A Reset for Senior Housing Properties Trust

In response to the financial difficulties of its primary tenant, Five Star Senior Living (FVE), Senior Housing Properties Trust (SNH) has been forced to negotiate a change in the structure of their business relationship.  Specifically, SNH has agreed to cancel its five master leases with FVE and will instead have FVE manage the properties for a 5% annual fee.  This move is a consequence of the nationwide building boom in senior housing communities over the past decade that has put downward pressure on occupancy rates.  After providing some background on this issue, I will focus on the projected impact of this new business arrangement on SNH’s future financial performance.  Complicating the analysis is SNH’s decision to sell $900 million of mostly non-core assets to upgrade its portfolio and reduce debt.  SNH is among the earliest in its industry to address this problem and that should serve it well as others eventually are forced to come to grips with it.

Industry Background.  Low interest rates and favorable long-term demographic trends sparked a boom in the development of senior living communities (SLCs) across the country over the past decade.  Major metropolitan areas, especially in warmer climates, have seen the greatest amount of new construction activity.  But the rising supply has been met with slower growth in demand, due to a temporary lull in the number of people entering the 65+ years of age cohort and the increasing propensity of seniors to remain longer in their own homes.  The combination of expanded supply and slow growth in demand has produced steady declines in industry occupancy rates over the past five years.

Declining occupancy has put pressure on senior living REITs that lease their properties to operators.  Before the construction boom, when senior living communities had greater market power, they were able to earn fat profits that supported high lease rates.  As occupancy rates declined steadily from 2012, their profits have been squeezed to the point where many have had greater difficulty paying those high lease rates.  The greatest pressure has been experienced by operators of skilled nursing facilities (SNFs), a/k/a nursing homes.

In 2018, after falling significantly behind on its lease payments, HCR ManorCare, one of the nation’s premier operators of senior living communities, agreed to turn its business over to its landlord, QCP Properties.  QCP was subsequently sold to a joint venture between Welltower (WELL) and ProMedica.  Recent senior living operator bankruptcies include Orianna Health Systems, Senior Care Centers, Welcov Healthcare and Preferred Care.  Most of these operators were focused on SNFs which have also faced pressure because the Federal government has been tight-fisted with Medicare reimbursement rates.

The current pressure faced by industry operators has raised questions about the viability of triple-net leases on senior living properties, especially those that require the operator to cover capital expenditures.  (Many older SLCs have needed to upgrade their properties to improve their competitiveness against newer SLCs.)   Some industry participants have even questioned the viability of the healthcare REIT model, especially for SNFs.  But while the arrangements between landlords and operators may be continually tweaked, I think that healthcare REITs are here to stay as long as the Federal government maintains their tax-exempt status.

SNH-FVE Background.  FVE announced in its 18Q3 earnings report that there was substantial doubt about its ability to continue as a going concern as a result of increased operating losses.  This was the trigger for negotiations that culminated in the April 2019 announcement that SNH would be cancelling its five master lease agreements with FVE covering 184 senior living properties and replacing them with management contracts on those properties at a 5% annual rate.  Since SNH will now be taking over from FVE as the operator of those properties, it must obtain licenses from state regulators.

The licensing transfer process will therefore delay the completion of the conversion until the end of 2019.  In the interim, SNH has reduced the monthly payment due under the leases from $17.4 million to $11 million.  That reduction, along with another quarter of improving occupancy, helped FVE return to profitability in 19Q2.

The New SNH Operating Model.  As a result of the conversion of the properties from Triple-Net Leases (TNLs) to Managed Senior Living Communities (MSLCs), SNH’s income statement will change significantly in 2020.  SNH will lose the rental income attributable to the TNLs but gain all of the revenues and operating expenses associated with the properties.

The lost rental income on the FVE TNLs for those properties was $204 million in 2018 (with little or no associated operating expense).  Instead, SNH will gain, according to my estimates, the $965 million in revenues and $192 million in net operating income (i.e. before depreciation and G&A expenses) that FVE recorded on those properties in 2018.  SNH will also pay a 5% management fee to FVE, which would have been $48 million in 2018.  So its 2018 pro forma net operating income (NOI) on those properties would be $144 million  ($192 million in estimated 2018 operating income minus the $48 million management fee).

In 2018 pro forma terms, SNH would therefore see its operating income drop by about $60 million ($204 million in TNL rental income vs. estimated managed property net operating income of $144 million).  However, other factors will affect SNH’s profitability this year and next.  On the positive side are the recent gains in occupancy and monthly rental income rates at FVE; while negative factors include the increases in staff salaries and benefits.  Furthermore, SNH will lose the income from properties that have been and will be sold under its current asset sale program.

