Investment Thesis: Sabra Healthcare REIT Inc.’s (SBRA) merger with Care Capital (CCP) has now been completed and we analyze the recently introduced 2018 guidance and operator rent reductions. We conclude that while that it is not a screaming buy, we like the company enough to keep holding our position.
Source: SBRA presentation
We have previously explored the merits of the merger in detail and we will start off now with how we see the company going forward.
1) Everybody loves senior housing (except SBRA and us)
SBRA now has a large platform that has low exposure to senior housing.
We have previously explored our not so great outlook for senior housing, and with SBRA at 17%, we felt it was a tolerable exposure. The balanced private-public pay mix is also a plus for us.
2) 2018 guidance
SBRA introduced 2018 guidance at about $ 2.40 of adjusted funds from operations (AFFO). That puts it at a reasonable 10X AFFO. What was interesting is that they did so in conjunction with large rent reductions for some operators.
Source: SBRA 2018 guidance
The result of these reductions is that skilled nursing facilities (SNF) and transitional care rent coverage will improve from 1.31 to 1.47X. We have repeatedly said that the biggest risk factor to both the senior housing and SNF sectors is the razor thin margins on which its operators currently run. For us rent reductions were a forgone conclusion, and we are seeing some more right here. Next in line is Omega Healthcare Inc. (OHI) where we see some fireworks possible with two of its largest tenants not being able to cover rent. But that is just a taste of things to come though as 11 operators are below 1.0X EBITDAR rent coverage and 23% of rent in OHI’s portfolio has less than 1.2X EBITDAR coverage.
3) It’s gonna get worse before it gets better
Superficially, the metrics appear better than they actually are.
Here you can see SBRA and OHI tenants having SNF rent coverage at 1.47X (after rent reductions) and 1.33X, respectively. There are two problems with being comforted by that metric.
- It does not break down the individual sets in distress. To be fair, both SBRA and OHI rigorously provide this information, but the mean itself can be highly misleading.
- This is a rolling 12-month coverage, which is going to get worse.
Source: Seniors Housing Business/NIC
While the declines in occupancy are slight (the only available chart we could find amplifies the impact by arbitrary Y-axis settings), the marginal impact on profitability in a sector struggling with 3-4% rent increases and 3-6% wage increases is quite dramatic.
Why the declines? Read what the healthcare analyst for NIC has to say.
“Pressure on occupancy witnessed over the last two years has several drivers, including policy changes from the Centers for Medicare & Medicaid Services (CMS) that discourage skilled nursing utilization or encourage short lengths of stay for Medicare patients in an attempt to bend the cost curve,” says Liz Liberman, healthcare analyst for NIC. “Indeed, NIC data indicates that pressure on Medicare patient day mix began in early 2015, which is also when overall occupancy started to decline.”
Whether we get big change from the federal level or not, policy changes are filtering down to this sector. These policy changes have been so effective that in a sector with virtually zero new supply and large number of demographic positivity, occupancy is trending down.
4) Geez… Why would you want own this then?
One thing we like about SNF is the lack of optimism towards it. This is best reflected in the complete lack of new supply for the sector compared to senior housing. Current construction is just 0.7% of existing inventory and cap rates for new deals are through the roof. We do think demand will catch up eventually, but we are not in group that thinks these are screaming buys. Additionally, SBRA management has delivered good returns for shareholders over the years while keeping operator coverage high. We don’t see any immediate financing issues or debt maturities that scare us either.
The net debt to EBITDA and interest coverage metrics are adequate to deal with any more hiccups that might come along.
In addition, the current dividend payout of $ 1.72 annualized represents just a 71% payout on the 2018 AFFO. We think that is a great cushion and ideally SBRA should raise this very slowly until industry fundamentals improve.
We owned CCP prior to the merger and we are sticking with our long position. We think the size created by the merger, along with reduced operator concentration, are positives for us and suffice at this valuation to combat the cyclical headwinds facing SNFs. We had modeled a worst case scenario for OHI previously where we looked at the rent reductions it might have to concede. We were happy to see SBRA get started on this in their own portfolio and still guide for good AFFO growth. On our scale of 1-10, where 1 would be “Avoid like the bubonic plague” and 10 would be “Buy like this is Apple (NASDAQ:AAPL) in March 2009,” we would rate SBRA a 6.5.
Disclaimer: Please note that this is not financial advice. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints. SBRA’s dividend for the August quarter was $ 0.36 or $ 1.44 annualized as shown on their website. The actual dividend payment for 12 months out is likely to be at a $ 1.72 rate annually.
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Disclosure: I am/we are long SBRA, OHI.
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.