Is the Market for Buying and Selling Long-term Facilities in a Bubble?

Is the market pricing for the sale of long-term facilities in a bubble?   That is an important question given the purchase and sale dynamics that exist today.   First, by the measure of per bed and per unit prices, 2013 senior healthcare and housing sale prices set record highs: 

·                 $73,300 per bed for Skilled Nursing Facilities, a 27% Increase over 2012 ($57,909/bed)

·                 $150,600 per unit for Assisted Living Facilities

·                 $191,950 per unit for Independent Living Communities

Depending on which data source you use (Irvin Levin Associates or National Center for Senior Housing and Health (NIC)) Cap Rates hit record lows, but not as striking as the per bed and per unit prices.  The Irvin Levin Cap Rate for the sale of skilled nursing home facilities was 13.0%, the NIC Cap Rate for the sale of skilled nursing home facilities was 12.2%.   At least as it pertains to the sale of skilled nursing facilities, piercing the historic Cap Rate floor of 13% is a historic first.

Second, more than 2,000 people attended the NIC Conference in Chicago last week, showing an exuberant interest and confidence in the senior housing and healthcare industry.   Wall-to-wall lenders and equity sources populated the receptions and networking lounges.  There were many more skilled nursing facility and assisted living and independent living facility buyers than sellers.  The industry is awash is low-cost capital looking for more than a few good long-term care facility sale deals.

Third, one other unprecedented sign is the sale of nursing home and assisted living operating companies sans ownership of the real estate.  I am hearing often about asset-less operating companies on the market whose physical plants are leased from third-parties, often public or private REITs.   To put this into perspective, I am hearing about deals of skilled nursing facility companies that sold their real estate to REITs, for say $125,000/bed or more, and are now asking $50,000/bed for the purchase of the operating company.  Keep in the mind that the operating company has lease obligations with annual rent escalators and there is no purchase option for the real estate.  Owners recapitalized their assets once by selling to a REIT, to employ capital on operations and acquisitions instead of real estate and to take money off the table.  Now, they are going back to the well and trying to sell their operations too.  The deals I am hearing about when you calculate the lease plus the operating company price on a per bed basis approach an aggregate of $200,000 per skilled nursing facility bed.  As the Gershwin song goes:   Nice work if you can get it.  And you can get it if you try

We need to dig deeper into this to decide if the long-term care facility industry is in a bubble.  In the 1990s, when I was working for Integrated Health Services, I was developing a five-year pro forma model of assisting living facilities.  Our model projected nosebleed valuations of $125,000 to $150,000 per assisted living unit.   When I showed the results to Dr. Robert Elkins, cofounder and CEO of Integrated Health Services, his poignant words to me were:  “You’re crazy.  Those are hospital prices.”  That was the end of that analysis.  Now the valuations that he considered crazy are average mundane deal prices for assisted living units, meaning that there are plenty of assisted living sales above $150,000 per unit.  Who would have thought that the Cap Rate for the sale of assisted living facilities would be around 8.5%?

The Wall Street Journal of October 11, 2014 had an article about Nobel-prize meaning Yale University finance professor and economist, Robert Schiller, known for his novel work regarding the valuation of stocks and real estate.  Professor Schiller, who incidentally spoke at the NIC Conference a couple of years back, prophetically predicated the tech stock and real estate bubbles in 2000 and in 2008, respectively.  Professor Schiller’s work on asset valuation essentially contests the efficient-market hypothesis, which predicates that because of efficient and widespread distribution of information about an asset to all potential buyers, market investors rationally determine stock prices on the expected receipt of future dividends, discounted to a present value.  However, Professor Schiller states in WSJ article that:  “The market is supposed to estimate the value of earnings, but the value of earnings depends on people’s perception of what they can sell it again for” to other investors.  Please reread the words of his statement in bold.  This is a stunning admission. Applying this theory to the sale of long-term care facilities, buyers are paying high prices on the expectation that in the long-run they can sell it for more.  This is the norm.  Some of this rationale as it applies to the sale of nursing homes and assisted living facilities is based on the premise that there is added value in better management and in potential synergies realized, thus justifying the incrementally higher price.  Nonetheless, Professor Schiller is correct, no matter the purchaser’s added value justification, there is also a prevailing expectation that they can probably sell it for an even higher price in the future.  As Professor Schiller says, the long-term average is “highly psychological” and that today’s prices “might be high relative to history, but how do we know that history has not changed.”  From my own experience, there were plenty of skilled nursing facility sale deals I closed a mere ten years ago, priced at between $45,000 to $50,000, that at the time seemed astronomically high, that would easily fetch more than $100,000 a skilled nursing facility bed today.