Planned Asset Sales.  Along with the conversion of the FVE TNL properties, SNH has announced that it plans to sell (or sign agreements to sell) properties worth $900 million during 2019.  The properties up for sale include both senior living communities and medical office buildings (MOBs).

The goal of the asset sale program is to reduce debt to regain an unequivocal investment grade rating from the two major rating agencies (or at least avoid another downgrade).   Currently, SNH’s debt has a split credit rating.  In May, Moody’s downgraded SNH’s unsecured debt rating to below investment grade from Baa3 to Ba1, citing the Trust’s high leverage and greater uncertainties in its profitability after the planned conversion of the FVE leases.  S&P currently still has SNH’s debt rated at BBB-.

SNH has given only a few details on what exactly it plans to sell.  It is focusing primarily on selling underperforming SLCs and non-core assets, including its wellness centers and standalone skilled nursing facilities.  SNH owns 10 wellness centers that generate roughly $18.5 million in annual net operating income.  At a 7% cap rate, those properties would be worth about $264 million.

The Trust began the year with 38 standalone SNFs with 3,874 units and a total carrying value of $167.7 million or roughly $43,000 per unit.  During the first half of 2019, it sold three of these properties for $21.5 million and recorded a gain on the sale of $15.2 million.  At June 30, SNH had 17 SNFs under sales agreements for an aggregate price of $17 million and expects to record a loss of $17.3 million on this sale.  That leaves 18 SNF properties with a carrying value of $127.7 million available for sale.

Besides the SNFs, SNH has closed this year on the sale of four MOBs for gross proceeds of $13.6 million and gains of $2.3 million.  At June 30, it had five MOBs located in Massachusetts with an undepreciated carrying value of $10.1 million under agreement for sale at $9.9 million.

Subsequent to June 30, SNH entered into agreements to sell 15 SLCs located in Kansas, Iowa and Nebraska for $135 million.  During 19Q2, it recorded an $8.3 million impairment charge to reduce the carrying value of those properties to their estimated fair value.

Altogether, SNH has received gross proceeds of $35.1 million and recorded net gains of $17.7 million on the sale of the three SNFs and four MOBs so far this year.  It anticipates receiving another $162 million, before transaction costs, from the sale of the 5 MOBs, 17 SNFs and 15 SLCs. 

Once those agreed sales close, the company will have raised $197 million, leaving $703 million to be closed or placed under agreement in the remaining five months of 2019 to reach the $900 million target.  That looks like a stretch at this time, but management has asserted that it will get the job done.  In its Aug. 8 earnings press release, the company said that it had 60 properties being actively marketed for sale.

SNH could conceivably reach the $900 million target quickly by agreeing to sell its two buildings located in the Boston Seaport District (or alternatively agreeing to sell its 50% interest in the joint venture that owns the properties).  95% of the 1.1 million rentable sf in those buildings is leased until 2028 (with a 10-year extension option) to Vertex Pharmaceuticals.  A sale could bring in more than $300 million in net proceeds to SNH and remove $620 million of mortgage debt from its balance sheet.  However, if the property is sold (rather than just SNH’s 50% joint venture interest), the gross amount of the sale would almost certainly exceed $1.2 billion, which is above the Trust’s stated goal of $900 million of asset sales. Consequently, only a sale of SNH’s 50% joint venture interest would seem to qualify under the parameters of its asset sale program.

On July 1, SNH sold 2.6 million shares of RMR Inc. in a public offering at a price of $40 per share. Net of underwriting expenses, the Trust received $98.9 million in proceeds from the sale. The sale of the RMR stake is not included in the $900 million asset sale target. SNH management said that the sale of the RMR shares gives it additional flexibility in meeting its asset sale and debt reduction goals. 

Once completed, the $900 million in asset sales will have a meaningful impact on SNH’s future profitability.  The mix of properties sold by type (e.g. SLC vs. MOB) and by geography and also the specific properties sold will establish a baseline for SNH’s revenues and profits from 2020 on.  SNH has presumably decided which properties to sell in part with an eye toward improving management efficiency (i.e. keeping the best properties with the densest geographic footprint to optimize management and other overhead costs).  Management has hinted that the average cap rate on the $900 million of properties will likely be around 7%.  If so, SNH will lose $63 million of net operating income (i.e. rental income minus property operating expenses before depreciation and G&A expenses).

