An Update on Senior Housing Properties Trust (SNH)

Pressure from Declining Occupancy; But SNH Has Sufficient Financial Flexibility to Cope for Next Two Years or More.

  • Lower occupancy rates at SNH’s managed senior living communities (SLCs) and medical office buildings (MOBs) have put downward pressure on its profitability and forced it to provide liquidity to its primary tenant, Five Star Senior Living (FVE).
  • The Trust has sold some of its most valuable MOB and SLC properties in part to provide financing for its purchases of properties from FVE.
  • SNH has used part of the proceeds from these property sales to pay down its revolving credit facility and lengthen the average maturity of its outstanding debt. This gives it greater flexibility to make future acquisitions (of both FVE SLCs and MOB properties).
  • Given the recent decline in occupancy attributable to this winter’s flu season, SNH’s property occupancy levels may soon show signs of stabilization. The recent rally in shares of SNH and its large cap peers reflects optimism about an improvement in occupancy.
  • Assuming no big drop in occupancy levels, SNH should be able to continue making its $1.56 annual distribution for at least the next two years. Although the stock has rallied sharply recently, its dividend yield is still 8.6%, suggesting higher risk, but also further potential upside vs. peers going forward.

SNH reported 2018 first quarter net income attributable to shareholders of $236.0 million ($0.99 per share) compared to $32.2 million ($0.14 per share) in the prior year quarter. This year’s results included $181.1 million or $0.76 per share of gains on the sale of properties and $27.1 million or $0.11 per share in unrealized net gains on its holdings of the Class A common stock of The RMR Group, Inc., the manager of SNH. (Under new accounting rules, unrealized net gains and losses now appear in the income statement. Before, they were included in other comprehensive income.)

Funds from operation (according to my definition), were $92.7 million or $0.39 per share, down 11.6% from $104.9 million or $0.44 last year. Substantially all of the decline was attributable to two factors: A little less than half was due to lower income (before depreciation) from SNH’s operations and about half was due to a full quarter’s impact this year from sharing the FFO from the Vertex Pharmaceuticals building with its joint venture partner. SNH’s prior year results included only a partial impact of the FFO sharing from the sale of the 50% joint venture interest which was completed in March 2017.

This was a noisy quarter for SNH, with unusual items such as the $181.2 million gain from the sale of SLCs and a $27.2 million unrealized gain on RMR Class A common stock. Realized gains from the sales of communities are a part of SNH’s ongoing business; but they are often lumpy as they were this quarter.

SNH’s profitability was also affected by the increase in business management incentive fees. This fee is earned if the total return on SNH stock over a three-year period exceeds that of the SNL US Healthcare REIT Index. By formula, RMR, the manager of SNH, realizes an incentive fee equal to 12% of that excess return (times its 2015 equity market capitalization) with a cap of 1.5% of SNH’s current equity market capitalization. This quarter’s incentive fee was $14.3 million, up from $3.3 million last year.

Total revenues rose 4.3% to $275.8 million, due to acquisitions of MOBs and managed SLCs and higher rental rates in triple-net leased SLCs, which more than offset the impact of lower occupancy in SNH’s Managed SLCs and MOBs and asset sales.

Property net operating income (NOI), which is equal to revenues minus property operating expenses, increased 2.6% to $167.2 million, due to acquisitions and increases in average rental rates on TNL SLCs, partially offset by higher operating expenses and declines in occupancy at MOB’s. All three of SNH’s business segments reported higher NOI. Yet, SNH’s operating income declined 3.9% to $72.2 million, as a sharp increase in general and administrative expenses, due to the higher business management incentive fee, was only partially offset by a decline in depreciation and amortization.

ACQUISITIONS AND DIVESTITURES
During the quarter, the Trust acquired two properties from its affiliate, FVE, for $42.5 million. This is part of a November 2017 agreement to acquire six properties. SNH acquired two properties for $39.5 million in December 2017 and plans to acquire the final two properties for $23.3 million (including $16.8 million of assumed mortgage notes) by the end of the second quarter.

In this latest round of SLC acquisitions, SNH enters into management contracts for FVE to operate the properties. In the previous purchase of SLCs completed in June 2016 for $112.5 million, SNH entered into a sale-leaseback transaction with FVE.

