Skilled Nursing in Financial Squeeze, But Bullishness Builds for Sector’s Next Phase

Rising interest rates are inflicting pain on the skilled nursing sector, with tough discussions between capital providers and operators to come in 2023.

But with more sophisticated operators serving higher-acuity residents than in the past, and Covid-19 changing perceptions of “stroke of the pen risk,” investors see an industry with attractive long-term prospects.

“I’ve been in it for 30 years — [it was] very sleepy for 20 years, the last eight or 10 years, the group has come in who are very thoughtful, very creative, and are using technology to create cash flow, and I think this is exactly why you’ve had the price increases,” said Alan Litt, a partner with Greystone Monticello, speaking Monday at the annual eCap conference in Miami.

Indeed, sky-high valuations have reflected a strong belief in the sector despite current financial and operational challenges, Litt and his co-panelists said, painting a bull case for skilled nursing even if deal prices do start to normalize.

Interest rate squeeze

As the Federal Reserve ratcheted up interest rates last year, skilled nursing deal volume declined, and the slowdown will likely continue through the first part of 2023.

“There was heavy M&A activity from about the middle or late-2020 until the third quarter of last year; we saw that stalled significantly as rates jumped like they did,” said VIUM Capital Senior Managing Director Tony Ruberg. “I think that will bleed through into probably the first and second quarter of this year.”

This perspective was echoed by James Thompson, senior director of healthcare lending at Signature Bank.

“I think deal flows will slow a bit in the first half of this year; you can’t ignore the impact of short-term rates on underwriting,” he said. “Even though we’re seeing occupancies creep up, NOI creep up, they’re not going fast enough to catch up with short rates.”

Pure-play PropCo investors are in a particularly tough spot if they are not protected with a swap or cap.

“A lot of our clients are underwater,” said Ari Adlerstein, senior managing director with Meridian Capital Group.

Another problematic situation involves two- to three-year bridge loan deals that do have a swap or cap but are maturing this summer, creating full exposure to rates, Adlerstein said.

“I’d rather be an owner/operator right now than just a landlord,” he noted. “I think they have a little more flexibility in that regard. But it’s going to be a partnership and probably a lot of discussions.”

A reduced pool of lenders also is affecting the sector, according to several speakers. “Tourist lenders” left the space during the pandemic, while at the same time, slower lease-ups have meant that properties aren’t exiting into the permanent debt markets at the usual pace, Adlerstein observed. Lenders in these situations are coming up against maximums that they can lend to a single borrower, constraining debt.

The difference from a year ago is stark, from the perspective of a firm like Meridian.

“A year ago, we’d be able to take a deal out to market … and we’d have six term sheets 24 hours later; it kind of feels like you’re king of the world — the biggest issue is, how do we let down five lenders gently and respectfully, because they’ve all put in time and energy into giving us a term sheet,” Adlerstein said. “Today, when we get a term sheet that we feel really good about, and we feel has certainty of execution and the terms are livable, we are excited.”

When it comes to nursing homes that have maturing loans but are not performing well enough to exit, Litt urged borrowers to be proactive in broaching difficult discussions with lenders, and said that lenders almost certainly will find ways to work with borrowers that have put in good-faith efforts and been transparent.

“At the end of the day, there has to be collaboration between all the parties,” he said.

Surviving and thriving in a new era

The pressure of higher interest rates could narrow a bid-ask gap and normalize high prices that skilled nursing assets have been commanding. But recent valuations have not merely been a function of cheap, plentiful and eager capital, and a skilled nursing bubble is not about to burst, according to Jonathan Slusher, partner and head of senior living and healthcare at private equity firm Northwind Group.

Rather, increased Medicaid rates are one key factor behind the valuations.

“If you look at certain states that have gotten to a level … where Medicaid residents actually start to become somewhat profitable, instead of buildings just focusing on [Medicare Part A], those valuations have been where the largest increases have occurred,” he said.

VIUM’s Ruberg also emphasized that several states have implemented “pretty significant increases,” and such Medicaid support has buoyed operators in those markets. The firm is expecting increases later this year in other states, including Ohio, Iowa and Michigan, and “there’s a lot riding on that,” he said.

High deal prices also have been a result of the support that the government extended to nursing homes during Covid-19, Slusher said, which was “the perfect episode” to counteract investors’ historical skittishness about “stroke of the pen risk,” with reimbursement rates being at the government’s discretion.

And with a potential economic contraction looming, skilled nursing’s reputation as a recession-proof — or at least recession-resistant — sector also adds to its luster.

A recession would help ease the single biggest headwind facing operators, which is an excruciatingly tight labor market — although Signature Bank’s Thompson is concerned about the unusual combination of low unemployment along with high interest rates resulting from high inflation.

“Unemployment is really the key,” he said. “It’s going to drive whether we can get adequate staffing, and adequate staffing is going to allow the industry to increase occupancy; there’s demand out there, hospitals have no place to put people. So, I think that everything is there, as long as we can deal with the staffing problem.”

He said operators are deploying every tool in the toolbox to attract and retain staff, including harnessing technology. And Greystone Monticello’s Litt also touted how progressive operators have harnessed tech to increase cash flow — all while caring for people who are “sicker and more clinically complex” than residents typically were 30 years ago.

This rise in acuity is yet another factor driving investors’ confidence in the long-term success of skilled nursing assets, and their belief in steadfast government support. It’s becoming impossible to see nursing homes as a potential locus of cost savings to the health system, because residents can no longer be moved to lower-cost settings.

“I tell my investors, these residents really can’t go anywhere else, and it’s a lot cheaper [to care for them in a SNF] than everybody showing up at a hospital, for Medicaid,” Litt said. “ … I think that gives us a little bit of a buffer of protection.”

Despite the general slowdown in dealmaking, Noble Care is “drinking from a firehose” of opportunities, said panel moderator Jacob Segal, CFO of the firm, which acquires and operates facilities.

This situation makes sense, Litt said, characterizing Noble Care as the type of organization that is likely to thrive in a changed skilled nursing environment.

“Are you in this for a quick pop, looking to make a flip? That might not be the industry moving forward,” Litt said. “Those that have built platforms, that have built infrastructure, that use technology, that have great relationships with the hospitals, those are the ones that are going to survive and thrive.”