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Executives

Ross Rodman - Investor Relations

Bill Doniger- Vice Chairman

Mark Schulte - Co-Chief Executive Officer

Mark Ohlendorf - Co-President and Chief Financial Officer

Analysts

Mark Biffert - Goldman Sachs

Kevin Fischbeck - Lehman Brothers

Matt Ripperger - Citigroup

Ryan Daniels - William Blair

Daniel Bernstein - Stifel Nicolaus

Jeff Ungler - Standard & Poor’s

Frank Morgan - Jefferies and Company

Brookdale Senior Living, Inc (BKD) Q3 2007 Earnings Call November 8, 2007 10:00 AM ET

Operator

Good day, and welcome to today's Brookdale Senior Living Third Quarter Earnings Call. Today's call is being recorded.

For opening remarks and introduction, I would like to turn the call over to Mr. Ross Rodman. Please go ahead.

Ross Roadman

Thank you, Tina. Good morning, everyone. I'd like to welcome all of you to the third quarter 2007 earnings call for Brookdale Senior Living. Joining us today are Bill Doniger, our Vice Chairman; Mark Schulte, our Co-CEO; and Mark Ohlendorf, our Co-President and Chief Financial Officer.

Before I turn the call over to Bill, as Tina mentioned this call is being recorded and the reply number is 888-203-1112 from within the U.S., or 719-457-0820 from outside the U.S., and reference the access code 4129480, as recorded in the press release.

This call will also be available via webcast on our website, www.brookdaleliving.com. I'd also like to point out that the statements today, which are not historical, facts may be deemed forward-looking statements. Actual results may differ materially from the estimates or expectations expressed in those statements.

Certain other factors that cause actual results to differ materially from Brookdale Senior Living's expectations are detailed in our SEC report. I direct you to Brookdale Senior Living's earnings release for the full forward-looking statements.

And now, I'd like to turn the call over to Bill Doniger. Bill.

Bill Doniger

Thanks, Ross. Today, we reported CFFO of $0.43 a share, a 59% increase from the third quarter 2006, reported CFFO of $0.27 a share. From an operating perspective, we continue to exhibit really attractive growth metrics.

Same-store NOI for the past 12 months increased 8.8% over the same period a year earlier and same-store NOI increased 8.2% for the third quarter 2007 over 2006. This organic growth rate, which translates into about 20%, 22% cash flow growth, underscores really the strength of our business model.

Now, that being said, this year will be below our expectations on two fronts. As we talked about last quarter, entrance fees, while they continue to show improvement, are still going to be below our full-year estimates near of about $13 million bucks, which is about $0.13 a share.

And, secondly occupancy as you see in the press release, our occupancy has remained flat. We had expected at the beginning of the year for occupancy to end up at around 93%, at 91%, that 2%, I guess 1% is about $0.14 a share. So 2% occupancy adjustment is about $0.20, $0.24, $0.25 a share.

Again, not going backwards, hanging in there pretty well, but not going forward as fast as we thought it would be at the end of the year. Why is that? Really, two reasons: Beginning in early August, as everybody knows, recessionary fears, subprime, housing slowdown, all of the following really caused residents to step back with their adult children and delay decisions to move in until they said, sell their houses. To us, this is a timing issue.

People are deciding to move into a Brookdale facility, because there is a need. What they live in their home is not appropriate, and so this is a decision that many people are making, again, because they have to. That being said, it's taking longer for people to move in, because they're waiting to sell their houses, and, as everybody know, that's taking longer, and in many cases people are getting less than what they had hoped for.

While it's easy to blame the market, I would say it's not a 100% of the reason for not being able to gain the occupancy that we had hoped. Some of it's our fault. We bought a lot of assets. We have a lot of integration activities and it's just taking longer.

Again, we're very confident we're going to get there; we just didn't get there when we thought. That being said, we have a lot of good things going on, which Mark Schulte will talk about.

So how do we think about the business going forward? Actually, very optimistically, we grew 8.8% year-over-year on an unleveraged basis this quarter in what we would think is a very, very challenging environment. Maybe the way to think about the business is, let's hold occupancy constant at 91%. Let's assume entrance fees don't change from where they are today, again, below historical levels, and we just continue to grow at 8% unleveraged on an NOI basis. That will generate 20ish percent free cash flow growth over the next year.

Why do we think we continue to do that in this environment? It's pretty simple. Our residents live in our facilities, for on average about three years. Every year they get 4% to 5% annual rate increases and nobody moves out down the block over rate increases. It's not the way the business works. There's a service component. This is not a commodity business.

Our expenses grow at about 3.5% annually, and we operate at a 36% margin. That part of the business we feel very, very good about and we're seeing it even in a very tough environment. Our October numbers are consistent with that as well.

So what you have is 8% NOI growth, low 20s organic cash flow growth, with some material upside, as I said before. We will get back to $44 million in entrance fees, another $0.13 a share. We cannot tell you when that's going to happen, because we're operating in a difficult economic environment.

