Tuesday, June 06, 2017

Juggling Chainsaws

Sometimes I get opaque on this blog, and this is one of those times.  I have been reading through several health care REITs' 10-Qs and 10-Ks, and while I am not ready to sound an alarm, I do see an area of concern.  In particular, REITs holding skilled nursing facilities worry me.  Skilled nursing investments are the medical sector that can juice up a healthcare portfolio.  Like student housing is to a multifamily portfolio or mezzanine loans are to a mortgage portfolio, skilled nursing has the potential to add return to a healthcare portfolio.  Skilled nursing properites typically trade at cap rate of 10% or more, which is 200 to 400 basis points or more than other healthcare properties, so when I see REITs buying these properties I take notice.

Skilled nursing is heavily dependent on medicaid reimbursements, which is the lowest level of reimbursement and can represent 80% or more of patients in a skilled nursing facility.  The balance is from much higher paying medicare and private pay patients.  A well run skilled nursing facility needs administrators that can work with hospitals and families to keep the "quality ratio" of medicare and private pay patients high compared to medicaid patients.  Skilled nursing properties that are subject to net leases with operators offer a REIT some protection, putting the patient risk on the operator, not the REIT.  I am seeing skilled nursing facilities in healthcare REITs where the REIT or a subsidiary is the operator, which means the REIT is taking on the operating risk of the facility.  
Skilled nursing facilities trade at cap rates higher than other healthcare properties for a reason - and that reason is risk.  If things go well the extra 200 to 400 basis points is great, but a slip in the quality ratio and that return goes away.  Investing in skilled nursing is a tantalizing opportunity for REIT managers to overcome loads, support distributions, and generate total return.  I am watching to see whether some managers went too far into skilled nursing and bought assets they did not fully understand.


Ockham said...

Thanks for providing this nuance on the sector. My instinct when the conventional wisdom is so one sided(demographic wave of old people-->buy healthcare REITs), is to get nervous. The demand has been well known for a long time now, do we really believe it won't end up getting oversupplied with properties?

Some of the healthcare REITs raised and deployed capital really quickly too. I realized their skilled investors, but overpaying is a real risk.

Rational Realist said...

thanks for the comment. the pressure for load surpassing returns leads to underestimating risk or at least a need or willingness to take on risk.