CareTrust REIT, Inc. Q3 FY2023 Earnings Call

Good day, everyone, and welcome to the CareTrust REIT Announces Third Quarter 2023 Operating Results. Today's call is being recorded and all lines have been muted to minimize background noise. After the speakers' remarks, there will be a question-and-answer session. I would now like to turn the call over to Lauren Beale, Senior Vice President and Controller. Please go ahead.

Thank you, and welcome to CareTrust REIT's third quarter 2023 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 like 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 FAD 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. In addition, certain operator coverage and financial information that we discuss is based on data provided by our operators that has not been independently verified by CareTrust. 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 James Callister, Chief Investment Officer. I'll now turn the call over to Dave Sedgwick, CareTrust REIT's President and CEO. Dave?

Well, good morning, everyone, and thank you for joining us. As we round third base on this year, we are pleased to report progress on several fronts. Not only have we made a significant return to external growth by investing $280 million year-to-date, but also we have set the table for 2024 and 2025, with an active pipeline and a ton of dry powder. We have financed that $280 million of investments by selling $420 million worth of equity of our ATM. The excess proceeds were used to completely pay down the $600 million line of credit, resulting in a net debt to EBITDA of 2.5 times at quarter end. We are willing to take some modest dilution in the short run to be positioned to take full advantage of the favorable investment environment we are in today and expect to be in for the foreseeable future. I will touch on our investment activity in the quarter and how we are thinking about next year. I'll also touch on the portfolio and the regulatory environment, and James and Bill will take it from there. First, investments. After a significant return to external growth in Q2, the team has continued to drive forward with its foot on the gas. Since Q2, we have invested another $79 million with a blended estimated stabilized yield of 10.2%. Investment activity since Q2 consists of two loans for just over $19 million at a blended rate of 9.6%. The loans we make are done strategically to borrowers and operators, who we believe will lead us to true acquisition opportunities in the future. That was certainly the case again with these two loans. Investments since Q2 also included two acquisitions, consisting of three skilled nursing facilities in California. We added one skilled nursing facility at a yield of 9.7%. The second deal was for two high-performing skilled nursing facilities with a lease in place operated by Covenant Care. You will notice in the supplemental that with this acquisition, Covenant Care's property-level EBITDAR coverage pops to 1.43 times. The leases in place initially yield just under 6%, but in 2027, the leases provide for a rent reset. Assuming current performance is maintained, our yield at the time of the reset is projected to be just under 11%. Now turning to the portfolio. You will see in the supplemental, lease coverage slightly improved overall. Let me chat about a couple of individual operators. Notably, and as I mentioned a second ago, Covenant Care EBITDAR coverage has popped up to 1.43x with the acquisition of two facilities with a very well covering lease in place. Additionally, the same-store Covenant Care properties continued its trailing 12-month coverage improvement for the third quarter in a row. Eduro's lease coverage has been on a downward trend the last couple of quarters. We are working with them on a solution for a couple of their non-core facilities that we agree should be in different hands. We have a great relationship with Eduro and are working closely with them to minimize any material impact to rent. Lastly, as of a few minutes ago, we are under contract to sell the 11 skilled nursing facilities in the Midwest that we classified as held for sale last quarter. We hope to close on that sale before our next earnings call. Finally, on the regulatory front, one quick comment. We add our voice to the thousands of others in our industry that have called for significant changes to the proposed minimum staffing mandate from the Federal Government. The proposed rule requires 24-hour RN coverage at 0.55 RN hours per patient day and 2.45 hours per patient day for certified nursing aides with no mention of LPN hours nor adjustment for acuity. Even with the delayed in-staged implementation schedules, the industry is unified in its efforts to work with CMS to modify the proposed rule to be in a form that the industry can work with. We're hopeful that CMS will pay attention to the feedback they've solicited and modify the rule. Now James will give you more color on the pipeline, but I'll just say this. The investment landscape is very favorable for us as we head into 2024. As I said before, the table is set for the next couple of years. We have a favorable cost of capital that allows for accretive investments. We have a balance sheet that provides enormous flexibility. We can do roughly $500 million of investments and still end up below our stated range of four to five times debt to EBITDA. And we have a macro environment that has sidelined some of our historic high leverage competitors, and we do not expect the banks to come roaring back with cheap debt anytime soon. So with that, James will talk to our recent activity and pipeline.

