Product Focus: Skills Nursing Facilities (March 2007)

Skilled nursing rebound

SOME SAY SMART MONEY IS SNIFFING AROUND SNFs

 

By Brian Busek

 

For many healthcare real estate investors, skilled nursing facilities (SNFs) gained a reputation in the 1990s and early 2000s as a product type to be avoided.

The Balanced Budget Act of 1997 had changed Medicare reimbursement from a cost-plus arrangement to a daily rate approach, reducing revenue for most SNF operators. Faced with budget troubles, some states also cut back on joint state-federal Medicaid programs.

Meanwhile, costly lawsuits over the quality of care in some facilities led to soaring liability insurance costs, particularly in Florida and Texas. That forced several SNF operators to exit those markets from 2000 to 2003.

As if that wasn’t enough, fierce competition emerged from newer senior housing concepts such as assisted living facilities (ALFs) and continuing care retirement communities (CCRCs). Five of the 10 largest operators of SNFs – or in common parlance, nursing homes — filed for bankruptcy in 1999 or 2000.

All of this left SNFs with few takers among capital investors.

Despite the obstacles, some investors remained committed to the category throughout the late 1990s and early 2000s. They navigated through the treacherous terrain to satisfying returns. The winners in skilled nursing often used innovative strategies to minimize some of the negatives while leveraging underlying strengths in the sector.

In fact, some industry experts now say that SNFs present one of the biggest opportunities in healthcare real estate – an opinion that most observers would have considered ridiculous just a few years ago.

‘The wind is at our back’

Arnold M. (Arnie) Whitman is one virtually unbruised veteran of the rough era in skilled nursing. The CEO and co-chairman of Formation Capital LLC, an advisory and equity investment firm specializing in senior housing and healthcare, goes so far as to argue that the sector is poised to thrive.

Mr. Whitman has been active the skilled nursing and senior living markets for more than 20 years. His company recently sold a majority interest in its nursing home portfolio to GE Healthcare Financial Services (GE HFS) for $1.4 billion but remains involved as an asset manager.

Mr. Whitman shared his views on skilled nursing facilities at the invitation-only “Senior Housing & Health Care Real Estate Conference” held recently in Key Biscayne, Fla. The conference was presented by Stifel Nicolaus Capital Markets.

During his keynote presentation, Mr. Whitman was unsparing in his depiction of the lean years of the 1990s. “It was a very difficult time,” he told the gathering of top healthcare operators and real estate executives.

By contrast Mr. Whitman sees favorable conditions in today’s SNF market.

“The wind is at our back,” he said.

Several factors suggest a potentially bright future in skilled nursing, Mr. Whitman said.

In fact, Mr. Whitman believes that plenty of opportunity awaits operators and real estate investors because a large percentage of skilled nursing facilities are considered to be “functionally obsolete.” Anyone who has the foresight to modernize, expand, or replace such facilities is sure to capitalize, he said.

One industry executive who agrees is Randall J. (Randy) Bufford, president and CEO of Trilogy Health Services LLC.

Mr. Bufford, who has more than two decades of experience in the healthcare industry, founded Trilogy in 1997. The firm, which focuses on adult day health, assisted living and skilled nursing, has grown to 42 properties in four Midwestern states. Many of its properties were replacements of functionally obsolete SNFs.

“We’re having a lot of fun,” Mr. Bufford said during a separate panel discussion at the Stifel Nicolaus conference. “We agree 100 percent with Arnie that a lot of the real estate in our markets – we can’t speak to across the country, but we can speak to the Midwestern markets – are functionally obsolete.”

Rather than trying to modernize existing nursing homes, Trilogy generally prefers to replace them, Mr. Bufford said.

“There needs to be a great deal of capital brought to bear to reposition these assets,” he said. “But the nice thing about it is we can show that every time we’ve done that we’ve had an outstanding return on investment, even when we buy older facilities and just do … the bulldozer, if you will, and move out to new locations.”

(For a example of one of Trilogy’s nursing home replacement projects, please see the Project Case Study, “Firm repositions, replaces dated asset” on Page 20 of the February edition of Healthcare Real Estate Insights^™.)

Surviving the slump

The age and antiquated design of skilled nursing facilities was one of the central factors in the sagging interest among both consumers and investors in the 1990s and early 2000s. Dated buildings suffered in comparison to assisted living facilities and CCRCs that were not only new but targeted to contemporary consumers.

Moreover, the image of SNFs suffered further with lawsuits over the quality of care, or lack thereof, at some facilities. The courtroom activity not only hurt the perception of the industry but caused investors to be concerned about their own exposure to liability in such lawsuits.

So how could an investor survive in such a market, let alone emerge to strike last year’s eye-opening GE HFS deal?

In his presentation, Mr. Whitman described how Formation Capital developed innovative strategies to neutralize some of the negatives of SNFs while, at the same time, looking for opportunities in a staggering industry.

