In the late 1990s, a double dose of trouble nearly sunk the nursing home industry. The federal government's Balanced Budget Act of 1997 gutted the Medicare reimbursement formula and cut into skilled nursing revenues. At the same time, plaintiff attorneys took aim at the industry for failing to roll patients over in bed often enough and providing other shoddy treatment, particularly in Florida and other states that possessed lax litigation laws.

The result: Longtime nursing home behemoths Integrated Health Services Inc., Mariner Post-Acute, Vencor and others sought bankruptcy or sold off their assets. But that's when private equity firm Formation Capital seized an opportunity. Between 2002 and 2006, the Alpharetta, Ga.-based investor spent $660 million to buy six nursing home portfolios comprising some 21,000 beds — about half in Florida and the remaining spread out over 20 other states — operated by six different companies.

Now, Formation Capital is cashing in on its investments. In June, Chicago-based GE Healthcare Financial Services agreed to buy Formation Capital's six portfolios for $1.4 billion. The deal, which includes 186 skilled nursing facilities, is scheduled to close sometime in the third quarter.

“Our industry went through a very tough time between 1999 and 2001, but now you have a very stable environment,” says Arnold Whitman, CEO of Formation Capital. “There's a terrific investment opportunity in the skilled nursing sector, particularly where you have good operators that are in modern facilities in good locations.”

Capital revival

Indeed, the GE Healthcare/Formation Capital deal signals a renewed interest of institutional investors in nursing homes, which, unlike the independent or assisted living sectors of the seniors housing industry, provide more hands-on care to short-term as well as long-term residents. During the first few years of this century, institutional investors avoided nursing homes even as they poured billions of dollars into other seniors housing assets.

But major transformations in the nursing home industry are attracting institutional investors, including a ground-breaking strategy shift in which nursing home operators are focusing on profitable short-term residents in need of physical rehabilitation.

The movement has spurred a debate among experts in the industry, with some suggesting seniors housing is bifurcating into distinct segments: residential facilities built for long-term renters who need little or no care versus skilled nursing centers; or “mini hospitals” that focus on short-stay patients who need more intense care.

But that argument ignores the continuing care retirement communities, which include acute care skilled nursing centers, assisted living facilities and independent living housing all in one campus, points out Michael Hargrave, sales and marketing director for the National Investment Center for the Seniors Housing & Care Industries (NIC). The Annapolis, Md.-based organization tracks business strategies and capital trends in the senior living industry.

The bottom line: Regardless of which model ultimately dominates the seniors housing industry, skilled nursing is once again attracting investors. Beyond the shift in strategy, capital providers say they like the government's consistent reimbursement policy, annual cash-on-cash returns in the low teens and stabilizing occupancies.

The average occupancy rate in skilled nursing facilities, for example, climbed one percentage point to 87.5% in the first quarter of this year from the last quarter of 2005, according to NIC (see chart below).

While average skilled nursing occupancy lags average occupancy in the independent living sector by five percentage points, the performance still illustrates improving nursing home fundamentals. In the fourth quarter of 2000, skilled nursing centers reported average occupancy of 82.4%.

Beyond increasing occupancy and dependable reimbursement policies, the outlook for skilled nursing homes appears favorable. The supply of new nursing homes is growing by 1% a year while the senior population is growing by 2% a year. In fact, some states are preventing new nursing home construction.

“It's a really great time for skilled nursing,” says John Cobb, senior managing director for GE Healthcare's real estate finance team. “You have consistent performance, and the supply is actually going down rather than going up.”

Tracking sales

Neither NIC nor other health care and real estate organizations track national property sales in the highly fragmented nursing home sector. Most experts say it's hard to separate real estate investors from regional operators who also own their properties.

In fact, while some companies such as Toledo, Ohio-based Health Care REIT typically invest in real estate and execute master leases with operators, Formation Capital invests in the nursing home companies who occupy the buildings as well as the properties themselves. In addition to receiving a rental income stream from operators, the private equity firm receives an even split of the company's profits.

What is clear is that lenders and other skilled nursing experts have noted an uptick in acquisition activity over the last six to nine months. NIC, which receives data from some of its members, suggests that average skilled nursing capitalization rates, which are a measure of a property's current yield, have stabilized at around 13%. That figure is down from 13.6% in late 2003.

Another measure of demand: Formation Capital paid $100,000 per bed for five skilled nursing facilities in the Dallas area, Whitman says, declining to provide more specifics. Although the facilities were relatively new, the price is more than double the average price per bed Formation Capital paid for the six portfolios earlier this decade.

“If you would have told me I was going to pay that price three years ago,” he says, “I'd have said you're drinking or smoking something that I don't want.”

Among other large transactions, San Francisco-based private equity investor Fillmore Capital earlier this year acquired Beverly Enterprises, a nursing home operator based in Fort Smith, Ark. The deal, which includes 346 skilled nursing facilities and some 75 other senior housing assets, was valued at $1.8 billion.

In July, Formation Capital joined with McLean, Va.-based JER Partners to pay $620 million for Tandem Health Care Inc. from New York private equity investor Behrman Capital. Tandem, based in Maitland, Fla., operates some 6,400 skilled nursing beds primarily in Ohio, Florida, Pennsylvania and Virginia.

“The skilled nursing industry generally sees waves of acquisition activity, and we're in one of those waves right now,” confirms Jim Thompson, senior vice president of Horsham, Pa.-based Capmark Financial Group, formerly known as GMAC Commercial Holding Corp. Thompson declined to elaborate on the size of Capmark's nursing home portfolio.

