Lately I’ve written rather extensively on what is occurring in the SNF sector to (rather) dramatically shift the fortunes for companies such as HCR/ManorCare, Kindred, Genesis, Signature, et.al. and a series of REITs that hold SNF assets (physical). In addition to my writings, I’ve consulted/conversed with numerous investment firms concerned and interested in this shift. Underlying all of my written thoughts and my discussions is a harsh reality check: A solid third of the industry today (SNF) has assets that I and other industry-watchers would consider/define as stranded.
I have embedded a link to a great article that covers the concept of “stranded assets”. It is from the HFMA and the focus is on hospitals but the issues are directly analogous to SNF physical plants. The link is here: http://www.hfma.org/Content.aspx?id=54453
The underlying issues that created this unique asset status are as follows.
- An SNF physical plant has value if the corresponding cash flow generated from the operations attached to the asset is positive with a margin. The HFMA hospital reference point is an EBITDA margin of 6% or higher. Depending on the age of physical plant, deferred maintenance and interest and tax costs, 6% is likely a “non-coverage” situation. For SNFs owned by REITs, we are seeing EBITDAR equal to a coverage ratio of 1 or less (cash to pay or cover rent costs). I contend that in this scenario, the asset (SNF) plant is now stranded.
- Stranded effectively means that the asset (the SNF) has no strategic or business value in the current state (with an EBITDAR coverage equal to 1 or less). Without significant changes to operations to increase the cash coverage margin, the value of the asset is impaired and by GAAP, should be written down. NOTE: I am not an accountant/CPA so I will leave any further reasoning or discussion on GAAP requirements, asset impairment and write-downs to the accountancy profession.
- Important to note about assets/SNFs that are stranded is that short-term advances/improvements in their cash flow may change this status by definition but the same is only temporary. The market, health policy and other business shifts away from certain types of institutional care and lower-rated providers is permanent. SNFs not properly positioned from an asset and operating perspective for these market changes will return to stranded status again and rather quickly. The point here is this: An asset that is stranded is characterized by,
- An aged physical plant with deferred maintenance
- A plant that is not current in terms of market expectations (private rooms, open dining, bistro areas, coffee bars, exercise and therapy gyms, etc.)
- A plant that is inefficient from a staff and resource perspective (too many units, too spread out, etc.)
- An asset with operations that have a poor history of compliance, rated below 3 stars, and with marginal to sub-par quality measures.
Today, the strategic value of the asset is tied directly to its ability, along with paired operations, to generate positive cash margins sufficient to cover debt payments or lease payments plus required capital improvements (funded or sequentially incurred period over period). If an asset is truly stranded, changing that position is a strategic and long-term endeavor: An approach that requires wholesale repositioning. For many SNFs, this approach may not be feasible.
- The dollars required to reposition the asset from a physical plant perspective are greater in total than the remaining Undepreciated Replacement Value of the plant. In other words, the cost to reposition is greater than the value of the asset.
- The return generated from the repositioning is insufficient from an ROI perspective (less than the cost of capital plus the imputed life-cycle cost of depreciation of the improvements).
- The operations of the asset are also impaired such that the compliance history and Star ratings, etc. are poor (historically) and changing the same would/will require a long-term horizon whereby, the same does not net cash flow improvement during the process. Referrals and permanent cash-flow improvements are the result of revenue model changes and the same can not occur overnight when Star ratings and compliance improvements are required. Changing Star ratings from a 3 to 4 for example, can take twelve months or longer.
The take-away points for the industry are simple. The industry has an abundance of buildings/assets that fit the stranded definition today and a good number reside in REIT portfolios. These assets/buildings, because of the points above, literally and figuratively, cannot be repositioned. Their value has shrunk precipitously and there is nothing regarding the circumstances that caused this shift that will change. Repositioning to avoid or change the stranded status is improbable due to the facts at-hand;
- The asset is old by current business-need standards, has moderate to significant deferred maintenance issues and improvement to the current standard will cost in-excess of the undepreciated replacement value of the asset.
- The operations tied to the asset are not highly rated, with strong compliance history and exceptional quality measure performance.
- The operations and asset together, are incorrectly matched within a market that has higher rated competitors with better outcomes and newer, better positioned physical plants. The preferred referrals for quality payers has moved to these competitors and the drivers such as bundled payments, value-based purchasing, Medicare Advantage plans, etc., plus a movement away from institutional care (to shorter stays, fewer stays) has altered the demand factors within the market.
In all probability, the above foreshadows a shrinking scenario combined with a valuation-shift (negative) for the SNF industry.