Some would argue cynically that the Professor Schiller’s insight is a sophisticated reconstruction of the “greater fool theory,” upon which bubbles ultimately derive their source.  Restated, the greater fool theory is that although an asset or market is fully valued, the price is justified because there are enough buyers to push prices further upward and resold to at a later date.  Of course, this is synonymous with the standard definition of a bubble.  This phenomenon is not new.  In 1890, The Chicago Tribune, writing about the then mania in real-estate prices, described "men who bought property at prices they knew perfectly well were fictitious, but who were prepared to pay such prices simply because they knew that some still greater fool could be depended on to take the property off their hands and leave them with a profit".

There are genuine value-added opportunities buyers in the skilled nursing and senior housing space who will pay a incremental premium based on the upside potential and improvements that they expect to carry out.  They are not willing to pay for one hundred percentage of what the value they can create; that would be irrational.  On the other hand, there are young and hungry first-time buyers who are willing to pay high prices today on the premise conditions continue to remain favorable, which is not an unreasonable assumption in the nursing home and senior housing industry, they will turn a profit in five years upon resale.  The only concern is that the speculators may be crowding out the value-added owner/operators who are in it for the long-haul, and that REITs are correspondingly  lowering their coverage ratios too, signals that the industry has reached the irrational exuberance phase

I do not know the answer.  But it appears the music continues to play in the skilled nursing and   senior housing industry and the fundamentals look excellent and promising from any vantage point.  When the music stops nobody knows.  “Nice work if you can get it.  And if you get it won't you tell me how?”

Reflections on the 24th Annual NIC National Conference

I just attended the 24th Annual NIC (National Investment Center for Senior Housing & Healthcare Industry) National Conference in Chicago. It was an intimate gathering of more than two thousand attendees interested in transactions involving sales, development, construction, and financing of skilled nursing facilities, assisted living and independent senior housing. There were lenders, operators, lawyers, intermediary and vendors present. Below are reflections and observations:

• Press the Flesh – It is hard to believe that in this 24/7 connected digital age in which we live in front of our desktop monitors and handheld cell phones, in which business transacted via email and data rooms, that people still feel the urge to meet in person to source and to advance opportunities and deals. This is a compelling testament to the fact that transactions are a relationship and social experience. It is all about networking. There is simply no substitute yet for shaking hands, sharing a drink and greeting and meeting in the physical confines of the conference. The great thing is while most attendees have a full schedule of meetings, serendipitous nonstop business conducted nonstop in elevators, at the receptions or in the hallways. This was the most well-attended conference ever and a veritable senior housing and healthcare Woodstock without the mud and drugs. Nonetheless, this was all about business, making connections, planting seeds and moving deals forward. This conference alone has a tremendous impact on shaping the direction of the post-acute healthcare and senior housing industry. Oh, there were also educational seminars to attend, but they seem to be a pretext for the meetings and the networking.
  
• It was 20 Years Ago Today, Sargent Pepper Taught the Band to Play -Twenty plus years ago, these NIC conferences were sparsely attended. Twenty years ago there was a plenty of doubt in the banking world whether this was a good asset class for loans and capital infusions. There were concerns about regulations, reimbursement and overbuilding. The joke in those days was the conference was an opportunity to meet the lender. One lender, that is, HUD. Today, the Meet the Lenders reception was populated by wall-to-wall capital sources. For sure, the data shows persuasively that this industry is among the best to lend to with the lowest level of default. Accordingly, NIC was awash in capital as there were tons of lenders of all types, REITs, both public and private and equity sources. The industry is no longer up and coming. We have made it and thus capital is readily attracted to it.
  
• Big Ideas - Post-conference, I reflected on the broad trends and drivers affecting the senior care and housing industry. Three factors could sum them up: 1 Historically low cost of capital and the abundant availability of this capital, 2. Although it is well-recognized and even platitudinous to recite again, the underlying demographics and demand continue to be compelling and robust; with the aging baby boomers the demand will continue to rise absorbing supply increases, and 3. The availability of government subsidies, i.e., ongoing reimbursement for nursing home care or HUD or other agency loans for acquisition (via bridge to HUD lenders) or refinancing. Over the last twenty years in the industry in satisfying the market need, a vast amount of private wealth has been garnered. In a sense, the entrepreneurs in this industry have slid uphill with the wind behind their backs without much resistance. I expect these trends to continue.
  
• More Buyers Than Sellers – There are more buyers of skilled nursing facilities, assisted living and independent living facilities than sellers. This includes consolidation from the top-down from mega-REITs and national chains and from the bottom-up from aggressive operators trying to acquire their first facilities. As a result of the seller’s market conditions, selling prices are high and CAP rates are low and this is further exaggerated for stabilized newly-constructed properties. After listening to attendees, including several lenders, I learned that the market valuation of a new SNF or ALF at stabilized occupancy is high. I now think the Cap Rate premium for new SNF construction at stabilized occupancy is at least 200 basis points or 2% lower, that is, say, a 10% Cap Rate, but I hear that for the AL properties, the Cap Rate premium is as low as 300 basis points or 3% lower. So, as a rule of thumb on the SNF-side, a 10% Cap Rate on the new stabilized occupancy is obtainable and an 8% to 9% Cap Rate is the asking price. For the AL, I would set a 5% Cap Rate for an asking price for new stabilized occupancy properties, which I hear is being realized.
  
