Mark:  Welcome Steve Monroe, Editor of The SeniorCare Investor newsletter and The Senior Care Acquisition Report, published by Irving Levin Associates. Could you tell me more about Irving Levin Associates?

Steve:  Irving Levin Associates, Norwalk, CT, is the leading publisher of business intelligence on M&A and finance in health care and seniors housing. For over 60 years, Levin Associates has been providing Wall Street investors, senior care providers and health care executives with timely, accurate and reliable market intelligence on mergers and acquisitions, mortgage financing, private placements, IPOs and secondary offerings, as well as critical information on growth strategies and best practices for the industry. Irving Levin Associates was established in 1948, covering the senior care market. In 1993, we started covering M&A for healthcare services and four or five years after that, we added healthcare technology. But we don’t get into the same detail in those areas as senior care, but we cover all sectors in our healthcare M&A reporting.

Mark:   When I studied healthcare economics in graduate school, the foremost guy I had to read, in addition to Martin Feldstein, was Irving Levin. Irving Levin did a lot of work in healthcare economics and was a pioneer.

Steve:   He was a smart individual and was way ahead of his time.

Mark:   How long have you been following the senior care industry?

Steve:   I have been doing this for 29 years come this October.

Mark:   I want to congratulate you on the 20th anniversary edition of the Senior Care Acquisition Report. It is the most extensive and fattest one I have ever seen.

Steve:   Oh yes, reflecting the market activity in the skilled nursing, assisted and independent living and home care sectors last year

Mark:   Before I get into other questions, because it is current and topical, what is your opinion of the Ventas REIT’s proposed spinning off of its skilled nursing facility portfolio, which they are referring to as “SpinCo”? Is this a reflection of the market valuation of nursing home real estate?

Steve:   Yes, obviously, if you have seen our statistics that the average nursing home sale price per bed hit record highs two years in a row. But I really think it is a reflection more of what’s been happening with Omega Healthcare Investors (OHI). In view of Omega’s purchase of Aviv, Omega is now the only skilled nursing REIT and if you look at Omega’s valuation on a per bed basis, it is so much higher than what is the market for skilled nursing beds. Ventas saw that with Aviv being merged into Omega, that there was definitively room for another skilled nursing oriented REIT. I think that is what driving it. Second, a lot of the Spinco assets came from the purchase of Nationwide Health Properties in 2010 and they probably not up to snuff for Ventas, would be my guess. So I think it is a combination of that, as opposed to a high market valuation for skilled nursing facilities per se. If it is on the SNF side, there is Omega and now Ventas’s “SpinCo” and that’s not a whole lot of competition.

Mark:   An analyst told me that Omega has been the best performing healthcare real estate REIT in the last 10 years. Is that correct?

Steve: It’s funny. They all do that and select the starting point for their analysis, which obviously will vary depending on what they select for a starting reference point. Ventas has often touted that it is the best performing REIT. But if you go back 10, 15 or even 20 years ago, you probably pick a point, where you can make the case that it is the best performing REIT in light of up and down cycles during these periods. It is all timing on that, again, depending on what reference point analysts use. But in general the healthcare REITs have been great performers.

Mark:   Given your long-involvement as a watcher of the senior care industry, do you see any recurrent cycles or trends? What do think they are?

Steve:   The recurrent cycle based on a graph I prepared using five or six different key indicators, such as sale price per assisted living unit, sale price per skilled nursing facility bed, dollar transaction value and deal transaction volume, among others, and it shows that the cycle is every seven to eight years and everyone has always said that this is a non-cyclical industry, the reality is that has been cyclical. We are now at the end of the seven year cycle and we are stretching it out longer for a number of reasons. As everyone jumps on the bandwagon, whether it was in the late 90s in assisted living or when Bob Elkins first started talking about subacute care and capitated rates, this resulted in overbuilding and overleveraged companies, respectively. Companies were overpaying and overleveraging and they got hit by the Great Recession, which sent some things down, not as badly as it could have been, and then the industry figured things out within two years and from 2010 on, it has been a long favorable ride. So, definitively, there have been cycles, and they end sometimes with external events, sometimes with internal events, but external events alone don’t necessarily kill a cycle. Usually it is something in the industry that brings it on such as overpaying or overleveraging.

Mark:   Looking back to the early 90s, when the assisted and retirement living industry was in its infancy, did you think or foresee at that time that this market would grow so large and rapidly in a relatively short time?

Steve:   In the 1990s, I was four years in the industry and I considered myself a novice, so I did not really have a historical perspective at that time. However, there was an active independent living and a CCRC market. Those had been around for some time. I don’t think anyone would have foreseen the rapid rise in assisted living, although it was pretty clear that an alternative to skilled nursing was needed and any such assisted living products at the time, such as converted hotels or a wings of a nursing home, were not what people wanted. The problem was there was a definite need. I don’t know if anyone could have predicted the explosion of the market.

