Company Profile: CareTrust Finds Its ‘Secret Sauce’

by Jeff Shaw

With operational history in its front office, the publicly traded REIT is succeeding where others have feared to tread — skilled nursing.

By Jeff Shaw

The skilled nursing sector faces some unique headwinds. As the most healthcare-heavy form of seniors housing, nursing homes require intense specialization on the part of operators. The falling occupancy rates stemming from COVID-19 have put enormous strain on operator’s net operating income. 

NIC data shows skilled nursing hit an all-time low of 70.7 percent in January, compared with 80.7 percent for independent living and assisted living. (There was an uptick in skilled nursing occupancy in February, leading NIC to suggest that the decline has stabilized.)

A slew of bad press during the COVID-19 pandemic made matters worse. Perhaps most infamously, a nursing home in Kirkland, Washington, was one of the first places in the U.S. to have a coronavirus outbreak. Approximately two-thirds of the residents tested positive and 35 died. Approximately 32 percent of all U.S. COVID deaths have occurred in long-term care facilities, according to the New York Times.

On top of those challenges, there is also the “stroke of the pen” risk. Since the sector depends largely on government reimbursement via Medicare and Medicaid, governmental changes could signal a massive shift in payments.

For that reason, many investors and owners shy away from skilled nursing. But others who have embraced the sector have found great success.

CareTrust REIT (NASDAQ: CTRE), a publicly traded owner based in San Clemente, California, has more than 200 properties totaling 24,000 units in its portfolio, and approximately 80 percent of that total is in skilled nursing. Despite the negative public image of skilled nursing, the company collected 99.3 percent of contractual rents in pandemic-plagued 2020, and reported 100 percent rent payment in the first quarter of 2021.

“Skilled nursing requires specialization,” says Dave Sedgwick, CareTrust’s president and chief operating officer. “It’s difficult to do skilled nursing really well.”

During the pandemic, the “stroke of the pen” risk has helped considerably more than it hurt, notes Mark Lamb, CareTrust’s chief investment officer. Government stimulus funds put a strong emphasis on skilled nursing facilities, providing a lot of capital to help operators survive the ordeal.

“CMS (Centers for Medicare & Medicaid Services) obviously understands how valuable the space is to the continuum of care,” says Lamb. “They got behind skilled nursing in a big way from a stimulus funds perspective.”

Roughly $21 billion of the initial CARES Act funding was earmarked for nursing homes.

CareTrust REIT was formed as a spin-off company in 2014, when The Ensign Group decided to separate its real estate ownership and healthcare operations into two separate entities. Ensign’s value-add acquisition strategy meant that there was much untapped value in the real estate (which was worth more following operational improvements than when the company bought it).

Ensign continued with its same business plan of turning around distressed assets while CareTrust became exclusively an owner of the 97 properties. 

Despite the company becoming a REIT, CEO Greg Stapley made an interesting decision. Two of his top lieutenants in Sedgwick and Lamb would come from an operations background rather than real estate. Both had started their careers on the front lines of seniors housing communities and served as executive directors before promotion to the head office.

Although Sedgwick says he was initially puzzled by Stapley’s decision to recruit him to help launch the REIT, he now sees the wisdom of wanting seasoned operators in high positions at a healthcare REIT.

“That’s really the secret sauce of what makes CareTrust successful: great operators as landlords picking great operators as tenants, period,” says Stapley. “In this particular sector, everything about the real estate ownership has far less to do with traditional factors like property location and age. It has far more to do with the sophistication, quality and culture of the operator.” 

“You can take the same facility, even with the same staff, and if you change out the operator you could have dramatically different results,” continues Sedgwick. “Our experience and knowledge that we gained from years in operations really informs how we underwrite, how we vet operators and how we go about our asset management functions.”

This attitude of not being a stereotypical, out-of-touch owner pervades the company. Sedgwick’s title at Ensign was “president of anti-corporate services” and the head office is called the “service center” because its purpose is to provide service to its communities.