When a single company owns and operates multiple facilities, Mr. Whitman said, its entire asset base can be put at risk when a problem occurs at any single property. Formation Capital’s key innovation was to develop strategies for separating the real estate from the operations in skilled nursing properties. This strategy significantly reduced potential liability for a company that owned a number of SNFs.

Mr. Whitman’s model was to create separate limited liability companies (LLCs) for the operation of each individual facility, with the operator leasing the real estate from the individual LLC. In that structure, liability at any single SNF affected only that property.

The strategy enabled Formation Capital to amass its sizable nursing home real estate portfolio in the early 2000s. In particular, the firm became a “white knight” for several of the financially troubled nursing home operators doing business in Florida. By acquiring their Florida real estate, Formation Capital freed the operators from many of the risks that went along with operating SNFs in that state. Yet, the company was insulated from most liability concerns thanks to the LLC structure.

The concept is illustrated by one of Mr. Whitman’s most notable deals: the $165 million acquisition of 53 senior living properties – 49 SNFs and 4 assisted living facilities – in Florida from operator Beverly Enterprises Inc. in mid-2001.

Fun in the sun

Mr. Whitman said he’d been interested in breaking into the Florida market for a number of years. He noted that the state’s demographics are great, the reimbursement rates are good and the facilities are relatively modern. At first, however, his company could not afford to buy in Florida – until the weak market of the early 2000s made the deal for the Beverly properties doable. After the acquisition, Mr. Whitman’s company set up LLCs with master leases.

A further innovation for Formation Capital has been to develop a “participation of earnings” model in which some of the profits from individual properties go to the real estate company. At the same time, the properties share in the profits from the real estate side if they have “a capital event.”

“It’s really a hybrid,” Mr. Whitman says.

The question remains, however: If a rough market in skilled nursing provides opportunities, what’s changed recently to make skilled nursing a generally attractive investment opportunity?

Mr. Whitman sees an industry that has plenty to attract customers – relatively low costs for many and favorable demographics. In addition, one of the industry’s major obstacles toward attracting customers – aged facilities – presents an opportunity for investors.

While a significant percentage of skilled nursing properties can be called “functionally obsolete,” consumers respond quite favorably to modern facilities with contemporary design, Mr. Whitman says. That creates an environment in which modernizing or building replacement facilities can often prove to be a winning use of capital.

Recent experiences in Texas and Indiana provide case studies for the impact of modernization in the industry, Mr. Whitman says.

On the surface, the SNF industry in those states appeared particularly troubled in recent years, as they were home to a high percentage of old inventory. However, modernized facilities – which can come on line relatively quickly in Texas and Indiana because of a lack of Certificate of Need (CON) laws – have had impressive results.

Formation Capital acquired properties in metro Dallas last year.

“Cash flow and margins are stunning,” he said.

Mr. Whitman does see what he calls a “bifurcation” in the market between metropolitan and rural properties. He sees the best investment opportunities in metro areas.

‘Functionally insolvent’

Not everyone sees a bright future for nursing homes, however.

“I would still say our industry is functionally insolvent,” said one industry source who declined to be identified. He noted that SNF operators have some of the lowest profit margins in the healthcare industry. One primary reason is that they tend to have a higher percentage of residents who rely on Medicaid, which reimburses SNF operators at a lower rate than private payers. Private payers are those who have long-term care insurance or other financial resources.

Some of the 1997 Medicare cuts have been restored by Congress and most state Medicaid reimbursement rates have stabilized. But while Medicaid can be enough for an operator to run a nursing home at a small profit, there often isn’t enough money left over for capital improvements.

So while the SNF industry looks marginally profitable, the unnamed source contends, that’s only because SNF operators have paid down debt on existing facilities. With thin margins and replacement costs that can run $140,000 per bed, they don’t have the capital nor the debt capacity to renovate, expand or replace outmoded facilities.

Such a scenario can unleash a vicious cycle. If a nursing home has thin margins because it houses mostly Medicaid-supported residents, it might not be able to afford to make capital improvements. As the property becomes increasingly dated, it becomes less and less attractive to prospective residents. Because private payers can afford to go elsewhere, the percentage of lower-reimbursed Medicaid patients in the facility increases, reducing revenues even further; the downward spiral continues.

“I think Medicaid will always be a big part of our business,” the source said. “It’s not going to go away, and you will see more and more assets, as they deteriorate from just a physical plant perspective, move into Medicaid only.”

In many nursing homes, two-thirds or more of residents rely on Medicaid. Reducing that proportion to 60 percent or less would have a positive impact on cash flows, growth and the ability for a facility to reinvest cash into capital improvements, the source said

“We need to continue to emphasize … this industry is becoming – is already and is becoming – increasingly functionally obsolete,” the source said. “We need to find a reimbursement system that will allow investment in this sector.” q

Brian Busek specializes in writing about commercial real estate and architecture.