CareTrust REIT, Inc. Q2 FY2022 Earnings Call

Ladies and gentlemen, thank you for standing by. Welcome to CareTrust REIT Second Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. I would now like to turn the call over to your host Lauren Beale. You may begin.

Thank you, and welcome to CareTrust REIT's second quarter 2022 earnings call. Participants should be aware that this call is being recorded, and listeners are advised that any forward-looking statements made on today's call are based on management's current expectations, assumptions and beliefs about CareTrust's business and the environment in which it operates. These statements may include projections regarding future financial performance, dividends, acquisitions, investments, returns, financings and other matters and may or may not reference other matters affecting the company's business or the businesses of its tenants, including factors that are beyond their control, such as natural disasters, pandemics such as COVID-19 and governmental actions. The company's statements today and its business generally are subject to risks and uncertainties that could cause actual results to materially differ from those expressed or implied herein. Listeners should not place undue reliance on forward-looking statements and are encouraged to review CareTrust's SEC filings for a more complete discussion of factors that could impact results as well as any financial or other statistical information required by SEC Regulation G. Except as required by law, CareTrust REIT and its affiliates do not undertake to publicly update or revise any forward-looking statements where changes arise as a result of new information, future events, changing circumstances or for any other reason. During the call, the company will reference non-GAAP metrics such as EBITDA, FFO and F-A-D or FAD and normalized EBITDA, FFO and FAD. When viewed together with GAAP results, the company believes these measures can provide a more complete understanding of its business, but cautions that they should not be relied upon to the exclusion of GAAP reports. Yesterday, CareTrust filed its Form 10-Q and accompanying press release and its quarterly financial supplement, each of which can be accessed on the Investor Relations section of CareTrust's website at www.caretrustreit.com. A replay of this call will also be available on the website for a limited period. On the call this morning are Dave Sedgwick, President and Chief Executive Officer; Bill Wagner, Chief Financial Officer; and Mark Lamb, Chief Investment Officer; and James Callister, Executive Vice President. I'll now turn the call over to Dave Sedgwick, CareTrust REIT's President and CEO. Dave?

Thank you, Lauren, and good morning, everyone. Today, we'll give you an update on the progress we're making on the announced dispositions, and on our current outlook for new investments. With this quarter supplemental, we begin to preview what the portfolio will look like after the dispositions or re-tenanting work is complete, by excluding those properties and tenants from the deck. But before I hand the call over to James, Mark and Bill, let me comment on the extraordinary time in which we live and operate. Since we announced plans in February to derisk the portfolio, the world has changed quite a bit for us and for our operators. The surge in inflation, rising rates, and daily talk of a recession have an impact. But for us and skilled nursing operators, it's not all headwinds. For our disposition work, yes, the motivation and ability of some buyers in the market has softened, particularly those dependent on lenders. That's okay. We adapt and run parallel paths of selling and re-tenanting and ultimately, we will end up with a substantially derisked portfolio. We're on track to close on most of that work in Q4. For our investment activity, as rates continue to rise and lenders become more cautious, we would expect a couple of things to tip in our favor when it comes to growth. First, pricing should moderate, and second, sellers should prefer the certainty buyers like ourselves present. We're seeing evidence of that just in recent weeks. Now as for how today's macro environment affects our operators, again, there are two sides to that coin. On the one hand, the persistence of COVID, inflation and a tight labor market make today a time unlike any of us can recall. The best operators truly distinguish themselves during times like this. Historically, skilled nursing has been a net beneficiary from recessionary periods because as the labor market loosens, people come back to work. Now looking at the portfolio, we reported 94% of rent collected in the quarter with cash deposits. And as for July, we collected 94% exclusive of any cash deposits. August collections appear to be in line with July. Average quarterly occupancy for skilled nursing operators grew by 1.4% or 98 basis points over Q1 and for seniors housing, occupancy grew 2.8% or 215 basis points over Q1. Now as for the regulatory environment, we were encouraged to see the final market basket adjustment from CMS come in better than expected at 2.7%. And we're also pleased to see CMS decide to recalibrate PDPM over two years instead of all at once. With that, I'll turn it over to James to update you on the disposition progress.

