Some investors are becoming more positive on the U.S. skilled nursing sector following a series of encouraging developments for the long-troubled asset class, but a real recovery in operating performance appears likely to be a year or more away.
Fueled by the prospect of demographic shifts, an overhauled government reimbursement structure and stabilizing fundamentals, shares of Omega Healthcare Investors Inc. and Sabra Health Care REIT Inc., the two real estate investment trusts that own the highest concentrations of skilled nursing properties, have outperformed benchmarks in 2018.
The optimism stems in part from a recent, relatively large rate increase by the federal Centers for Medicare & Medicaid Services, which determine how nursing facility operators are paid for patient care. Other factors include a decline in the number of skilled nursing properties nationwide and an expectation in the industry that occupancy will begin to rise as early as the end of 2019 as the U.S. population ages.
The Medicare agency also plans to roll out a new payment calculation model on Oct. 1, 2019. Industry executives hope the new system, known as the Patient-Driven Payment Model, will be simpler and clearer than the old model and will reduce the risk of U.S. Justice Department investigations into operators accused of gaming the old system.
Over the course of 2018, many healthcare real estate-oriented equity investors have rotated from the perceived safety of medical office buildings into higher-risk, higher-upside skilled nursing, Mizuho Securities USA analyst Richard Anderson said in an interview.
"There's a lot of evidence, not one piece of which is enough reason to own the space, but that collectively has got people a little bit jazzed up toward skilled nursing," Anderson said.
The skilled nursing category generally comprises nursing homes, which provide long-term residential and healthcare services for those unable to care for themselves, and post-acute care facilities, where patients receive therapy after hospital stays. REITs such as Omega, Sabra and Welltower Inc. own the physical properties and lease them to operating companies, which run the day-to-day operations. Operators, in turn, depend on payments for patient care from the government through its Medicare and Medicaid programs.
Operators have come under pressure in recent years, and several have struggled to pay their rent, as facility-level occupancy fell and government agencies cut back their reimbursements. Moreover, two of the largest operators, HCR ManorCare and Genesis Healthcare Inc., were burdened by high debt and by lease agreements with property owners, including REITs, that included steep annual rent escalators.
Rick Matros, chairman, president and CEO of Sabra, formerly a major Genesis landlord, said the two giant operators were uniquely vulnerable to industry weakness in recent years. Private equity firms that acquired them about a decade ago — Formation Capital LLC in Genesis' case and Carlyle Group LP in ManorCare's case — left them with high levels of leverage.
Formation and Carlyle also sold off the operators' real estate to REITs. Welltower, then known as Healthcare REIT Inc., acquired Genesis' buildings, and HCP Inc. acquired HCR ManorCare's. The operators then leased them back, agreeing to exceptionally large annual rent escalators, of 3.5% or 4%, compared to typical industry increases of 2.0% to 2.5%.
Anderson said those transactions, and the two operators' efforts to grow quickly afterward, helped lead to their problems in the subsequent years.
"They overextended themselves, and the REITs didn't control that," the analyst said. In fact, Anderson said, Healthcare REIT and HCP "spouted about the big rent escalators that they were able to negotiate into the transactions, forgetting about the fact that big escalators cut into the profit of the operator, if they're not able to grow their own business by an amount equal to or greater than the escalators themselves."
Yet, after a series of transactions, there are signs that the operators' portfolios could be out of the worst danger — a possibility that has contributed to investor optimism. Genesis renegotiated its lease with Welltower in 2018, and HCR ManorCare was acquired by ProMedica Health System Inc. and Welltower, in a transaction in which Welltower bought the real estate portfolio that the operator manages.
Still, Genesis and ManorCare are not the only operators to run into trouble. Both Omega and Sabra restructured their agreements with Signature HealthCARE in deals designed to give the operator time to gain its footing. In July, Omega said it was terminating an agreement to support another troubled tenant, Orianna Health Systems, during that operator's restructuring.
While analysts said they expect Omega to emerge relatively safely from the Orianna relationship, the episode was a reminder that a skilled nursing recovery may not be linear.
Chad Vanacore, an analyst at Stifel, said in an email that occupancy and length of stay in skilled nursing are still waning, and rate growth remains below cost inflation. Stifel expects the operating environment to get worse before it gets better, resulting in more restructurings, Vanacore added.
And, despite some observers' optimism, "I'm not there yet," Anderson said, adding that improvement will likely be gradual, with the potential for setbacks that could spook shareholders of both operators and landlords. In short, Anderson said, "Skilled nursing doesn't get rebuilt in a day."
Risk and reward
Omega believes that difficulties stemming from reimbursement policy will abate in the next 18 months, making operators better able to cover their rents, executives said in a May investor presentation.
Matros said Sabra expects facility-level occupancy to begin recovering in late 2019, with operators gaining the power to raise rents in 2020. Because operating costs are largely constant, the executive argued that even small occupancy improvements from the industry's current levels in the low-80% range will bring a disproportional benefit to operators' bottom lines.
Neither Welltower nor HCP responded on the record to requests for comment, but Welltower's CEO, Tom DeRosa, has criticized the structure of the private equity buyouts that left the operators with massive debt levels and hurt their ability to survive when industry fundamentals slowed. HCR ManorCare was "doomed" by high leverage, DeRosa said at a conference in June, adding, however, that its troubles do not mean skilled nursing is a "bad business."
Part of the appeal of skilled nursing for property owners is that facilities generate high yields — among the highest of any commercial real estate property type — relative to what they cost. Properties currently trade at prices that imply unlevered yields of 11% to 13%, compared to yields in the 7% range for private-pay seniors housing, Dan Baker, a director at brokerage firm Cushman & Wakefield, said in an interview.
With long-term debt financing available in the 3% to 4% range, skilled nursing buyers can generate cash-on-cash returns of 20% or more, Baker said. The downside, he added, is that those returns come as a result of the "tremendous risk" involved in owning nursing homes.
Baker said there are more sellers than buyers in the current property market and that much of the deal volume is driven by industry turmoil rather than by high demand. The owners and operators best positioned to survive are those small enough to remain nimble but with large enough property count to gain cost efficiencies, he argued.
"I don't know what that exact sweet spot is," he said. "It's certainly more than one, but it's less than a few hundred."