Occupancy, we should get to 93% occupancy here. Again, not going to tell you when, but that's another $0.25 a share, and last, expansions. We're doing a fair bit on the expansion, adding another level of care, very need-based type expansion work. Those numbers start to show up in 2009, so you're not really going to see that in 2008, but if we billed out what we billed out, $500 million in capital, at 15% returns on asset, you get into the $0.25, $0.30 a share in earnings benefits. Again, not really showing up to 2009, but that will be there eventually.

Really, to conclude, before I turn it over to Mark Schulte, while we don't love where we are this quarter, we think we have a fantastic growth model and our optimism for the business remains undiminished. At the beginning of the year or the middle of the year, people were worried about overbuilding. We didn't think that's a risk. We still don't think that's a risk. Actually, in the current environment I think it even pushes out theoretical building even farther. That, the overbuilding issue, is something that if it happens in excess capacity, that affects the long-term growth rate of the business. The stuff we're talking about today we view is temporary; can't tell you when it's going to end, but our business remains sound and robust and we're very optimistic about where we're going prospectively

.

So with that, I'll turn it over to Mark Schulte.

Mark Schulte

Thanks, Bill. There are a few things I want to talk about this morning. As Bill talked about, Brookdale's occupancy did not improve as we targeted. Let me talk about some initiatives that we've been working on that we're confident will overcome some of the environmental challenges that we're experiencing. These initiatives are focused on not only attracting new customers, but also addressing the demand that already exists within our resident population.

One of the biggest initiatives of our recent integration has been to coordinate our local marketing and leverage our multiple product offerings in the same market. Internally, we call this initiative major market management, or for short we call it M3. Specifically, we now have one group in charge of marketing for all of our locations and product offerings in a particular market where we already have a lot of units. This lets us provide prospective and existing residents with the full range-of-care options, and, particularly those needing a higher level of care, and we do this at different Brookdale facilities in the same local region where they already live, in effect creating a local or a regional CCRC.

By offering more options to residents who typically move to other local operators, as their acuity needs change, we are able to recapture a portion of those move outs and tap into an existing source to increase occupancy even in a weak economy.

Let me give you an example: We have four facilities with 542 units in the Denver area that were 87.5% occupied as of June 30th. We initiated the M3 effort in the third quarter in Denver, and within three months, occupancy at those facilities increased to over 98%, primarily as a result of marketing the higher acuity services, at these communities to the outgoing residents from our other nearly 1,200 units in the Denver area.

By the end of this year, we will also have completed our branding initiative at all Brookdale locations, so that our signage, name, advertising, collateral material, come under the Brookdale brand standards easily identifiable for our customers, and support our M3 initiatives in all of our major markets.

In the next few weeks, we're also going to be rolling out a new, more attractive and user friendly website that's designed to utilize the latest technology and to maximize our search engine exposure. This is very important, because the percentage of leads we generate from our website and the Internet, now exceeds the number of leads we generate by traditional offline advertising, like print advertising, radio, and other types of media.

Second thing I want to talk about, our expansions initiative has also been planned to take advantage of this local CCRC concept. Our current plan is to expand our portfolio by over 2,000 units over the next three years, with a total construction budget of roughly $500 million. You should see the accretion to earnings begin to show up in 2009.

When we look at doing expansions, we focus on adding like units to existing facilities or to take advantage of excess demand or adding another level of care in a strong market where we already are present and are doing well. For example, we're working on a building that contains 180 assisted living, memory care, and skilled nursing beds as an expansion near one of our large independent living buildings in the Kansas City area.

In total, we already have 776 units in the Kansas City area that are substantially full and will act as a referral source for the expansion. We will be translating the demand for the higher acuity services already present in our buildings to this expansion and allow our residents to maintain the high level of care and high quality that they currently experience at Brookdale.

As of September 30th, we had completed five expansions with 213 units, representing approximately $35 million of project costs. Expansions open since the first quarter, with 98 units were 82% occupied and already earning an approximately 14% run rate unlevered return.

The third thing I want to talk about is our ancillary services. Our ancillary service revenue totaled $29 million for the quarter, up 12.8% from the second quarter. Our growth expectation for ancillary services in the third quarter was impacted by unforeseen delays and obtaining licenses and permits to open licensed home health agencies in several markets. We have the infrastructure and staffing in place to provide these services. The licensing delays are slowing that rollout, which we now expect to happen in the first half of 2008. And I just want to point out, this isn't an instance where for some reason, we wouldn't qualify for a license. It's that the bureaucratic processing and staffing of these agencies is very low and it's just taking more time to process them.

One last point I want to make about our business is to take a look at the demographic trends that we believe will continue to drive our future growth. At Brookdale, we strongly believe that over the medium to long-term, the needs of an aging population will cause steadily increasing demand for senior living services, regardless of the business environment.

The senior segment of the U.S. population has been, and will continue to be, the fastest growing segment of the population. This growth is driven both by the aging of the baby boomers, as well as significant increases in longevity. Life expectancy in the U.S. has increased from 47 years in 1900 to 68 years in 1950 to 78 today. The joke is, that it won't be long before we all live to be 150, but the bad news is that we'll spend the last 50 years in a nursing home.

