I Am A 'FearLeader' For Senior Housing Properties

Summary

• Risk #1: High concentration with Five Star.
• Risk #2: Office.
• Risk #3: The balance sheet.
• Risk #4: No dividend growth.
• Don't be too greedy.

In case you missed it, I wrote a detailed article on an externally managed REIT, Government Properties Income Trust (GOV), yesterday in which I explained:

"I can assure you that I am extremely discriminating when it comes to recommendations and hopefully the message is clear. My article today is one such example, and I can assure you that I am no cheerleader for Government Properties Income Trust."

As much as we like REITs, we are highly disciplined with our approach and we're always lending a critical eye to each and every company we research.

In other words, the purpose for the countless hours I spend writing on REITs is not just to slap BUY-BUY-BUY on every REIT, but instead to take a cautious approach hoping to lead investors to the safest names that will outperform in good times and bad.

Yesterday someone asked me what I meant by the term "cheerleader" and I decided to "google" the opposite of cheerleader and I found this:

"I thought of a new name for this type of presence that people can have in others' lives and "fearleaders" to me pretty much captured it. "Fearleaders" are people who through their support and attempts at encouragement end up tapping into people's fears, which then becomes their basis for action."

Bingo! A new name, and while Webster doesn't authenticate it, I decided I would use it in my article to suggest exactly what I am trying to communicate, that is that "I am a fearleader for Senior Housing Properties".

An Externally-Managed Healthcare REIT

Senior Housing Properties Trust (SNH) was founded in 1986 and commenced as a public REIT on September 17, 1999. With more than 19 years of public history, SNH has evolved into a $7.5 billion diversified healthcare REIT with 440 properties in 43 states and Washington D.C.

The portfolio consists of 68 independent living properties, 198 assisted living properties, 39 nursing homes, 102 medical office buildings, 23 Life Science properties, and 10 wellness centers.

Although SNH is considered a "diversified" REIT, as noted above, around 55% of the portfolio is comprised of Senior Living and the second largest category (around 45%) is Medical Office (19%). SNH has just 3% exposure to skilled nursing.

The portfolio includes over 675 tenants with the highest geographic concentration in MA (15%), CA (10%), and FL (9%).

SNH owns around 97% (based on NOI) of its properties with private pay structures, and the balance is primarily nursing homes (3%). As you can see below, SNH has reduced its reliance to government reimbursement, similar to Ventas, Inc. (VTR) and HCP, Inc. (HCP). Welltower (HCN) is working to reduce its skilled nursing, but the Genesis (GEN) portfolio sell has been delayed "indefinitely".

Now that I have explained SNH's composition, I will take a closer look at the "fear" I am seeing behind this diversified healthcare REIT.

Risk #1: High Concentration with Five Star

SNH's Senior Living portfolio consists of 304 communities and more than 35,000 units in 39 states. The largest senior living tenant, Five Star Quality Care (NYSE:FVE), and is also the largest tenant of the REIT. SNH derives around 27.4% of its overall revenue from Five Star's communities.

In a recent research report, RBC Analyst, Michael Carroll, explained:

"We are cautious on SNH's largest tenant, which generates for 32.9% (NNN lease) of NOI and manages 13.3% (or TRS). The master leases coverage ratios continue to decline with the TTM ended 3Q17 EBITDARM ratio falling 1 bps sequentially and 7 bps YOY to 1.15x.

We estimate the operator is currently losing $1-2 million a quarter assuming an annual capital expenditure reserve of $750/unit. The tenant will likely not be able to meaningfully improve results until fundamentals recover. Despite this concern, Five Star Senior Living appears to have time to work through these problems as we estimate it has a significant collateral position with ~$80 million of cash and ~$350 million of owned communities offset by ~$125 million of liabilities."

Keep in mind that SNH's concentration with FVE has decreased substantially since my previous article when FVE derived around 45% of revenue for SNH. However, SNH still derives over a quarter of income from the FVE assets and the conflicts of interest are still relevant. As the chart below illustrates, this is why you don't want to have a lot of eggs in one basket:

Clearly FVE has been punished, but look at SNH's performance as it relates to other healthcare REIT peers:

Chart by Brad Thomas

Risk #2: Office

As I said above, SNH has purposely moved to diversify its portfolio to mitigate Risk #1 (above); however, I'm not sure that SNH has the experience to compete in the "office" sub-sector. Simply put, what is SNH's "circle of competence"?

It's clear that SNH does not have a competitive advantage in owning MOBs. This REIT simply does not enjoy the deep-standing tenant relationships with its core customers because it's not the company's primary business.

Unlike Healthcare Trust of America (NYSE:HTA) or Physicians Realty (NYSE:DOC) that operates almost exclusively in the MOB space, SNH owns a portfolio of buildings that are on campus, off campus, or biotech related.