These purchases of SLCs from Five Star have taken place against a backdrop of declining profitability for most SLC operators. Low interest rates have fueled a boom in the construction of new SLCs and the resulting expansion in supply has pushed down the occupancy rates of most established SLC operators in many U.S. metropolitan areas. SNH also notes that the medical advances which have lengthened life spans are also enabling seniors to staying longer in their primary residences (or perhaps with members of their families). On top of the expansion in supply and slower-than-expected growth of demand, this year’s severe flu season forced many SLCs to temporarily stop admitting new residents.

SNH has sourced the funds required to buy FVE’s SLCs by disposing of or selling partial interests in its own properties. As already noted, the Trust entered into a joint venture arrangement on the Vertex Pharmaceuticals buildings, whereby a sovereign investor paid $261 million for a 45% interest. In 2017, SNH allocated $4.2 million of net income and $20.5 million of FFO and distributed $13.8 million to its joint venture partner.
In December 2017, SNH agreed to sell four communities currently leased to Sunrise Senior Living LLC. It booked a gain of $49.5 million on the sale of one of those properties in December 2017. Two were sold in March 2018 for the gain of $181.2 million recorded in the first quarter. SNH expects to sell the one remaining property by the end of second quarter for proceeds of $96 million.

The sold SLCs are large, averaging about 400 units. By comparison, the average SLC in SNH’s TNL portfolio is about 107 units. The carrying value of those four properties has been nearly fully amortized; so the gains booked on their sales have been large: about 83.5% of the sales price. If the same percentage holds for the sale of the final property, SNH will book a gain of about $80 million.

It makes sense for SNH to take profits on some of its most valuable properties at a time when cap rates across all real estate types are beginning to rise with interest rates. These property sales have helped fund the purchases of SLCs from FVE without SNH having to take on more debt. Those purchases have given FVE the liquidity to sustain its operations until occupancy rates begin to turn around and FVE’s profitability improves, but the sales of the joint venture interest and Sunrise SLCs also reduce SNH’s net operating income going forward.

Besides the FVE SLC acquisitions, SNH has been actively buying MOBs. Last year, for example, SNH completed five separate purchase transactions for six MOBs with a total of 630,000 sq. ft. for $179.6 million or roughly $180 per sq. ft. In the 2018 first quarter, the Trust completed the purchase of four MOBs with 535,000 sq. ft. for $115 million or about $215 per sq. ft. On the first quarter conference call, newly installed President and COO Jennifer B. Clark said that with the recent MOB acquisitions, SNH has essentially made up all of the operating income that it lost through the Vertex Pharmaceuticals property joint venture.

SUMMING IT UP
SNH has responded to FVE’s declining profitability by purchasing FVE’s unencumbered SLCs to provide FVE with the funds to sustain its operations. SNH has funded the purchase of FVE properties by selling some of its own properties. Since the FVE properties that it has purchased are unlikely to generate sufficient operating income in the near-term to replace the income lost from Sunrise Senior Living properties that it has sold, SNH is also seeking to add to its MOB portfolio.

SNH’s ratio of debt-to-total capitalization has risen steadily from 51.0% at the end of 2015 to 54.2% at the end of 2017. Although SNH’s overall debt has risen, its borrowing availability has also increased because it issued $500 million of 4.75% Senior Notes due 2028 in February 2018 and, along with asset sales, used the proceeds to pay down MOB mortgage debt and amounts outstanding under its $1.0 billion revolving credit facility. On May 9, 2018, SNH said that it had $35 million outstanding and $965 million of borrowing availability on its revolver. Its disclosures suggest that there are currently no covenant restrictions that would limit availability under the revolving credit facility. In addition, both FVE and SNH have unencumbered assets which can be sold, if necessary, to finance ongoing cash shortfalls at FVE, make additional acquisitions or support SNH’s distributions.

At year-end 2017, FVE reported that it owned 24 SLCs with a total of 2,474 units. It is not clear from FVE’s disclosures whether the 4 SLCs with 385 units that were classified as “held for sale” (to SNH) were included in this total. Assuming that they were not, and that each unit has an average potential sales value of $150,000 (which is less than the average $171,000 per unit that SNH paid in the November 2017 transaction agreement), FVE may be able to raise another $371 million from SNH through sales of additional SLCs in the future. Thus, it appears that both SNH and FVE have some time – perhaps a couple of years, maybe more – to achieve a turnaround of FVE’s operations.

