Capital Structures In Flux

From revamped RIDEA structures to renegotiated triple-net lease agreements, owners and operators seek to better align financial interests.

By Jane Adler

Market realities are forcing owners and operators to take a hard look at the underlying capital structure of properties with an aim to better align each party’s interests.

Stressed operators face soft occupancies amid an oversupply of product in some markets. Rent deferrals for underperforming properties that have triple-net leases in place are becoming more common. 

Competition from private equity groups for high-quality properties is pushing real estate investment trusts (REITs) to favor RIDEA partnerships — authorized by the REIT Investment Diversification and Empowerment Act of 2007. Specifically, the act allows REITs to participate in the operating cash flow of an asset. 

At the same time, owners are finding creative ways to include incentives for the operator in leases, or in joint venture agreements. Some industry experts say the new structures are poised to benefit both owners and operators, especially if the market is ready to turn the corner as new construction slows. 

“There needs to be an alignment of interests between the operating partners and the capital partner,” says Shankh Mitra, chief investment officer at Welltower (NYSE: WELL), a big healthcare REIT based in Toledo, Ohio. 

Welltower owns 877 senior living buildings, of which 560 are in operating or RIDEA agreements. Welltower works with 21 operators. “We win or lose together,” says Mitra. 

Other investors agree. The interests of the operator and the capital partner ideally should be aligned in the capital structure. 

“We structure joint ventures with incentives for the operator,” says Kathryn Sweeney, co-founder and managing partner at Blue Moon Capital Partners based in Boston. The private equity firm owns 17 buildings. Blue Moon isn’t a REIT, so it doesn’t have RIDEA partnerships. 

Blue Moon doesn’t use triple-net leases either because the operator shoulders the risk in those structures, says Sweeney. An operator keeps the cash flow generated after the lease payment, which benefits the operator in good times and hurts them when the market is soft. 

“We don’t find that to be a good alignment of interests,” says Sweeney. “We are willing to take risk alongside our operating partner.”

RIDEA 3.0 

Many of the capital structures created a decade ago are outdated, sources say. Under early RIDEA structures the operator received a 5 percent management fee whether the property performed well or not, explains Mitra at Welltower. A property’s cash flow could drop 20 percent, but the operator’s profit remained stable. 

“That’s the problem,” says Mitra. “The interests of the operator and owner were not aligned.” 

RIDEA structures have undergone several reboots, according to Mitra. The second iteration of RIDEA structures — what Mitra calls RIDEA 2.0 — included incentives for the operator as well as variations of operating company/property company (opco/propco) structures.

Today’s agreements — RIDEA 3.0 — have moved well past earlier versions, says Mitra. Structures now include different levels of cash flow and rewards relative to different levels of growth. “It’s not a straight line incentive,” says Mitra. “We are very creative. I want our operators to make money through operations.”

RIDEA structures generate the best earnings in big, high-growth markets with significant room for rent increases, he adds, emphasizing that in many situations leases are best. 

Last August, Welltower and Brandywine Living announced the conversion of the companies’ master lease from a triple-net structure to a RIDEA agreement. In a press release, Welltower described the new agreement as “an incentive-based management contract.” The portfolio includes 27 Welltower owned and Brandywine-operated communities in Connecticut, Delaware, New Jersey, New York, Pennsylvania and Virginia. Brandywine is based in Mount Laurel, New Jersey.

“Brandywine operates a high-quality portfolio of newly built communities with an average age of 13 years, primarily in metropolitan statistical areas (MSAs) in the Northeast that represent some of the highest demographic scores in our portfolio,” according to Welltower’s
second-quarter earnings release. “We believe this structure aligns our interest, as well as Brandywine’s, to benefit from strong growth from this great real estate in the long term.”

Last June, Welltower announced the formation of a RIDEA venture with Pegasus Senior Living, a newly created management group based in Dallas. Previously, Brookdale Senior Living managed the 37 properties through a triple-net lease structure under terms of the agreement.

RIDEA structures are on the rise, both for older properties and new ones. Many existing triple-net leases are 10 to 20 years old and have seen a significant decline in lease coverage ratios — which measure the ability of the operator to pay the rent and debt obligations. (NOI ÷ debt service + rent = lease coverage ratio. A ratio below 1.0 indicates NOI is insufficient to meet obligations.)  In short, net operating income has not kept pace with regular lease escalations of approximately 2 percent annually. 

Nearing the end of the lease term, operators are less likely to invest capital in a property, says Kendall Young, executive vice president and senior managing director of senior housing properties at HCP (NYSE: HCP), a big healthcare REIT based in Irvine, California. “Capital investment is critical to maintaining performance with all the new competition.”

As a result, the interests of the owner and operator can be misaligned as leases near their maturity, or if the lease coverage ratio has deteriorated. The conversion of a triple-net lease to a RIDEA structure may better align the interests and incentives of each party, says Young. 

At HCP, new RIDEA structures include a base management fee and incentive fee if performance is better than expected. A provision for a reduced management fee is also included in the event performance is weaker than expected. 

HCP funds capital expenditures to keep the properties competitive so the operator can achieve or exceed expected performance, adds Young. 

In a challenging market, RIDEA agreements may benefit REITs for another reason, sources say. The REIT has the flexibility to switch operators if results are below expectations under a RIDEA agreement. A lease ties the operator to the REIT as long as the payments are made. 

The private equity factor

Rising values for high-quality seniors housing properties that are in demand favor RIDEA structures. Private equity investors have bid up the prices on the highest quality assets, now trading at cap rates in the low- to mid-5 percent range, according to sources. At that level, it’s difficult to create a triple-net lease that provides both adequate yields for the owner and cash flow in excess of the rent and debt payments to provide a profit for the operator. 