Thanks, Dave. Let me just briefly provide an update on the current investment environment and add some color on our current pipeline. With respect to seniors housing, most of the proposed transactions that we see continue to involve facilities that are in some stage of operational distress, typically due to maturity date risk or variable interest rate loans, including risks related to the expiration of interest rate cap agreements. As a result, the bid-ask gap in seniors housing remains wide. We nevertheless continue to look for attractive senior housing deals where a triple-net lease structure might, given current rates in the constrained lending market, be an attractive alternative to traditional debt financing for those operators who are looking to grow and add scale to their operations. We continue to see robust deal flow in skilled nursing transactions. Pricing that is based on stabilized cash flows and coverage is still very rare. With that said, we're also seeing a decrease from the last couple of years in transactions involving portfolios that are experiencing negative cash flows and heavy losses. A combination of factors, including Medicaid rate increases, healthier labor markets, census recovery, and lower agency staffing levels, has facilitated some measure of recovery in many portfolios. As a result, most skilled nursing assets being marketed currently reflect recent performance landing at breakeven or better but still a fair distance from stabilization. As facilities show muted improvement in performance, sellers bringing buildings to market range from institutional owners and REITs continuing to dispose of non-core and non-strategic assets to regional owner-operators or mom-and-pops, who are fatigued and are looking to capitalize on a return to positive cash flow by selling and exiting the space. Sellers' pricing expectations and correspondingly brokers' guidance appear to be gradually softening to take into account performance results that fall short of stabilization, but the pace of price softening is still lower than anticipated. We expect to see a continued narrowing of the bid-ask in skilled nursing, given the continuing high interest rates, lenders' enhanced credit and recourse requirements, maturity date risk, and a smaller buyer pool. As purchase prices slowly continue to settle, lease yields will also likely continue their slight push up towards and in some cases beyond 10% with attractive basis levels better able to support a higher-yielding rent stream. Given opportunistic market dynamics, we continue to look for occasions where our attractive cost of capital and our flexibility in sourcing and structuring transactions can be used to create additional acquisition and investment opportunities that are accretive to our operators. We will continue to execute on our acquisition strategy of disciplined growth with risk-adjusted returns consistent with what CareTrust has been built over the past several years. The pipeline today is around $175 million and mainly consists of singles and doubles. We are also continuing to review a few larger portfolio opportunities that would not only strengthen existing tenant relationships but would also allow us to further diversify our tenant base by commencing relationships with outstanding operators that we have been pivoting for some time. Please remember that when we quote our pipeline, we only quote deals we are actively pursuing under our current underwriting standards, and only if we have a reasonable level of confidence that we can lock them up and close them in the relative near-term. And with that, I'll turn it over to Bill.

Thanks, James. For the quarter, normalized FFO increased 1.5% over the prior year quarter to $36.6 million, and normalized FAD increased by 2% to $38.8 million. On a per-share basis, normalized FFO decreased $0.02 to $0.35 per share and normalized FAD decreased $0.02 to $0.37 per share. Rental income for the quarter was $51.2 million compared to $47.7 million in Q2. The increase of $3.5 million is due largely to the following items. First, we received approximately $2.5 million from new investments. Second, we received approximately $402,000 in CPI bumps. Third, tenant reimbursements, which are non-income and FFO producing, because they have a corresponding expense, increased $775,000 to $2 million. Lastly, these positive items were offset by $272,000, which is mostly from properties that we have sold. If you exclude the tenant reimbursements amount of $2 million, contractual cash rental revenue was $49.2 million for the quarter. Interest income was up $851,000 due to new loans of $1 million, slightly offset by $191,000 of lower money market interest. The quarterly interest income run rate on our Notes portfolio is approximately $4.5 million. Interest expense was up $710,000 from Q2, due to higher average borrowings during the quarter and higher rates. G&A expense increased $801,000 from Q2, mostly due to stock compensation returning to the quarterly run rate of roughly $1.6 million as I previously discussed on last quarter's call. I expect that G&A expense for the year will be around $21.4 million. Cash collections for the quarter came in at 97.5% of contractual rent. And in October, we collected 99.3%. Under our ATM program, through today, we have sold approximately 18.2 million shares at an average gross price of $19.90 for gross proceeds of approximately $362 million. We have approximately $60 million still outstanding on forward contracts that we have not settled. As a result, our liquidity remains extremely strong with approximately $36 million in cash on hand, our entire $600 million available under our revolver and the $60 million of future ATM proceeds. I expect we will settle these remaining contracts before year-end, depending on the timing of closing future investments. Leverage is at an all-time low with a net debt to normalized EBITDA ratio of 2.5 times, which is well below our stated range of four to five times. Our net debt to enterprise value was 16.8% as of quarter-end, and we achieved a fixed charge coverage ratio of 4.5 times. We wouldn't be surprised to see leverage tick further downward as we continue to fund our pipeline with equity, given where the total cost of debt is at today relative to our cost of equity. And with that, I'll turn it back to Dave.