FVE’s ability to turn around its business depends in part on the future new supply of SLCs. Based upon management’s statements, FVE should report at least a small bump up in occupancy for the balance of 2018 as it has begun admitting residents to facilities that were closed to new admittances as a result of this winter’s severe flu season. Furthermore, with short-term interest rates now up 175 basis points over the past two-and-a-half years and possibly more to come, new projects face higher hurdle rates. Given the slower-than-anticipated rise in demand for senior living housing and services and falling occupancies, it is reasonable to expect that the pace of construction of new senior housing will at least taper off or perhaps even fall more sharply over time. This should eventually enable SLC operators like FVE to stabilize occupancy levels.

Even so, FVE still seems to be a long way off from generating adequate profitability. As a result of the profit squeeze at FVE, SNH has not generated sufficient cash flow from operating and investing activities to pay its annual distribution to shareholders. It has, in effect, had to borrow money to pay the distribution, which is unsustainable in the long-run. That is the primary reason that SNH’s stock trades at an 8.6% dividend yield, which is 210 basis points higher than the average 6.5% yield of its large cap peer group.

SNH’s stock has rallied 20% since April 24, better than the average 15.4% average gain in its large cap peer group, according to my calculations, on optimism about improving occupancy rates in the senior housing sector.

I project that SNH will post GAAP earnings of $1.81 in 2018, due primarily to gains on asset sales, and $0.69 in 2019. I project FFO per share, according to my definition, of $1.59 in 2018 and $1.71 in 2019. My projections anticipate free cash flow (defined as cash flow from operating activities plus cash flow from investing activities) of $1.92 per share in 2018 and $1.34 per share in 2019.

My projections anticipate that SNH’s ratio of debt-to-total capitalization will decline from 54.2% in 2017 to 53.6% in 2018 and then rise to 55.8% in 2019. They assume that SNH will make no additional acquisitions for the balance of 2018 and all of 2019 (except those that have already been announced and are currently pending); but SNH may acquire more FVE properties and management says that it is eyeing additional acquisitions of MOBs.

My projections also anticipate that SNH will pay a business incentive management fee to RMR of $27.5 million in 2018, down from $55.7 million in 2017. The Trust recorded a fee of $14.3 million in the 2018 first quarter, based upon the outperformance of SNH’s share price vs. the SNL U.S. Healthcare REIT index. I do not know the composition of and methodology behind the SNL index, but my calculations show that SNH shares have handily outperformed an equal-weighted average of its large cap peers’ shares so far in the 2018 second quarter, with one week left to go. Thus, the 2018 second quarter business management fee may very well equal or exceed the first quarter’s fee. If that relative outperformance continues, my business management incentive fee estimate for 2018 will prove to be too low.

Similarly, my 2018 projections assume the unrealized gain on RMR and FVE shares owned by SNH equals the $27.2 million booked in the first quarter. Yet, I estimate that SNH is sitting on another unrealized gain of $19.4 million so far during the second quarter (as of June 22).

Valuation
My FFO per share projection of $1.59 for 2018 is below the current consensus estimate of $1.72. Likewise, my FFO per share projection of $1.71 for 2019 is below the current consensus estimate of $1.82. Consequently, SNH’s forward valuation multiples based upon my projections are 11.4 for 2018 and 10.6 for 2019, higher than the implied forward multiples of 10.6 and 10.0 times, respectively for consensus estimates, but below the average forward multiples of 12.6 and 11.5 times for SNH’s peer group. (The large cap peer group includes WELL, VTR, HCP, OHI, MPW, HTA, MPW, SBRA and HR. As of this writing, WELL’s forward estimates were not included in the peer group totals.)

Since SNH shares bottomed most recently on April 24, they have rallied 19.9% (through 6/22). By comparison, the shares of SNH’s larger cap peers are up 15.4% on average over the same time period, while the S&P 500 was up 2.4%. The strong relative performance represents a rebound off of the lows. Even with this rally, however, many healthcare REITs are still down on the year and have underperformed the broader market. The strong recent relative performance for healthcare REITs probably reflects an improving outlook for occupancy across the sector.


         Chart provided courtesy of StockCharts.com

Although SNH’s stock looks overbought near-term, its valuation discount suggests that it can still outperform the peer group provided that the Trust makes progress addressing the ongoing decline in occupancy. That is a reasonable bet for this year. President and COO Jennifer Clark plans to develop operating strategies for each property that SNH owns, which should lead to better overall performance for the consolidated enterprise over time. Beyond 2018, SNH will need to demonstrate that it can cover its distribution out of free cash flow, while keeping its leverage in check, if it hopes to close that valuation gap on a sustained basis.

June 24, 2018

Stephen P. Percoco
Lark Research
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Linden, New Jersey 07036
(908) 448-2246
admin@larkresearch.com

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