REITs Gain Dealmaking Edge, Will Pursue Prized Skilled Nursing Operator Relationships

Real estate investment trust (REIT) dealmaking for the rest of this year and into 2023 will largely be driven by the desire to deepen existing or secure new partnerships with skilled nursing operators that have “weathered the storm exceptionally well.”

That’s according to Michael Segal, executive managing director and partner at Blueprint Healthcare Real Estate Advisors.

And rising interest rates will level the playing field to the benefit of REITs, with private capital investors seeing a substantial increase in cost of capital.

Changing Medicaid reimbursement rates, stabilizing net hires and current inflation costs also play a role in REIT dealmaking plans for the rest of this year and into 2023, according to Steve Kennedy, executive managing director for VIUM Capital.

“The increase in both inflationary costs but especially this rapid run up in interest rates is bringing some caution, as well as some reality, back into the M&A market,” he added.

For Zach Bowyer, senior managing director and head of living sectors at Cushman & Wakefield, interest rate increases actually “tipped the scales” in terms of giving REITs more buying power. Cost of capital isn’t necessarily driven by the debt market anymore.

A lot of the real interest moving ahead, in terms of acquisition targets and opportunities, will be in favor of those communities and providers with a sustainable and strong financial position at this stage of the pandemic, added Segal.

Another plus for REITs: Operators that are eager to expand and have a smart strategy in mind for what markets they want to enter.

The Ensign Group (Nasdaq: ENSG) and its captive REIT, Standard Bearer, provide a case in point. Ensign is the perfect example of an operator that changed its strategy to better fit the changing sector landscape. Ensign reported a 14.7% increase in year-over-year revenue despite a still challenging operating environment for nursing homes, and a 15% adjusted EBITDA growth in its latest earnings report.

Its small market model, which focuses on having executive teams specific to each major market within their footprint, has been adopted by other large operators, including Genesis HealthCare.

Standard Bearer has added six new SNF real estate operations, which capture the upside created by Ensign affiliates.

In another example, LTC Properties (NYSE: LTC) and PruittHealth entered into a joint venture to purchase three Florida facilities for $62 million. LTC CFO Pam Kessler said the venture was linked to flexibility on the part of LTC and listening to Pruitt, meeting their needs and what they wanted to accomplish.

LTC also made moves to strengthen its bond with another operator the REIT considers a superstar – Ignite Medical Resorts – in a $51.5 million deal involving four Texas facilities.

“REITs will reward their operating partners that have remained vigilant and disciplined throughout this downturn in the market and through the COVID-19 pandemic,” said Segal. “Those that have remained disciplined and stuck to a consistent business plan without overextending themselves will have the best opportunities for growth.”

Primed for competition in 2023

While there has been some acquisition activity for REITs this year, both public and private REITs have been defined by a “pruning” of the portfolio, getting rid of underperforming facilities.

Sabra Health Care REIT (Nasdaq: SBRA), for one, announced plans earlier in 2021 to divest between $100 million and $300 million in its skilled nursing assets. During the second quarter alone, Sabra generated $40.2 million in gross proceeds from the disposition of eight facilities, in addition to the sale of two facilities completed after June 30.

However, Sabra still is very bullish on the SNF sector and pursued these deals largely to gain a more desirable portfolio balance with other types of assets, CEO Rick Matros said at the Skilled Nursing News RETHINK event in Chicago about a month ago.

As the sector approaches a new year, Segal believes the pruning has set up REITs perfectly to deepen relationships and form new ones with operators they feel hold potential.

Over the past five years, but especially during Covid, REITs have been optimizing their portfolios based on challenges from a market or operational standpoint, added Bowyer. If they don’t divest of properties altogether, REITs have been restructuring leases to get positive coverage.

Ultimately, Bowyer agrees REIT pruning of underperforming assets, coupled with rising interest rates, has put a positive spin on dealmaking for 2023 and created opportunity in a normalizing market.

“I think it’s been the desire of the REITs to ultimately be more active on the acquisition side; to date, that has certainly been their intention,” noted Segal. “You may see some sellers more attracted to the ‘all cash buyer’ profile of a REIT, compared to private capital investors that have risk exposure to the debt markets.”

Over the past several years, pricing has been dictated by how much rent their operators are comfortable paying, so that has limited REITs in their ability to get more aggressive pricing and compete with the private capital market, he said.

While the private market is feeling the pressure of rising interest rates, this change is also making transactions more difficult to execute – the goalposts are moving for some lenders, which in turn moves the goalposts for equity requirements.

“I think it all comes down to the cost of debt and the amount of leverage your private equity buyer is going to want to invest with,” said Bowyer.

It’s more difficult for buyers to fully capitalize on these transactions.

Kennedy said REITs will have the opportunity to acquire projects at a reasonable basis as a result; they tend not to use as much leverage compared to independent sponsors or private equity.

“When the Fed is increasing rates every other month, that creates a lot of volatility and movement on the lending side, which then changes the equity requirements and makes deals more challenging to get done, but they are still getting done,” added Segal.

For the remainder of 2022, rising interest rates have caused a bit of a pause for both the private equity end as well as REITs, according to Bowyer. Finance players in the sector are taking some time to understand the full impact interest rates will have on valuations.

Medicaid rates: uncertainty vs. incentive

The skilled nursing sector is different than private-pay senior living in that costs related torising interest rates can’t be passed on to the consumer. SNFs are overwhelmingly paid through Medicare and Medicaid reimbursements, so services and bed rates are dictated by state and federal agencies.

Depending on the state, Medicaid budget increases could be considered an incentive or a pain point; it’s dependent on what support facilities have seen leading up to and during the pandemic.

“There are several states that have been expanding their Medicaid budgets and are increasing their Medicaid daily reimbursement rates for facilities,” said Segal. “That has been very helpful in weathering the storm a bit for the operators in particular, but the increased interest rate environment is just putting even further pressure … it goes all the way up the ladder to real estate ownership as well.”

There has always been stroke-of-the-pen risk in the skilled nursing sector, Bowyer said. He doesn’t remember a time in his 20 years working in the industry when the space was actually seeing the level of increasing reimbursement rates that it’s seeing now.

“The question always remains – how long will that last? We’re also seeing an increase in operating costs,” he added. “But those reimbursement rates are really prolific to the bottom line.”

It’s ultimately a sign of some level of confidence from the government, Bowyer said, and that margins will be able to remain relatively intact even with inflation costs.

Sabra is highly attuned to the differing reimbursement environments across various states. The REIT published a summary of rate increases across its key states as part of its Q2 2022 earnings report. Some increases were add-ons allocated by states to nursing home reimbursements, drawing on additional Federal Medical Assistance Percentages (FMAP) funds via the Families First Coronavirus Response Act. Other rate increases were to base Medicaid rates.

“Medicaid is an important source of revenue for the skilled nursing industry and we feel very good about the increases we are seeing in those rates, which creates a smoother path to recovery as the federal assistance we have been accustomed to expires over time,” Matros said in the earnings release.

Meanwhile, a slow increase in net hires – and decrease in contracted labor – has helped bolster REIT confidence as the expense side of operators’ budgets begin to normalize, Kennedy told SNN.

That’s coupled with the Centers for Medicare & Medicaid Services (CMS) decision to give SNFs a 2.7% bump in payments for 2023, he said, and two-year phase-in of an adjustment to the Patient-Driven Payment Model (PDPM).

“We’ve staved off what the Biden administration was originally planning – a Medicare decrease,” said Kennedy. “We’ve put that in the rearview mirror and now we’re seeing Medicaid rates increase state by state; those increases are really important just to try to offset some of these increases in costs.”