Description

Investment Overview

Brookdale (BKD) and the senior housing industry have been among the worst hit by Covid-19 due to higher vulnerability and death rates of the elderly population.  Since February, BKD’s census level declined 10% and shares are down 50% from pre-Covid levels, even after the recent rally from vaccine news.  However, I believe long-term fundamental of this business has not changed.  Brookdale provides “essential” services (e.g., meals, bathing, transportation, medication management, etc.) for the aging population that are difficult to replicate at home.  In fact, Brookdale will come out of this pandemic into one of the best supply-demand dynamics the senior housing industry has seen.  Demand will surge from Baby boomers hitting their prime age of 80+ to enter the senior housing community while supply growth will be subdued for the next 12-24 months from halted construction projects.  A combination of these two macro trends and pent up demand will help build back lost occupancy faster than the market expects. 

Brookdale owns the underlying real estate for 50% of the communities it operates, so I view this company as an OpCo / PropCo combination and value the real estate using a NAV approach.  Applying a conservative 7% cap rate on today’s depressed NOI for the owned properties, Brookdale’s NAV estimate is $6/sh, excluding value for the operating business.  This is a meaningful discount to NAV and a floor value that is 50% higher than today’s share price of $4/sh.  I think as the virus subsides, occupancy will return to the long-term average of 85% over the next 2 years as the company recovers from the pandemic.  This will increase NOI by $160 million from the owned properties and unlock an additional $10/sh of value at 7% cap rate.  Therefore, Brookdale’s NAV on the owned real estate alone is $16/sh, implying a 4x from today’s share price.  The leasing business is currently a money-losing business, but if investors view this as an option value, it could add an additional $4/sh as operations improve.  That boosts total NAV potential to $20/sh.  As such, Brookdale provides an enormous upside potential with a substantial margin of safety.   

Business Overview

Brookdale operates 725 senior housing communities spread throughout the country.  It provides independent living, assisted living, and memory care.  In this writing, we will group memory care and assisted living together and consider them as assisted living.  Under this breakdown, Brookdale’s portfolio is heavily weighted to assisted living: 75% assisted living / 25% independent living. 

Assisted living is typically considered recession proof, because it provides “needs”-based services at a great value.  According to a study done by Boston Consulting Group, assisted living is 40-60% less costly than re-creating similar services at home.  It also provides a community that is less isolating for seniors.  However, the average age of residents is high at 82-86 years and many enter with pre-existing conditions.  Average length of stay is relatively short at 2-3 years as residents typically pass away or move to higher acuity settings such as skilled nursing or hospitals.  These aspects make economics of assisted living particularly difficult during a health crisis. 

Brookdale’s portfolio is separated into three buckets: owned, leased, and managed.  Owned represents 50% of Brookdale communities and is where we will focus our valuation.  The remainder is mostly leased business primarily from the Big 3 healthcare REITS—Welltower, Ventas, and Healthpeak.  The leasing business is currently losing money as it struggles to stay above 1x EBITDAR-to-rent coverage ratio, meaning all operating income goes to paying rent.  Over the past 3 years, Brookdale renegotiated the underlying rents to raise the coverage ratio, but it has fallen back to <1x post-Covid.  There could be value in the leasing business if operations improve, but for now, we will consider this as an option value and focus on the owned real estate. 

Covid wreaked havoc, but BKD should recover rather quickly

As mentioned earlier, Covid hit the senior housing industry especially hard.  This caused Brookdale’s occupancy to drop 10% in a very short time from 85% in February to 75% in October.  As lock-downs and tour restrictions limit marketing to new residents, Brookdale’s move-ins plunged 40% year-over-year.  Move-ins are very important, because senior housing average length of stay is 2-3 years, which means 30-50% of units need to be refilled every year to maintain the same occupancy level.  However, to throw fuel into fire, Brookdale also experienced increased move-outs from higher death rates, lockdowns, and restrictions from outside visitors.  Seniors were moving back to live with adult children, because who wants to live in a place isolated from family visit?  Also, horrid news articles of virus spread at these communities created fear of both senior housing and skilled nursing facilities.  The drop in occupancy caused Brookdale to experience 8% year-over-year decline in same-store revenues, 600 bps margin compression, and 21% decline in same-store NOI. 