Today, over 90% of our potential customers do not live in senior living facilities and it's estimated that the number of Americans over 70, who need help with the activities of daily living, will grow from roughly $8.5 million in 2000, to $21 million in 2030.

And according to a study cited by the National Family Caregivers Association, American businesses can lose as much as $34 billion annually as a result of employee's need to care for loved ones over the age of 50. And on a personal level, these family caregivers also tend to suffer high absentee and outsized rates of emotional distress.

We believe that the improved quality and acceptance of institutional senior living, as well as the inability of family caregivers, to trade work for care giving will increase the penetration of senior living services and, hence, Brookdale's occupancy. To this end, we've recently created several new business development positions, that on a regional and national basis will work with large employers and other institutions to offer elder care counseling and referrals for their employees that are experiencing these difficulties.

In short, we look at these fundamentals as not only getting stronger, but we're very excited on the prospects of Brookdale and the industry as a whole. Our fundamentals, our need-driven customers, our same-store operating growth, our scale, and our superior level of service will continue to serve Brookdale well over the long term.

With that, I'd like to turn things over to our Chief Financial Officer, Mark Ohlendorf.

Mark Ohlendorf

Brookdale's reported CFFO for the third quarter was $0.43 per share. This does not reflect our recurring run rate cash flow, because it includes expenses related to our acquisition in ancillary service initiatives. The net impact on our third quarter results of these items is approximately $0.06 per share. Included in the integration and startup expenses are integration and acquisition related expenses of $4 million or $0.04 per share, which are primarily related to systems and process integration, as well as spending on activities to achieve Sarbox compliance at acquired locations.

And second, approximately $1.6 million or $0.02 per share of losses and startup expenses related to our various growth initiatives. These include employees training costs for communities that we've acquired within the last year and startup losses related to the rollout of our ancillary service programs. Not included in these CFFO calculations are approximately $4.1 million or $0.04 per share of amortization related to capital leases and mortgage debt. A table is included in our press release that provides the detail of this debt and lease amortization. The net effect of all these changes is $1.6 million or approximately $0.02 per share.

Our integration activities continue to proceed on plan. In October, we completed the migration of the entire enterprise to common financial, human resources, and purchasing systems. Virtually all of our support departments are now organized on a Brookdale-wide basis. In addition, we've begun to combine our field operating management structure on a geographic basis within seven large operating divisions. This realignment of the field management structure will organize our operations on a geographic market basis, rather than on a product basis.

A few points of clarification as you look at our operating results for the third quarter. In spite of the soft market that Bill spoke about, rates in the quarter, excluding community fee deferrals, averaged $3,639, a 1.8% increase over the second quarter, or an annualized rate of growth of more than 7.3%. Similarly strong revenue metrics can be seen in our same-store results. For the 12 months ended September 2007, compared to the 12 months ended September 2006, revenue grew 7.2%, while occupancy improved a modest 10 basis points between these 12-month periods. While we targeted occupancy growth of approximately 2% this year, occupancy has been flat and averaged 90.8% in the third quarter.

Second, we did experience some increases in our operating costs in the third quarter. Following a relatively temperate second quarter, utility costs increased in the third quarter by around $4.4 million over the second quarter to $20.9 million. This seasonal increase is driven by higher summer cooling costs and, to a lesser extent, higher energy prices. In addition, we implement annual wage adjustments for a substantial portion of our community level personnel on July 1st. The impact of that wage adjustment totaled approximately $2.9 million in the quarter.

These increases are not new to 2007, but have happened at the same time historically as well. However, with no increase in occupancy, higher utility costs and the modestly higher labor costs, the combined effect has been to lower facility operating income on a sequential quarter basis.

Third, our net entrance fees for the quarter were $9.3 million. This consists of $14.4 million of gross entry fee sales, and $5.1 million of entry fee refunds. You'll see that we've added some tables in the 10-Q this quarter that add some further historical detail on our entry fee results.

And finally, on the liquidity front, we believe that we're well capitalized to execute our business plan over the next two years. As of today, we have approximately $187 million of undrawn capacity on our corporate line, together with $39 million worth of cash, gives us total liquidity of $226 million. That capital, plus expected financings, should satisfy most of our capital needs over the next two years. We current estimate that assuming we complete all budgeted expansions and refinancings, we may need to raise in the range of $50 million towards the second half of 2009.

I'll now turn it over to the operator for questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question is from Mark Biffert of Goldman Sachs. Please proceed with your question.

Mark Biffert - Goldman Sachs

Hi, guys. Thanks for the color, Mark, on the utility costs. Another question I have is, of that utilities expense: how much of that do you expect to be recurring, given that we're coming into the winter season and you're going to have additional heating costs as well?

Mark Ohlendorf

Yes. On a historical basis, our higher utility cost quarters are the third quarter, because of cooling costs and the first quarter because of heating costs. And then the cost moderates somewhat in the other two quarters.