Great. Well, we hope our report has been helpful and happy now to take your questions.

Thank you. We'll take our first question from Connor Siversky with Wells Fargo.

Hi there. Thanks for the time. Question on the competitive environment for skilled nursing and senior housing assets. I mean, as of last week, one of the other players in the group expressed an interest in skilled nursing in particular. So, I'm wondering with this kind of new entrant in the space, we're not a new entrant, but with this increased interest in the space. Does this affect the way you're looking at pricing, whether or not you're willing to move up the risk curve and maybe take on a relatively distressed operator in order to get a yield? I'm just curious how you're thinking about these dynamics?

Yes. This is James. There is a smaller buyer pool, I would say of the time of well carrying entering the space a little bit more. I'm not sure we compete for many of the same deals. But I think we look at each deal on its own and we look at the basis that can support and the operators that can get comfortable with the rent. And if we get an actionable deal that falls within kind of that criteria of what we're looking for, we really get as aggressive as we can to tie it up and to get the deal done and to work with an operator to help us give the most aggressive or highest bid we can and still feel good about the deal. So I think there's definitely a little bit of increase in competition even though it's a smaller buyer pool. But I wouldn't say it impacts how we view what pricing we feel we can be competitive at and have a successful run with that asset.

Okay. And then when we take 2024 into consideration, should we be expecting maybe two, three asset deals? Or are there some portfolios out there that can make a big dent at one time?

Well, Connor, historically, when we've had kind of our larger investment years, there's always been kind of a chunkier deal in there. And so we're always reviewing those. Those are smaller, lower probability of getting it done, but they're certainly out there. And we expect those to continue to cross our desk into next year. But right now, the visibility that we have and the confidence that we have are more of the singles and doubles that you're used to seeing us put together.

Okay. And then very quickly for Bill, it's a great job with the balance sheet. It looks like the next slug of activity is pretty much prefunded. But you still have the cost of equity. There is still some ATM capacity out there. Should we just assume that any acquisitions for the next year go straight onto the revolver? Or could we still see some equity issuance to balance it out?

No. I think you can assume, as I said in my prepared remarks, that we would continue to fund investments with equity given where the cost of debt is relative to our cost of equity right now.

We'll take our next question from Austin Wurschmidt with KeyBanc Capital Markets.

Great. Good morning out there. You guys have mentioned that you really highlight and focus on deals that you have a reasonable confidence you can close. So I guess I'm just curious, what kind of the probability is that you're able to get one of these across the finish line? And then can you also discuss about the yields on portfolio transactions relative to the singles and doubles in that $175 million pipeline you discussed?

I'll begin, and then James can follow up. When we discuss our pipeline, we aim to focus on deals that have genuine potential for closure. We don't include everything that's on our radar. Instead, we concentrate on opportunities that are either under a Letter of Intent or very close to that stage, where we feel confident about closing. The timeframe for closing these deals can range from almost immediate to nine months or even longer, based on how each transaction progresses. Therefore, if we mention a figure like $175 million, you shouldn't expect it to be finalized by the end of the year. It's reasonable to anticipate a grace period of one to nine months, plus or minus. Occasionally, deals can fall out of our pipeline, but given the current activity, we're confident that we can quickly secure replacements if needed. James?