“If you want to be a big player in today’s environment, you need to be willing to do RIDEA,” says Danny Prosky, founding principal at American Healthcare Investors, a real estate advisory firm. The company sponsors two nontraded REITs, Griffin-American Healthcare REIT III and IV, which invest in healthcare real estate, including medical office buildings, seniors housing and skilled nursing facilities. Prosky’s office is in Irvine, California. 

“Investors that want to acquire a nice, quality assisted living facility with a decent yield of 7 percent or higher must consider a RIDEA structure,” says Prosky. “That’s what the market demands.” 

RIDEA structures, however, tend to have choppy returns, notes Prosky. “You may have some good years, but also flat years where you don’t see any earnings growth.”

Looking ahead, Prosky thinks the overall senior living market is poised to improve as new construction slows. That will help boost occupancies and rental rates, and could give traditional lease structures a boost. “All things being equal, we prefer a lease structure,” he says. “It’s easier to predict rent flows 10 to 15 years ahead.”

Despite an uptick in RIDEA structures, they’re not right in every situation. Publicly traded Brookdale Senior Living (NYSE: BKD) is cutting back on its RIDEA partnerships as it realigns its portfolio. 

As of Dec. 31, 2018, Brookdale operated 892 communities. It owns 344 communities and leases 343 communities. Brookdale manages 205 properties for third parties. The company would not confirm the number of properties with RIDEA agreements but the number has declined. 

A year ago, Brookdale had 202 communities in RIDEA structures out of a total of 1,031 communities. “It’s a conscious strategy,” says Lucinda “Cindy” Baier, president and CEO at Brookdale based in Brentwood, Tennessee. “We are increasing our 100-percent-owned properties and decreasing the number of communities we lease or manage through RIDEA.” She adds that Brookdale has also increased its third-party management of buildings in which it has no ownership stake. 

The Brookdale switch from RIDEA partnerships has been spurred by SEC reporting requirements, says Baier. RIDEA results must be reported separately from financial results, which tends to present a complicated story to retail investors. “We don’t feel we get the same value for our stock price,” she says. “RIDEA is a good structure for private operators.”

Outright ownership also allows Brookdale to control its own destiny, says Baier. Joint ventures of any type are more complex to operate with multiple levels of approvals needed to make decisions. 

“You want to be nimble,” says Baier, citing today’s tough operating environment with increased competition among providers for residents and workers. “It’s easier when you own the property.” 

Baier is quick to add, however, that the overall impact of the capital structure is small compared with the big picture. “What primarily drives stock prices is improved operating results,” she says. 

Other operators cite the difficulty of multiple approval levels as a reason to avoid joint ventures and RIDEA partnerships.

Juniper Communities operates 23 senior living buildings. It owns 16 buildings, leases five buildings and manages two others. The company has never entered into a RIDEA structure with a REIT, though it considered doing so about seven years ago. 

“Negotiating the agreement was more difficult in terms of daily operations than we thought,” says Lynne Katzmann, founder and CEO of Juniper, baased in Bloomfield, New Jersey. The company prefers a mixture of ownership, non-RIDEA management agreements and leases. That helps spread the risk associated with each capital structure. “We believe in a diversified portfolio of risk,” says Katzmann. 

Juniper has a triple-net lease arrangement with LTC Properties, a healthcare REIT based in Westlake Village, California. In a third-quarter 2018 earnings call, LTC’s CEO and President Wendy Simpson noted that even though the big healthcare REITs are inking more RIDEA deals, many operators in LTC’s target group shun RIDEA structures. 

Joint ventures

Balfour Senior Living operates eight communities with two more scheduled to open in the next 12 months.  None of Balfour’s properties are in RIDEA structures, but they are in joint venture agreements with capital partners. Balfour co-invests about 10 percent equity in the projects. Balfour also has a development arm that receives a development fee for the new projects.

Balfour is currently considering a RIDEA agreement with a REIT for the acquisition of some of its existing assets along with the expectation to jointly develop future projects. 

The benefit to Balfour is that REITs tend to have a longer hold period of about 15 years compared with private equity firms that may want to sell the asset after five to seven years. Operators can lose the management contract when a property is sold. “Long-term management contracts are appealing to us,” says Michael Schonbrun, founder and CEO at Balfour, which is headquartered in Louisville, Colorado. 

REITs also have the deep pockets for Balfour’s big, upscale developments that feature 100 to 200 units. “I prefer to have a capital partner whose interests are not just collecting lease payments, but also sweating the same things we are,” says Schonbrun. 

REITs are experimenting with other structures. Omega Healthcare Investors (NYSE: OHI) is a publicly traded REIT based in Hunt Valley, Maryland. About 83 percent of its portfolio consists of skilled nursing facilities. None are owned under RIDEA structures because nursing homes tend to generate less cash flow than seniors housing properties. Also, the REIT can be held liable for insurance claims at skilled nursing facilities, according to Taylor Pickett, CEO of Omega. 

Low occupancies are putting skilled nursing providers under pressure, so Omega is renegotiating leases with some operators. A portion of the rent is deferred with the expectation that as occupancy improves, higher cash flows will be used to repay the deferred rent — an arrangement Pickett likens to a RIDEA structure. 

Omega will consider RIDEA agreements as it expands its senior housing portfolio, says Pickett. The REIT is also creating new structures to align its interests with the operator. 

More specifically, the company is building a $280 million assisted living high-rise on Second Avenue in New York City. Maplewood Senior Living, which will operate the property, can share in the future value of the high-rise, says Pickett. “It far outweighs the incentives they would receive under a RIDEA structure.”