Description

This post discusses one of Fortress’ ‘permanent capital’ vehicles that was recently the target of an open letter from top five shareholder, Levin Capital Strategies LP (i.e. John Levin).

SNR is a senior housing REIT with 88 percent occupancy spread across a geographically diverse portfolio of 152 US facilities. Some 92 percent of its residents pay privately. Forty percent of the portfolio is triple-net-leased for between 15 and 17 years with an average of between one and two years in on the contract life. Debt? Sixty percent of the stack is fixed rate at reasonable interest rates (3.65 percent to 8.00 percent depending on the nursing home site) and the remaining 40 percent of the debt pays floating rate interest based on a short term measure of LIBOR plus 2.20 percent to 3.25 percent. The average debt maturity is around 6.8 years. Notably, 82 percent of the debt associated with the triple-net leased assets are set to fixed rate, so the company is positioned to gain as each year it takes pre-arranged rent increases of 2.5 percent to 3.5 percent, thereby outpacing any rise in interest expense directly related to these assets.

SNR boasts 3Q15 annualized net operating income of approximately $200 million and $90 million of distributable cash flow (26c/quarter dividend = $1.04/share). So where’s the downside? Theoretically, a drop in occupancy. But all data point to the fact that senior citizens as a percentage of the general population are on the rise for the next 30 years and beyond. If occupancy at SNR were to drop, the business could be forced to cut the dividend to avoid defaulting on its debt. According to the company’s 2014 annual report, the average occupancy rates for their managed properties were 83.6 percent and 82.5 percent in 2014 and 2013, respectively.  The average 2013 and 2014 occupancy rates for their triple-net properties were 88.8 percent and 89.1 percent, respectively. So this year occupancy has actually improved on average relative to the past two years. No surprise then that SNR actually increased the annual dividend by 2c a share this past June.

Consider as well that so-called Baby Boomers (Americans born between 1945 and 1964) account for about half the American population. According to a report by Nielsen, Boomers, who are now entering into the ranks of retirees and are in search of senior housing, could by next year hold 70 percent of disposable income in America and buy half of all consumer-packaged goods. So again, a drop in occupancy would come more because of aggressive new construction around SNR’s existing facilities rather than a reverse of a demographic trends.

According to New Senior Investment Group’s CEO, Susan Givens, there are 1.4 million senior housing units in the United States and 32 million people over the age of 70. Of those 32 million people, only 1.2 million of them live in senior housing units today, said Givens during 2015’s third quarter earnings call. The penetration rate is at just under 4 percent and a small increase of just 50 basis points to 4.5 percent would absorb all of the existing supply in the industry, Givens said. “As senior housing continues to be an increasingly accepted option for these individuals, we think this penetration rate will only increase over time,” she said during the call.

Givens also said that over the next five years, projections show that there will be another 6.5 million seniors over the age of 70. Assuming penetration rates stay constant, that’s an additional demand for more than 250,000 senior housing units. Put another way, we’re looking at a 10 percent increase in demand for inventory over the next five years alone. Competition? Nursing homes, retirement homes, and senior communities each cater to different clienteles. For example, an independent living facility would not compete with a high intensity nursing facility – even if the two were built next door to one another. Givens said that if one were to segment by category the construction taking place around SNR’s 152 facilities, then only 11 percent of the company’s total net operating income could be though to be experiencing competitive pressure.  It’s also worth noting the SNR has the ability to shift the mix of their portfolio by buying and selling over time if they feel one location or another has gotten crowded.

Fortress Investment Group externally manages the REIT and takes in between $20 million and $25 million in fees each year (about $17.5mm/yr run rate if we exclude fees charged by Fortress for buying and selling nursing homes). In addition, Fortress owns the two management companies (Blue Harbor and Holiday) that operate SNR’s 94 managed properties. Blue Harbor and Holiday are paid 2 to 3 percent more than average for their services. Fortress also gets 25 percent of any growth in an adjusted calculation of book value that’s beyond a 10 percent return on equity.

Holiday Retirement is owned by Fortress and is the second largest operator of senior housing assets in the US. Holiday manages properties that account for roughly 75% of SNR's net operating income. Fortress is in the process of selling Holiday, though it's unclear whether the change of control will mean SNR gets to renegotiate its contracts on more favorable terms.

Fortress also receives options as a bonus whenever SNR sells new stock to the public. Under this externally managed arrangement, some investors might be justified in feeling their upside is capped and their rights are being abused. Indeed, externally managed REITS are typically seen to pose a conflict of interest and often trade at persistent discounts. But we would remind those who feel that way that SNR’s share price has been cut in half since it was spun out of NCT in October of 2014, and that it currently trades at better than an 11 percent yield. So to those who feel abused, we say, why not get paid to wait? Also note that SNR did a secondary offering of shares for the purpose of acquisition finance and in doing so scared investors in the spring of last year (see stock price chart below). It also didn’t help that BAML put a sell rating on the stock at the time.

Share Price Trailing 12 months

https://www.dropbox.com/s/vu35i1kuka8jnd6/SNR%20Chart.png?dl=0

Source: Google Finance

Let’s suppose there were a change of control. A likely scenario could be that a strategic acquirer such as Ventas or perhaps HCP bought the REIT and was able to eliminate the ‘Fortress tax.’ That could free up, say, $25 million a year, and those savings alone capitalized at 6 percent to 12 percent would be worth between $200 million and $400 million, or $2.50 to $5.00 a share.

Fortress has a series of these so-called “permanent capital” vehicles that have all gotten smacked (NRZ, NCT, NEWM, ECT, FTAI)… like this stock, which has been cut in half. To be sure, these vehicles can be a double-edged sword. On the one hand, their presence is good because the management is smart. But on the other it’s bad because the P&L, balance sheet, and contracts are all rigged to feed Fortress instead of the shareholders. To that we say, so what? Those special vehicles and fees are the reason the stock is currently so cheap.

In other developments, New Senior Investment Group has attracted a 13D filing from John Levin & Co. In response to an open letter written by Levin, NSR recently conducted a $30 million Dutch tender offer at $9.00 a share and announced a $100 million buyback authorization. So despite Fortress’s aggressive fees, and minimal stock ownership (1.8 percent) they are not entirely deaf to the cries of shareholders.  After all, it can’t be easy for a group of over-achievers like the folks at Fortress to watch the shares plummet of no fewer than six permanent capital vehicles (SNR among them). Maybe they’ll cut their fees one day and maybe not. But for those new to the stock, Mr. Market has already mightily penalized the share price.

The low share price and related high dividend yield could be viewed in a different light. Perhaps it’s Mr. Market’s revenge! The 11 percent yield is the public’s fee to Fortress for the privilege of ‘permanent capital.’ This notion is reinforced by the observation that SNR is quite literally the highest yielding healthcare REIT in the market today and trades on the lowest ratio of 2016 price to FFO (similar to P/E). Please note SNR’s stats highlighted in green in the table below.

https://www.dropbox.com/s/dd5lz2c2477kero/SNR%20Comp.png?dl=0

Catalyst

SNR reports 2/25/16