Mark Biffert - Goldman Sachs

Okay. And when you look at the entrance fees going forward, last quarter you guys had mentioned that you had deposits of about $4 million. I guess my first question is: how much of that $4 million was part of the $14 million you signed and then currently, what do you have in terms of deposits going into the next quarter?

Mark Ohlendorf

The rollover activity is not some data we've got on right in front of us here right now. The $5 million in October, I think, the volume of this activity is relatively consistent with where we were at through the third quarter, perhaps up just a touch. Again, the cycle of closing houses in markets tends to be expanding right now. So, looking at those deposit levels, even over an immediate 90-day period may be a little bit too short.

Mark Biffert - Goldman Sachs

Okay. And back to the rent growth. You guys have talked about 5% to 6% in terms of rent growth. Do you think that given the occupancy's been relatively flat, that you're going to be able to continue to push rents as we look into '08?

Mark Ohlendorf

Yes.

Mark Biffert - Goldman Sachs

Okay. The next question is related to the ancillary revenues business. I noted that the ACR portfolio, the average income per unit dropped from 195 to 183. Can you provide any color on that?

Mark Ohlendorf

There was a slight decline in the quarter in the Part A expenses in the SNFs on the CCRCs. So, it's primarily a volume driven change quarter-to-quarter.

Mark Biffert - Goldman Sachs

So, is that [180] a better number to use to measure income from there?

Mark Ohlendorf

Well, again, we're forecasting as we roll this business out, in the range of $150 a unit.

Mark Biffert - Goldman Sachs

Okay.

Mark Ohlendorf

You know, this clearly will move a little bit from quarter-to-quarter.

Mark Biffert - Goldman Sachs

Okay. And so, in regards to the additional items that or units that you expect to bring online for building up ancillary revenues through your Brookdale legacy portfolio: what do you expect over the remainder of the year in terms of units built out or having exposure to that?

Mark Ohlendorf

In terms of: continuing to roll this out in the fourth quarter?

Mark Biffert - Goldman Sachs

Yes.

Mark Ohlendorf

The rollout plan in the fourth quarter is relatively modest, a few hundred additional units. As you know, we're well ahead of the initial plan we had for this year. So, the focus right now is on stabilizing the operations that we've reached.

Mark Biffert - Goldman Sachs

Okay. And lastly, Bill, if you could, last quarter you kind of went through your math to come up with a recurring run rate for your cash net income or cash from facility operations. Can you kind of go through that now, given that you've seen the increase in operating expenses and to where you think that run rate is?

Bill Doniger

Yes. The way I would try to answer that is, we would not expect a whole lot of growth in the fourth quarter, because our run rate or where we thought we were getting to, as I mentioned, on an occupancy basis, was roughly 93%. We're staying closer to 91%. The way our business is run, we've grown our occupancy over the end of the year. And so I don't think it's really an expense issue. It's really just an assumption about occupancy and entrance fees, which I told you we kind of view as staying relatively flat.

What you see, though, will be, for instance, our assisted living business at markets jump in on this; changed where we raised all of the resident rates at the first of the year. So, the big rate increase that will move the numbers materially will be at January, unlike the independent living business, where rates kind of grow annually based upon when people move in.

And that bit of change will basically push the growth into the first quarter versus the fourth quarter. Again, the difference from what we talked about in the summer was really an occupancy based assumption, which given the markets we just are not too optimistic about this part of the year.

Mark Biffert - Goldman Sachs

So, as we look at your run rate, it's going to come in a little bit shy of a $2 dividend that you guys are paying. How does it affect your decision, the Board's decision, on future dividend growth?

Bill Doniger

Sure. That's a good question. And we obviously have a couple hundred million dollars in liquidity. If you look at our payout ratio, since we've gone public, it has come down almost every quarter. And so we're probably at the lowest payout ratio that we've ever been.

We've always been forward looking. The reason for that has been we've been buying a lot of things; as we bought less, because we don't really need to buy anything at this point to create what we think is pretty attractive growth. We obviously are going to be more conservative, if you will, in terms of dividend increases relative to what we think the kind of current growth is and prospective growth. So, the payout ratio has gotten a lot tighter and I would expect it to continue that way. As to more specific than that, obviously, that's a Board decision.

Mark Biffert - Goldman Sachs

Okay. Thanks again.

Operator

Our next question is from Kevin Fischbeck of Lehman Brothers. Please proceed with your question.

Kevin Fischbeck - Lehman Brothers

Okay. Thank you. Good morning. I wanted to clarify a couple of the metrics that you provided. The same-store revenue growth in the actual quarter of 6.3 and operating income of 8.2, those numbers include the ancillary services; is that correct?

Mark Ohlendorf

That's correct.

Kevin Fischbeck - Lehman Brothers

Okay. And does it include the startup losses from ancillary services on the NOI?

Mark Ohlendorf

Yes, it would.

