Why Skilled Nursing Deal Volume Could be ‘Exorbitant, Voluminous’ in Back Half of 2023

Mergers & acquisitions activity is expected to remain “exorbitant,” and “voluminous” in the second half of the year for the nursing home industry despite higher interest rates, with transfer times slowed slightly by state regulations.

This is the view held by industry brokers who spoke to Skilled Nursing News on the state of current deal making, although it isn’t one that is universally held. Other M&A players say that while property performance has held steady or improved recently, deal volume is down compared to 2021 and the first half of 2022, and may trend downward with staffing pressures and interest rate hike fears.

That said, quite a few deals are expected for late summer and early fall this year, with many M&A closures happening some time in 2024, according to Daniel Morris, partner, senior housing and health care with Oklahoma-based Plains Commercial Real Estate.

Mark Myers, managing director at brokerage Walker & Dunlop, said his team at the moment is working on a 40-plus SNF transaction in the Northwest, and knows of other industry advisors working on similarly sized portfolios.

“The key to this volume has been the extensive capital base of SNF buyers,” said Myers. “While debt has been much more difficult to procure, and it is expensive, buyers of SNFs continue to have voracious appetites.”

This is due in part to higher returns on a stabilized basis for SNF properties, compared to other property types, Myers told SNN. Buyers also have their own ancillary companies that generate additional profits – sometimes as profitable or more so than underlying profits from SNFs, he said.

While the appetite exists and there remains considerable equity available, debt markets remain highly volatile, said Dan Baker, director of senior housing at JLL capital markets. Only the most experienced, well capitalized borrowers are able to get decent terms, he said.

“There has been a significant amount of capital tightening in a compressed timeline,” added Stephen Taylor, principal at CliftonLarsonAllen (CLA). “Banks may continue to tighten lending more than they already have, in response to higher rates from the Federal Reserve.”

Baker agrees that rate hikes, one of many “conflicting forces” in play along with regulatory changes and Medicaid rebasing, is yet another M&A consideration.

“[A rate hike] could continue to erode purchasing power of most active investors,” Baker noted. “The looming proposed federal staffing mandate may also hinder M&A.”

Although the Fed avoided increasing interest rates in its last meeting, it has successively been raising rates to battle inflation. And Taylor’s wealth advisory colleagues at CLA expect inflation to fall sharply in the summer months, but there’s still the risk that the Fed has drained too much liquidity. The “seeds of a sharp slow-down have been planted,” he said.

Sellers and buyers come into focus

Sellers increasingly fall into two buckets: distressed properties feeling the pressure to sell amid complicated financial and logistical issues, and legacy properties that are looking to get out of the business after Covid.

So long as there continues to be downward pressure in the market, there will be motivation for owners to sell, Morris said. Plains Commercial brokers skilled nursing deals across 15 states in the Midwest and East Coast, with a large concentration in Texas and Oklahoma.

Distressed properties, or what Morris calls “broken properties,” can span a wide spectrum of complications. Such properties could be mom-and-pops that are barely breaking even, without much space for disruptions. Other owners may be facing more severe complications, like a defaulted bond portfolio.

The second bucket – the legacy properties – are trusted in the community, but are simply weighed down in the last couple years by current regulatory changes and staffing crises.

“There are a number of operators who have been operating for 25 to 35-plus years, who are either slowing down or looking to exit. Covid didn’t help anybody, in terms of being worn out,” Morris said of the legacy SNF sellers. “I think in the back half of the year there will still be plenty of SNF transactions that happen.”

Among the legacy providers, the same buildings have been built and operated by the same operator for decades.

Three out of four properties in one portfolio handled by Plains had never been sold, Morris said.

“It’s very state specific. There are a couple of deals where it’s just a pure price-per-pound type valuation,” added Morris. In one case, buyers would come in and know they could make a property work over time despite a financial bleed, or concerns over a particularly litigious state.

“Those who expect to be in the business for the long haul and are looking to grow their portfolio in the right way, I don’t think that the current state of litigation is making a difference on their transaction volume,” said Morris.

Litigation’s impact

Myers echoed these thoughts on litigation in the space, and said its effect on dealmaking is weighed by the returns. Even with the recent Supreme Court ruling on the resident’s right to sue publicly-owned nursing homes, Myers said potential litigation is an “adjustment, but not a game changer for the industry.”

Litigation pitfalls in general are not stalling deal making as much as capital market turmoil is, Baker added. The SNF space has always been litigious, and operators as well as owners plan accordingly, he said.

For buyers, the demand for assets in the SNF space hasn’t lessened either. While many buyers see the coming years as a financial drain, they tend to make deals for the long haul, said Morris.

Morris has seen operator outlook go long-term. And so, those looking for assets now plan to keep and build upon them for the next 10 to 15 years. They have to see into the future, he said, given the labor shortage and regulatory climate.

In one instance, SNF executives told Morris a portfolio would be a “three-year bleed,” but that they still felt it was a good deal.

“If you only plan on being in business for another two to four years, well, you’re not going to go buy that kind of deal,” said Morris. “If you plan on being there for the next 20, that deal is going to be wonderful in 10, 15 years.”

Buyers are “reloading for the next cycle” with their purchases, added Morris, despite transactions getting a whole lot more complicated with more legal fees and other factors.

M&A trends expected to continue with downward pressure

Macro downward pressures like the interest rate environment, along with state-specific Medicaid rebasing, are still significant contributors to the M&A climate, said Morris.

In other words, there’s still a motivation to sell, between macro trends and state-specific drivers.

“We’ve underwritten a number of portfolios recently, where effectively these different owners are waiting on a potential rate increase in various states,” said Morris.

One Plains Commercial client looking to sell its portfolio was facing a $12 million loss in value, Morris said, as its three years of Covid funding was due to go away with no permanent FMAP dollars in place moving ahead.

“That’s a hinge point. Nobody’s going to give me value for it if it’s going away tomorrow,” said Morris. “You’ve had three years of this Covid add-on funding. If this becomes permanent, and certainly if there’s any addition then great, we can give you credit for all that revenue.”

The Texas legislature, for one, agreed to a permanent Covid add-on of $19.63 per day. And, there’s conjecture that this might be pushed up further to $26 or $27 per day, Morris said, although he’s “very skeptical” of anything beyond what was already agreed to, given the state’s poor track record for Medicaid increases.

The state hadn’t increased Medicaid rates in about a decade.

Interest rates continue to tick up too, Morris said. Some deals may be cash-flow positive, but not positive enough to get out from under an unfavorable cap rate. Still, such properties are rare enough, he said, with brokers seeing many more distressed properties or those that are barely breaking even.

“For institutional or private equity groups you don’t have to have this conversation, but with some of the smaller mom-and-pops and regional operators, sometimes you have to get into the teaching process,” said Morris. “An investor still needs to get the same spread … that cap rate has to go up, which pushes the value of your building down.”

Myers expects the Fed rate to increase by 25 basis points in July and another 25 basis points in September, then come back down this time next year.

If projected rate increases materialize, they would bring interest rates to levels not seen since 2001, added Taylor.

“Anyone borrowing money right now should seriously consider borrowing short term with no prepayment penalties, and then placing permanent debt on their portfolio next spring or summer,” said Myers. “This will allow them to lock in lower interest rates than if they lock in long-term now.”