Mid-sized senior living providers that are looking to grow have opted to build rather than buy lately, in part because they’ve been priced out of the acquisition market. But these operators soon could be seeing more opportunities to expand their footprints by purchasing — if they’re willing and able to navigate the more complex types of deals around distressed properties.
Financial distress is increasing in the health care sector — including senior housing — even as bankruptcies have fallen sharply across U.S. industries as a whole, attorney Bobby Guy, a shareholder in the health care practice at Kansas City, Missouri-based firm Polsinelli, tells SHN.
While acquiring these properties has historically been the province of a relatively small “distress community,” they present a “significant strategic opportunity” that should not be overlooked by the development departments of senior living operators, including smaller players, Guy says.
Health care reform and market forces make it likely that financial distress will continue to increase in the seniors housing space, so providers looking to grow through acquisitions could see a more inviting playing field, experts tell SHN. The takeaway? Now is the time to develop the right skills for this game.
Winners and losers
The fact that financial distress in on the rise in seniors housing is not a secret. Guy’s former firm, Frost Brown Todd, has published a “Distress Index” showing the development of this trend over the past three quarters.
The latest edition of the Index, for the fourth quarter of 2014, showed that Chapter 11 filings in the health care services sector continued on an upward trend. Among all Index-measured Chapter 11 filings, health care filings increased from 1.1% in 2010 to 3.8% in the latest report.
“We have not made a determination yet as to the causes of why the health care index is climbing,” he explains.
However, he notes that the industry is seeing sweeping changes and increased pressures, both legal and competitive, due to a variety of factors. These include the Affordable Care Act and the evolution of health care technologies.
Providers that can adapt to these changes — such as by partnering with larger health systems — are emerging as winners, while the losers may be struggling financially and ultimately entering Chapter 11, Guy surmises.
The health care services part of the index includes hospitals as well as senior care settings, and Frost Brown Todd has not broken out those individual sectors. However, it is likely that a “fairly high percentage” of the bankruptcy filings come from across the spectrum of seniors housing, Guy says.
Continuing care retirement communities in particular continue to face financial distress challenges, which they’ve encountered ever since the economic crisis made it difficult for prospective residents to tap into their home equity to pay for high entrance fees, says Louis E. Robichaux, principal at consulting firm Deloitte Transactions and Business Analytics LLP.
Although Robichaux believes the market may be returning for CCRCs, for years they have had to pursue creative strategies to avoid bankruptcy.
Skilled nursing facilities also are facing performance challenges as they try to adapt to a post-ACA world, Robichaux says. He does not see financial distress or bankruptcy as a particular issue for assisted living providers.
However, given that health care reform aims to more closely align providers across the whole continuum of care, it’s likely that every type of provider will need to make changes — or face potentially unsustainable balance sheets.
“We would anticipate some uptick [in bankruptcies] across the seniors housing market as the change separates the winners from the losers,” Guy explains.
A REIT end-run
As a senior living provider nears or enters bankruptcy, it becomes an acquisition prospect — so more providers in Chapter 11 or heading that way means more potential targets for buyers.
“Chapter 11 is always an acquisition opportunity,” Guy says.
In particular, these properties could be ripe for the picking for the smaller and mid-sized operators and owners that have not been able to compete with large-cap real estate investment trusts (REITs) in terms of acquisitions, as per-unit prices in seniors housing have reached such high levels that it has led to talk of a bubble.
“Distressed, underperforming properties that may or may not be on the verge of bankruptcy are not attractive to the REITs and funds going after stabilized [properties],” says Rick Shamberg, co-managing partner of Cerulean Partners, a venture capital-backed real estate investment firm specializing in acquiring and developing undervalued senior living properties. He also is a consultant to both private equity firm Chicago Pacific Founders and senior living developer Grace Management.
While even Fortune 500-size companies go after distressed properties, Guy also emphasizes that “there’s a pricing opportunity” there for mid-market buyers. However, there’s still plenty of reason to proceed with caution, he advises.
High risk, high reward
Acquiring a distressed property is not to be undertaken lightly, Guy, Robichaux and Shamberg agree.
“Distressed health care acquisitions are highly specialized,” Guys says. “It’s not everyone’s cup of tea.”
To execute this type of deal and come out a winner demands due diligence, he emphasizes. This stands to reason — the property mostly likely was distressed for a number of reasons and these may not all be revealed without some digging. For example, financials may be inaccurate, as sellers sometimes believe they own items they don’t, and liabilities that they believed were small actually turn out to be much larger.
There also could be legal issues behind a bankruptcy. Take the case of California-based North American Health Care, a skilled nursing operator which has sought Chapter 11 protection due to being faced with multiple quality of care lawsuits. Its bankruptcy attracted attention from The New York Times.
Some suggest that providers such as North American Health Care are subpar operators taking advantage of Chapter 11 to escape legal consequences and sell off buildings, while others argue that this is not a new or underhanded tactic, and that it may represent a responsible strategy to preserve as much value as possible for stakeholders in the enterprise.
Bankruptcy also is a public process, so properties that actually have entered Chapter 11 go through a public bidding process. This means that an organization could sink significant resources on the potential acquisition and still not come away with the prize, Guy notes.
“Medicare has become more strict on forcing a buyer to take all of the exposure when you transfer … you get all the liabilities, if there were civil money penalties or overpayments to repay,” Robichaux adds. “There are only so many things you can do in bankruptcy to scrub those things off.”
Being strategic about which opportunities to pursue is essential, Shamberg says. There are multiple variables to consider when determining whether a distressed property can be turned around.
“You’ve got to be thoughtful about the property’s location and unit mix, ask if it’s functionally obsolete, think about how much capital expenditure is it going to take to make it competitive in the marketplace,” he says.
Even after weighing all these factors, there’s not a surefire formula for success.
“It’s an art more than science,” Shamberg says. “You’ve got to look at each project as its own animal.”
Despite these challenges, there’s a reason why this type of acquisition remains attractive: The potential rewards justify the risks.
First, buyers are afforded certain valuable legal protections if they are acquiring a Chapter 11 property, Guy explains. For example, the buyer may be able to pick and choose contracts it wants to retain. The buyer also generally does not have legal successor liability, which means that the creditors of the distressed seller cannot come after the buyer for debts owed.
And then there’s the return on investment if the property can be turned around.
“In an ideal case, you buy something for $5 million, put $2 million in, you’re all in for say $7 million, you fill it up, raise the rates, put a new name on it, come to market with a fresh concept and energy, and three to five years later you’ve got a $12 million building,” Shamberg says, offering ballpark figures that he believes are reasonable for the current market. “That’s a really nice return.”
At that point, the building becomes attractive to the REIT or private equity market, he notes.
“I’ve seen assets that were financially challenged, highly difficult assets for the seller become the flagship asset in the portfolio of the buyer,” Guy says.
Considering this potential, these types of deals could — and perhaps should — be appealing to a wider pool of buyers.
“Distressed health care acquisitions are a specialized area, but are not only for a small cadre of players,” Guy says. “They’re a growth opportunity for many operators in the industry, but they need to go in prepared, with eyes wide open.”
Written by Tim Mullaney