Kevin Fischbeck - Lehman Brothers

Okay. All right. And you talked a little bit about the financing transactions that you completed in the quarter and then I guess subsequent to the quarter. The numbers that you gave about the 187 of undrawn capacity, if there's $9 million in cash, is that after the most recent transaction closed in the quarter?

Mark Ohlendorf

It is. That's actually at the close of business yesterday.

Kevin Fischbeck - Lehman Brothers

Okay. And so the point is, I just want to clarify, I think you said that you feel comfortable about your finance position for the next two years, potentially second half of '09, was…?

Bill Doniger

Yes. Kevin, it's Bill. I mean, basically, if you think about our business, we finance our assets at, I don't know 60% leverage and we grow unleveraged at 8%. So, we deleverage on an asset basis relatively quickly. given our stock prices, we don't really feel like issuing equity.

So, what we do is we refinance assets and use that to pay off our line, which is being used basically to fund expansions. And so, if we just run out kind of a stabilized number on our portfolio and assume assets that are not prohibited from being refinanced, get refinanced, it's not a lot. We just use that to basically pay down our line.

And at the end of, we said kind of the second half of '09, is when we theoretically have about 50 million; it could be zero, frankly, but just using mathematical numbers and assumptions that's where we get to. And the line we view is kind of a bridge to our equity. But that's really the plan.

Kevin Fischbeck - Lehman Brothers

Okay. And then, I guess, one other clarification: the 20% organic growth that would include the ancillary service rollout?

Bill Doniger

That's correct.

Kevin Fischbeck - Lehman Brothers

Okay. The other thing that I want to go over clarity on it seems like, obviously, you're not doing the same size deals you have last couple years, but you have announced a couple deals in the last quarter or so. What are you seeing there about the acquisition environment? How are prices? And what are you looking for over the next 12 months?

Bill Doniger

Again, I think the story in terms of prices is that my guess is prices are going in the direction of a buyer versus a seller, but we're not that focused actually on acquisitions. Again, if we can grow, we -- I don't know. Where we're trading today on a free cash flow basis, it's roughly in a 5-plus percent current free cash flow yield. If we can grow organically, which we believe we can, at 20-ish percent, we talk about the total return, 25% area.

We're a pretty big company. And so, these small acquisitions are a lot of work. They just don't move the meter nearly as much as just filling up the beds that we want to fill up and doing our expansions. So, we're not even looking at acquisitions, primarily for that reason. We just don't need to do them to create pretty good growth. That's really the answer to the question.

Kevin Fischbeck - Lehman Brothers

Okay, great. Thanks.

Operator

Our next question comes from Matt Ripperger of Citigroup. Please proceed with your question.

Matt Ripperger - Citigroup

Hi. Thanks very much. A couple of questions: On the CapEx front: can you give a little more detail about the EBITDA enhancing CapEx, which is $20 million in the quarter? And what specifically is that capital going towards? And, when we think about projecting that forward, what kind of trend should we assume?

Mark Ohlendorf

Generally, what's going to be in that line, Matt, are two groups of projects. One group of projects is the capital projects that we're doing to improve acquired locations. So, I think as we've discussed before, when we underwrite an acquisition, we often underwrite as part of our effective cost of the deal, doing some capital spending to reposition the property. So that's one piece of this.

And given the volume of acquisitions that occurred in '06, a fair amount of this activity is occurring.

The second group of this relates to doing major projects within the existing portfolio to reposition those assets. Now, that doesn't happen quite as frequently as it does with the acquired locations, but it does happen in the existing portfolio as well. Obviously, we generally wouldn't invest this capital unless we see a yield, which is why we refer to it in that way.

Matt Ripperger - Citigroup

Given that your acquisition pace is decelerating relative to '06, is it fair to assume that your EBITDA enhancing CapEx will materially decline in '08?

Mark Ohlendorf

It clearly will decline as we go through '08.

Matt Ripperger - Citigroup

And the EBITDA enhancing CapEx is consistent with what your expectations were when you bought these assets in '06?

Mark Ohlendorf

Yes, it is. That the one thing that's probably a little different is, just given the magnitude of acquisition work that was done in '06, it's taking us a little longer to complete the projects than we would like.

Matt Ripperger - Citigroup

Is there any one or two portfolios of properties where the majority of this EBITDA enhancing CapEx is being allocated?

Mark Ohlendorf

I would say not. It's probably spread across a number of the acquisitions. Obviously, the acquisitions that include assets that are older, were built 12 or 15 years ago, as opposed to five years ago, are going to get more of this capital.

Matt Ripperger - Citigroup

And there's the ACR portfolio, given the newness of those properties is probably not getting much of it.

Mark Ohlendorf

Correct.

Matt Ripperger - Citigroup

Okay. The second question is: on the ancillary business, you said $29 million in revenues this quarter, and you gave the monthly NOI for the legacy ACR units. Can you give a sense of where you are in terms of the breakout between revenues for home health versus rehab? And where you are in terms of revenue per unit or NOI per unit for the Brookdale, Legacy Brookdale units? And how that is projected to ramp up going forward?

