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What is the RIDEA structure?

posted Aug 26, 2014, 9:25 AM by Scott McCorvie   [ updated May 6, 2017, 7:41 AM ]

By Scott McCorvie, Senior Living Growth Advisors - www.srgrowth.com.
There’s been a lot of news lately about the RIDEA structure, but there seems to be some confusion on the make-up, utilization, and perceived benefits and risks of the structure. Within this article, I’ll examine the history of the RIDEA act, describe how it is typically utilized by REITs, and list some of the benefits and risks inherent within the design.

RIDEA (typically pronounced Rye-Dee-Uh, or Rye-Day-Uh) is an acronym that stands for the REIT Investment Diversification and Empowerment Act. This legislation was enacted in a REIT reform act of 2007 and allowed REITs to change the way they accounted for healthcare real estate income. Prior to this act, healthcare real estate investments had to be structured as leases (typically triple-net leases) with annual rent payments and escalations. The RIDEA act allowed REITs to participate in the actual net operating income, as long as there was an involved third party manager. The legal structuring includes creating Taxable REIT Subsidiaries (TRS), with an in-place lease between the landlord and tenant entities (both owned by the REIT).

How did this change the landscape of the industry? Instead of just underwriting a steady rent payment and annual escalation, REITs could analyze and underwrite larger shifts in operations and income. This is critical for value-add projects where there is material upside from enhanced operations and occupancy, and opened the door for REITs to expand their investment horizon (including joint venture structures).  Additionally, the underwriting mentality shifted from tenant credit profile and lease coverage analysis (net operating income / rent payment), to sophisticated operating underwriting proforma models, in-depth market analysis, and operator knowledge and industry experience.

So, what are some of the benefits of this structure? The main benefit is the ability for the REIT to invest in non-stable assets, and the opportunity capture increased annual income growth from enhanced operations. Instead of the standard 2-3% rent escalations in a triple-net lease structure, the REITs can benefit from the market rent increases (or rent adjustments), occupancy increases, and overall operational improvement and efficiencies. This has led to normalized income growth well above the 2-3% range. For example, during the second quarter of 2014, Ventas (VTR) reported their U.S. RIDEA portfolio (called their seniors housing operating portfolio) experienced income growth of 6.6% on a year-over-year, same-store basis. This is almost double the range of any typical escalation within a NNN lease investment. Another benefit is a hedge against inflation, as increased inflation will lead to larger increases in rental rates, operating expenses, and overall NOI. The Tenant/Manager can also benefit, as they do not need to assume the long-term liability, but still maintain favorable management fees from operations, as well as potential incentive management fees linked to superior performance.

But, there are also some additional risks. Along with the ability to greatly increase the operations, there is also a risk of decreased operations and income (no credit guaranteed rent). However, this can be partially mitigated by creating credit enhancements within the Management Agreement (to be discussed in a later article). These credit enhancements can also create favorable alignment between the REIT and Manager, as both are focused on maximizing operational efficiency and operating income.  Additionally, since the REIT is participating in the operations, there is additional risk of potential legal liability. There are also increased on-going operating costs, including a TRS income tax (from the difference in the TRS lease rent), as well as on-going capital expenditure investments to maintain a competitive advantage and appeal within the market. Last, it’s critical the REIT maintains a solid asset management platform, including constant monitoring of operating metrics, and a team experienced in seniors housing operations and market fundamentals.

Overall, the RIDEA structure has definitely changed the way REITs look at potential investments, and with effective underwriting, program implementation, and asset management, and coupled with traditional NNN investments, the RIDEA structure can positively enhance the income growth and overall returns of a seniors housing portfolio. Feel free to contact me at scott@srgrowth.com. Or, visit my consulting website at www.srgrowth.com.

Per Resident Day Analysis

posted Jul 15, 2014, 7:59 PM by Scott McCorvie   [ updated May 6, 2017, 7:41 AM ]

By Scott McCorvie, Senior Living Growth Advisors - www.srgrowth.com.

 

Whether you’re creating a proforma model with varying lease-up and stabilization scenarios, or comparing the operating performance between different assets and operators, you’ve probably heard the term, “Per Resident Day” (PRD).  The PRD metric is one of the most useful performance tools within the industry, and can be successfully leveraged to add value in a number of different situations. Within this article, I’ll analyze the actual PRD calculation, discuss why this industry tool is so useful, and demonstrate several ways it can be used to create value in everyday applications.  

