In an effort to align common interests and boost revenues in a choppy market, healthcare REITs are switching operators.
By Jane Adler
In a challenging environment, healthcare real estate investment trusts (REITs) are changing partners and optimizing their operator mix. Regional providers are gaining favor as the REITs diversify their partnerships and look for geographic balance in their portfolios.
The structures of operating agreements are also under review. Joint-venture partnerships and income-sharing agreements have always been important, but are now being re-examined and fine-tuned to better align the interests of owners and operators for the realities of today’s market.
At the same time, new operators are emerging.
They’re managing chunks of big, older portfolios to improve individual property performance.
“This has largely been a year of portfolio repositionings for the healthcare REITs,” says Chad Vanacore, a senior analyst at investment banking firm Stifel, whose office is based in Saratoga Springs, New York. “The REITs are diversifying their portfolios by operator and geographically.”
Consider some of these changes at the big three healthcare REITs:
• Welltower (NYSE: WELL) and Brookdale Senior Living (NYSE: BKD) announced plans in June 2018 to transition 63 properties to different operators. Lease obligations for 37 of the communities will be managed by Pegasus Senior Living, a newly formed management group headquartered in Dallas.
• Ventas (NYSE: VTR) transitioned a portfolio of about 70 seniors housing properties from Elmcroft Senior Living to a relatively new operating company, Eclipse Senior Living, based in Lake Oswego, Oregon. Eclipse now operates two brands: Elmcroft for assisted living and memory care buildings; and Embark for independent living buildings. Ventas is reported to own a stake in Eclipse.
• HCP (NYSE: HCP) transitioned 24 communities in March from Brookdale to Atria Senior Living. Other Brookdale-managed properties have been transferred to Sunrise Senior Living and Eclipse.
Changing partners comes at a critical time for operators and owners alike.
Stock prices for publicly traded healthcare REITs fell mid-year 2018 but have since regained their footing, says Vanacore. For example, Welltower’s stock price closed at $50.52 per share on April 25, but closed at $73.04 per share on Friday, Jan. 18.
Investors are being drawn back to REITs as they shore up their balance sheets and trim their portfolios, says Vanacore. “Investors see an opportunity.”
New kinds of relationships are being formed by the REITs and healthcare systems. The most notable example is the $4.4 billion deal by Welltower and nonprofit ProMedica Health System to purchase Quality Care Properties and HCR ManorCare.
The REITs are positioning themselves for 10 to 15 years down the road, when the oldest baby boomers, now 73 years old, will need seniors housing, notes Vanacore.
“They are looking at a decade of future growth as long as they can take the short-term underperformance of the current market.”
NOI under pressure
Today’s operating environment in seniors housing remains tough. The occupancy rate in the top 31 markets held steady at 87.9 percent in the third quarter of 2018, but remained at its lowest level since the second quarter of 2011 (87.5%), according to the National Investment Center for Seniors Housing & Care (NIC) based in Annapolis, Maryland.
The absorption rate in the third quarter was unchanged from the second quarter at 2.4 percent, according to NIC. Construction starts remained relatively high, totaling about 18,000 units over the last four quarters.
Rent growth hasn’t kept pace with rising wages. During the third quarter of 2018, the average asking rent rose 2.9 percent on a year-over-year basis, up 20 basis points from the prior quarter but still down from a recent high of 3.8 percent in the fourth quarter of 2016, according to NIC. For comparison purposes, average hourly earnings at assisted living facilities climbed 4.2 percent in the second quarter of 2018 on a year-over-year basis, according to the Bureau of Labor Statistics.
Changing of the guard
New operators are winning business with their own take on how to best operate a community. At the same time, the REITs are diversifying their operator base to spread risk.
A consensus is emerging that big national operators aren’t necessarily well suited to handle the day-to-day challenges of personal resident care. Managers at the property level need to be empowered to make decisions rather than take orders from a central office.
“Many operators are more prominent in different regions,” says Mercedes Kerr, executive vice president of business and relationship management for Welltower, headquartered in Toledo, Ohio. “We have a diversified pool of operators.” Welltower’s top operators include companies such as Belmont Village, Benchmark Senior Living and Sunrise Senior Living.
The new operator, Eclipse, is bucking the regional trend and scaling up nationally instead. Eclipse was launched in November 2017 and already operates 101 communities in 27 states. It has clusters of projects in the Northeast, Southeast and Texas. The properties are owned separately by Ventas, HCP and Apollo Global Management, the latter of which is a private equity group.
Eclipse is led by CEO Kai Hsiao, former CEO of Holiday Retirement. He also worked at HCP and has experience in the hospitality industry.
“How big can you get before you get bad?” asks Hsiao. “It depends on the strength of your infrastructure.”
Eclipse centralizes processes, such as sales and procurement, and has real-time reporting systems. Too much of the decision making in senior living has been left to the executive director, says Hsiao.
“Our job is to lighten the load on executive directors so they can spend their time where it matters most — on resident care.”
Operators drive value
The diversification of operators is a goal at Sabra Health Care REIT (NASDAQ: SBRA). The company sold 20 properties leased by Genesis HealthCare (NYSE: GEN) in an effort to minimize its exposure to the troubled skilled nursing operator.
No one Sabra tenant now accounts for more than 8 percent of the company’s net operating income, says Rick Matros, president and CEO at Irvine, California-based Sabra. More specifically, the share of NOI ranges from 2.8 percent to 8 percent among Sabra’s top nine partners. “We don’t want so much exposure to one operator,” he explains, adding that a troubled operator can drive Sabra’s narrative and impact its stock price.
