Why Do People Invest in Skilled Nursing Facilities (SNFs)?

chart01.pngHere is a real estate investment proposition that might spark your interest. You will own facilities whose tenants serve an increasing amount of elderly patients in the United States. The majority of the patients will pay your tenants through government program reimbursements. Remember, governmental programs depend on federal and state budgets, some of which may have shortfalls. Over the past years, the reimbursements have increased by a compound annual growth rate (CAGR) of 2-3%. Tenant profitability is low, and in a previous budget sequestration, government programs have not been preserved and Medicare has suffered cuts. Would you invest in skilled nursing facilities?

The skilled nursing facility industry today provides many excellent benefits but also downfalls. One of the best aspects of the industry is the future demographics. As the baby boom generation ages, they will need to visit healthcare facilities more frequently. The United States census notes that the number of citizens older than 85 years will increase significantly in the coming decades.

On the other hand, there is a highly regulatory aspect of the business. Obamacare increased the number of insured citizens; however, the healthcare system has suffered regular changes and scrutiny has intensified. The Center for Medicare and Medicaid Services (CMS), a federal agency within the United States Department of Health and Human Services (HHS), has been executing details of Obamacare. CMS is trying to increase transparency within the industry by tracking payroll, staffing and number of penalties (see website here). They are also looking to contain growth in Medicaid expenditures and control daily rates which affects SNFs’ revenues and profitability.

The performance of Genesis Healthcare Inc. in the financial market may reflect the invest mood of the SNF industry. Genesis Healthcare is a publicly-traded company and one of the largest post-acute care operators in the United States. Genesis Healthcare is a tenant of healthcare REITs Omega Healthcare and LTC Properties. In January 2015, it was downgraded by Standard & Poor’s to B- for challenging prospects in the SNF industry. Their year-to-date share price has plummeted by almost 50%.

In Standard & Poor’s January 2015 report, they highlighted the following: “The downgrade follows a review of the industry prospects for nursing facilities and reflects our assessment that Genesis will be challenged to generate substantial free cash flow on a sustained basis,” said credit analyst David Kaplan. Our rating on Genesis reflects our assessment of its business risk profile as “weak” and the financial risk profile as “highly leveraged”, and our view that the company’s financial risk is comparatively weak within the highly leveraged assessment. Our outlook is stable, reflecting our view that industry headwinds will offset margin expansion initiatives, leading to thin margins near current levels, and that the company will generate only modestly positive free cash flow.”

In summary, the SNF business offers excellent demographic fundamentals with minor upside and major downside as a result of constantly changing government regulations. If that is the case, why invest in the industry? First, healthcare REITs have historically been immune to the swings of the stock market. Second, yields have been one of the highest among equity REITs. Furthermore, if we saw less regulatory impact and revenues continued to grow incrementally, healthcare would be the ideal REIT stocks. They would provide stable, gradually-increasing dividends over time.

Source: Omega Healthcare Investors, Inc. (NYSE:OHI), Standard & Poor’s, Genesis Healthcare, Inc.(NYSE:GEN), LTC Properties Inc.(NYSE:LTC), CMS, Ventas, Inc.(NYSE:VTR)

Disclaimer: This newsletter is not engaged in rendering tax, accounting, or other professional advice through this publication. No statement in this issue is to be construed as a recommendation to buy or sell any security or other investment. Please do your own due diligence before making any investment decision. Some information presented in this publication has been obtained from third-party sources considered to be reliable. Sources are not required to make representations as to the accuracy of the information, however, and consequently the publisher cannot guarantee accuracy.

Disclosure: The author has no positions in any shares mentioned, and no plans to initiate any positions within the next 72 hours.

What Can We Learn From HCP?

chart01In 2015, HCP recorded a $1.3 billion impairment related to their HCR ManorCare investments. HCR ManorCare, their biggest tenant in the post-acute/skilled nursing segment, has experienced deteriorating operational performance due to changes in reimbursement rules. Also, the U.S. Department of Justice has sued HCR ManorCare on the grounds that they had filed claims to Medicare for services not needed by their patients.

Although the litigation is at an early stage, this is nonetheless a reminder to investors who invest in skilled nursing facilities (SNFs) through healthcare REITs that their investments tend to be reliant on Medicare and Medicaid reimbursement. As a result, changes in Medicare and Medicaid reimbursement can have enormous consequences for their investments, which can catch them by surprise.

How Can You Evaluate Healthcare REITs Investing in SNFs?

Before evaluating healthcare REITs that invest in SNFs, it is important to mention some of the background. In brief, Medicare and Medicaid reimbursement rates tend to increase over time, as shown by how average Medicare reimbursement rates rose from $408 per day in 2008 to $484 per day in 2014 while average Medicaid reimbursement rates rose from $164 per day to $186 per day across the same period of time according to Eljay LLC and CMS. This means that SNFs possess potential in the long run, though the same cannot be said in all periods of time.

If you are interested in investing in SNFs through healthcare REITs, there are some simple ways to evaluate your potential investments:

* The Centers for Medicare and Medicaid Services post updates such as the payment rates for 2016, meaning that it can be worthwhile for investors to monitor their website. While its updates can have a wide range of effects on SNFs, most may not prove pleasing to investors because it has an unsurprising interest in ensuring that the costs of Medicare and Medicaid are as low as possible.

* Some SNFs have slimmer margins than others, meaning that a negative occurrence can hurt them and thus their investors more than competitors. One way to avoid such SNFs is to examine their EBITDAR coverage ratio, which is their earnings before interest, taxes, depreciation, amortization, and rent divided by rent costs. A higher coverage ratio means that a SNF is more resilient in the face of negative occurrences because it has the earnings needed to tough them out.

* Occupancy is a useful figure for telling whether a SNF will be profitable or not because each occupied unit is a unit that is earning revenue for the SNF. There is a problem in that the occupancy at which a SNF becomes profitable is not the same from SNF to SNF. However, it is very much possible to compare occupancy from year to year for the same SNF, meaning that a rising occupancy is a positive sign for its profitability.

* Finally, check whether a healthcare REIT has all of its investments in the same state or has taken the proper precautions by spreading them out. You should avoid healthcare REITs that cannot be bothered with diversification because a statewide change for the worse can hammer their figures, which is particularly problematic because state governments can have significant influence over Medicaid spending.

Source: HCP, Inc.(NYSE:HCP), Ventas, Inc.(NYSE:VTR), CMS

Disclaimer: This newsletter is not engaged in rendering tax, accounting, or other professional advice through this publication. No statement in this issue is to be construed as a recommendation to buy or sell any security or other investment. Please do your own due diligence before making any investment decision. Some information presented in this publication has been obtained from third-party sources considered to be reliable. Sources are not required to make representations as to the accuracy of the information, however, and consequently the publisher cannot guarantee accuracy.

Disclosure: The author has no positions in any shares mentioned, and no plans to initiate any positions within the next 72 hours.