Senior Living Capital Structures in Question as Owner, Operator Tensions Rise

During the last year, many senior living ownership groups worked closely with operators and granted them leeway on certain pre-pandemic expectations. But the situation is now changing, creating tension and generating debate about whether new capital structures are needed.

Corporate talent management firm Ferguson Partners recently had conversations with 13 industry executives, including owner and operator leaders. Several of them expressed dissatisfaction with current structures, Managing Director Amy Pisciotta told me.

“There is a misalignment here, and we don’t have a solution,” she said, summing up their sentiments.


I’ve also heard this concern from various senior living leaders in recent weeks, and it also came up Wednesday in a webinar. The timing makes sense, according to NIC Chief Economist Beth Mace.

As the industry emerges from the Covid-19 crisis, operators face elevated expenses — including surging labor costs and insurance rates — while ownership groups, particularly private investment firms, are again trying to hit their return expectations.

“So there is a tension, for sure — probably more exacerbated than it was,” Mace told me.


Resolving misalignment between owners and operators will not be easy, but now is the moment to start creating more sustainable capital structures, to strengthen the industry for the post-pandemic era.

Investing for innovation

The misalignment problem might be most acute in the typical management model, in which an owner pays a fee to an operating company.

Even before the pandemic, some industry leaders were flagging problems with this model; Aegis Living CEO Dwayne Clark even penned a column for SHN proposing that the management contract might be “dead.”

He cited various problems, including that the rising cost of operations makes it difficult for management companies to turn a profit on a typical 5% or 6% fee on gross revenue.

Now, Covid-19 has further increased expenses while also revealing areas in which operational innovations are needed; for example, a robust technology infrastructure is no longer a negotiable feature of communities.

“It is true that there are some improvements that really need to be made in the industry right now, and we’re looking at operators who are strapped for cash,” Pisciotta said. “Where are we going to find the time and money to invest in tech?”

The simplest answer might be that owners need to invest more capital. But doing so requires that they take a more big-picture, long-term view of capital expenditures than they might be accustomed to — or are able to, depending on their exit timelines. In other words, they are apt to put in a new carpet while overlooking investment into, say, technology systems.

“I think it’s a real problem in the industry … even though we all know that investment in technology creates some efficiency, it’s not the kind of thing that gets calculated into [private investors’] returns,” Rick Matros, CEO of Sabra Health Care REIT (Nasdaq: SBRA), said this week during SHN+ TALKS.

Public REITs, because they underwrite for longer timelines and are increasingly engaged in RIDEA ventures with operators, are willing to make those “long haul” investments, he said. It’s true that, at least publicly, operator CEOs — such as Brandywine Living’s Brenda Bacon — have been complimentary of REIT partners during Covid-19.

But more tension could make its way into this part of the market, as analysts and investors will be carefully tracking the pace of recovery and putting REIT execs on the hotseat if occupancy or other metrics lag expectations. Shareholder pressure will inevitably cascade down to operators.

Avoiding ongoing questions about the pace of Enlivant’s recovery is one reason why Sabra is seeking to exit its investment in the Chicago-based operator, despite believing that it is a well-managed portfolio with significant upside.

“That’s a lot of noise around the company that we will be talking about on every quarterly call, on every investor conference, every interview we do for the next two years,” Matros said, describing the scenario if Sabra held the portfolio.

Tough conversations

One route toward better alignment is increasing incentive fees for high performance in management contracts. But a “chicken-and-egg” problem exists, Pisciotta pointed out.

That is, operators make the case for more upfront investment to drive better performance, while capital providers prefer to tie financial incentives to better performance.

And higher management fees or incentives might not get at the root of misalignment between capital and operations.

To gain true alignment, any structural changes must be made on a foundation of clear and honest communication between the two parties, Mace argued, and she is hopeful that Covid-19 paved the way for greater transparency and coordination.

“Because of Covid, that line of communication, and understanding the challenges that operators went through, is probably more in the headspace of capital providers,” she said.

She emphasized that “it’s not all hunky-dory” all the time; good communication does not prevent conflicts and disagreements. However, senior living is a “relationship business,” she said, and this is why operators and capital providers that click often work together frequently.