Combined with the anticipated $60 million decline in operating income from the conversion of the FVE leases, baseline net operating income (i.e. operating income before G&A expense and depreciation & amortization expense) for 2020, should therefore be down $123 million.  Actual results for next year will of course also depend upon trends in occupancy, monthly rental and lease rates and operating and G&A expenses, among other factors.

219 First Half Performance.  SNH reported 19H1 normalized funds from operations (FFO) of $169.4 million or $0.71 per share, down from $211.8 million or $0.89 per share.  Virtually all of the decline in normalized FFO was due to a 13.1% decline in property net operating income from $334.8 million to $290.9 million.  The decline in property NOI was due primarily to the cut in rental income on the FVE TNL properties and an increase in wages and benefits at managed SLCs.

19H1 rental income from MOBs increased by 1.3%, despite a 320 bp decline in occupancy to 92.5%.  A significant portion of the occupancy decline is due to two properties – a 140,000 sf MOB in Minneapolis and a 90,000 sf MOB in Fremont, CA (in the San Francisco Bay area), both of which are being repositioned in their respective markets.  The Trust is also working on repositioning a 130,000 sf MOB located within the Washington DC central business district.  Management said that it expects to re-lease in the near-term a large portion of the Minneapolis property, which is being converted from a single tenant to a multi-tenant building.  Plans are also underway to redevelop a 160,000 sf, three-building Life Sciences campus in San Diego.

The decline in MOB occupancy was offset by a contractual 8% rent increase on the 95% of 1.1 million sf of space located within Boston’s Seaport district that is leased to Vertex Pharmaceuticals.  As noted, SNH controls the property through a joint venture in which it has a 50% economic interest.  The Trust also reported strong leasing results in the rest of its MOB portfolio with 300,000 sf of new and renewal leases executed in 19Q2 at an average term of 15.3 years and 6.2% roll-up in rents.

In its TNL SLC portfolio, rental income fell 29.6% to $94.4 million, due to the rent cut on the FVE-leased properties.  Effective Feb. 1, 2019, the minimum monthly rent due to SNH under the five master lease agreements was reduced from $17.4 million to $11.0 million.

In its Managed SLC portfolio, residents fees and services revenues increased 6% to $217 million, due entirely to an increase in properties under management, which more than offset a 20 bp decline in occupancy to 85.8% and a 1.3% decline in the average monthly rental rate to $4,222.  (Comparable property occupancy was flat at 85.9%, so the decline in overall occupancy was due to the properties that were acquired from FVE.) Property operating expenses increased 10.7% to $172.7 million, as the Trust has moved to raise staff wages and benefits to reduce employee turnover and the use of costly contract labor. As a result, net operating income on the Managed SLC portfolio declined 9% to $44.2 million.

Projected Financial Performance.  With the decline in 19H1 normalized FFO and the expected impact of the FVE master lease minimum rent payment reduction and higher wages and benefit costs, I project that SNH’s normalized FFO per share for the full year 2019 will decline to $1.27 from $1.59 in 2018.  The current consensus estimate for 2019 is $1.35.  Both my projections and the consensus estimate assume continued earnings pressure in addition to the estimated full year impact of rent reduction and wage level boost. Although the Trust will benefit from the reduction in the business management fee from $40.6 million in 2018 to $0 in 2019, it will likely continue to face margin pressure from lower occupancy rates and perhaps modestly lower lease rates across much of its portfolio for the balance of the year.

In 2020, with the conversion of the FVE-leased properties to managed properties and the completion of the asset sale program, SNH will have a smaller portfolio, but it will also have less debt.  My projections anticipate that normalized FFO in 2020 will increase to $1.33 (vs. the current consensus estimate of $1.25).  According to my analysis, the Trust will generate slightly higher operating income from its managed SLCs than it earned from its TNLs in 2019 (after the 37% cut in lease rates). It will also benefit from a reduction in interest expense (from $187.9 million to $152.6 million, according to my projections).  In addition, SNH should begin to deliver more meaningful improvements in net operating income from higher occupancy and lease rates (at its existing MOBs) and gains in operating efficiency from a leaner and more focused property portfolio.

My projections anticipate that the Trust’s ratio of debt-to-total capitalization will decline from 54.7% in 2018 to 52.3% in 2019 and then to 48.7% in 2020.  Net debt-to-EBITDA is projected to drop from 6.0 times at the end of 2018 and 6.8 times at mid-year 2018 to about 5.3 times at year-end 2019 and 2020.  If so, that could prompt an upgrade from Moody’s back to Baa3 (investment grade).