Mark Ohlendorf

We can. Yes. On the ARC side, just to give you a sense of the distribution in the NOI, of the 183 of monthly NOI, about 33 of that comes out of home health in terms of that delivery system, the balance out of therapy. Were you asking about the ramp up in the Brookdale units and how that's…

Matt Ripperger - Citigroup

Yes. Are the Legacy Brookdale units generating positive NOI on the ancillary business yet?

Mark Ohlendorf

Well, when we look at the clinics that have been in place, let's say a year, so they've been in place a meaningful period of time, I think the business is tracking where we would have expected. I think where we're at right now, that first year average is in the mid-50s, from an NOI standpoint, and the run rate today is in the low 70s, from an NOI standpoint.

The delay in getting licensure in some of the home health agencies is slowing us down a little bit, because particularly, as we get to the more geographically dispersed Brookdale locations, and in many cases that will be the free-standing assisted living. I think, the experience is, home health will be a more viable delivery model there. But I think the performance area is pretty much in line with the expectations we had.

Matt Ripperger - Citigroup

And what's the NOI margin at the ACR facilities per ancillary?

Mark Ohlendorf

I believe, low 30s, right now. Well, overall, it's mid-30s, I believe, excuse me.

Matt Ripperger - Citigroup

Okay.

Mark Ohlendorf

Yes. Call it 32%, 33%.

Matt Ripperger - Citigroup

And in the past you've given a little color about specific regions where you were seeing pockets of weakness, Florida, Arizona, etcetera. Is there any elaboration you could provide on what you're seeing locally?

Mark Ohlendorf

You're talking about senior housing occupancy?

Matt Ripperger - Citigroup

Yes, senior housing occupancy in demand trends.

Mark Ohlendorf

I'm not sure, Mark, that we would spot any significant trends from what we -- differences in the trends from what we have said before.

Mark Schulte

Yes. I think that generally, the markets we talked about before, obviously the Phoenix area where we have large CCRC presence and some parts of Florida, but it's very difficulty to tar a whole geographic area. I mean, we have properties that are doing extraordinarily well in Florida, and some that are more affected by weak housing markets.

So geographically, we're -- I can't really generalize and say one region of the country is worse than another.

Matt Ripperger - Citigroup

Okay. And what was the $43 million expense related to change in fair value of derivative. What was that related to?

Mark Ohlendorf

Well, again, we do not match our hedges. We do not try to qualify for matched hedge accounting. So that is simply the change in the value of the hedges in the quarter. It's a non-cash item, but as interest rates declined in the quarter, that's the accounting impact, the non-cash impact of those hedges, to mark-to-market, essentially.

Matt Ripperger - Citigroup

Okay. And then the last question I had is: in the entrance fee business, which did show a sequential improvement, does that include the presale of the village units?

Mark Ohlendorf

That does not.

Matt Ripperger - Citigroup

And how is the presale of that community going?

Mark Ohlendorf

It's going well. I think we're roughly 60% pre-sold in that project right now.

Matt Ripperger - Citigroup

And you still have not begun construction?

Mark Ohlendorf

We have not.

Matt Ripperger - Citigroup

Okay. Thank you.

Operator

Our next question comes from Ryan Daniels of William Blair. Please proceed with your question.

Ryan Daniels - William Blair

Yes. Good morning, guys. I had a couple of quick, housekeeping-oriented, questions up front. First off: earlier in the year, you guided towards the integration and startup expenses of about $25 million. And, if my math is right, it looks like you're at $18 million year-to-date. So I'm curious: if you anticipate that, that cost is going to spike up in the fourth quarter, or if you're just a little bit lower on a run rate basis, and Q4 should be stable with Q3?

Mark Ohlendorf

Well, you're adding together both the capital and the operating piece of this I take it, to get to your number?

Ryan Daniels - William Blair

Yes.

Mark Ohlendorf

I think in the fourth quarter, the operating piece is likely to go up, because we're much more in the implementation mode, and the capital piece will come down somewhat. We are likely to be under the $25 million number in 2007 standalone.

Ryan Daniels - William Blair

Okay. And then if we look forward to 2008, I know you guys probably don't want to give a lot of numbers on that right now, but what might that look like as we go into '08? Should that continue to trail off throughout the year or will that just stabilize it at some point and run through the entire year at a given level?

Mark Ohlendorf

Well, it clearly should trail off as we go through 2008.

Ryan Daniels - William Blair

Okay. And then, I appreciate all the color on the drop in the facility operating income margins due to the labor and the utility costs, that's very helpful, can you comment on how much of that was offset during the quarter by some of the cost savings you've talked about?

I think you had identified about $4 million in cost savings in last quarter that you hope to achieve in the back end of the year. Have we seen the impact of that or is a lot of that still going to be seen in the coming quarter or two?

Mark Ohlendorf

I think, obviously, the $4 million number that we had provided was an estimate at that point.

Ryan Daniels - William Blair

Yes.

Mark Ohlendorf

I think we have seen the lion share of that come into the numbers in the third quarter.