As the virus still surges across the nation and as the U.S. enters flu season, Brookdale will face a very challenging next 3 months.  However, I think the long-term earnings power of the business is unaffected.  This isn’t like malls or office where fundamentals have changed dramatically.  Demand and need for senior living is still strong and picking up.  Word from operators is that people are waiting for safety protocols to be lifted to actually pull the trigger to move.  Adult children are also realizing caring for parents is much harder than they had expected.  Google keyword search data support these anecdotes, where the data shows searches for terms such as “senior living” saw significant softness in March and April but have rebounded and trending to reach three-year high by February 2021.  Therefore, I am quite positive on a faster senior housing recovery than expected, particularly given senior housing residents and staff will be vaccinated in the first wave.  There could be herd immunity at these facilities very quickly in 1Q21, which I do not believe is factored into shares/estimates. 

Brookdale also has enough financial reserves to weather through the next couple months.  Balance sheet leverage is 50% with mostly secured mortgage loans on real estate, not at the corporate level.  Leverage is slightly higher than that of health care REITs with relatively low leverage of 30-40%, but not high enough to warrant concern.  It also has no significant debt maturity until 2022. 

Entering a favorable supply-demand environment

As the pandemic subsides, Brookdale will have favorable macro tailwinds with the long-awaited demand from aging Baby boomers finally arriving and declining new construction starts.  This is not a big secret, but the market seems to be ignoring these facts at the moment due to low near-term expectations around occupancy and operating income growth. 

The 80+ age cohort has been growing 0-2% annually for the past five years but will accelerate to 3-4% in 2021-2023 and 4-7% in 2024-2027.  This will add 4 million people to the 80+ cohort over the next 7 years.  Applying a senior housing penetration rate of 12% for this age group, that will add 480k of new demand.  According to NIC, a leading data provider in senior housing, there are 1.7 million senior housing units in the U.S, so 480k should fill 30% of today’s inventory.  If we also assume penetration rate to increase 0.5% by 2025, this will add another 100k of demand.  This is a reasonable assumption, because penetration rate has been trending higher 1% every 10 years from better awareness of senior housing value proposition.  Overall, I believe senior housing demand will surge over the next couple years due to favorable demographic trends.

On the other side of the equation, supply growth is set to decelerate as new construction starts come to a halt.  Senior housing supply growth has been an issue for some time as developers jumped to benefit from the aging population story.  Assisted living construction as a % of inventory was elevated at 6-8% for the most part in 2016-2019, while independent living was lower at 3-4%.  Starting in the 2^nd half of 2019, things started to turn the corner with new starts declining.  Then Covid put everything to a stop.  Lockdowns and declining occupancy scared developers and operators from expanding.  Within 20 minutes of Brookdale communities, new starts came down 70% from the peak in 2015 and construction pipeline is 30% lower year-over-year.  We believe this environment will continue for the next 12-24 months as halted construction projects take time to restart and operators have their hands full with the current crisis.    

Combining the demand and supply trends, demand growth will outpace supply growth by 200 bps annually over the next 2-8 years.  Today’s depressed Brookdale occupancy will be one of the lowest we will see.   

Raising all tides, but BKD is best positioned as an investment

Pandemic recovery and strong macro tailwinds will lift tides for all senior housing operators, but Brookdale provides the best risk/reward ratio.  Capital Senior Living and Five Star Senior Living are the only other pure-play senior housing operators that are public.  Most are operated by private companies or mom and pop operators.  However, Capital Senior Living has a leverage that is >90%, so it comes with a significant balance sheet risk and Five Star is fully valued after rising 100%+ this year.  Alternatively, you can invest in REITs, such as Welltower, Ventas, Healthpeak, Sabra, National Health Investors, but they don’t provide a clean investment into senior living, because they also own other healthcare property types like life science, skilled nursing, and hospital.  Additionally, they either trade at NAV or at slight discount to NAV, so they don’t provide as much of an upside as Brookdale.  Brookdale’s portfolio is well-diversified across 44 states to capture the benefits when the tide rises.  It is also priced in the market to provide a multi-bagger opportunity with a strong downside protection.

NAV valuation

Following are 3 scenarios to value Brookdale: (1) NAV of owned real estate at today’s depressed NOI, (2) NAV of owned real estate at stabilized NOI, (3) stabilized NAV for owned real estate + option value from leasing business. 

