[UPDATE] Sabra Plans to Sell 29 Genesis Properties

Sabra Health Care REIT (Nasdaq: SBRA) is joining the ranks of real estate investment trusts that are taking significant steps to limit their exposure to skilled nursing. Sabra and its major skilled nursing tenant, Genesis HealthCare Inc. (NYSE: GEN), have reached an agreement to market up to 29 leased buildings for sale, the REIT announced Monday.

The move is part of Sabra’s ongoing efforts to diversify its portfolio and follows a rocky period for Kennett Square, Pennsylvania-based Genesis. Also on Monday, the large skilled nursing, senior living, and rehabilitation care company announced a pending $52.7 million settlement with the Department of Justice (DOJ) over four ongoing investigations. And the DOJ attention has been only one of the factors contributing to a significant slide in Genesis’ share price since the beginning of 2015.

These challenges are behind a broader turnaround strategy that Genesis is set to undertake, Sabra CEO and Chairman Rick Matros said Tuesday in a call with analysts. Details of that plan are likely to be unveiled Friday after Genesis releases its most recent quarterly earnings, but exiting certain markets through the dispositions with Sabra is one component, Matros said.

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The 29 skilled nursing facilities that are set to be marketed are located in Kentucky, Ohio, Montana, Indiana, Georgia, and Connecticut, according to a form 10-Q filed Monday with the Securities and Exchange Commission (SEC). Genesis itself will take them to market, while Sabra will be involved in the process, Matros said. The communities could be sold as a single portfolio, individually, or in smaller combinations.

Genesis may be facing current headwinds, but the company is doing the right things to adapt to changes in markets, regulations, and reimbursements, in Matros’ opinion. The issue is that it will take time for these industry transformations to come to fruition, and Genesis likewise cannot make rapid adjustments due to its scale–therefore, the company may face short-term downside as it executes on its plans for the future.

“Genesis is a battleship,” Matros said.

So, while maintaining confidence in Genesis, Sabra at the moment is taking steps to limit its risks.

Preparing for the Inevitable

If all 29 of the buildings are sold, and previously announced potential Genesis sales go through, it would take the number of Genesis leases in the Sabra portfolio down to 43, the Irvine, California-based REIT stated Monday.

There were 78 Genesis-leased buildings in the Sabra portfolio as of June 30, 2016. As of that date, Genesis represented 33.6% of Sabra’s annualized revenues; its second-largest tenant, independent living giant Holiday Retirement, accounted for 16.6%.

“Our objectives are to grow our investment portfolio while diversifying our portfolio by tenant, asset class and geography within the health care sector,” Sabra stated in its 10-Q. “We plan to achieve these objectives primarily through making investments directly or indirectly in health care real estate. We may also achieve our objective of diversifying our portfolio by tenant and asset class through select asset sales and other arrangements with Genesis.”

Upon sales of the facilities, Genesis will reduce annual rental amounts paid to Sabra by an amount equal to 7.5% of the net proceeds received from the sale. In addition, Sabra is adjusting the laddering of maturities for Genesis leases, as a result of which 30% of revenues from Genesis leases will mature by the end of 2021, as opposed to the 71% currently, the company announced.

The exact ramifications of these parts of the deal are still being determined; analysts on Tuesday’s call repeatedly asked Matros and other Sabra executives for clarification about the potential rent adjustments. But one crucial assumption to take into account is that, for many of these 29 properties, Genesis most likely would have walked away once the current lease agreements expired in 2020 and 2021, Matros emphasized.

With this in mind, Sabra and Genesis sought to get ahead of the game by selling the properties now and working out a mutually beneficial arrangement. This is behind the decision to extend certain attractive leases that otherwise would have matured earlier, and implement the rent reductions pegged to the sale prices the 29 properties fetch.

Another aspect of the deal is that the 29 properties are not all poor performers; in some cases, the decision to sell them had more to do with other factors, such as their location. Therefore, rent coverage for some of the communities is strong, and it is weaker for others. Overall, selling the portfolio should not have much immediate impact on coverage, Matros told analysts.

Longer term, trimming its portfolio should help Genesis improve its performance and therefore be a stronger tenant, the Sabra leaders said.

Unless it is extended, the memorandum of agreement regarding the facility sales will terminate if the 29 properties are not sold by Oct. 31, 2017. Matros and his leadership team are optimistic about finding buyers, particularly given strong interest in skilled nursing among private market players who have been involved in the industry for a long time and understand current opportunities.

“Private buyers, many of whom are strategic … understand how well positioned SNFs are as the lowest cost provider,” Matros said. There’s “huge upside” if a buyer can get an underperforming building in a good market and then bring in a strong operator, he added.

Mixed Signals on Skilled Nursing

Sabra’s move to reduce its exposure to Genesis comes during a turbulent time for skilled nursing operators. Regulatory and reimbursement pressures have compromised their financial performance, and other large health care REITs such as Ventas Inc. (NYSE: VTR) and HCP Inc. (NYSE: HCP) have spun-off their skilled nursing assets to keep them from being a drag on their other assets, including private-pay senior housing.

In particular, many of the country’s largest skilled nursing providers have faced DOJ investigations into Medicare billing practices. One such ongoing investigation of HCP’s major tenant, HCR ManorCare, was among the reasons the REIT spun off those properties. And post-acute care giant Kindred Healthcare (NYSE: KND) paid out $125 million in a DOJ settlement earlier this year.

The settlement that Genesis has worked out with the feds is less costly than Kindred’s, and Genesis has been preparing for it; the company will incur a $13.6 million contingency loss for the quarter ended June 30, after having already set aside $39.1 million.

But while putting the investigations to rest may bring Genesis’ investors and business partners a welcome measure of certainty, it may also stir up continued doubts about the stability of skilled nursing as an asset class.

Leaders at other REITs—notably Welltower Inc. (NYSE: HCN)—have derided these worries. Concerns over skilled nursing are overblown, as long-term trends favor these operators and best-in-class companies have strong upside potential, Welltower CEO Tom DeRosa and other industry leaders have said.

Matros has not shied away from skilled nursing investments, even while acknowledging that Genesis—which gained even greater scale through the 2014 acquisition of Skilled Healthcare Group—is still trying to gain focus.

Longer term, he is bullish on larger, more sophisticated skilled nursing operators that can serve residents with higher acuity and navigate increasingly complex payment and care models. Traditional mom-and-pops could go bust, he believes, with those in competitive urban markets failing first and presenting acquisition opportunities.

Sabra is in a good position to act on these sorts of opportunities, but in the near-term, the REIT is focused primarily on private pay senior living, with a $300 million pipeline mostly of assisted living and memory care properties, Matros said.

Investors seemed to like Sabra’s strategy, with shares up 1.72% when the market closed Tuesday. They also had reason to like Sabra’s earnings report for the second quarter of 2016, which came out in conjunction with the Genesis announcement. Sabra’s revenue of $74.25 million was a 31.2% year-over-year increase and beat analysts’ expectations by $17.57 million.

Also in the second quarter, Sabra completed its exit from troubled hospital investments.

Written by Tim Mullaney

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