Description

Recommendation

Long SBRA at $13.18 is a highly asymmetric opportunity.  I believe the upside is 56% plus dividends and the downside - from a value, not stock price perspective - is de minimus.

Why does this opportunity exist?

The high-level narrative is that occupancy of Skilled Nursing Facilities (SNF) and Senior Housing (SH) are down severely due to the pandemic. Since operators - the tenants of the REIT - have high fixed cost leverage, their ability to pay rent is being questioned.  

More specifically, EBITDARM lease coverage for the Genesis Healthcare relationship (4.6% of cash NOI), is well below 1x. Second, SBRA surprisingly wrote off straight-line rent receivables related to Avamere (9.3% of cash NOI) in the latest quarter (3Q21), causing an unexpected decline to GAAP revenue and funds from operations (FFO). Although issues with Genesis are known for some time, Avamere was on a recovery path right before the pandemic, and the impairment this quarter is a surprise.  

As a result, investors are concerned with the durability of earnings. At the very least, near-term earnings growth will be muted - thereby SBRA is uninvestable to many investors.

Background

SBRA is a healthcare REIT that owns SNF and SH facilities and loans collateralized by healthcare real estate. As of 3Q21, about 69% of annualized cash net operating income (NOI) is from SNF, 19% from SH, and 12% from Hospitals.  Roughly 86% of SBRA’s cash NOI is from triple-net leases.  Less than 10% of lease revenue will expire in the next two years. 

The Enlivant joint venture (assisted living) with private equity firm TPG is being sold.  SBRA has stated it will not purchase TPG’s stake. TPG is currently running the sale process and the transaction is expected to close in 2H22 or later.

Investment Thesis

SBRA is a stable business with high revenue visibility underpinned by: 1) a diversified tenant base; 2) long-duration lease term; and 3) steady organic growth - rent bumps - embedded in existing leases. The business model is straightforward and easy to analyze.  Moreover, the story will become even simpler once Enlivant is sold.  

In short, the value proposition of SBRA to tenants remains strong.  The headwind caused by the pandemic is transitory.  Current valuation offers an attractive entry point to own a steady cash flow business. The discount to intrinsic value will close as fundamentals stabilize (which is already happening at the tenant level). The dividend ($1.20 per share; 9.1% dividend yield) is covered even in my bear case scenario and offers downside protection. 

Diversified Tenant Base

The company originates as a REIT spin-off of Sun Healthcare Group back in 2010. It has since diversified geographically and more importantly, its tenant relationships. The portfolio consists of 398 facilities across 76 tenant relationships. The top ten tenants now generate slightly less than 55% of cash NOI, as opposed to being completely dependant on SUN at the time of the spin. 

As SBRA grows and reduces tenant concentration, S&P and Fitch have upgraded SBRA to investment-grade which has a material impact on its cost of debt.

Lease Structure Creates Margin of Safety 

Leases are structured to give SBRA  a senior priority in the capital stack as owners of the real estate. Importantly, each relationship falls under a master lease so that operators cannot “cherry-pick” and vacant unprofitable properties and keep the good ones. The master lease structure provides additional safety to SBRA.

Revenue Visibility and Steady Cash flow with Organic Growth

With the exception of the SH-managed portfolio and loans receivables, all leases are triple-net, meaning the tenants are responsible for all expenses, including capex.  Initial terms are typically 10 to 15 years, with 5 to 10-year renewal options which also limit re-investment risks and ensure steady cash flow.

Additionally, all leases have rent escalators that are linked to the consumer price index (CPI) subject to floors and caps in the range of 1% to 5%, offering protection against certain levels of inflation.  Some leases have a lower floor but never below zero.

Therefore, the net lease structure provides a high-margin, consistent income stream with built-in organic growth. Given the current macro environment, I expect escalators to hit their cap in the foreseeable future. 

Valuation Proposition to Operators Remain Strong

Operators enter into sales-leaseback of their real estate to enhance their return on equity. By partnering with SBRA, operators can invest capital into their core business (operating and managing SNF and SH properties), avoid locking up capital in the real estate, and thus improve their cash-on-cash returns.

