REITs Sheltered from Skilled Nursing Headwinds—For Now

Meaningful headwinds are currently impacting skilled nursing facility (SNF) operators, with little chance of abating any time soon.

Still, there’s scarce reason to expect sector-wide bankruptcies, as occurred less than 20 years ago. And despite its recent downward revision of HCP Inc.’s (NYSE: HCP) rating outlook, most health care real estate investment trusts (REITs) remain fairly protected from a rating perspective, according to a new report from Fitch Ratings.

“REITs, generally, are very well insulted from the issues that SNF operators are facing,” Fitch Ratings Director Britton Costa tells Senior Housing News.

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Skilled Nursing Vulnerable

SNF margins are under pressure due to increasing coverage under Medicare Advantage, which is resulting in lower rates and shorter stays, according to the report released Tuesday. The pressure is compounded by U.S. Department of Justice (DOJ) investigations that could potentially influence billing practices, and pilot programs for bundled payments and coordinated care.

In the near-term, the DOJ investigations into billing practices may decrease corporate liquidity and dampen capital markets access, the report says. Longer-term, the investigations could limit more aggressive billing practices, decreasing margins and revenues.

Strong operators should be well-equipped to manage all of these long-term challenges, however, as they have a firmer sense of what’s coming than they did when changes to the payment methodology occurred in the Balanced Budget Act of 1997, the report says. That altered the basis for reimbursement from “cost-plus” to “fee-for-service,” leading to a rash of bankruptcies in 1999 and 2000, including of Genesis Healthcare, Mariner Post-Acute Network Inc., and Sun Healthcare Group Inc.

Those bankruptcies occurred in part due to operators levering up to fund a preceding period of consolidation and growth, the report says. The debt left the operators with few options when reimbursement cuts came down from the government.

Recent earnings reports confirm that SNFs again are in a challenging operating environment—Genesis revised its 2015 guidance downward, and HCR ManorCare’s earnings decreased 25% year-over-year as of the fourth quarter of 2015. While SNFs generally are in a better position than they were when the widespread bankruptcies occurred, Fitch has its eye on how they’re doing business in addition to the pressures they face from a public policy perspective.

“Fitch views most for-profit post-acute operators to be ‘B’ category credits where capacity to meet obligations is currently being met but is vulnerable to deterioration in the business and economic environment,” the report states. “SNFs’ financial policies will play as meaningful of a role as reimbursement in determining tenant outcomes.”

REIT Exposure

When it comes to SNF ownership, the majority of REITs still have a cushion and can manage in the current environment, the report says. Specifically, REITs with tenant EBITDAR/rent coverage higher than 1.4x should be insulated from operator challenges, Fitch says. At the same time, REITs at the lower end of their leverage range have the capacity to lower or restructure rents.

Tenant operators with coverage higher than 1.4x should be able to continue meeting rental payments despite meaningful declines in EBITDAR, even when assuming no change in other operating expenses, the report says. Additionally, smaller reductions in revenues could lead to larger EBITDAR declines, given SNFs’ high operating leverage.

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Still, the increased potential for SNF-related earnings reductions could impact equity values and, thus, capacity for external growth on a leverage-neutral basis, the report concludes.

Inside Look at HCP

One REIT that is feeling the sting of skilled nursing woes is HCP Inc., and in its report Fitch detailed how it stacks up against its peers—and what drove the rating agency to revise its outlook from Stable to Negative last month.

HCP’s outlook was downgraded in part because of its exposure to HCR ManorCare, which like other skilled nursing operators not only is facing operational challenges from the rise of Medicare Advantage and other factors, but is under a federal probe of its therapy billing practices.

“Coverage for HCP’s lease with HCR (its largest tenant at 24% of annualized revenues) has been significantly weaker than its peers,” the Fitch authors wrote. “We believe the thinner coverage is attributable to both HCR’s operating headwinds and the initial rents prior to a negotiated rent reduction in 1Q15 being set too high with meaningful annual rental escalators.”

Prior to that rent reduction in 1Q15, Fitch maintained HCP’s outlook at stable, but now the REIT has leverage at the high end of what’s appropriate to a BBB+ rating. Specifically, it was at 5.9x in the fourth quarter of 2015, while it had been between 4.9x and 5.7x for every quarter from the third quarter of 2012 to the first quarter of 2015.

As for what comes next, another rent reduction appears to be one of HCP’s only options for improving HCR’s financial picture. That would likely increase HCP’s leverage further. Absent issuing equity—which Fitch does not expect HCP to do—the REIT is left with asset sales and organic EBITDA growth as its means for de-levering.

Written by Mary Kate Nelson

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