Yes. On your question about the yield on portfolio transactions, I mean the easier answer is it depends on the transaction. But I would say the general concept with our experience with portfolio deals is that if we really like them and we have the right operator solution or solutions, then I think we probably would be willing to do a yield that is maybe a couple of turns lower than what we would usually be underwriting at to try and be more competitive. But we're never going to go below what we feel like at the time is the right spread between our cost of capital and yield. So we will go a little bit lower to be aggressive and try to get the deal, but typically not somewhere we're even close to not really having a spread on that deal.

That's helpful. And then can you just discuss or confirm, I guess, the terms on the 11 property portfolio you mentioned just one under contract. And then did you collect any rent from those assets in the third quarter?

Well, in terms of the terms of the deal, I'm going to demur on that just because even though we just put it under contract today, if it falls out of contract, it wouldn't be wise to signal to the market what we're willing to transact at this point. And in terms of rent, yes, we did receive rents in the quarter from that operator.

And then just last... That's fair. And then just the last one for me. On the Covenant Care deal, did you consider putting those into a single master lease with the existing assets that you owned? I guess, how did you just get comfortable with the operator given you were below 1 time coverage. I know you've talked about them quite a bit in the past, but just curious about the latest thoughts on this new deal and how you thought about structure.

Yes. Great question. What's encouraged us about the rationale for that really comes to a few different points. One is, like I said in my prepared remarks, Covenant Care same-store outside of these two, we have seen three quarters in a row of improving trailing 12 EBITDAR coverage getting closer and closer to covering just at the property level EBITDAR. So that's encouraging. The second point is because these reset in a few years as January 2027 is the reset, we think that that does a couple of things for us. It continues to provide them with some time to continue to improve our same-store assets with them and strengthens our relationship with them as well. If there's like a downside scenario, we've always talked about how attractive the Covenant Care facilities are and how much interest we regularly receive from unsolicited interest from operators to take on those assets. And so having these two included in our real estate-owned properties really improves our position with them in a downside scenario. We're not expecting that, but it certainly helps. But when you have the lease rate being reset shortly. You throw all of that together, and we feel like it was a no-brainer and we're excited about that acquisition.

That’s great. Thanks for the time.

You bet. Thank you.

We'll take our next question from Michael Carroll with RBC Capital Markets.

Yes, thanks. I guess, James, in your prepared remarks, you kind of discussed that pricing is starting to come down. So what's driving that? Are buyers pushing and sellers willing to accept higher yields? Or are these stakeholders just being more conservative in underwriting where EBITDARM is trending or where it could potentially stabilize?

Yes, Mike, I believe it's a mix of factors. Many institutional groups with positive cash flow from their buildings are looking to take advantage of the current market and are putting their properties up for sale. If they have any concerns about interest rate risks or upcoming maturity dates, they're motivated to be more flexible in order to close deals faster. Additionally, they are keen to attract all-cash or quick buyers, so they may accept lower proceeds in exchange for more certainty in execution and timing. This is likely why there has been a decrease in pricing. Furthermore, if a property is marketed at a stabilized price that isn't aligned with current market conditions, it will struggle to attract quality buyers capable of closing quickly. I feel this realization is finally starting to affect the market and is helping to narrow the gap between buyers' offers and sellers' expectations, ensuring a higher likelihood of closing with reliable buyers.

Okay. And then can you kind of provide some color on who are the sellers? And maybe you could talk about it generally or even kind of discussing related to this Covenant Care deal, I guess, why do they want to sell? Was there a certain reason in this situation, why the seller wanted to get out?

Regarding the two Covenant Care deals, the sellers are a family-owned third-party landlord who has not been heavily invested in skilled nursing. They have owned the asset for a long time and believed it was the right moment to sell at a favorable price. While I can't fully represent their thoughts, it seems to be a common trend among various sellers, whether institutional or small operators, who are feeling fatigued after years of challenges or are dealing with refinancing issues and maturity date risks. As a result, they are listing properties for sale. You also see some institutions and REITs liquidating non-core assets because the current buyer market is somewhat stable, providing them with the certainty of cash buyers, allowing them to capitalize on the positive cash flow situation for most assets.