Let’s start with the actual calculation. Just as it sounds, the PRD calculation is the actual hard revenue and expense line-items divided by the number of resident days in the period (month, quarter, year, etc.). The revenues and departmental expenses are easily identified within the financials, but what if you don’t know the number of resident days? Well, this can actually be estimated by taking the number of occupied beds in the period, adding an estimate (or ratio) for second residents (double occupied units), and multiplying this figure by the number of days. So, if you had 90 occupied beds in June, and typically 10% are double occupied, the calculation would be ((90+9) x 30) = 2,970 resident days. You would then take the monthly expense (i.e., raw food costs of $18,500) and divide by the number of days (2,970) to calculate the PRD ($18,500 / 2,790) = $6.23 raw food costs PRD.

So, why is this metric so important? One of the greatest advantages in this tool is the ability to compare the operational performance between properties with varying sizes (number of units) and occupancy. Obviously the expenses are going to be higher at a 100% occupied 120-unit AL/MC property compared to a 90% occupied 40-unit MC property, but how do the same departmental expenses compare on a PRD basis? The 40-unit property may be doing a more efficient job in expense management, and actually have a lower PRD expense indication than the larger property. Or, the smaller property may be doing an excellent job in dietary, but the housekeeping and nursing expenses are much higher PRD. Having a solid understanding of the PRD performance between properties is not only valuable in comparing performance, but can also be used to identify key areas of inefficiency and help create plans for future improvement. Linking this performance to industry reports (State of Seniors Housing, etc.) can provide dynamic industry benchmarking analysis and dashboard reports.

PRD assumptions are also very crucial in creating sophisticated senior housing proforma models. Analyzing the revenues and expenses on a PRD basis can show regressions and trends within the performance that can be utilized to more accurately project the go-forward performance. Linking the proforma model to the appropriate PRD assumptions can also provide a more precise sensitively and scenario analysis. Last, including the PRD  variables with a multi-year staffing model, unit revenue matrix, and a monthly absorption can provide more in-depth forecast on future lease-up performance and stabilization. This can be crucial in accurately projecting the financial performance for new development, conversion projects, management transitions, and other lease-up scenarios.

Overall, the PRD metric is one of the more vital tools within the industry, and can be used within a number of applications. Feel free to send any comments or questions to me at scott@srgrowth.com. www.srgrowth.com

Senior Housing Development Feasibility

posted Jul 8, 2014, 7:44 AM by Scott McCorvie   [ updated May 6, 2017, 7:42 AM ]

By Scott McCorvie, Senior Living Growth Advisors - www.srgrowth.com.
With the increasing number of seniors housing transactions trading at a large premium to the replacement cost (sometimes double), along with the increased availability of construction debt, there seems to be a renewed energy in the seniors housing development space. However, what makes a seniors housing development project feasible?

Simply put, a development project is feasible with the expected returns are greater than (or equal to) the weighted average cost of capital (WACC). But, what is the WACC of each project, and how is it calculated? As an equation, the WACC is a percentage-based average of the cost of debt added to the cost of equity (WACC = (% debt x cost of debt) + (% equity x cost of equity)). Since the equity is in a riskier position then the debt (remember, the debt holder will always be paid first), the cost of equity is always higher than the cost of debt.

Let’s say you receive a 75% loan-to-cost construction loan with an effective (inclusive of loan fees, etc.) interest rate of 6%. Also, let’s say you were able to secure the remaining 25% equity from an investor expecting to make a total return of 20%. Multiplying these together will give you the implied WACC of 9.5% ((75% x 6%) + (25% x 20%)). In other words, you would need an unleveraged internal rate of return (IRR, or annualized total return) higher than or equal to 9.5% for the project to be feasible.

