In senior housing, the relationship between owner and operator is essential to unlocking a property’s revenue potential, flexibility throughout the terms of a lease and access to capital from lenders.
Unlocking the opportunities within lease structures was the dominant theme during Day 2 of the National Investment Center for Seniors Housing & Care (NIC) fall conference in Chicago, highlighted during a panel discussion between top executives of Brookdale Senior Living (NYSE: BKD), MidCap Financial Services, HCP (NYSE: HCP) and Welltower (NYSE: WELL).
From an operator standpoint, Brookdale — which has spent most of 2018 undergoing a turnaround — is emphasizing strategic flexibility and strong alignment of interests with with its capital sources, president and CEO Cindy Baier said during the panel. The Brentwood, Tennessee-based provider is working to simplify its capital structure so that it can operate assets where it has a “right to win.”
“This is a people business and people are going to increase or decrease the value of our real estate,” Baier said. “If you have the right operator, leadership team and community, they can win and increase the value of the assets.”
Brookdale is reviewing its leases and reviewing the objectives of itself and the capital provider, to determine areas of overlap and work with partners to create lease structures where both parties invest capital expenditures and reap the rewards of a more flexible lease structure. RIDEA leases are not good for Brookdale because of SEC rules, Baier said.
“If we were private, we would be more interested in RIDEA structures,” she said.
The RIDEA vs. triple-net argument
HCP is converting expiring triple-net leases into RIDEA, noted EVP and Senior Managing Director, Senior Housing Properties Kendall Young, adding that RIDEA is easier to structure as cap rates compress because of liquidity in the market, and operators have little incentive to invest capital in their properties as leases reach maturity. This is causing a misalignment between operator and landlord, Young said. Coverage levels in existing leases have declined due to new construction driving down rates and occupancy.
“While the NOI isn’t growing as quickly as it used to, the lease escalators are typically fixed and continue to grow, which is driving down coverage in the leases,” Young said.
For underwater leases, HCP is able to get a termination fee dependent on coverage level, remaining lease term and how underwater the lease is. Under a RIDEA structure, HCP pays the operator a base management fee and an incentive fee based on performance. It also likes to have a downside fee baked into the lease, in case performance is less than projected.
“We think the RIDEA structure is something that creates much better alignment than a triple-net structure,” Young said.
Providers are even finding flexibility within the tight confines of triple-net lease structures.
“Not everything needs to be RIDEA,” Welltower EVP and Chief Investment Officer Shankh Mitra said.
Mitra is optimistic about triple-net leases. If a rent is too high, for example, a landlord can lower the leverage by cutting the rent. Landlords need to be more realistic about what the right level of leverage on a property should be. Triple net leases can be structured so that a provider can recoup some of the economics it is giving up. Going forward, Welltower is structuring its triple net leases so that both the REIT and the operator have realistic views of capex.
This alignment between provider and operator is essential, Mitra said. The actual brick and mortar of a property only contributes a finite amount of value. A successful operator will truly unlock the value of an asset in senior housing, more than in any other real estate product type.
“We need to invest in operator culture and operations. These things matter in our community,” Mitra said.
Alignment of interests with borrowers
MidCap Financial’s McMeen said the alignment of interests extends to lender and borrower, as well. MidCap looks at where a borrower’s capital is coming from: is it coming from the operator, a third party, or is it syndicated?
Through that alignment, a lender can get better focus on an asset’s performance.
“At the end of the day, the people making the decisions around the day-to-day operations and performance of the asset need to have real stake in the game,” McMeen said. “There is meaningful downside risks to them, as well as their partners.”
Written by Chuck Sudo