SNFs need to 'tough it out' for the first part of 2005.

Skilled nursing providers have been experiencing a relatively stable operating environment during the past few years. However, because of continued concern over the ability to sustain recent performance, capital providers have not yet loosened their purse strings for skilled nursing. And until the resolution of the RUGs refinement in July, financiers will continue to be circumspect about investing in the sector.

SNF Loan Volume Lagging

Each quarter, the National Investment Center for the Seniors Housing & Care Industries (NIC) compiles key performance and financial data from the nation's leading seniors living lenders, owners/operators, and appraisal professionals. Part of that data is the quarterly lending activity of the top lenders (non-REITs) that make permanent debt or short-term debt investments in seniors housing and care, including Fannie Mae, Freddie Mac, and several of the larger credit companies and banks.

For the third quarter of 2004, the NIC Key Financial Indicators[TM] showed that loan volume placed in the industry was up significantly from a low in the second quarter--$783 million compared with $336 million--but skilled nursing facilities continued to lag behind independent living and assisted living facilities in terms of the total number of investments.

The funding discrepancy was particularly true with permanent debt. Whereas skilled nursing had a slight rise in financing from the second to the third quarters of 2004, the amount of assisted living funding increased almost threefold and independent living rose approximately 35%. The likely reason is that there really are not, other than HUD, any significant sources of long-term, fixed-rate financing for skilled nursing facilities. Most of the current financing sources are short-term credit companies and bank sources.

We can expect this trend to continue through 2005, although some new development does appear to be on the horizon. For example, Credit Suisse First Boston apparently has completed recently a large commercial mortgage-backed securities (CMBS) financing for the acquisition of Mariner Health Care. This is a significant development in the industry because it represents the first major nursing home/CMBS financing in a number of years. In addition, several other companies are developing capital market capabilities that use CMBS financing, which they plan on offering to skilled nursing customers. Thus, although no real permanent debt was placed in the third quarter of 2004, we should see the beginnings of more CMBS-like permanent debt products for skilled nursing facilities later in 2005.

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Occupancy Rates Flat

According to the NIC Key Financial Indicators, third quarter occupancy rates for skilled nursing facilities stabilized in the 86 to 87% range on average. In fact, the average occupancy rate for these properties has been stuck in a fairly narrow range between 85 and 88% for the past four years.

While overall occupancy has remained relatively flat, these statistics don't show how astute operators are shifting the composition and quality mix of their census to drive more profitability into the facilities. Strategically, they are shifting their census away from the custodial care, long-term, Medicaid residents toward the more short-term, subacute care, Medicare-paid patients to generate incremental profits. As average length of stay decreases, the properties experience higher vacancy, but profits improve because of significantly higher margins on Medicare reimbursement.

Anthony J. Mullen, NIC research director, believes that occupancy rates are not going to go much higher over the next couple of years. "The only way that operators can really help grow their net operating income is to increase revenues by increasing their services or what they charge for their services," he said. "And since most operators are already charging the most that they can, it probably comes down to increasing their services. Either that or they can concentrate on decreasing expenses. So they need to ask themselves questions such as, 'How do I become a better manager?' and 'How can I become much more creative on how I add services?'"

Wide Range in Capitalization Rates

Toward the end of 2004, capitalization rates started to come down for independent living and assisted living, in particular. But capitalization rates for skilled nursing remained relatively flat.

Moreover, we didn't see compression in capitalization rates for skilled nursing as in the other sectors. The NIC indicators showed that the range between the highest and lowest reported assisted living capitalization rates increased 160 basis points in the third quarter, with the lowest at 8.4% and the highest at 14%. For skilled nursing, the spread increased 440 basis points, with 9.2% reported for the lowest capitalization rate and 16.8% for the highest. That means a wide range of rates is still being used by purchasers of skilled nursing properties, with capitalization rates on the lower end reserved for top operators with stabilized properties in premier locations.

Operators should know that capitalization rates used for properties actually trading in the marketplace tend to be lower than those reported by lenders for their internal valuation approach, which generally means more equity will be necessary to complete transactions. Also, selling off a number of properties in a portfolio will generally yield a much better capitalization rate than one-off transactions.

Reimbursement Issues

Perhaps the biggest question mark hanging over the nursing sector is the RUGs refinement. Developed as an add-on to the Balanced Budget Refinement Act of 1999, it was the federal government's attempt to make up inadequate reimbursement rates to nursing homes for patients in high-acuity RUGs categories. Every year since 2002, the government has been meaning to reassess the refinement to see if it's working and still needed. To date, the reassessment has kept getting deferred, and it comes up for review again this year.

Although the government may choose to again defer this issue and not deal with it, it may decide that the nursing home industry has been helped enough. The add-on may be taken back, cut, or tweaked in some way in which it could impact the profitability of nursing homes.

While interest is strong in large portfolio opportunities, until the RUGs refinement issue has clarity, we're not going to see investors aggressively bidding up the pricing for individual skilled nursing facilities. That's because concern still exists that cash flow could have near-term volatility as a result of an adverse outcome on the RUGs refinement issue. However, many experts believe that reimbursements in general will remain stable for the foreseeable future.

Tom Scully, former CMS administrator, agrees that the uncertainly of the RUGs add-on is a concern in the financial community. "We have a tidal wave of seniors coming our way, and having people who are rational investors not wanting to invest in long-term care is not a good thing," he said in his address on this topic to providers and financiers at the NIC conference this past fall. "The nursing home margins are a lot better than they were two to three years ago, but they're still not great. When you see the [large investment firms] start to invest in SNFs, then you'll know it's turned around and OK."

Fortunately, because nursing homes were the first sector to push Quality Measures, Scully believes that they have a good reason for convincing the second Bush administration to keep the add-on. He also pointed out that Congressman Bill Thomas (R-Calif.), chair of the House Committee on Ways and Means, would be the dominant player in healthcare in 2005. Scully believes that Thomas is "very focused on quality" and was impressed with the Quality Measures put in place by the nursing home sector. "I think it's a lot less likely somebody's going to whack your reimbursement if you're pushing the edge of the envelope on quality," Scully advised.

Renovating Older Properties

Given the current reimbursement levels, it's still generally not profitable to develop new skilled nursing facilities with the traditional payer mix. In fact, the amount of new development will likely continue at a very modest pace. This raises the issue of the existing stock being as old as it is.

"There's going to be an evolution and, in some cases, a revolution, in what happens on a typical nursing home site as we go forward," said Mullen. "The reason is that the average age of nursing homes is 29 years. But many properties are 35 years or older. And they need renovating. Many are going to need to have additions or new buildings built on the site, if there is excess land. And many will need an equity partner to help renovate and/or add to the campus." Mullen admitted that in addition to the regulatory hurdles, there are some financial ones. For example, "there may not be a lot of absolute dollars involved, so it won't be easy. But equity investors that are set up to do this type of business will be in demand," he said.

In the meantime, it seems to be a wait-and-see situation because, once again, the current regulatory environment makes it difficult to forecast future profitability with certainty. But with the promise of more stable long-term financing options coming on line and, if Scully proves right, a deferral of the RUGs refinement, then the second half of 2005 could be a breakout time for skilled nursing.

Raymond J. Lewis is Senior Vice-President and Chief Investment Officer of Ventas Healthcare Properties and is past Chair of the National Investment Center for the Seniors Housing & Care Industries (NIC). A leading healthcare REIT, Ventas rapidly delivers up to 100% financing through highly customized deal structures. For more information, visit www.ventasreit.com or call [phone]. For more information on NIC, visit www.NIC.org. To send your comments to the author and editors, e-mail [e-mail].