Limited investment potential

Experts don't anticipate a deep well of activity, however. Complex federal and state regulations govern the industry, but laws and reimbursement policies differ dramatically from state to state, adding even more potential complexity to owning skilled nursing centers.

The aging stock of nursing homes also is a concern (see sidebar, p. 77). And, Cobb adds, nursing homes derive a majority of their revenue from the federal government. But as in the 1990s, the government can change its reimbursement policy. “That's difficult for a lot of institutional investors to understand,” he says.

Still, the added risks have failed to dissuade some investors. In fact, the Formation Capital transaction marked GE Healthcare's first major equity investment in the seniors housing and care industries. Previously, the company had only provided floating-rate debt to health care real estate investors and had amassed a loan portfolio of $2.6 billion comprising medical office buildings, seniors housing properties and nursing homes.

But GE Healthcare added the private equity component after reassessing its products and receiving feedback from its clients when Cobb took the division's leadership reins three years ago. While the Formation Capital acquisition increases GE Healthcare's debt and equity property portfolio to $4 billion, the company anticipates announcing two more major seniors housing equity deals this fall, Cobb adds.

Profit equation

Skilled nursing's push for profitability certainly is behind the growing investor interest in the assets. How are operators doing it? Not only have nursing home companies adapted to the federal government's Medicare reimbursement formula that caused so much trauma in the late 1990s, but they're also trying to attract a larger percentage of Medicare and private-pay residents who require 30- to 60-day stays for physical rehabilitation or recovery. Those patients are much more lucrative than a nursing home's long-term residents, who typically receive Medicaid benefits, the state and federal program that primarily benefits the indigent.

Here's a likely scenario: An elderly patient who lives independently breaks his hip. He goes to the hospital and has surgery. While Medicare requires that patient to leave the hospital after a few days, he's still in no shape to return home. Medicare, however, will pay for an extended period in a nursing home, which is viewed as a lower-cost alternative to hospitals.

That's a major shift from the past, when long-term Medicaid residents generally generated the lion's share of a nursing home's revenues. But Medicaid typically provides nursing homes with a bare-bones reimbursement amount. In fact, experts say, many small nursing homes of 50 to 75 beds with a large percentage of Medicaid residents lose money. On average, Medicare reimbursements are two to three times the size of Medicaid reimbursements.

Case in point: Toledo, Ohio-based Manor Care, an operator of short-term post-acute and long-term care centers, received an average of $382 per day via Medicare reimbursements during the second quarter this year, compared with $151 per day in Medicaid and $228 a day in private reimbursements. Meanwhile, the company's quarter-over-quarter ratio, or “quality mix” of Medicare and private pay patients, grew two percentage points to 72% while occupancy grew one percentage point to 89%.

In a second quarter earnings call, Manor Care Chairman and CEO Paul Ormond told analysts that the company was positioned to take advantage of the growing number of short-term patients seeking lower-cost alternatives for acute care.

“Our company and our industry have done an awful lot to confirm over the past year that we are appropriate and capable providers for patients requiring much more intensive services and rehabilitation than we have traditionally cared for in the past in our skilled nursing centers,” Ormond commented.

Although federal and state laws still generally require nursing homes to take Medicaid patients, skilled nursing operators usually find success in facilities with an average of about 120 beds. Combined with a decent quality mix, that size allows operators to still take residents on Medicaid, which can help pay for an operator's fixed costs, Whitman says.

The bottom line: The model's success will attract capital to nursing homes going forward, he predicts. “This business has changed from being a Medicaid-driven industry for the indigent who end up in nursing homes in their last years, to one that's providing a lot of care and service in a low-cost environment,” Whitman concludes. “That's a dramatic and opportunistic evolution.”

Joe Gose is a Kansas City-based reporter.

Ungraceful aging of nursing home supply

The aging stock of nursing homes is a chief concern among healthcare experts, who have only recently witnessed institutional capital return to the industry after a several-year hiatus. In the top 30 metropolitan markets, the median age of nursing homes is 29 years and almost 33% of skilled nursing properties need upgrades, according to the National Investment Center for the Senior Housing & Care Industries, an organization based in Annapolis, Md., that tracks investment trends in the industry.

For nursing home operators, presenting a modern facility to potential residents is a critical marketing component, especially as a growing number of skilled nursing centers compete for profitable short-term residents in need of physical therapy.

“If you're taking your mom around to different nursing homes for post-surgical care, the quality of care matters a great deal, but so does the physical appearance,” says Michael Monticello, senior vice president of commercial banking for Chicago-based LaSalle Bank. “That type of resident can often make a decision between five different nursing homes in their community.”

As a result, many nursing home operators and owners have renovated their buildings to include rehabilitation centers, private rooms, private baths and other amenities over the last several years. Many are still pursuing renovations to add beds or expand therapy centers.

During the second quarter of this year, Toledo, Ohio-based Manor Care spent some $40 million to expand 36 skilled nursing centers — most of which focused on physical rehab space additions — and to build five new skilled nursing homes. In the first quarter, Toledo-based Health Care REIT acquired seven skilled nursing properties totaling 766 beds in Ohio and is conducting a major rehab of all the assets. The total capital committed for the purchase and renovations: $63 million.

Some skilled nursing facilities are simply obsolete, however, and cannot be rehabbed cost-effectively. But a wholesale replacement of such buildings is hardly on the horizon: Many states require nursing homes to acquire a “certificate of need” before any new beds can be added to the existing stock, restricting new development. And some states have placed a moratorium on the issuance of certificates of need.

“The aging stock is a huge and very important issue,” says Arnold Whitman, CEO of Formation Capital. “The overall population is dated and is in need of repair or razing, one or the other.”
Joe Gose