The SeniorCare Investor: Hearthstone Announces Sale–

Nationwide Health Properties Is The Surprise Winner
After months of speculation, with many rumors about some very high preliminary pricing levels, a deal was finally struck for the Hearthstone Assisted Living portfolio.  Most of the major players looked at the portfolio, with early bid indications for many of them in the $300 million to $350 million range, even though we heard last summer that in the first round there were preliminary bids (with no commitments, of course) above $500 million, a level that shocked many and one that obviously was not realistic when hard money was involved.
The one name that was most frequently mentioned as the likely buyer, and one that apparently had a bid slightly higher than the final deal but ran into some complications with regard to structure and its partner for the deal, was CNL Retirement Properties.  We had always heard that one of the stumbling blocks had been the desire, on the part of the sellers, to do a stock deal rather than an asset sale, with the latter structure obviously preferred by REITs.  In the end, Nationwide Health Properties (NYSE: NHP) was able to come up with a price and structure that satisfied everyone.  NHP is buying the 32 assisted living facilities in 10 states for a price of $419 million plus an estimated $12 million in debt defeasance and closing costs for a total investment of $431 million, or about $197,000 per unit, which is just above the average for assisted living portfolios sold in 2005.  That is an eye-popping number, even in this market, but we believe that between 70% and 80% of the units are (or can be) utilized for double occupancy, and the price comes down to just over $108,000 per bed.
Based in Ft. Worth, Texas, Hearthstone is a solid company that was backed by Fremont Realty Capital, Krosberg & Associates and funds advised by Apax Partners, L.P.  The company has 15 assisted living facilities in Texas, four in Tennessee, three in Alabama, two each in Arizona, Georgia and Michigan and just one each in four other states.  All of the facilities were built by Hearthstone in the past 10 years.  NHP’s announcement indicated that there were 3,097 units with an occupancy rate of 89%.  But some of the “units,” with two bedrooms, or another similar configuration with some measure of individual privacy, were counted as two units.  We understand that the actual unit count is closer to 2,200 and the licensed bed count is just under 4,000. This is important because Hearthstone has deliberately gone after the double-occupancy model in a way that few of its competitors have been willing to do.  A NIC study came out last September that showed semi-private units produced an average of 52% more revenue per unit than private units, or $1,473 per month more.  As long as the incremental cost of that additional resident is less than $1,473 per month, and it should be, cash flow will be greater.  And, as we quoted Bill Sheriff two months ago, it is the absolute level of cash flow, not the operating margin, that counts the most.
During the marketing period, we heard that revenues and EBITDA for 2005 were expected to be about $95 million and $31 million, respectively.  It turns out that EBITDA may have ended up just shy of $31 million, which would yield a cap rate of 7.2% based on the most recent year.  But Hearthstone is growing, and cash flow in 2006 is expected to increase by at least 15%.  NHP stated that with an initial lease rate of 8.06% on a $431 million total investment, the EBITDAR coverage, after a 5% management fee and $300 per unit reserves, would be 1.0x at closing and rise to 1.1x by the end of 2006.  Since our cap rate statistics have always excluded reserves (for a variety of reasons), we calculate that annualized EBITDAR without reserves is expected to be close to $35.7 million at the May 31 closing, and $39.1 million by December 31, when the coverage is forecast by NHP to be 1.1x.
The first number produces a cap rate of 8.3%, and the year-end number a cap rate of nearly 9.1%.  We don’t know whether these forecasts are based on increased occupancy, higher rents or both, but the pro forma cap rates are certainly within the parameters of the recent market for large portfolios of newer properties.  Aggressive yes, but record levels, no.
Now to the lease with NHP.  Starting off any lease term with a 1.0x coverage ratio is aggressive and risky, but we assume that NHP management is taking a much longer view for the entire transaction.  While the initial lease rate is just 8.06%, there is an annual 1% increase (starting at about $350,000) in the rent, which brings the effective rent yield to 8.66% over the 15-year initial term.  In addition, there is a CPI-based annual rent increase of up to 2% plus revenue-based rent increases starting at 0.54% of revenues in the first year and increasing to 2.63% during the initial term of the lease.  So the actual yield will end up being well over 9%.
The other potential profit from the deal comes from NHP’s exclusive right to finance the next $150 million of Hearthstone’s new investments, and the right of first offer/last look on an additional $150 million.  We assume that these transactions will be more lucrative than the initial $431 million deal, which would push the overall yield even higher.  NHP’s stock has a dividend yield of just over 7.0%, and the REIT just completed an equity offering to help fund the Hearthstone acquisition.  The rest will come from debt at rates below the 8% initial lease rate.  We doubt that NHP would have priced a much smaller deal this aggressively, but with more than $400 million, and potentially growing to up to $700 million, there are some apparent economies of scale.
The transaction is not without risks, however.  The Hearthstone assets will represent almost 20% of NHP’s assets, which is a large concentration with what we assume will be one thinly capitalized entity.  In addition, the lease deposit is only $6 million, representing two months’ rent, and NHP’s EBITDAR assumes $300 per unit for reserves, which is just $20,000 per facility.  Even though all the facilities are relatively new, we all know that more than $20,000 per year is spent on replacements for an average facility, and with 70% or more double occupancy, the wear and tear per unit may be higher than average.
And speaking of double occupancy, that may be the greatest risk for NHP.  Hearthstone has obviously done a great job with its model, but the double occupancy does account for a good portion of the cash flow.  What would happen if, in a number of their markets, double occupancy became less popular or similarly priced private units were developed?  Would occupancy, and cash flow, slip to levels that would make it difficult to cover rent?  This is hypothetical, of course, but the coverage is tight to begin with in the transaction, so there is little room for error.
As part of the transaction, Hearthstone’s president and CEO, Tim Hekker, and various partners will “acquire” 100% ownership of the company that will operate the Hearthstone assets.  We don’t know if this is a new shell entity or just the old Hearthstone, what they are paying or what they are getting, other than the leases on their facilities and presumably the management office and operating capacity.  Despite the aggressive pricing and tight coverage, this is obviously an important transaction for NHP, and its largest one in years.  Lisa Widmier of CB Richard Ellis represented Hearthstone Assisted Living in this transaction.