Ryan Daniels - William Blair

Okay. And given that that was an estimate, was it similar to the $4 million, a little bit lower, higher? Any…

Mark Ohlendorf

It was a little bit lower, would be the experience.

Ryan Daniels - William Blair

Okay. And then this is more of a philosophical question, I guess you guys have hit on this a few times Bill did, in talking about the dividend payment. But: do you consider one of the ways to create value here, putting in revenue or EBITDA enhancing capital in the facilities and then, longer term, recapitalizing those and cashing out on some of that investment?

How do you look at that in terms of using that recapitalization to pay a dividend, maybe above CFFO, versus using that cash to reinvest in new developments or other facilities, just how you guys think internally about that?

Mark Schulte

I think the way, I think to answer your question is, we spend capital to -- we bought assets, a fair number of assets we acquired were, we'll call them 87% occupied, little deferred capital, charging below market rates because they don't look as nice as stuff in town. So we made acquisitions. We assumed we put more capital in and then, obviously improves the quality of the asset; it should be able to charge more and get more people to show up, which will grow NOI.

And so, we do refinancings to once we get access to stabilized financing, we refinance the assets that will take excess proceeds out. As I mentioned, we're using capital now basically to fund expansions. And that's what basically we could do it two ways. We can issue equity, which we don't really feel like doing.

Ryan Daniels - William Blair

All right.

Mark Schulte

Or we could basically use these under-leveraged assets as a way to finance those, and that is our plan.

Ryan Daniels - William Blair

Okay. That helps clarify it. And then two more quick ones, then I'll hop off. First off: on the with the ancillary services kind of being rolled out across your network, are you guys seeing any trends and that actually helping the health of residents, and, in turn, increasing the length of stay? And, in longer term: do you think that's something that could also boost your occupancy, as well as some of the three initiatives you laid out at the start of the call?

Mark Schulte

Yes. I think I made that point before, but a lot of these ancillary services aren't just simply reactive, like after someone fell and broke their hip, and they're proactive to try to keep people from falling or if they're experiencing, in that example, balance problems, we can make it, so there isn't a fall.

So, yes, I mean that, we're not really able to quantify it at this point, but we would expect that length of stay, for a number of residents, it's going to be increased due to the availability of the therapy services.

Ryan Daniels - William Blair

Okay, great. And then the last one is just on the licensing delays: You have probably looked at this, but is there potential where you run into delays in the future to acquire maybe a smaller operator at a fairly cheap investment rate if you will, to get a license from them, and then roll that out more quickly? Is that something you would consider?

Mark Ohlendorf

Excellent question! Yes, it is. We actually have made acquisitions of home health in Florida already, which, as you know, it's kind of a monopolistic market for those kind of permits.

Ryan Daniels - William Blair

Right.

Mark Ohlendorf

And we are, as you said, looking at that in other markets now as well.

Ryan Daniels - William Blair

Okay, great. Thanks again, guys.

Operator

Our next question comes from Daniel Bernstein of Stifel Nicolaus. Please proceed with your question.

Daniel Bernstein - Stifel Nicolaus

Good morning, gentlemen. When I'm computing average occupied units, just taking the average rate for the quarter and the number of units in the quarter, I get an average occupied units was down just a little bit from Q2 did you take any units offline for the EBITDA enhancing CapEx or expansion?

Mark Ohlendorf

We did not. If you're using the units in service that's off the table in the press release and trying to tie that back in to the average rates, there's actually 920 units included in the CCRC total, that are equity homes. So we actually take those out of the total when we calculate the average rate. I'd suspect that may be the difference in your math there.

Daniel Bernstein - Stifel Nicolaus

Okay. And in the cash flow statement, there was a change in future service costs that was an add-back, just trying to figure out what that was and if that was and where that would be in the income statement?

Mark Ohlendorf

It's actually not in the income statement. It's a technical change in the valuation of those reserves. This is very inside baseball. It was triggered by the refinancing of a CCRC.

Daniel Bernstein - Stifel Nicolaus

So it's not in the CFFO or anything like that?

Mark Ohlendorf

It's not. Part of the future service obligation calculation for a CCRC is effectively based on the book value of the asset and the implied financing around an asset, and we had a refinancing of a CCRC in the quarter.

Daniel Bernstein - Stifel Nicolaus

All my other questions were answered. Thank you.

Operator

Our next question comes from Jeff [Ungler] of Standard and Poor's. Please proceed with your question.

Jeff Ungler - Standard & Poor’s

Good morning. Just one quick question: Assuming the occupancy and efficacy to stay at the current levels for a prolonged period, at what point would you consider scaling back the rollout of the ancillary services, assuming you get the licensing issues worked out?

Mark Ohlendorf

We would not. We see the ancillary service business as a tremendous revenue opportunity, which I think it's proven itself out. I mean, the two really aren't connected, whether it's -- in fact the ancillary service and availability actually enhances occupancy and marketability of these properties.

Jeff Ungler - Standard & Poor’s

Okay, great. Thanks very much.