“The Ensign Group revolutionized the top-down, corporate, know-it-all model and turned it on its head,” says Sedgwick. “We carry that DNA with us.”

The operational background of Sedgwick and Lamb gives the REIT credibility with its operators, notes Lamb. It allows CareTrust to sympathize with an operator’s challenges, while also better able to underwrite a community’s operations and understand where a specific operator’s strengths and weaknesses may lie.

“Like most landlords, we’d love to have a portfolio filled with AAA-credit tenants, and we do have a few,” says Stapley. “But the large, well-capitalized operators typically have a variety of competitive financing options for their real estate. We have learned to grow our own credit tenants by giving the right people their start and then helping them grow intelligently over time, just like we and our partners grew the company back at Ensign.”

CareTrust has helped launch eight operators from the ground up. Sedgwick recalls one in particular — WLC Management Firm in Southern Illinois. CareTrust knew the founder, Scott Stout, from his work as chief operating officer at a regional operator, where he explained the nuances of the region’s reimbursement issues when CareTrust was looking at a potential acquisition in the state.

CareTrust ultimately passed on those assets, but not on Stout. Knowing he was smart and knowledgeable, CareTrust supported him launching his own operations company, and WLC is now the REIT’s 10th largest partner with eight facilities — “and we’d like to add more,” notes Sedgwick. 

WLC’s lease coverage ratio was 2.84 at the end of the year, adds Sedgwick, much higher than the REIT’s standard of approximately 1.4 for skilled nursing.

Diversify and grow

The first order of business following CareTrust’s 2014 creation was clear to the higher-ups in the company. While the company launched with 97 properties, Ensign operated the entire portfolio. 

“REIT investors initially insisted that we diversify the portfolio away from the single-
operator concentration we had with Ensign,” says Stapley. “But we knew that the Ensign leases were solid, and that every new acquisition would — at least temporarily — dilute the overall quality of the portfolio. It took several years, but around the time we had brought Ensign down to about 50 percent of revenue, investors started to understand the quality represented by the Ensign relationship, and that diversification away from them was a bit of a double-edged sword.”

CareTrust wanted to grow on every level following the spin-off — from portfolio size to operational partnerships to revenues.

And grow CareTrust did. In the seven years since the spin-off:

• The company grew from one operator partner to 23.

• The portfolio grew from 97 assets to 222 totaling 23,222 beds/units, with a total investment of $1.4 billion and an average yield of 9.1 percent.

• Total asset value grew from $600 million to $1.8 billion.

• Annual revenues grew from $61 million to $178 million.

In the last five years, shareholder return was 157 percent, adds Sedgwick.

While Ensign only accounts for one-third of CareTrust’s portfolio now, “the need to reduce our Ensign concentration has been more bitter than sweet,” says Sedgwick. Ensign is generally considered a top-tier operator, and its stock price has continued to soar even during the pandemic. Starting at around $4 per share when it first went public in 2007, the company hit a peak of $96.13 per share in March of this year.

“We’d love to start growing with them again,” says Sedgwick.

As for the types of properties it owns, CareTrust has a strong focus on middle-market seniors for its assisted living and memory care properties. Sedgwick says that the new construction is largely for high-end consumers, and all that new supply will compete for a limited supply of well-heeled residents.

Middle-class seniors, meanwhile, have fewer options. This leaves the door open for CareTrust to pursue value-add opportunities that serve those forgotten seniors.

“Those middle-market operations are somewhat shielded from new development,” says Sedgwick. “From a pricing perspective, we can acquire those facilities with healthier lease coverage for our operators and adequate returns for our cost of capital.”

Sedgwick defines middle-market seniors housing as generally charging rents between 25 and 50 percent less than the high-end competition in a market.

All about the operator

Although CareTrust has certainly grown in its seven years, it has done so strategically, according to Sedgwick.