Thanks, Dave. We continue to actively work on selling, re-tenanting and repositioning certain assets in an effort to fortify the portfolio. Since our earnings call in February, the acquisition disposition market for skilled nursing and seniors housing facilities has been in a state of change as lenders considered tightening or pulling back on lending due to concerns of a possible recession. Despite the changing circumstances, during Q2 and since we have made meaningful progress on pushing our plans for dispositions forward. We have entered into a purchase and sale agreement to sell the skilled nursing portfolio that we brought to market. We've also signed up several letters of intent and as a result are well into the negotiations on several purchase and sale agreements. We're also negotiating several LOIs and currently we continue to regularly receive written offers from potential buyers that we are considering and evaluating. As Dave mentioned, in some cases, we've adapted and are pursuing parallel paths of selling and re-tenanting with the same ultimate destination in mind, a substantially derisked portfolio. We remain on track to close and wrap up much of the disposition work by the end of Q4. And we'll provide updates to you as deals further solidify. With that, I'll turn it over to Mark.

In Q2, we closed on a $75 million C piece loan, which is secured by a large portfolio of skilled nursing facilities located in the mid-Atlantic at a rate of 8.4% and a term of five years. As part of the transaction, we also originated a $25 million mezzanine loan that bears a rate of 11% for 10 years. This past Monday, we closed on a $22.3 million “B” piece secured by five California skilled nursing assets. The loan is a SOFR-based rate with a floor of 8.5%. These fundings bring our 2022 year-to-date total up to $144 million at an average of approximately 9%. Looking into the market, we've seen an uptick in our bread and butter acquisition opportunities for skilled nursing facilities. Seemingly, as the debt markets tighten up, in some instances sellers are looking to buyers that have the ability to check for the acquisition; we view this as a shift in the market to prioritizing certain deals we have closed, a position the REITs have not enjoyed for some time now. Despite these shifts, we are very careful to underwrite in value assets in today's market as we need to ensure the fundamentals at the facility level are in place or have the ability to reach the necessary key factors for operators to execute on their business plans for the life of our long-term leases. The pipeline today is in our normal $100 to $125 million range, with a couple of big deals out there that could push this number up. As we said before, large portfolio transactions are low probability for us. But we continue to look for opportunities that can be accretive to our operators' deal perspective by either adding buildings in a market or by entering a market with enough purchasing power to attract the right kind of staff to effectively plan for providing first-class resident care. We will continue to execute on our acquisition strategy of disciplined growth just as we have over the past eight years in building CareTrust. And now I'll turn it to Bill to discuss the financials.

Thanks Mark. As previously mentioned, good progress continues to be made on our dispositions. When they firm up and we begin announcing the multiple expected sales deals, which will make the forward-looking financial picture a little more clear, I would expect that we would resume publishing guidance. In the meantime, stay tuned for the upcoming disposition announcements. Now under the quarter and a little color on the numbers. For the quarter, normalized FFO slightly decreased 0.7% over the prior quarter to $35.6 million. Normalized FAD slightly decreased by 1.7% to $37.5 million. On a per share basis, normalized FFO was flat over the prior year quarter at $0.37 per share. Normalized FAD slightly decreased by 2.5% to $0.30 per share. Rental income for the quarter was $46.8 million compared to $46 million in Q1. The increase of $800,000 is due to the following three items. One, a $253,000 decrease in cash rents which is made up of unpaid rent of $916,000 offset by an increase from new investments and CPI bumps of $663,000. Two, an increase in reimbursed property expenses of $77,000 and three, a decrease in write-offs of $977,000 as we had none this quarter. Interest expense was up $561,000 from Q1 due to a higher LIBOR rate, which accounted for most of the increase totaling $502,000 and higher borrowings under our revolver, which made up the remaining $59,000. G&A expense was down $237,000 from Q1 to compensation-related items of $655,000 offset by other corporate-related items of $418,000. I'm expecting this year's G&A to be around $20 million. Cash collections for the quarter came in at 93.9% of contractual rent and includes the application of $900,000 security deposits. Without the application of the security deposits, cash collections was 92.1% of contractual cash rent. In July, we collected 102.1% of contractual cash rents due from our operators, but that percentage includes cash deposits; excluding those cash deposits, contractual cash rents collected was 94.1%. We expect August collections to be similar to what July with $0 coming from the application of security deposits. Our liquidity remains extremely strong with approximately $16 million in cash, and $385 million available under the revolver. Leverage also continued to be strong with a net debt to normalized EBITDA ratio of 4.3 times. Our net debt to enterprise value was 30.2% as of quarter end, and we achieved a fixed charge coverage ratio of 7.5 times. And with that, I'll turn it back to Dave.