Operator

Our next question comes from Frank Morgan of Jefferies and Company. Please proceed with your question.

Frank Morgan - Jefferies and Company

Good morning. First question relates to the regulatory delays: Could you specifically tell us what markets you're seeing those or what states you're seeing those delays in?

Mark Ohlendorf

I think the primary markets that we're working through now are Arizona, Texas -- Arizona and Texas I believe are the larger scale markets.

Frank Morgan - Jefferies and Company

Where you're experiencing the regulatory delays?

Mark Ohlendorf

Yes. These are cases where we have applied for the licenses and permits and the regulatory approval process has been drawn out.

Frank Morgan - Jefferies and Company

Okay.

Mark Schulte

They're either delaying the processing of the application or the inspections. Some of this should get a little more granular is more tied to a lot of these state budgets that have cut back their staffing that does these licensing applications. So, the work is really piling up for the few people that are there.

Frank Morgan - Jefferies and Company

Okay. On the subject of ancillaries, I think Mark or somebody answered a question talking about the impact of part A on the ancillary growth. Could you elaborate on that? I didn't quite catch that.

Mark Ohlendorf

It wasn't really on the ancillary growth, Frank. If you look inside the ARC legacy portfolio, the NOI per unit from ancillary has changed from roughly 190 a unit last quarter to roughly 180 a unit this quarter. And it was an answer to that question.

Frank Morgan - Jefferies and Company

But I thought most of this was part B business. I mean, is your part A business you're doing for nursing homes in local markets that gets rolled into that number?

Mark Ohlendorf

No, no. Our owned SNFS on our CCRCs, that's our own operation, deliver ancillary services, and the delivery mechanism is our owned therapy company.

Frank Morgan - Jefferies and Company

Okay. So, you're delivering part, you're delivering to your own contract to your own patient, you're delivering therapy services to people who are part A patients?

Mark Ohlendorf

That's right. And because that's such an intensive therapy regiment, when the part A census drops a bit, it does impact that per unit number.

Frank Morgan - Jefferies and Company

Okay. Alright, so: part A census to your own. Okay. Alright, and I was wondering: could you quantify the earnings drag related to the new development openings? I mean, it sounds like maybe there isn't that much of one, because they're already at 83%, but: how big a number is the drag from the new openings on the expansions? And: is there any drag that's associated with therapy staff that you have that you may not be able to bill yet because of all these delays?

Mark Ohlendorf

Well, the answer to the first question in terms of the net impact of the expansions, there is a negligible impact on earnings in the quarter for those expansions that are open right now.

Frank Morgan - Jefferies and Company

Okay.

Mark Ohlendorf

Second question related to the therapy services: Therapy or home health was your question?

Frank Morgan - Jefferies and Company

I guess the delay related to home healthcare, so home health.

Mark Ohlendorf

Yes, there's kind of a holding cost of $10,000 to $20,000 a month per location per agency, as those agencies sit in waiting for their licenses. Obviously, the bigger impact here is, we are not getting to the ramp up of profitability after they open, which is substantially greater than $10,000 or $20,000 a month.

Frank Morgan - Jefferies and Company

And remind me: what is causing that delay in the ramp up?

Mark Ohlendorf

The delay in the ramp up is because we do not yet have our permits to operate.

Frank Morgan - Jefferies and Company

Okay. It's not one that's already open. Once it opens and the delay from the time you get opened and licensed until you get to your normal optimal performance, that's not being delayed?

Mark Ohlendorf

Correct.

Frank Morgan - Jefferies and Company

Okay. And then finally: just this is more and more philosophical. Somebody asked this question earlier. They asked about: do you think you can raise rates in a flat occupancy environment? And your answer was: “yes”. Could you elaborate on the “yes” part?

Mark Ohlendorf

I guess I'm not sure how to elaborate on it, other than to say that as we run the business every day, that's what happens with our rates.

Mark Schulte

Generally, there's a large segment that are on annual agreements. If those agreements turn over, we give those people a 46% increase. The assisted living, which is on a month-to-month, we continued like all of the other operators to see good rate growth, and the ability to attract new customers or whatever, doesn't really necessarily affect what people are charging in any given market.

Frank Morgan - Jefferies and Company

Okay. Last one and I'll hop off. Just kind of where were things at the end of the quarter in terms of, like say in the month of September, with regard to occupancy and just basic operating trends? And how much of that would maybe carry over into the fourth? Thanks.

Mark Ohlendorf

Sure. Well, actually, let me fast-forward a month, because we've been looking at October results. The trends are modestly positive, I guess you would say. Occupancy is clearly holding to growing a little bit, particularly on the assisted living side. No meteoric changes, but things are clearly firm to slightly up.

Bill Doniger

With that, we'll close. We appreciate your participation and we'll be around for follow-up questions. Thank you very much.

Operator

This concludes the conference call. Thank you everyone for joining. You may now disconnect.

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Source: Brookdale Senior Living Q3 2007 Earnings Call Transcript
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