Publicly traded and private real estate investment trusts are entering into RIDEA structures with senior housing operators at a level not seen for at least three years. This reflects that REITs have a better understanding of how RIDEA works, after an initial flurry of activity a decade ago, and they are more selective with their operating partners, markets and individual assets.
The learning curve to understanding when and how to execute a RIDEA agreement has been rapid since the first major agreement, a $817 million partnership between Seattle-based operator Merrill Gardens and Toledo, Ohio-based Health Care REIT, now known as Welltower (NYSE: WELL). That first RIDEA deal took place in September 2010.
The journey to REITs growing more comfortable with RIDEA has not been without its struggles. As senior living operators contend with persistent pressures due to labor and operational expenses, they are more willing to enter RIDEA structures with REITs, which has industry analysts bullish that RIDEA will continue its upward trend.
Still, there is a learning curve for REITs late to the RIDEA game, and some market watchers are anticipating that not all of the recent RIDEA arrangements will thrive in the long term, depending on market factors.
Riding the bandwagon
RIDEA agreements have always been an option for REITs, but the REIT Investment Diversification and Empowerment Act of 2007 approved by Congress made it more attractive from a tax perspective, RBC Capital Markets (NYSE, TSX: RY) Director and REIT analyst Michael Carroll told SHN.
The RIDEA Act allows REITS to establish a taxable REIT subsidiary (TRS) with an in-place lease between the landlord and tenant entities, both owned by the REIT. The legislation also allows a REIT to take a deeper role into the operating company portion of an agreement, underwriting larger portions in operations and income, rather than the basic rent and escalations common in triple-net leases.
“[RIDEA structures] are essentially managed contracts,” Carroll said.
The Health Care REIT-Merrill Gardens deal inspired other REITs to pursue RIDEA structures, attracted by the opportunity to be accretive and to compete with private equity to enter into joint ventures with the best operators, CBRE (NYSE: CBRE) Capital Markets Vice Chairman Aron Will told SHN. Will co-heads CBRE Capital Markets’ National Senior Housing platform.
“[REITs] utilized triple-net in 15-year terms to stay out of the operation side of the business and for the durability of cash flow streams,” Will said.
The emergence of private equity capital in the senior living space hastened the REITs’ early shift to RIDEA. With the influx of private equity, top-tier operators became weary of guaranteeing long-term rent bases and annual escalations, via triple-net leases.
But problems emerged. As REITs scrambled to put together the next Merrill Gardens deal, they did not do their due diligence on which markets, assets and operators to convert. This came to bear when market fundamentals shifted and shifts in labor and supply conditions compounded cash growth, and RIDEA agreements with increased exposure to these pressures began to underperform, Will told SHN
“A bunch of RIDEA structures worked out because they were in insulated markets with good escalators; a lot didn’t,” he said.
The REITs then took a step back how and when to execute a RIDEA agreement, versus sticking to a triple-net lease. REITs are more confident in the RIDEA structures they execute these days, and that has led to an uptick in activity not seen in years, Will told SHN.
In 2016, the “Big 3” health care REITS — Welltower, Ventas (NYSE: VTR) and HCP (NYSE: HCP) — increased their RIDEA NOI share. RIDEA accounted for just over 40% of Welltower’s NOI share, 32% of Ventas’ portfolio NOI and 17% for HCP.
Just in the last six months, senior housing REITs have continued this trend.
Notably, Irvine, California-based HCP transitioned 18 properties in its portfolio operated by Sunrise Senior Living to RIDEA in the first quarter, and will move another 17 by year-end. HCP also expanded its RIDEA agreement with Oakmont Senior Living.
Welltower has been active on the RIDEA front this year, as well. In April, the REIT entered into a RIDEA relationship with Frontier Management, which is now taking over operations of the Welltower’s 20-property portfolio of memory care communities formerly operated by Silverado. Welltower also converted 27 properties operated by Brandywine Senior Living from triple-net to RIDEA.
The learning curve continues
Equity analysts are bullish on RIDEA because of the added level of transparency, Carroll told SHN. In addition to base payment to the operator, the REITs report same-store stats, occupancy rates, rent growth and operating expenses. This gives analysts a more detailed view of how an asset and portfolio is being managed.
“I think [RIDEA] is a big improvement [over triple-net] because it better aligns the interests of the REIT and operator,” Carroll said.
The increased transparency is one area in which operators and REITs must sometimes manage through some friction, however.
“It has a little tension there, between their quarterly earnings perspective as a public company, and us as a private company,” Merrill Gardens CFO Doug Spear told SHN.
This is not a major impediment in the relationship thought, compared with the benefits of RIDEA, Spear said. By entering into its RIDEA deal with Welltower, Merrill Gardens was able to adjust its capital model for greater diversification and flexibility, shifting to a significant minority interest rather than having 100% ownership in its properties — without bringing in investors looking to turn a quick profit.
“Ultimately, both [Merrill Gardens and Welltower] have a long-term perspective in investing in the industry, so we’re not faced with a fund that has a lifecycle that needs to recapitalize and move on, but to be able to be invested in some super communities that can be a long-term investment,” Spear said.
The REITs themselves have been investing into their own operating platforms, obtaining market level data and adding more staff to track facilities performance, as they’re now exposed on operations. That has accelerated as REIT platforms have grown more meaningfully.
I think here we can make the point that the RIDEA activity has not entirely been driven by the desire for closer alignment and the need to compete with private equity. Rather, triple-net lease escalators proved unsustainable, particularly as oversupply and labor headwinds hit the senior living marketplace.
This has prompted some REITs to transition triple-net leases into RIDEA or similar joint venture structures. Welltower’s Brandywine conversion is one example.
These conversions will work well is the underlying operating business is sustainable, Welltower CEO Tom DeRosa told SHN during a recent interview in Chicago.
“We’ve managed the RIDEA portfolio to ensure that the assets that sit in that structure are sustainable operating platforms and when they aren’t, we get rid of them,” he said.
So, RIDEA ultimately might not be the best structural and economic decision for a poor performing facility.
“If it was the right real estate in the right market with the right operator, then [RIDEA] works,” DeRosa said. “If that is not leading the decision to convert, you’ve got a problem.”
Welltower has been in the RIDEA game since the outset, but the REIT is still learning new things “every day” about how to find success in this model, DeRosa noted.
But one testament to RIDEA’s durability in the long-term is the continued success of Welltower’s relationship with Merrill Gardens.
Today, Welltower has 11 Merrill Gardens communities in its operating portfolio.
“It’s been a great alignment for us in that partnership, with a REIT that’s a long-term investor, and it fits well with the Merrill Gardens and R.D. Merrill family investment model,” Merrill’s Spear said.