Okay. And then with regard to the expected Eduro transition, can you quantify the type of rent disruption we should expect on that?

No, not at this point. We're still working through a couple of different scenarios with them. But like I said, as we sit here today, we don't think that it's going to be anything material to us.

We will take our next question from Juan Sanabria with BMO Capital Markets.

Hi. Good morning. Just hoping you could comment on your thoughts on the California health care and minimum wages. I mean, you guys obviously have a big exposure there. If you could maybe give us a sense of where that exposure lies. I know you have a big exposure to Ensign, obviously, he's big in the state. If you could just bifurcate where your assets account for who those operators are broadly as well? Thank you.

Thank you, Juan. I would say that our strongest group of operators is in California. We are not very concerned about the mandate there since the skilled nursing sector is generally excluded. While there will be some competitive pressure from other health care settings, we aren't overly worried because the implementation schedule spans several years. During this time, we expect continued occupancy recovery and improvements in agency staffing. Additionally, we anticipate increased Medicaid and Medicare rates over the next five years. Together, we believe all these factors will be manageable for our strong operators in California.

And then just curious, if you have any sense of what the level of agency or a lack of staffing still is in the portfolio today? And any way to quantify how much that's holding back a further improvement in occupancy at this point?

Yeah. The last part of that question is a real challenge to figure out. Anecdotally, we know that there are still constraints for some of our operators to admit because of staffing constraints. As far as agency, that actually, as you look at it, provides another bit of tailwind for our operators in terms of their coverage because we're still quite a ways off of our pre-pandemic agency usage. Portfolio-wide, before the pandemic, we were at about $1.50 on a per patient day basis for agency usage in the portfolio. And we still are a few dollars north of that. So we have a ways to come down. And we've steadily seen that improve from last quarter to this quarter, agency in our portfolio decreased by about 8.5%. And we're encouraged to see that, and we believe it's part of the reason why we should expect occupancy and overall recovery to continue.

The 8.5% was it year-over-year or sequential decline?

Sequential decline from last quarter from Q2 to Q3.

I have a follow-up question regarding the rent that was recorded in the third quarter for the 11 SNF portfolio. From a modeling perspective, how much rent or NOI is expected to decrease?

Their annual rent is approximately $4.8 million.

And all that was captured in the third quarter?

No, they did not pay 100% of contractual cash rent in Q3. They make up a small portion of the 2.5% that we did not collect.

Hey Juan, let me make a quick correction. The improvement in agency that I cited of 8.5% was actually from Q1 to Q2. We're a little bit too early to talk about Q3.

And we'll take our next question from Alex with Baird.

Hello. Thank you for taking my question today. First one is on the types of the initial yields that CareTrust is seeing in the pipeline right now and then the expected stabilization rate?

Yes, what's your question?

Just what are those yields specifically on the pipeline right now?

They vary from deal to deal. In some situations, it depends on whether we provide any ramp in rent. As James mentioned, much of what we are underwriting and bidding on currently requires some form of value-add turnaround or stabilization. To enhance the chances of success for our operators, we may occasionally offer a ramp of anywhere from two to three months, and in extreme cases, possibly a one or two-year ramp. Generally, the initial yield for skilled nursing facilities will be in the nines after adjusting for the ramps.

Okay. That's helpful. Thank you. And to touch on the Eduro Group comments that you made in your prepared remarks and other people have asked. What kind of visibility do you have in their financials? And how confident are you that they're going to keep paying rent to end the quarter?

Yeah. We, like I said, we have a really great relationship with those guys. They're an open book to us, and we're working with them on how to transition a couple of buildings into better hands, we don't expect a hiccup to rent.

Okay. Thank you.

You bet.

There are no further questions at this time. I'd like to turn the call back over to Dave Sedgwick for any additional or closing remarks.

Well, thank you. I really appreciate everybody's support and interest. Have a Happy Veterans Day and a great weekend. Thank you.

Thank you. That does conclude today's presentation. Thank you for your participation, and you may now disconnect.