Since the internal rate of return includes a holding period assumption and uncertain exit cap rate (to be discussed in a later article), another simpler way to analyze the feasibility of the project is to measure the WACC to the stabilized yield-to-cost. The stabilized yield-to-cost is similar to a cap rate, but divides the expected stabilized net operating income by the total development budget (YTC = stab. income / dev. budget). The development budget should include all fees and costs needed to fully stabilize the project (including pre-marketing costs, development fees, and lease-up/interest reserves). So, for a senior housing development project to be feasible, the stabilized YTC must be higher than the WACC. Also, the selected market rates, care charges, and operating margin should be carefully analyzed to determine the suitability of the proforma assumptions. Since the annual income drives both feasibility metrics, an unrealistic proforma model can artificially inflate or deflate the returns.

Last, one of the most important metrics to determine the feasibility of the seniors housing development project is to analyze the total development budget on a per unit basis. If the development per unit cost is too high, there is risk that another developer will construct a less expensive seniors housing project down the street, be able to charge lower rates/fees, and most likely drive down your operating performance. But, what is an appropriate development cost per unit? Unfortunately, this varies from market-to-market (varying land costs, entitlement, licensure, CON, construction costs), and operator-to-operator (varying pre-marketing costs, management fees, lease-up reserves), but generally can be compared on a segmented basis by allocating the land costs, hard costs, soft costs, FF&E, contingencies, developer fees, pre-marketing costs, and reserves. Feel free to e-mail me at scott@srgrowth.com. www.srgrowth.com.

Senior Housing Cap Rates

posted Jul 4, 2014, 6:09 AM by Scott McCorvie   [ updated May 6, 2017, 7:44 AM ]

By Scott McCorvie, Senior Living Growth Advisors - www.srgrowth.com.
If you're involved in the senior housing real estate industry, you’ve likely heard the term ‘cap rate’ more than once. But, what is a cap rate? And, how does it affect the value of a senior housing property? And last, what are some senior housing characteristics that can impact the cap rates?

Capitalization Rates (or Cap Rates) are one of the primary metrics used by investors in evaluating commercial real estate investments. In short, cap rates measure the relationship between the price (or value) to the expected annual income (cap rate = income / price). Therefore, given even income at a property, a lower cap rate indicates an investor is willing to pay more for a property with a higher cap rate indicating a lower price.  

How does this affect value? As in algebra, as long as we know two variables, we can solve for the third. So, if we know (or can reasonably estimate) the expected annual income at the property and can derive an appropriate cap rate from similar market transactions, we can solve for the expected price, or value (value = income / cap rate). So, the expected price of a senior housing property can ultimately be derived from both the income and market expectations of the capital (cap rate).

However, what property characteristics contribute to the variance in cap rates? Like all investments, an investor requires a higher rate of return for taking on additional risk. Simply put, with all other things being equal, cap rates measure the perceived risk in an investment. So, what makes a senior housing real estate investment more or less risky? One of the major factors in senior housing risk relates to the acuity level. A lower-acuity independent living community is not licensed, and does not provide nursing services, so the risk of improper care (or losing an AL license) is much lower than a higher-acuity memory care or skilled nursing facility. Although the income might be higher at a memory care facility, resulting in a higher value per unit, the overall cap rate will be lower with level income. Accordingly, a property located in a larger market is deemed to have a larger demand and employee pool, and is perceived to be a lower risk to a similar property in a smaller, tertiary market.

There are many characteristics that can impact the perceived risk and cap rate at a property. In general, qualities that are perceived to have lower risk include larger markets, stabilized operations, larger property size (number of units), private pay reimbursement, newer construction, continuum of care, reputation of operator, and superior building quality. Alternatively, the risk is perceived to be higher (with higher cap rates) in smaller, tertiary markets, non-stable operations (lease-up or turnaround), smaller property size (less units), management transitions, government reimbursement (Medicare and Medicaid), older construction, and inferior building quality. In short, properties with the lower risk profile tend to trade for lower cap rates than similar property types with the higher risk profile.
Although there are many other macro-level influences on the cap rate environment (capital markets, interest rates, supply of equity/debt, etc.), the above attributes  are a few of the micro-level attributes. Also, when a property's income stream is inconsistent, an investor may also use a discounted cash flow analysis to calculate the present value of the future income stream (with an appropriate risk-adjusted discount rate). Feel free to send me your questions and thoughts to Scott McCorvie at scott@srgrowth.com, www.srgrowth.com.

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