My projections also anticipate that SNH will be able to generate sufficient free cash flow (which I define as cash flow from operating and investing activities) to cover its distribution in 2020 by 1.4 times.  Excluding asset sales (which for simplicity’s sake, I assume will occur at the end of 2019), I project that SNH will have a modest shortfall in free cash flow coverage of its distribution (0.8 times) in 2019; but it will have ample cash on hand following the asset sales to fund the distribution in 2019 and still reduce debt.  

Valuation.  Based upon my FFO projections, which are roughly in line with consensus, SNH’s stock trades at 6.6 times projected 2019 normalized FFO and 6.3 times projected 2020 normalized FFO.  By comparison, SNH’s peer group trades at average forward multiples of 15.3 times 2019 FFO and 14.6 times.  SNH’s stock also sports a dividend yield of 7.2%, higher than the peer group average dividend yield of 5.4%.

If my projections prove to be reasonably on target, I believe that the market will gradually eliminate the forward FFO multiple discount on SNH shares. 

It is also worth noting that SNH shareholders will receive about 1.1 shares of FVE as a result of SNH’s agreement to invest $75 million in FVE in exchange for an 85% stake.  SNH’s equity ownership of FVE will increase from about 8.3% currently to 34% under the current plan and the remaining 51% stake in FVE will be distributed to SNH shareholders.  At the current price of $0.50, those 1.1 FVE shares are worth $0.55 of SNH’s share price.  So excluding the FVE share distribution, the market price for SNH alone is effectively $7.84 (with SNH currently trading at $8.39), its forward FFO valuation multiples are implicitly lower (around 5.8 times vs. 6.3 times) and the current dividend yield is higher (7.6% vs. 7.2%).

By any measure, therefore, SNH’s share price looks cheap.  Of course, the current valuation reflects concerns about the Trust’s to complete its asset sale program and also what its baseline profitability will be once the asset sales are completed.  Implicit in that low valuation is the concern that it may not be able to generate stable or growing profits from its core portfolio of senior living properties and medical office buildings.  However, the recent stabilization in occupancy in the managed SLCs of SNH and modest improvement in occupancy in the managed SLCs of FVE, as well as the expected improvement in occupancy and lease rates at MOB properties that are currently being repositioned or redeveloped, offer hope for the future.

If, in fact, the Trust can demonstrate its ability to sustain its $0.60 per share annual distribution, the market will almost certainly reward it with a higher valuation multiple.  At a target valuation of 13.5 times projected 2020 FFO, which is still below the current peer group average of 14.6 times, the stock would be valued around $18.00 and its dividend yield would decline from 7.2% (ignoring the FVE share distribution) to 3.3% (which would open the door to a distribution rate increase).

Closing Thoughts.  While the Trust has been forced to take action as a result of FVE’s inability to continue to make its lease payments, it is also now in the forefront of healthcare REITs in addressing on a longer-term sustainable basis the problems of declining occupancy.  Although there are tentative signs of a slowdown in new capacity additions, it is still too early to call a bottom in occupancy rates.  Yet, the industry should begin to benefit from a modestly favorable demographics tailwind, as the population of those aged 65 and older is expected to grow by 16.4% from 2020 to 2025 or at an average annual rate of 3.1%, which is more than four times the expected annual increase of 0.70% in the U.S. populations.

SNH and FVE are moving quickly to shore up and enhance their competitive position – by selling non-core properties, reducing debt, upgrading properties (to compete more effectively against newly-built SLCs), raising wages (to reduce staff turnover and the use of contract labor) and improving the quality of  their service offering (for example, by obtaining certifications from J.D. Power and collaborating with the MIT AgeLab to develop new services for seniors housing and potentially new models for senior living communities.

Although uncertainties remain, SNH’s initiatives appear to me to be reasonable and achievable. Consequently, I believe that both SNH and FVE have a good chance of success in their efforts to improve operating and financial performance.  Each has a solid base of experience and sufficiently strong market position to support improvement in their operations.  As the Trust demonstrates progress toward achieving its goals over the next year-and-a-half, I expect that the share price valuation discount between SNH and its peer group will narrow.

August 28, 2019 (revised September 1, 2019 with refined projection model assumptions that raised my 2020 FFO per share forecast to $1.33 (from $1.28) and also raised my price target on the stock to $18.00 (from $16.50). Some changes were also made to correct typographical errors or in an attempt to improve the prose.)

Stephen P. Percoco
Lark Research
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