Company Profile: AdCare’s bold strategic shift

Owner/operator moves toward becoming a skilled nursing REIT adept at small transactions.

By Jeff Shaw

The skilled nursing sector is going through plenty of changes right now. 

As the U.S. population ages amid longer life expectancies, third-party payors (particularly Medicaid and Medicare) now strongly encourage treatment of short-stay, high-acuity patients in skilled nursing facilities. 

Many owners and operators have shifted their focus to short-stay patients to maximize their reimbursement.

Some of the largest owner/operators, meanwhile, are spinning off their skilled nursing portfolios into separate companies in order to operate more efficiently — a recent example being Ensign Group’s recent creation of Care Trust.

AdCare Health Systems (NYSE MKT: ADK), which owns 37 skilled nursing facilities and two assisted living facilities largely concentrated in the Southeast, elected to take a different approach.

Rather than create a new company for its operations, AdCare decided to simply lease out its facilities to quality local operators who know each market — transitioning from an owner/operator of healthcare properties to a healthcare real estate holding and leasing company. 

Essentially, AdCare is reorganizing itself as a real estate investment trust (REIT), though the company doesn’t expect to elect official REIT status until at least next year when it meets the qualifications.

“Given the size of the company at 39 facilities, and the company’s somewhat limited access to capital as an operating company, being able to grow significantly as an operator was just not feasible,” says William McBride, chairman and CEO of AdCare. “At that size, the board of directors felt it was too small to operate independently. The best avenue was to lease out our properties and convert to a REIT.”

The company considered a wide range of alternatives, including selling to a REIT rather than forming its own, but executives were not satisfied with the proposals received. The interested REITs did not want to undergo the effort of transitioning to new operators.

“We’re doing the hard work of bringing in new operators, so that in a few months we’re just collecting rents,” says Allan Rimland, the company’s CFO and president.

Big changes in a short timespan

The decision to lease out all properties won shareholder approval last year after a four-year acquisition spree during which the company honed its focus on skilled nursing. From 2010 to 2014, AdCare purchased 23 skilled nursing facilities while divesting five of its seven assisted living communities.

The company also moved from Ohio to Atlanta during that period, incorporating in Georgia in 2013. The company was drawn to a wider hiring pool in Atlanta and proximity to most of the company’s portfolio, which is currently spread across Georgia, North Carolina, South Carolina, Alabama, Arkansas, Oklahoma and Ohio.

AdCare hired McBride in October of 2014 to lead the company through its transition and benefit from his experience as co-founder of public healthcare REIT LTC Properties Inc. (NYSE: LTC). He in turn recruited Rimland, a former colleague with extensive experience in healthcare REIT finance and M&A, in April.

“I’ve worked with Allan for over 20 years; he was involved in LTC Properties” says McBride. “He has lots of banking background. I brought him on to help me run and grow the company.”

David Tenwick, who founded the company in 1991 with the acquisition of Passport Retirement Inc., will continue as a director at the company. Because his experience stems more from the operations part of the business, Tenwick decided to act more as an advisor than take an active role in company changes.

“He’s a valuable resource for me and the board,” says McBride about Tenwick. “Dave’s been doing this a long time and he was ready to take a step back with his role in the company.”

The plan for converting to a real estate holding company is well underway. In July, the company leased out its last three facilities, and 34 of the 39 facilities have already transferred to their new operators as of press time.

AdCare facilities — all of which are triple-net leased — vary in size from 52 to 154 skilled nursing beds, with 100 beds being the average. Several of the company’s facilities are financed through HUD, which requires a lengthy approval process to change operators.

“The strategy on the financing side is a mix of HUD financing, senior secured mortgage financing with commercial banks, convertible debt and other methods,” says Rimland. “That mix of financing gives us flexibility in the market.”

The average age of an AdCare facility is approximately 15 to 20 years, adds Rimland. “We don’t like the risk-reward on new builds. There are a lot of development deals going around, but we shy away from those.”

Better risk-reward tradeoff

AdCare decided to hang its hat on the skilled nursing sector for two reasons. For one, it was already the company’s specialty. Secondly, skilled nursing assets feature a higher capitalization rate — or rate of return based on the purchase price of an asset and its cash flow — than other sectors of seniors housing. 

Skilled nursing cap rates are generally around 10 to 12 percent, while assisted living averages closer to 8 or 9 percent, says Rimland. “Skilled nursing continues to have a favorable risk-reward balance.”

The company also likes the fact that many of the skilled nursing facilities already have certificates of need, which is a barrier to entry for new competition, says Rimland.

However, the risks are real for skilled nursing, Rimland is quick to add. With a larger healthcare services component, operators in skilled nursing must deal with heavy government regulations and navigate complicated procedures to receive government reimbursement for services.

“Skilled nursing facilities are more difficult to operate because of the healthcare component,” says Rimland. “But we assess the risks, evaluate them, look at them relative to assisted living, and feel we’re in a better part of the senior care continuum.”

The basis of the company’s success in the sector also depends on finding quality, local operators to manage each facility, says McBride. 

“Local operators are hungrier; they’re more efficient; they live and die by the local referral pattern. They really get it.”

When the conversion to a real estate holding company is complete, AdCare will work with six to eight different companies to operate the 39 facilities. Currently, the company’s largest partner is Birmingham, Ala.-based Aria Health Group, to which AdCare leases eight of its Arkansas facilities.

“The experience they have in the industry, and in particular in the state of Arkansas, has made Aria a good partner for us,” says McBride.

The wide variety of operating partners, along with geographic diversity, is how AdCare keeps its portfolio diverse — a trend the company plans to continue as it expands by purchasing and improving more properties.

Entering acquisitions mode

In June, AdCare completed a preferred stock offering that resulted in $14.1 million in net proceeds. That money will come in handy as AdCare shifts its focus away from leasing its current facilities to acquiring new facilities.

“As we continue to finish up our operational transfers, we start to think about new investment opportunities,” says Rimland. “We basically raised capital to refinance debt and provide capital for growth.”

The company chose to offer preferred stock instead of common stock because the company had success in previous preferred offerings, and the attractive features of the instrument, according to Rimland.

The growth spurred by the newly available cash will include upgrading existing properties
in the portfolio and acquiring new facilities.

“The first focus will be some reinvestment renovations of our existing 39 facilities,” says McBride. “Then we will look to make selective acquisitions, primarily in states that would help diversify us both geographically and with our operator base.”

AdCare has no plans to build its own facilities, so the company is looking for small portfolios to acquire — groups of skilled nursing facilities that large REITs might overlook.

“We are not one of the mega-REITs in the industry. We positioned ourselves to do smaller transactions in the marketplace that are a little overlooked,” says McBride. “Given our size, portfolios of two to five facilities or so has a real impact on shareholder value creation.”

Another advantage is AdCare’s focus on skilled nursing, where there is less competition because larger REITs tend to focus on assisted living, adds McBride.

Now that AdCare is primed to put its full effort into acquisitions and becoming a REIT, McBride says the future is bright for the company.

“We have the management resources and capability to really grow this thing as a stand-alone healthcare REIT,” says McBride. “My goal is to position the company to be one of the fastest growing healthcare REITs focused on skilled nursing facilities.”