot of room for error in this sector.
What All This Means for Investors
All in all, capitalization rates went down and multiples went up throughout the industry’s sectors last year. For assisted living, rates settled down between 10 to 11%. Multiples in skilled nursing expanded from 6 to 6 1/2 times to 7 to 7 1/2 times EBITDA. The primary drivers for these numbers were more dollars chasing fewer attractive opportunities. Interest rates also contributed to increased valuations. With the availability of competitive long-term, fixed-rate financing, investors could afford to pay higher multiples and still generate attractive cash returns on equity. While paying a higher price creates potential risk if the market reverses in the near term, those who can hold on to their properties for the long term–that is, for 10 to 12 years–should be able to get good, constant returns on invested capital and pay down debt.
A majority of lenders reported their intention to increase, or at least maintain, previous levels of funding to all sectors of senior living in 2003, according to the 2003 Lender and Equity Investor Surveys, a report issued by NIC. Projected funding was estimated at $9.75 billion or more during last year, and many of the lenders were primarily invested in freestanding assisted living and nursing facilities, with both housing types showing equal investment preference.
What to Expect in 2004
Now that we’re well into the first quarter of 2004, all signs indicate that the senior living industry can expect to see a continued interest in skilled nursing and assisted living by financiers. Although both sectors were out of favor for quite some time, they appear to have turned the corner.
In the near term, there will be continued emphasis on investing in cash-flowing properties. This is because people are not going to risk investing in speculative projects unless they can find strong in-fill market locations to build, or can acquire turnaround properties at bargain basement prices. These situations tend to be few and far between.
Toward the end of 2003, we were beginning to see evidence of a bifurcation of the market, particularly in assisted living. The industry should expect to see this trend continue this year. High-quality, stabilized properties should attract significant interest from the real estate investment trusts (REITs) and institutional investors, while the poorly managed, underperforming properties will likely be ignored.
REIT financing is a growing option for operators seeking nondilutive growth capital because it can provide a good alternative to conventional debt and equity sources. All of the healthcare REITs are taking advantage of the attractive industry fundamentals and have raised significant amounts of capital. This could translate into a robust selling environment for facility operators as the REITs compete for the limited number of deals in the market.
One thing that could be different in 2004 is that private equity sources could become more impatient. Many firms that invested in the go-go nineties have been waiting for the public markets to return or for their properties to reach a point where they can exit with a profit. As more time passes, they may well realize that they bought in at the top and will not be able to generate the kinds of returns that they originally forecast. As this reality takes hold, the industry should start to see larger portfolios coming on the market and some big opportunities for consolidation in the assisted living sector.
In comparison to previous years, 2004 could be a good year for nursing home and assisted living mergers and acquisitions. More capital is available, and the rates are at all-time lows. Operators looking for an exit should be prepared to take advantage of these factors. If they do, 2004 could be an exciting year for the long-term care industry.
Raymond J. Lewis is Senior Vice-President and Chief Investment Officer for Ventas Healthcare Properties, a national healthcare REIT with offices in Chicago and Louisville, Ky. Lewis is past Chair of the National Investment Center for the Seniors Housing & Care Industries (NIC). For more information about Ventas, visit www.ventasreit.com or call (877) 483-6827. For more information on NIC, visit www.nic.org. To comment on this article, please send an e-mail to lewis0304@nursinghomesmagazine.com.
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