Thank you, Bill. We hope this discussion has been helpful. Thank you for your interest, and I'd be happy to take your questions.

Our first question comes from Austin Wurschmidt with KeyBanc Capital Markets.

So it sounded like in the release, you talked about running this parallel process and there's a chance that you could re-tenant maybe more of these assets than maybe it seemed like 30, 60 days ago. So I guess I'm just curious, first, am I reading that correctly? And then given your comments about still some strength in the transaction market, why not sell into that trend?

Well, I'll start, and you guys can clean up for me. I'd say that it's pretty fluid, not just on the buyers' ability, but also on the operators' ability to step in, in some cases where we are today with the particular operator that we might have liked to enter originally. Maybe they’re a lot stronger today than they were at the start of the year, and that option to re-tenant offsets. And for those into an existing net lease are pretty attractive. In some cases, for that reason and other cases, we're looking at it because just an abundance of caution, we want to have a solid plan B in case somebody on the buyer side falls through.

How much of this reflects an improvement across the portfolio and fundamentals? Is that a factor? How should we view the timeline or process needed to re-tenant and initiate improvements compared to the ability to redeploy that into a more stabilized acquisition?

The first part of your question does have a part to it, as we do see some operators’ portfolios improving, that gives them the mindset to shift from defense to offense. And there might be an opportunity to. From a timing perspective, it's always going to be quicker, generally speaking, to re-tenant than to a sales process. So in any event, like James mentioned, we feel like, even though things have gotten pushed a month or two because of how the world has changed, we're still confident that most of this work should be done by year-end.

Next question comes from Steven Valiquette with Barclays.

I guess my question, it kind of builds a little bit on the first one. As you think through all the scenarios, and that last comment you made about re-tenanting being quicker than asset sales, and then having to redeploy that. I guess I'm just curious how high you value the avoidance of dilution in all your decisions around this versus just doing what's right for the company longer term. Consensus right now still has numbers going up, pretty meaningfully versus '23 versus '22. And you're not giving any guidance today, but how should we just think about potential short-term dilution around this whole process versus what you thought six months ago? And just any updated thoughts around that at a high level would be great.

Our mindset has remained consistent since we initiated the asset management and disposition derisking process in February. We were not merely reacting to the few operators who faced payment issues; we also anticipated potential difficulties for others. That’s how we identified the specific assets and operators we are working with. Our preference continues to lean toward disposition rather than re-tenanting in most situations, as our analysis suggests that this approach will yield greater long-term earnings. Essentially, we compare the future rental income from redeployed sales to the potentially lower earnings from re-tenanting. This analysis is central to our decision-making, and we will always prioritize the long-term financial strength of our portfolio.

Our next question comes from Juan Sanabria with BMO.

Just curious on the transactions market, you kind of spoke to a change recently. So what do you think that actually means in terms of where cap rates could be and/or coverage levels could be, if you're able to kind of reengage traditional fee simple acquisitions for either seniors housing or skilled nursing? I'm not sure how the pipeline is skewed.