• New Blood – One phenomenon that was interesting to observe is the large number of young people present. Many are new to the industry working their way up the line. But there also many young hungry entrepreneurs with some operating experience, full of “piss and vinegar” in search of skilled nursing facilities or assisted living facilities to buy were in large supply. With the availability of low-cost capital, they have a chance to make this work. Essentially the next generation has entered the industry and is staking their claims. They definitively have the desire to own and operate at a younger age than many of today’s leaders of the industry, who worked their way up and went on their own after fifteen to twenty years of progressive industry experience. We trail blazed the way to riches and the young folks are impatient for their piece of the pie and want to short-circuit the learning process. This is kind of millennial thing and I hope it does not lead to failures because of arrogance, lack of knowledge and inexperience. When the consumers’ health and well-being is at stake, the risks of disaster are serious and potentially lethal. Hopefully, lenders and investors are still looking at operating capabilities as a major criterion for lending and setting that bar high. That is good for the industry and for end-users. 

Next year the NIC National Conference will be in Washington DC.  I wonder if attendance will set a new record.  By all indications, the only direction is up.

Healthcare Mergers and Acquisitions Jargon, Part 2

• “Bandwidth” – buyer has ability to review and evaluate multiple deals

• Indemnity – What seller has to provide to stand behind statements represented and warranted in a sale contract

• MAC Provision – part of purchase contract that deals with material adverse events before closing

• “CHOW” – In healthcare industry, there is typically a licensure or change of ownership application process.

• Pro Forma – Financial Model of Projected Revenues and Expenses, incorporating buyer’s operating assumptions and plans often testing multiple scenarios.

• TLM – Trailing Twelve Months of Financial and Statistical Data

• Re-Trade –Buyer’s Renegotiating Purchase Price Reduction After Agreeing to Purchase at a Higher Price Buyer Signs Deal That They Don’t Intend to Honor. Bait and Switch

• Earn-Out - An arrangement in which sellers receives additional future payment, usually based on future earnings.

Healthcare Mergers and Acquisitions Jargon, Part 1

• Middle-Market – Transactions generally under $1 billion and involve non-publicly-traded companies.

• One-Off Deal – Purchase of a single facility or entity, not a multiple entity deal

• Portfolio Deal – Multiple facility or service sale

• “Deal Has Hair” – a complexities and complications of selling company

• ‘’Tuck-in’’ Deal – small niche deal that fills hole in company’s portfolio

• “The Ask” – A term or condition of the business deal that one side is requested

• "Open Up the Kimono” – seller is willing to disclose confidential company information

• Data Room – online virtual cloud where confidential due diligence is stored

• “Cratered” – as in the deal crated…fell apart

Cap Rates Used In Skilled Nursing Facility Valuations

The baseline metric for the valuation of a skilled nursing facility is the amount of Net Operating Income generated by operations, or more specifically, EBITDAR, consisting of Earnings before Interest, Taxes, Depreciation, Amortization and Rent, divided by rates of return specific to the nursing home industry (known as the “Capitalization Rates” or “Cap Rates”).  Cap Rates are derived from historical nursing home sales data.  In addition, the practice in nursing home valuations is that EBITDAR is calculated net of a management fee computed at five percent (5.0%) of revenue.  (EBITDAR is thus EBITDARM less the management fee.)  While the management fee percentage applied could vary from 3% to 5%, by buyers’ assumptions of synergies from the business combination, 5% is the heuristic benchmark.  This formula is known as the Income Capitalization Model.  It is based on the premise that asset value is predicated on the amount of free and clear cash flow a business generates per year.  In other words, the Income Capitalization Model translates Net Operating Income into value.  Consequently,


Value = Business Income/Capitalization Rate

The Capitalization Rates (denominator) for skilled nursing facility valuations are derived from historical nursing home sales data, so that:

Annual EBITDAR/Sale Price = Capitalization or Cap Rate

Therefore:

Prospective Valuation    = Annual EBITDAR/Historical Cap Rate(s)

For Example,

Prospective Pricing at a 13% Cap Rate = 

    Annual EBITDA/Historical Cap Rate: $1,000,000/0.13 = $7,692,231

Earnings Multiplier is Inverse of Cap Rate:   

13% Cap Rate = 1.00/0.13  =  7.69 X, or

7.69 x $1,000.000 = $7,692,231