Analysts tend to value BKD on earnings multiple, but an NAV approach allows us to look at OpCo / PropCo separately with valuation emphasis on PropCo.  BKD is not currently seeking to spin-off PropCo, but a REIT spin-off is always an option and there have been several companies that successfully spun-off real estate into REITs (e.g., Park/Hilton, MGP/MGM, CareTrust/Ensign, Four Corners/Darden).  Investors have rewarded most spinoffs and have seen these transactions as effective and permanent methods to unlocking shareholder value.  

Bear Case: $6 NAV.  50% return.  For the trailing 12-months, Brookdale reported $370 million of NOI for the owned communities.  This represents a conservative measure of NOI as occupancy plunged to an all-time low of 74% and operating margin compressed to 20%.  Applying a 7% cap rate and subtracting all corporate liabilities result in a $6/sh NAV.  

I believe a 7% cap rate is reasonable for Brookdale’s owned real estate, despite challenges senior housing industry currently faces.  Recent senior housing transactions show that cap rates remained stable throughout the pandemic.  Welltower, the largest healthcare REIT, recently sold over $1 billion of senior housing assets at 5% cap rate or $325/unit.  This is a very strong pricing on a per unit basis, but the properties were higher quality than Brookdale’s.  A more comparable portfolio to Brookdale’s is Healthpeak (based on RevPOR, building age, geography, same-store NOI growth, and operating margins).  Healthpeak recently announced to exit its senior housing portfolio by selling more than $4 billion of properties in the high 5% pre-Covid cash NOI and 3% post-Covid NOI.  That amounts to approximately $250k per unit.  Comparing these large portfolio deals to BKD, a 7% cap rate is a conservative estimate, but appropriate for the size of the portfolio.  At 7% cap rate, BKD’s owned real estate is valued at $165/unit.  According to CBRE, development cost for new senior housing buildings range from $200k-$350k per unit.  Therefore, $6/sh is a comfortable floor for Brookdale valued at below replacement cost. 

Base Case: $16 NAV.  4x return.  The pandemic will pass and occupancy will return to the long-term average of 85%.  Once the occupancy level hits 75%, senior housing has high operating leverage from lower proportion of variable cost than fixed cost.  For every new resident, there are variable costs, such as food, PPE, utilities and nurses, but you don’t have to hire additional executive director, property manager or pay more for real estate-related costs to go from 75% occupancy to 85% occupancy.  Most of these costs are already in place.  Therefore, any additional resident will add higher margin gains to the bottom line, like the last seat on a plane. 

Brookdale’s average RevPOR per month is $5,000.  An 11% occupancy increase to 85% from today’s 74% will raise revenues by $200 million.  Assuming marginal operating expense of 20%, this will increase NOI by $160 million.  Capping this NOI at 7% and discounted to present value will add $10/sh to Brookdale’s NAV for total stabilized owned NAV value of $16/sh.  This is a 4x potential return from today’s $4/sh assuming owned real estate recovers to 85% occupancy.  I believe the market is not correctly pricing this additional value because it is focused on near-term operational challenges and occupancy. 

Bull Case: $20 NAV.  5x return.  The leasing business has been ignored throughout this analysis, because it is currently a money losing business and a smaller portion of value.  But if we make a similar assumption that occupancy for the leased business increases 10% and go through the similar math, BKD will add $70 million of EBITDA after paying rent.  A 10x multiple will add $4/sh to arrive at a total of $20/sh NAV. 

Risks

Change of consumer preference: If the perception of senior housing changes negatively, seniors could delay move-ins.  Also, Brookdale’s buildings are on average 20 years old and Baby boomers could have different tastes than prior generations.  This could lead to higher cap-ex to entice new residents vs. newer and shinier buildings.  

Uptick in construction: Barriers-to-entry for senior housing construction is relatively low.  If developers see operations improve and increase in demand, they could drive up supply growth again.  However, I think developers learned in 2016-2019 that you also need a strong operator to succeed in senior living.  And there are only a select few that can run them efficiently.

Elongated pandemic: If upcoming vaccines are ineffective and the Covid situation elongates for years, the industry could experience further decline in occupancy and a slower recovery. 

Catalyst

-        Asset sales, sale/leaseback, or real estate spin-off

-        Divestment of ancillary business

-        PE takeover

-        Increase in demand from aging population

-        Slower supply growth from halted construction activity

-        Government support

-        Covid vaccine