Description

LONG: BROOKDALE SENIOR LIVING INC. (BKD)

Senior housing owner/operator BKD is our current favorite COVID recovery play, while providing stealthy housing exposure as a powerful kicker. We believe recent marks suggest 50 - 100% near-term return potential, with 3x+ based on a 3 year outlook. Just this last Friday, BKD reported accelerating occupancy growth, which we expect will continue in coming months.  

Despite equity appreciation since November, we believe the market continues to think incrementally. The speed of the likely recovery, and the structurally improved Senior Housing market, are yet to be captured in street numbers nor remotely embedded in valuation. Long-term buyers have taken note: M&A activity has been picking up across the sector, and we believe recent transactions support 50-100% upside to BKD’s share price. While we have no knowledge of any current or potential sale process, BKD appears to have been deliberately eliminating potential obstacles to a change of control. 

However, perhaps counter-intuitively, we believe these prices provide a margin-of-safety/floor for BKD, understating the long-term return potential should it remain an independent entity. Industry-wide supply growth, which had outpaced demand growth during the mid 2010s, is set to slow materially in the coming years, just as demand should begin to inflect as a result of well understood demographic tailwinds. The sharp appreciation in home values and increases in construction costs represent a further tailwind to Senior Housing asset values that we believe remain underappreciated. As a result, we believe the Senior Housing industry is likely headed toward all-time high occupancies, while maintaining above-inflation pricing growth, resulting in dramatic improvements in profitability. If this plays out as we anticipate, BKD’s equity could triple over the next 3-4 years.

Key Points:

• The Senior Housing industry is in the initial stages of a long-term NOI growth cycle

• Occupancy has bottomed and is now accelerating. Following COVID-driven disruptions, occupancy bottomed in February. Occupancy reported just this last Friday shows that occupancy gains are accelerating; we expect these gains to continue during the upcoming peak Q3 move-in season. 

• Supply / demand crunch predictable and on the horizon (i.e. few inputs, simple math). Similar to most real estate, supply / demand (and resulting occupancy) are key. We believe S/D is set to tighten significantly over a multi-year time horizon (we believe to record highs). Given the nature of the inputs, most of this is fully-baked and simple math, yet market participants are still focused on the COVID recovery, overlooking this set-up. We walk through the dummy math further below, but the key inputs are:

• Supply: Construction starts have declined meaningfully. Given the lag between starts and completion, we have a high ability to forecast medium-term supply. 

• Demand: Baby Boomers aging (i.e. the termed “Silver Tsunami”) is on the precipice of accelerating. Again, this is simple demographics with readily available data. 

• Leverage to well-reported housing strength. Housing shortages are well-known and driving significant home price appreciation. Material and labor shortages are causing construction bottlenecks and driving up replacement costs. Despite the benefit to Senior Housing, this connection has not yet been a focus.   

• Brookdale is the best way to get exposure to this bullish industry backdrop.

• Pure-play Senior Housing exposure. Pure-play on the theme, with operating and financial leverage, leads to coiled-spring dynamics. 

• Repaired and now robust balance sheet. Asset sales, lease restructurings, and refinancings have substantially repaired a previously challenging balance sheet, and left BKD in a robust liquidity position. 

• Upgraded assets.. Significant capital and operating investments have already been made. Current shareholders will benefit from these costs that have resulted in upgraded assets. 

• Takeout candidate. During the pandemic (and prior to), BKD took actions to clean up its balance sheet and Master Leases, some of which appear specifically aimed at cleaning the company up for a sale (i.e. modifications to change of control provisions). M&A activity across the space has been picking up, dry powder is awash, and unimpaired/duration assets are in historic demand in the current yield starved environment. 

Situation Background

Given ppsm920 write-up last year, we will refrain from extensive background, but will quickly cover the basics. Brookdale currently operates 695 Senior Living communities, with ~60k total units, making it the largest operator of Senior Housing in the country by both measures. 349 of these communities (32k units) are owned by Brookdale, making the company the 3rd largest owner in the country, while the remainder are operated under long-term leases or management agreements. The owned facilities are likely responsible for >90% of asset value at the company, and will be the focus of our analysis. 

Senior Living facilities are generally classified across a continuum of care offered to residents, as detailed in the below table from CBRE. Brookdale is active in the Independent Living (IL), Assisted Living (AL) and Memory Care (MC) categories, which together constitute Senior Housing. BKD’s portfolio is skewed toward Assisted Living and Memory Care, which make up about 70% of total units. Nursing Care (Skilled Nursing Facilities or “SNFs”) is generally viewed as a distinct product category considering more intensive care and real estate requirements. 