I believe cap rates are not shifting as rapidly because we've observed a phenomenon in recent weeks. In the traditional buying or bank lending markets, lenders are becoming more cautious, not extending their reach as far in the capital stack, and obviously, interest rates are increasing. We're beginning to see interest in opportunities where potential partners might join us or where sellers might approach us, along with brokers who recognize our capacity to fund transactions. It's still too early to determine the trajectory of cap rates. We're witnessing a transition from competitive auction processes, with multiple rounds and high bids seen in Q1, to a softer market where our transactional expertise and straightforwardness are valued, along with our ability to pay. While we're observing a decline in per bed pricing, it's premature to say how rapidly cap rates are increasing; it's still an evolving situation. However, I believe we'll gain clarity in the next few quarters.

Will you get to a point where the use of pricing per unit is dropping, just wanted to clarify that?

Price per bed is, in some markets, we're starting to see it's down pretty substantially.

Okay. And then just maybe a clarification on a point made on the prepared remarks. I'm not sure if I misunderstood this. Did you say in August there's no security deposits expected in terms of helping to pay cash rents? Is that because the security deposits have been utilized? Just clarification there?

No, what I meant was, we expect cash collections to come in at around 94%, which does not include using any security deposits.

And then one quick one, I noticed Noble dropped off the top tenant. Is that because they're part of what's anticipated that you said that the supplemental is changed or just curious on that driver?

So the change in the supplemental this quarter is previewing what we expect it to look like pro forma of the disposition and re-tenanting work to be complete.

Our next question comes from David Rodgers with Baird.

Dave, maybe you can talk a little bit about originating more loans versus acquisitions of your more traditional product? Obviously, that was skewed one way in the quarter and year-to-date. But how do you view that with this emerging acquisition pipeline? Are you still balanced between them, or how are you leaning I guess, at this point in time?

We're primarily focused on traditional acquisitions, as they are essential for our long-term growth. This year, lending and debt investments have become a significant way for us to allocate funds in the absence of traditional options. It's also allowed us to strengthen our relationships with operators we respect or already work with. Moving forward, we need to be mindful of upcoming surety schedules. If we have $50 million due in 2027, failing to grow from that position means we’re just maintaining our status quo. We see our debt strategy primarily as a means to build relationships. We will continue to prioritize working with operators we trust and who are committed to improving the sector. However, we will always emphasize long-term growth over debt as we consider where to invest our resources.

Maybe just a quick follow-up on that. I think of late, you've talked about branching into different product types that would still fit within, like behavioral health and other things. Is that part of this investment pipeline or is it really the core of what you've historically done that's emerging where that maybe becomes less relevant?

Yeah, currently on the $125 million pipeline, I don't think there's any behavioral health in there today. But when we do quote it now and in the future, we will be in those types of investments pipeline. We do expect to pursue real health investments. And we would like to grow that investment. I'd say we're kind of in the means of putting those operators together. And like in skilled nursing and seniors, having a great pipeline will be critical to growing that for us.

Our next question comes from Daniel Bernstein with Capital One.

I guess I have another follow-up on the pipeline as well. Just trying to understand maybe a little bit where the opportunities are coming from? Are they coming more from your existing operators, or kind of what you would do with tightening lending standards, or lending market that you’re having a bunch of new potential relationships coming your way?

We have been collaborating with various brokers, buyers, and operators in the past, so the opportunities are coming from a wide range of parties rather than just one specific group. We strive to be the best transactional partner possible. In some cases, it might be necessary for us to take a more supportive role in a transaction, especially if a project is still in its early stages, allowing us more time to evaluate who the operators are partnering with on the buildings. Overall, we are engaging with many of our existing relationships, and we've started to receive inquiries from them.

And I have a question on how you're thinking about potential wage growth within the seniors housing and SNF space. It seems like looking at the job report today, there were some pretty good hiring in health care. I think some of that has to do with wages in total comp for seniors and SNFs coming up to where the broader healthcare space has been. And so if you think we maybe should expect some moderation in wage growth in the seniors housing and SNF space?