You can see that SNH has acquitted quite a few office buildings with cap rates ranging from 8.0% to 13.1% (average 9.1%). Clearly SNH is not acquiring buildings with the same quality as HTA and DOC as many of SNH's office assets are located in secondary and tertiary markets.

Risk #3: The Balance Sheet

SNH has a capital structure that consists of common equity (49%), $1.7 billion of unsecured notes (21%), secured debt (10%), an unsecured revolver (7%). The company has no preferred stock.

SNH ended the year with total debt to gross assets of 42%, down from 43.4% a year ago, and 5.9x debt to EBITDA (excluding the incentive fee). Interest expense decreased $3.1 million or 7.1% in Q4-17 compared to Q4-16. Borrowings on the credit facility at the end of 2017 totaled $596 million.

Subsequent to the end of 2017 SNH announced that it had entered into an agreement to sell four senior living assets leased to Sunrise and expects to realize gains of approximately $308 million. The communities were sold at 4% cap rate and the company uses proceeds to further pay down the balance on the revolving credit facility until they could be reinvested accretively.

I am glad to see SNH deleveraging the balance sheet and hopefully the company will continue to improve its costs of capital so that it can be more competitive with VTR, HTA, and DOC. However, I am concerned that the sustained deterioration in the credit profile from FVE could lead to negative rating pressure.

Personally, I would like to see more discipline in the capital markets arena to mitigate the tenant concentration risks with FVE. Also, as noted above, SNH has a disadvantage on the equity side and that makes it difficult for the company to compete with the MOB REITs that enjoy a much lower cost of capital (see valuation metrics below).

Risk #4: No Dividend Growth

SNH has the third-highest dividend yield in the healthcare sector:

Chart by Brad Thomas

Here's a snapshot of the company's historical dividend growth:

As you can see, SNH has not grown its dividend since 2012, and upon closer examination, we can see that SNH's profit margins have not been as healthy as other healthcare REITs. Take a look at the company's FFO per share forecaster:

Chart by Brad Thomas

The FFO growth does not look that bad, but the deeper issue is that SNH's is very close to having an underfunded dividend. Take a look at the FFO payout ratio.

Chart by Brad Thomas

However, when you examine SNH's AFFO payout ratio, you can see that the dividend is underfunded, and that does not take into account incentives fees (externally managed REIT) in 2018. More importantly, remember that around 27% of the rental proceeds from SNH is generated from FVE.

In RBC's Research report, Michael Carroll, explains:

"The company will most likely be required to payout the maximum incentive fee ~$58 million to RMR in 2018. We note the incentive fee cap is based on the stock's market capitalization. The fee today is so far in the money that the shares would need to underperform the SNL US REIT Healthcare index by ~1,500 bps in order for the payment to drop below the cap and by ~3,000 bps in order for the payment to be completely wiped out. Additionally, given the stock's outperformance in 2017 and in 2018, SNH would be in-line to pay a $20 million fee in 2019."

Don't Be Too Greedy

SNH's dividend yield is tempting but do not get too greedy:

Chart by Brad Thomas

SNH's P/FFO multiple looks cheap, but there is a reason…

Chart by Brad Thomas

In closing, I am obviously no "cheerleader" for SNH as I believe there are better opportunities with Ventas, LTC Properties (LTC), Healthcare Trust America, and Physicians Realty.

If you want to own shares in an externally-managed REIT that has no dividend growth, high leverage (than most peers), tenant concentration risk, and a dividend not funded by AFFO, SNH is your pick. But I can assure you, this REIT is nowhere close to being a "sleep well at night" operation and now you know why I titled this article, "I Am A 'FearLeader' For Senior Housing Properties."

Note: Brad Thomas is a Wall Street writer, and that means he is not always right with his predictions or recommendations. That also applies to his grammar. Please excuse any typos, and be assured that he will do his best to correct any errors if they are overlooked.

Finally, this article is free, and the sole purpose for writing it is to assist with research, while also providing a forum for second-level thinking. If you have not followed him, please take five seconds and click his name above (top of the page).

Source: F.A.S.T. Graphs and SNH Supplemental and Investor Presentation.

Analyst’s Disclosure: I am/we are long ACC, AHP, APTS, ARI, BRX, BXMT, CCI, CHCT, CIO, CLDT, CONE, CORR, CUBE, DDR, DEA, DLR, DOC, EPR, EXR, FPI, FRT, GEO, GMRE, GPT, HASI, HTA, INN, IRET, IRM, JCAP, KIM, LADR, LAND, LMRK, LTC, MNR, NXRT, O, OFC, OHI, OUT, PEB, PEI, PK, PSB, QTS, REG, RHP, ROIC, SBRA, SKT, SPG, STAG, STOR, TCO, UBA, UMH, UNIT, VER, VTR, WPC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.