Conversations today likely are tough, with operators conveying the unwelcome message that challenges are not receding as quickly as Covid-19 infection rates. At least in the short term, investors might have to accept some margin compression, Maxwell Group CEO Donald Thompson believes, and Mace made a similar point.

“Capital providers have to accept that these are issues — operators aren’t making this stuff up,” she said, referring to current expenses and other challenges. “… Maybe some go back and revise and reassess realistic assumptions. Certainly the pro formas that were written pre-Covid aren’t in place today.”

New structures

Relationship management and open communication are no doubt crucial, but new frameworks also are needed to support alignment of capital and operations.

One persistent issue is that the management fee is treated essentially as an expense item in the budget, which incentivizes owners to keep fees low — and that situation leads to some management companies that pursue a business model of gaining a high volume of contracts, with little incentive to maximize the performance of particular communities.

Increasing the base management fee or incentive fees — or finding other ways to change the fee structure to give operators more upside as a building’s performance improves — could result in more efficient operations, more satisfied customers, stronger referral streams and longer length of stay, and the ultimate result could be a stronger valuation on a property.

Another helpful tool could come in the form of a “quality growth curve.” Under the auspices of NIC, a group of industry leaders including The Springs Living CEO Fee Stubblefield was working on this concept prior to the pandemic. Stubblefield hopes to return to it soon.

The curve would define certain quality metrics to gauge the operational strength of a senior living community. To the extent that a community or portfolio is meeting those quality standards, a company would be in a good position to grow; if those standards are not being met, it is a sign that more attention and perhaps investment is needed in operations.

A quality curve might curb the impulse toward ill-advised growth that currently exists not only among investors but operators, which may get ahead of their skis in pursuit of additional revenue without the needed infrastructure. The quality growth curve might also increase the predictability of senior housing performance and returns, theoretically making the space less risky and enabling capital providers to invest with lower expectations on risk-adjusted returns.

“I think that if we can come up with ways of making those returns consistent, predictable, stable, we’re going to be able to attract capital that has a lower cost, and continue to invest in [operations],” Stubblefield said — although, he also used the chicken-and-egg analogy to say that some investors will need to take the lead, to demonstrate that such risk-adjusted returns are possible.

“It’s going to have to be folks that have that vision that we need to get to the same level of quality and professionalism that we’ve seen in every other industry, whether it’s hotels or medical or other [areas],” he said.

While a quality growth curve could be a useful tool in the coming years, probably the most obvious way to create alignment between owners and operators is for each group to have “skin the game.” Capital structures were already moving in this direction before the pandemic.

In just one example, Aegis Living shifted away from management contracts to focus on an owner-operator model — no surprise, given Clark’s position on third-party management. Aegis has partnered with Blue Moon Capital, and most recently the firms’ joint venture acquired a 10-property, $350 million portfolio that previously was in triple-net leases with real estate investment trust Healthpeak (NYSE: PEAK).

The ability to contribute real estate equity adds a barrier to entry for operators, given that relatively little capital is otherwise needed to start a management company — a point recently made by Maxwell Group’s Thompson.

Indeed, the post-pandemic landscape might lend itself to the growth of already strong and well-capitalized operators and ownership groups with the “strategic thinking” to make long-term investments, Pisciotta said.

That could also be good news for REITs, which have been trying to gain more owner-operator alignment through shifts toward RIDEA, as well as new triple-net lease structures with lower escalators and more performance-based incentives.

Matros also believes that REITs might have opportunities to add new operating partners as relationships with private investors break up, he said during SHN+ TALKS.

But large private equity firms that have strong operator relationships also could benefit from these breakups, and the PE firms have large funds at the ready. Just last week, Harrison Street announced a $1.2 billion deal involving Oakmont Senior Living communities.

“Those that are big enough and have the ability to invest are going to get way far ahead,” Pisciotta predicted.

This type of industry consolidation — widening the gulf between the “haves” and “have-nots” — likely would make it even more challenging for newer senior living investors to find high-quality operating partners, which was already difficult pre-pandemic.

But given the demographics, new capital will keep seeking opportunities in senior living. Hopefully, as this occurs, owners will have new tools to create alignment with operators, as well as plenty of examples of successfully structured partnerships to emulate.

The alternative — forging fee-based relationships with operating companies that are contract-hungry — will not serve investors, management companies or the industry well.

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