Skilled Nursing Rents 10% Too High, Analysts Say

Skilled nursing rents must decline by about 10% across the board in order to ensure the facilities’ long-term stability, a Wednesday report from Green Street Advisors has concluded.

Real estate investment trusts (REITs) must achieve rent coverage of around 1.9 times to achieve stability for their tenants, the real estate research firm’s analysts Lukas Hartwich and John Magee wrote — a figure that several players in the space currently fall below.

“On average, SNF rents need to come down 10% to achieve 1.9X EBITDARM coverage,” the pair concluded.

LTC Properties (NYSE: LTC), Sabra Health Care REIT (Nasdaq: SBRA), Omega Healthcare Investors (NYSE: OHI), and Welltower Inc. (NYSE: WELL) all fall short of the target, with varying rent cuts needed to achieve that level of coverage, according to Green Street. The exact figures range from 6% for LTC to 12% for Welltower, though Green Street noted that Welltower’s coverage did not include any of the properties acquired in its 2018 deal to purchase the facilities operated by skilled nursing giant HCR ManorCare.

National Health Investors (NYSE: NHI) and CareTrust REIT (Nasdaq: CTRE), meanwhile, far exceeded that coverage level.

When a rent cut isn’t a cut

The industry has seen something of a rent reckoning over the past few years, but usually in the context of distress, with the flagship REITs negotiating new deals as part of overall restructuring plans. Sabra last May extended a $15 million annual rent deferral to struggling operator Signature HealthCARE as it sorted through medical malpractice claims and a civil investigation into its therapy services; the operator received a similar deal from landlord Omega that same month.

In addition, a few months after closing the ManorCare deal in an 80-20 joint venture with hospital system ProMedica, Welltower slashed rents considerably. Under its new lease, the operator will be on the hook for $179 million in rent during the first year of a 15-year deal, down substantially from the nearly $400 million in annual rents generated before ManorCare entered bankruptcy protection, according to an analysis by Fitch Ratings.

While Hartwich acknowledged that a rent cut during the normal course of business might spook investors in the short term, he told SNN that the market seems to be pricing the potential for lowered rents into its current valuations. Hartwich also noted that the adjustments don’t necessarily need to take the form of a headline-grabbing rent break.

“There’s other avenues,” he said. “One example could be that the property won’t be able to fund cap ex over time, and that will lead to degradation, and at some point that will lead to a discussion of: This property needs some capital.”

In that case, the landlord could kick in some extra money for building improvements, setting up the asset for long-term success without constricting rent flow.

“There’s really a whole bunch of different scenarios that can play out,” Hartwich said. “The point that we’re trying to make is: If you assume the current regime continues, at some point, something’s going to have to give.”

Greed isn’t good

In particular, Hartwich and Magee cautioned SNF owners against being too greedy when setting rents, identifying profitable operators and fully funded capital expenditures as vital to the success of a skilled nursing investment.

“Operations for facilities that fall short in these two areas are destined to spiral downward, inevitably leading to value impairment (e.g., rent cuts),” they wrote.

Poorly maintained physical plants have been blamed for lackluster performance in the skilled nursing world in recent years — perhaps most prominently by Welltower CEO Tom DeRosa, who attributed ManorCare’s woes and eventual bankruptcy to a lack of capital expenditure investments on the part of its previous owner, The Carlyle Group.

“These are very good assets — great real estate that’s been run by a very effective management team with one hand tied behind its back because they’ve been capital-starved,” DeRosa said during a presentation last June.

Capital expenditures indeed have been on the decline, Green Street found, dropping from a 12-year peak of more than 5% of revenue in 2007 to just about 2% in 2017 among operators Genesis Healthcare (NYSE: GEN), the Ensign Group (Nasdaq: ENSG), and Diversicare (Nasdaq: DVCR).

Good owners should reserve about 2% to 3% of revenues in order to cover cap ex requirements, Green Street concluded, while also providing operators with about a 7% share of facility revenue — or an additional 3% over current prevailing trends.

Despite the cautions about rent levels, Green Street affirmed that skilled nursing assets represent a solid investment with internal rates of return higher than other real estate sectors.

“In any case, given the significant return premium, it’s not surprising that SNF pure-plays (e.g., OHI) have consistently traded at large premiums to private-market value,” Green Street concluded.

The Green Street analysis also did not account for substantial swings in government reimbursement levels, a fact that could change once the Centers for Medicare & Medicaid Services (CMS) has a chance to analyze the early results from the Patient-Driven Payment Model (PDPM). In the short term, the outlook for national and regional chains under the new system is bright, according to Hartwich.

“It’s zero sum, and the losers will be the mom-and-pops who just don’t have the systems in place to be able to adjust to the new system,” he said. “The REITs tend to focus on the operators who are more focused on the rehab side of things, the short-term stay, and those players will probably improve at the expense of some of the less sophisticated operators.”