You would think so. From the analysis of our portfolio, we saw wages peak I think in March, February, March, and it's come down somewhat modestly since then, anecdotally, as we've talked with operators as recently as yesterday. What we're hearing is that applications for jobs are up. Agency usage is trending downward. I spoke with an operator on the East Coast the other day, who said they are now hiring everybody at their facility, a seniors housing operator, at the historical rates before the big spike. So while it's still elevated, I think we're going to see some signs that wages are moderating again.

Next question comes from Tayo Okusanya with Credit Suisse.

A couple of quick ones for me. The first one is, we all realize that there's a lot going to transition right now. I guess some of your peers that have gone through similar things. And I think some of them have kind of given us some sense of net-net what the impact is, or what they will to their revenues from the expected combinations of sales and re-tenanting kind of new rents. I mean, are you guys at the point where you can kind of provide some color in regards to that when this is all kind of said and done?

My sense is that we will be in a position to do that on our next call. But at this point, I think it's just a little bit premature. I think, compared to our peers, it's probably fair to say that we started this process of asset management and restructuring work much later than they did. And so little bit of a tough apples-to-apples comparison. But as soon as we can, which I think will be next quarter, we'll be able to give you a little bit more than we have so far.

And then stripping out the 27 assets and taking a look at the sub, you still have a handful of tenants where the rent coverage still kind of skates at or below one times. Some of the opening remark comments you made were helpful. But I guess at the end of the day, how do you look at those new tenants relative to your outlook, both for skilled nursing and senior housing?

So as you look at the sub, you may see a handful of theirs that don't have the coverage that we would like to see. I think one thing I would point out is the timeframe here is through March of this year, which really reflects some of the hardest hit quarters and periods for our operators as it relates to COVID and the labor market and all of that. So, it is a pretty tough period to look at. I think historically, if you look back at that period, it’s maybe the toughest for operators. If you drill down at the individual operators in our top 10, what I can tell you is that based on our ongoing and regular conversations with them and what I would characterize as a very healthy, positive and transparent relationship with each of those folks that are in our top 10, we really have concern about defaults in the short-term there. If you look down at the all other tenant list, you see looking at the EBITDAR coverage, excluding HHS funds, 0.99 times for all other tenants. A little bit of color on that for you, Tayo, is if you take out just one operator who actually has negative coverage, that 0.99 times goes to 1.75 times. And the total portfolio coverage goes from 2.02 times in that column to 2.11. Now, that other operator is part of the 32 assets that we've talked about. Although we talked with them about pursuing that early on in the year, they are working through a turnaround plan and are current with their obligations and continue to show improvement. So that's some color on our coverage slide.

That's actually very helpful. Then one more, if you could indulge me please. So the color you guys give about debt markets getting tougher and kind of give you some advantage on the acquisition side. I mean, on the flip side, again, it also kind of takes a bunch of sellers out of the market, and you guys are trying to sell a sizable portfolio. So curious, again, if that's part of what's causing this dual track issue, number one? And then number two, how the potential sellers out there go about underwriting this pool of assets where the rent coverage is particularly low?

Hey, Tayo, it's Mark. I want to clarify that we don’t have a concentration of assets in just one state. We have a few assets here and there. I believe operators interested in these assets can provide a compelling narrative to lenders, pointing to existing communities in or near the market that may inspire confidence in new lenders. This creates a more favorable situation for new operators compared to existing operators attempting to restructure their own debt. You’re correct that the market is evolving. However, there are some advantages with assets that may not currently be performing well, as they can support an operator who has a solid track record and has built some momentum in a particular market.

And I'm not showing any further questions at this time. I'd like to turn the call back for any closing remarks.

I really appreciate your support, the time, and the interest. If you have any inquiries, you know where to find us. Have a great weekend.

Ladies and gentlemen, this concludes today's presentation. You may now disconnect and have a wonderful day.