Mark:   I was working at Integrated Health Services (IHS) at that time, and we were considering two major strategic paths and potential growth markets to pursue, one was subacute care and the other was a non-institutional assisted living product. I remember, at that time, I worked on a 5 to 10 year model of assisted living valuations and we were coming up with eventual eye-popping valuations of $100,000 to $125,000 per unit. Bob Elkins, who was founder and chairman of IHS, who was a peerless visionary in his own right, told me “that’s crazy, that’s impossible, that will never happen.” Of course, it’s funny, in retrospect that is exactly what happened.

Mark:   I keep hearing as an article of faith from public and private companies alike that the skilled nursing facility and post-acute market “is highly fragmented.” Is that really true anymore? Do the market share statistics really support this contention?

Steve:   The problem when talking about this question this how you break this down. One is the ownership of the real estate. And two, is the ownership of the operations. If you look at Omega or Ventas’ “SpinCo”, are those assets fragmented? Because they might have a very diversified collection of tenant-operators, but the real estate is owned by one entity. Yes, that is relatively fragmented at maybe five to ten properties per operator. That is where the data gets to be kind of funny in talking about fragmentation. There are certainly a lot of providers out there and new and small operators are popping up all the time. So I would say, yes, it is still fragmented because the local and regional guys are buying up the ma and pa homes, the not-for-profits and county homes, who are exiting the business. When you look at the sales of the not for profits and county facilities in particular, most people have never heard of the buyers. The buyers may now have 4, 5, 6 or maybe 10 skilled nursing facilities. So I still think there is fragmentation on the operating side, but less and less so, on the real estate side, because of REIT concentration.

Mark: What about an entity such as Formation Capital? They seem to be everywhere now.

Steve:   They are a hybrid. They own the real estate and own part of the operations. And they have done extremely well.

Mark:   Is the supply of skilled nursing facility beds declining or increasing? Do you see any boom of construction of new nursing homes?

Steve:   When I read the statistics coming out of Washington, nationally, the number of skilled nursing facility beds is decreasing regularly, but not by a huge amount. As you know what’s happening in states what such as Connecticut and Massachusetts, they have been forcing the closure of some smaller, inefficient nursing homes, such as 40, 50, 60 bed capacity ones, built say in 1965. They are not able to compete and it is not worth putting more money into them. That said, where you are seeing the new construction is all the people trying to build the new stuff trying to compete with inpatient rehabilitation hospitals. That is place to be. It is much easier to compete in that market if you have a brand new skilled nursing facility with all the modern amenities, equipment and technology. Again, nationally, the stock of skilled nursing facility beds is declining, but there are pockets of new nursing home construction activity such as Indiana, Texas and Arizona where there are no regulatory impediments, which is irritating to the existing operators.

Mark:   There are also a lot of skilled nursing facilities that neither staff nor operate all the beds on their license, particularly if these beds are in three- and four-bedded rooms. So the usable and used supply number is also typically less than the licensed bed complement.

Steve:   That’s also true.

Mark:   There has been a steady rise in sale prices in skilled nursing and housing and corresponding decline in CAP rates, including record high prices in 2014. Is the market due for a correction? What could cause a correction?

Steve:   I have been the “Debby Downer” of the industry. I have been saying that we are due for a correction for the past year. Although something has to cause that correction, whether it’s the financial crisis like in 2008, or a PPS change in reimbursement in 2000, which everyone knew about, but everyone ignored; and companies were nonetheless leveraging up and buying other companies for their public investors. Yes, I think the correction could or should happen. It is probable. What could cause a correction is a jump in interest rates by more than 100 basis points, but really in the 200 basis points or more area. Or the bankruptcy of several development firms, which are doing say twelve new assisted living properties a year. If three or four of them go belly up and default, that would cause some people to step back and say, “What is going on here”. Everyone is talking about how the market is on steroids, that the per-bed nursing home sale values and assisted living per-unit sale prices are too high and the CAP rates are too low. They are saying this privately. Publicly, they won’t say that. In fact, privately, almost everyone is saying that.

Mark:   Part of this is a straight supply and demand problem. There are more buyers interested in the skilled nursing facility and assisted living market than there is the product available for purchase.

Steve:   There is a lot of demand, but the other problem is too much cheap capital.

Mark:   I think the interest rates hikes will be gradual. Historically, the number one cause of corrections in the skilled nursing facility care industry is a dramatic change in the payments or in payment systems and models. The system is moving toward a bundled and value-based payment model and how that translates into skilled nursing facility industry is a big question mark. However, if that becomes more prevalent, the changes would be massive and possibly painful transformation.