Sabra sometimes changes operators, but not all that often, adds Matros. He also won’t buy a state-of-the-art facility with a poor operator if a new operator can’t be brought in. “Value is driven by the quality of the operator,” says Matros, who has spent much of his career on the operating side of the business.
Sabra seeks operators with geographic density or a number of buildings in the same area — a feature sought by other REITs. An operator might be able to manage 150 buildings located in the Midwest and Northwest, says Matros, but not if the properties are spread over 40 states. “It would be impossible to run them efficiently,” he says.
Buildings located near each other provide infrastructure and management support, and generally produce better resident outcomes, he explains. But Matros is quick to draw a distinction between skilled nursing properties and assisted living buildings. Assisted living is a simpler business model to operate and buildings can be more spread out, he points out.
National Health Investors (NYSE: NHI), a REIT based in Murfreesboro, Tennessee, prefers smaller or regional operators. “We like the ones that can get to a building and affect outcomes quickly. We want the operator to have a good relationship with the families and residents, and we think having owners and executives of the company in the buildings helps with that,” says Kevin Pascoe, chief investment officer at NHI. “We like to have the C-suite execs close to the buildings.”
With 229 properties, NHI has 34 operating partners in 33 states. Four major operating groups each make up about 15 percent of NHI’s revenue: Bickford Senior Living, Senior Living Communities, Holiday Retirement and National Health Care.
Regional operators are a focus at LTC Properties (NYSE: LTC), a REIT based in Westlake Village, California. “We are looking for growth-oriented partners,” says Clint Malin, executive vice president and chief investment officer at LTC. The company owns 205 properties, about half are assisted living facilities and the other half are skilled nursing facilities.
LTC recently closed on a sale-leaseback transaction with Koelsch Communities that included two memory care buildings in the Dallas area. Koelsch operates two other communities near Dallas.
Koelsch, which is based in Olympia, Washington, operates a total of 30 buildings. It has regional concentrations in Arizona, California, Illinois, Texas and Washington. “We are hopeful our relationship will continue to grow,” says Malin.
Geography isn’t the only factor when selecting an operator. As the acuity of residents in skilled nursing continues to rise, LTC is seeking operators that can care for residents with complex medical conditions.
LTC also wants forward-looking operators that understand managed care and the changing reimbursement landscape, notes Malin. “Are they investing in technology?” he asks. “They need to be able to provide data to show their outcomes to managed care providers, health systems and hospitals.”
Agreements with operating partners are under review. The shift has generally been from triple-net leases to some form of partnership model, according to sources.
Rent payment coverage ratios have come down to the point where in some cases 100 percent of the net operating income is going toward lease payments. That means the operator may cut corners on services and not have the ability to maintain the property.
“That can create problems down the road,” says Lukas Hartwich, senior analyst at Green Street Advisors based in Newport Beach, California. “In a tough operating environment, the REITs are trying to optimize performance.”
The REIT Investment Diversification and Empowerment Act (RIDEA) of 2007 allows REITs to share in the net operating income generated by the healthcare assets they own as long as a third-party manager is in place. In short, the RIDEA structure permits the REIT to participate in the upside of a property, allowing the opportunity to capture increased annual income growth as operations improve. RIDEA agreements are becoming more common.
The REITs are also exploring joint venture agreements in which the operator shares in the ownership of the real estate.
“Alignment of interests is the name of the game,” says Kerr of Welltower, which recently converted a lease structure with Brandywine Living into a RIDEA contract.
Welltower’s complex transaction with ProMedica combines a lease and a joint venture agreement. “There are ways to create alignment with a lease,” says Kerr.
Sabra has a joint venture agreement with the Chicago-based operator Enlivant for 173 buildings. Matros expects to convert those agreements to RIDEA structures over the next few years.
Triple-net leases still have a role to play. Sabra uses only triple-net leases for skilled nursing facilities because nursing homes are a complex business subject to government rules and reimbursement, as well as liability, notes Matros. “The lack of separation between the owner and the operator is problematic.”
NHI exited its RIDEA partnership agreement with Bickford Senior Living about two years ago. It was replaced with a triple-net lease structure along with construction loans for new developments, which will be purchased by NHI when the properties stabilize. “This approach has eliminated complexity and was a mutually beneficial outcome for NHI and its partner,” says Pascoe.
Good operators in demand
Are there enough quality operating partners out there? New operating companies are being formed, but property owners are looking forward to the next generation of managers. “Good operators are hard to find,” says Pascoe of NHI. But finding a company that is starting to build its brand can result in a win, he adds.
Comfort Care Senior Living is a new operator for NHI. Based in Michigan, Comfort Care operates a cluster of assisted living and memory care buildings and a skilled nursing facility in the state. In June, NHI purchased Comfort Care’s 51-unit assisted living and memory care building in Bridgeport, Michigan, and a similar facility in Saginaw, Michigan, for $17.1 million. The properties have triple-net leases in place.
NHI liked the fact that the operator was relatively new to the senior living business. The management team had industry experience, but it wasn’t tied to standard solutions.
For example, Comfort Care had to address a scheduling problem that resulted in a lot of overtime for workers. Rather than use an off-the-shelf software solution from the seniors housing industry, the managers turned to a text-based program called “7shifts” from the restaurant industry.
The system allows managers to send out a text to fill an open shift. The first worker to respond gets the shift. But if more than one person responds, the software defaults to the worker who would not trigger overtime. “We like that Comfort Care has a young management group,” says Pascoe. “They’ve found new ways to figure things out.”