Another benefit for operators is the debt is non-recourse. If the property runs into operating issues (i.e. covid), the operator can just walk away and let the landlord deal with the problem.

Leverage at Renewal/Restructuring Negotiation

In lease renewal or restructure negotiation, SBRA has leverage over the tenant as long as the property level profitability is near or above breakeven. 

Both landlord and tenant face switching costs, but the cost is higher for the tenant. The landlord can always find another operator; the tenant, however, has to make a binary decision as ownership lies with the landlord. The sensible decision is to renew unless the property is in deep distress. For that reason, the landlord can normally extract or maintain value in a lease renewal/restructuring.

For example, Genesis was still paying rent and SBRA is in-touch with other operators to take over the facilities if necessary.

Fundamentals at the Operator Level is on the Path to Recovery

According to the latest NIC MAP data, national SNF occupancy has improved for seven months after hitting bottom (71.5%) in January 2021. September occupancy stood at 75.1% which is down sequentially relative to August.  For context, pre-pandemic occupancy was 85.7%.

For SH, occupancy started to rebound in July 2021 and has continued into October. Occupancy improved 140 basis points in 3Q21 which is the highest sequential growth since 2005.

* SNF occupancy

Key Questions

Looking at the trend of AFFO/share, Is SBRA in secular decline?

A cursory look suggests earnings are in secular decline since peaking in 2016 and contradicts with the aforementioned steady business model. The reason for the discrepancy is due to the adjustments management made to the NAREIT FFO.  

Most of the adjustments have merits i.e. straight-line rents, loss on extinguishment of debt.  However, there are three add-backs in which I believe are recurring in nature or have a real economic impact; the adjustments actually distorted real earnings.

I have reversed the adjustments below and have also subtracted SH Managed Portfolio Capex to derive real earnings. As shown below, SBRA was growing earnings again after the Care Capital Properties (CCP) merger and the resultant portfolio restructuring efforts in 2018.

Is the management team bad capital allocators?

It’s fair to question management investment decisions given the CCP blunder. I don’t think management’s investment process is inherently flawed. I think the CCP merger was akin to a stock picker making a bad concentrated bet on a company that is “outside” of his or her investment process. In SBRA’s case management was chasing scale and tenant diversification - turns out it was a mistake.

Recall, SBRA still had significant tenant concentration in 2016.  Two relationships generated 48.5% of annualized revenue; Genesis (the old SUN) was 32.3% and Holiday was 16.2%.  In pursuit of scale, diversification of tenant relationships, and the consequent IG credit rating (which they got post-closing), management made an avoidable mistake by acquiring CCP, the SNF spin-off from VTR.  Post merger, exposure to Genesis and Holiday was down to 11% and 6% respectively. Two relationships acquired through CCP - Signature and Senior Care - quickly soured.

Management quickly remedy the mistake by restructuring the portfolio in 2018. They restructured the Signature lease, sold some Genesis assets, sold Senior Care assets after the default, and converted the Holiday lease into a RIDEA structure.  

As it turns out, the mistake did not permanently impair earnings power and growth.  EPS in 2018 were essentially the same as in 2015 and earnings growth resumed.  The pandemic is obviously a black swan event and I don’t blame management for current difficulties.

I view management’s decision to not purchase Enlivant as evidence they have learned from the CCP fiasco and therefore a repeat of the same mistake is unlikely. Given the size of the asset, uncertainties with covid, the timing of the recovery, and the potential restructuring of Avamere, management chose to be cautious, and I think the current course of simplifying the story, doing small acquisitions is the right one.

Valuation

Key Assumptions

I have reset the lease to 2x lease coverage.  I have also haircut North American Healthcare, the 2nd largest tenant, for conservatism.

Base Case

Assuming 9.5% cost of equity and 2% terminal growth, SBRA is worth $20.5/share ~ 56% upside plus dividends.

Bear Case

8.5% dividend yield (700 bps spread to 10-year treasury yield of 1.5%) implies the stock is worth $14.1 ~ 7% upside plus dividends. Pre-pandemic the spread is often under 700 bps.

Catalyst

Improvement in EBITDARM coverage

Increase in dividends

Occupancy normalization of SNF and SH post-covid