Steve:   Yes, that is true. I think we are already beginning to see that with Medicare Advantage plans. Take a look at what happened with HCR Manor Care, and we are looking at Medicaid Managed Care, probably cutting lengths of stay and eligibility. So I think things can definitely change in this area. I think what may happen is that this will separate the quality providers from the no so quality providers. It is going be a long evolution. Paul Diaz and Kindred Healthcare have been ahead of their time and they have been trying to get ready for this type of shift in payment models. But the market will change and this will force something that will happen with the nursing homes doing a lot more high intensity care. And those 30 to 40 year old nursing homes will be assisted living “heavy,” providing custodial care only. So the long-stay nursing home patient who effectively needs custodial care can be served more cheaply in an assisted living setting. Thus, this is also a solution to the aging stock of nursing homes. They are not all really skilled nursing facilities serving the high-acuity rehab patients. They are essentially intermediate care facilities. Today’s assisted living facility is very much like the old intermediate care facilities that existed when you and I got into the business, but they look a lot nicer.

Mark:   Maybe there will be either Medicare rehab oriented skilled nursing facilities and light care facility nursing homes or in other words, assisted living facilities?  Maybe that is what is going to evolve?

Steve:   My opinion is that it is not going to be the state who decides to revamp the system, but whoever is paying the healthcare bill. They are going to look for the best alternative. There is just not enough money to go around.

Mark:   In your opinion, do you think certain senior healthcare and/or housing providers are overleveraged and may be facing serious headwinds?

Steve:   It depends on when these transactions were done. It depends less on their leverage, but the fact is that they are paying high prices with low interest floating rate debt, or they are selling the real estate to a REIT at the top of the market and they will have lease payments based on peak prices. It is really what happens five years from now when their escalators kick in. Or when that floater is no longer such a good deal. Their capital costs will go through the roof. That worries me. More so on the REIT lease side because you are locked for fifteen years with lease rates increasing by 2% to 3% per year. I am not so sure, especially on the skilled nursing facility side that your EBITDA will increase to support this.

Mark:   We are seeing fewer IPOs (Initial Public Offerings) for skilled nursing facility companies. What is the outlook for that?

Steve: I think the IPO market for skilled nursing and assisted living companies is basically dead. I think everyone has realized that with that kind of leverage, with that kind of capital costs and leases and all the public company obligations, it is hard to make a profit. Everyone focuses now on different metrics other than net income. EPS (Earning per Share) does not count anymore. But the real thing in the public market is that it is all about the REITs. Everyone loves REITs. Investors love REITs. Investors would much, much rather buy a healthcare REIT than they would an operating company; whether it is a completely asset-less operating company or a Brookdale. They see the value in the kind of consistent cash flow that only a REIT can offer. I think that is what is driving the public markets. Plus, it is just so hard to be a public company in this industry with all the changes, when you have new construction and developments. You have to think longer term in this industry than most public companies do. Quarter to quarter earnings? You can postpone three developments because of how it could impact next quarter’s earnings due to its cost. I really don’t see IPOs in this industry in the future. In the 1990s, everyone was going public in the skilled nursing facility sector. That was a different era. That is the place of private equity today. There is almost unlimited REIT money today.

Mark:   REITs are liked by Wall Street for return and their lowered risk because of their theoretical immunity from the operations. But are they really that immune? If there are dramatic skilled nursing facility industry changes in reimbursement payment models, wouldn’t that impact the REITs.

Steve:   People have asked me that and it is an interesting question. Yes, but it would hurt a REIT like Omega more than anyone because it is all skilled nursing. You look at the big three REITs and HCP in particular, their big difficulties with HCR ManorCare, and yet HCP and the other REITs saw their stock prices continue to rise, and thus investors did not seem to care. They can bury the losses or problems because they are so large. Healthcare REIT (HCN) or Ventas can have a $500 million client or tenant go bankrupt and they will just kick them out and get new tenants in, adjust the lease rates and do more at the backend. They are so big and so diverse that they can withstand a big hiccup. To withstand a hiccup of a $6 billion investment that HCP made in HCR ManorCare, you would think would be a negative, but it actually turned out to be a huge positive because it showed to the market that even a negative event that large could not topple one of these REITs. These REITs are so large they can withstand a lot.

Mark:   Yes, but now Ventas is less diverse and its SpinCo of its skilled nursing facility portfolio is more exposed to reimbursement changes.

Steve:   If the system moves to a more value and outcomes based reimbursement system away from the per diem model, then surely SpinCo would be at risk because it is mostly smaller providers who are technically less sophisticated providers that would be at risk. But with forty or fifty operators there, they are not all going to run into problems or default. And some of them will be very nimble to adapt quickly to changes in payment methodology. Although the 2% to 3% escalators remain a continuing problem for the operators and that worries me. At the end of the day, I don’t foresee the pool of money for skilled nursing facility reimbursement increasing by the same percentage annually. At some point something has to give.