“Philosophically there are two approaches to growth. One approach is to grow for growth’s sake, and to grow as big and fast as you can, as there are advantages to having scale. That is not our approach.

“We intentionally decided since the beginning that we would not grow as fast as we could, but rather grow on a per-share basis. That requires that each investment stand on its own, while being accretive and sustainable. That means that we get our necessary return on our investment, but also that our operators have sustainable lease coverage.”

The depth of operational knowledge helps as well, according to Lamb. CareTrust is able to understand which operator is a perfect fit for a new property or portfolio, and how many new properties they can take on at once. He says the question is, “Which operators are in a position to grow?”

“A couple years ago we added 10 facilities with an operator,” says Lamb. “It took them about 12 to 24 months to assimilate those 10 buildings into their ecosystem and get their culture right in those buildings. We didn’t do much with them right after that deal was done. We gave them a chance to catch their breath.”

“We can really like a building that comes across our desk, but if we don’t have the right operator in that market, it’s not a fit for us,” he adds. “It’s completely operator-driven in terms of where we decide to go.”

CareTrust has even developed a “scorecard” for choosing operators. The rating considers over 100 data points such as creditworthiness, financial history, systems in use and some “more qualitative and subjective” items, according to Sedgwick.

“We don’t just wake up in the morning to grow FFO (funds from operations) per share. We deeply care about raising the standard of care across the country. So, we know that we’ve got to put facilities into strong hands.”

Sedgwick says he follows a lesson that he learned from, of all people, a nun — Sister Mary Jean Ryan, at the time CEO of SSM Health Care — who spoke at an Ensign Group meeting in his earlier days with the company. While he was expecting mostly soft talk about mission and care, she surprised him by pointing out that if there is no profit margin, then the mission can’t succeed.

“What we’re trying to do at CareTrust is find operators who are mission-driven, who will raise the standard of care for our seniors, but that do it in a sustainable way,” says Sedgwick. “It’s our responsibility to match the operator with properties where they can deliver on their mission — which is the same as our mission — at a profit margin that makes that sustainable.”

“I wish we could say that we’ve batted 1,000. We haven’t,” continues Sedgwick. “We’ve made mistakes and misjudged operators and opportunities in the past. But, we do learn. And I believe we’re many times stronger today than when we began.”

Survival in a pandemic

CareTrust’s focus on middle-income seniors in assisted living and memory care is one of the reasons the company and its operators continued to thrive during the COVID-19 pandemic, according to Sedgwick. 

“What some of our operators discovered was that a lot of their potential residents simply couldn’t afford to wait out the pandemic on their own. It is possible that the brand-new, expensive seniors housing offerings suffered more from an occupancy perspective because their potential residents could afford to wait it out at home. We saw through the summer of last year some of our facilities actually increase census a little bit from earlier in the year.”

That doesn’t mean the company was immune from the crisis, however. CareTrust sourced over $1 million of personal protective equipment (PPE) for struggling communities in its portfolio. CareTrust also shared best practices for dealing with the virus that it gleaned from the REIT’s top operating partners. 

While Sedgwick says most of its portfolio performed very well through the first six to eight months of the pandemic, the end-of-year surge in cases finally took a toll on occupancy. 

However, he expects a “return to pre-pandemic performance” in the future that will vary by operator and market.

“Anytime you talk about the industry for the whole country it’s trouble because healthcare is so local,” says Sedgwick. “So we could have an operator by the end of this year be fully back into pre-pandemic performance, while another takes much longer.”

CareTrust’s success through the pandemic stems from its careful choice of operators, says Sedgwick. The company is “willing to give up yield for coverage.” That is to say, CareTrust is willing to sacrifice a portion of its own return on investment to ensure that the operator is making a healthy enough profit to survive tough times.

“It’s all about choosing certain operators to partner with while passing on others,” says Sedgwick. “Sometimes we as a REIT have to tap the brakes. Just because someone’s willing to pay rent doesn’t necessarily mean they’re right for that asset.”

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