Currently, industry-wide occupancy is just off all-time lows after a year of disruption related to the pandemic. COVID suppressed move-in demand as health concerns impacted seniors’ desire to live in congregate settings, and for many families it was easier to look after loved ones while working from home (i.e. home care was temporarily a more viable substitute). Compounding the issue, voluntary move-outs increased as well at times, as visitation limitations meant residents were prevented from seeing family unless they moved out of a facility. 

However, a rapid vaccination campaign in the first quarter has largely eliminated COVID from Senior Living facilities, enabling an occupancy rebound that began in March, and has continued to pick up steam. Brookdale has been reporting monthly occupancy statistics throughout the pandemic (shown below), with the most recent update (out Friday) showing a further improvement in the rate of occupancy improvement in June, adding a full 100bps of occupancy from the end of May. Moving into the peak Q3 move-in season we expect substantial further occupancy improvements, which momentum we expect to carry into the next several years.

Thesis Point 1: The Senior Housing industry is in the initial stages of a long-term NOI growth cycle

Ramifications of the developing supply shock remain underappreciated

Relatively well understood among industry participants are the significant demand tailwinds the Senior Housing industry should experience as Baby Boomers age into the addressable market of 80+ year olds. Relative to +10% growth from 2015-2020, this population is expected to grow 17-18% from 2020-25, with growth to accelerate further to +26% from 2025-2030. This acceleration is beginning to occur in near-real time, and will continue, with the 80+ population set to experience accelerating y/y growth in each of the next five years. This structural growth in demand will require substantial additional supply of Senior Housing in the coming years.

Perversely, however, this looming demand tailwind was essentially a headwind to industry returns pre-pandemic, as it attracted significant capital in pursuit of the development of additional inventory, which came online ahead of the demand inflection. A surge in construction beginning in earnest in 2014, resulted in supply growth outpacing demand growth in each of the 5 years prior to the pandemic, weighing on pricing, occupancy and same-store NOI growth. Core to our thesis is that these dynamics are set to reverse.

As a result of disappointing returns for new entrants pre-pandemic and the severe disruption on a number of fronts during the pandemic, the industry has seen a major slowdown in new construction starts, which will continue to impact industry supply growth as these projects are completed over the next 12-18 months. Supply growth slowed in each of 2018 and 2019, and new starts, the second-derivative leading indicator, have only continued to fall, as shown in the below chart from Welltower. 

While the slowdown in industry-wide construction starts has been discussed at length by operators in the space, we don’t believe the ramifications longer-term are widely appreciated. The collapse in construction starts over the last 12 months will really only begin to feed into supply growth over the next several quarters, causing a material further slowdown. Over the next several years there is a real likelihood that we could see a squeeze on Senior Housing supply would prove quite lucrative for existing operators. 

As a high-level framing of what the unfolding supply / demand situation could portend for occupancy:

• As of 2020 there are approximately 13.2m US residents aged 80 or older, a figure expected to grow to 15.6m by 2025, adding 2.4m people to the addressable population

• Of these 13.2m people, ~6.24% lived in Senior Housing facilities at year-end 2020, down from a high of 6.74% at the end of 2019 due to the negative impacts of pandemic -- we expect penetration to rebound to at least 2019 levels as COVID headwinds fade

• This accelerated population growth, and recovering penetration rates will create demand for an additional 226k units, or ~22% of current industry capacity

• Given data on units under construction and construction starts, we have reasonable visibility into unit growth through 2022, which we expect to run <1.5%, adding just 25k net new units over the next two years; beyond this, even assuming construction levels snap-back to new record levels beginning in 2022, it will be challenging for the market to add more than 112k total net new units by 2025

• On these assumptions (occupied units increasing by 226k units while supply increases by just 112k), industry-wide occupancy would reach ~93% by 2025, roughly all-time highs

We think these assumptions are broadly conservative, and believe there is risk to the upside, particularly if new construction is slower to recover than we have baked into the above. Nevertheless, the implications are not priced into Senior Housing equities, particularly Brookdale. While consensus estimates aren’t available for Brookdale beyond 2023, a return to 90%+ levels would drive revenue and NOI well above current market expectations.

Recent appreciation in home values supports Senior Housing pricing power

We are believers in a “stronger for longer” housing market (some combination of both price and starts). Our view is predicated on a structurally undersupplied market following a decade of under-production. The aggregate vacancy rate (homeownership + rental) is near multi-decade lows, and we don’t see a realistic path for this to change any time soon. Fed-induced liquidity has increased asset prices across the board, yet housing market participants are sticky and thinking incrementally, overlooking the generationally strong fundamental outlook. Despite occasional commentator comparisons to the bubble-like housing market of the early/mid 2000s, we believe the fundamentals are diametrically opposed (then: near-record high vacancy rates; now: near record-low vacancy rates). In short, we believe the upward cycle and price appreciation are just getting started.

However, with those biases aside, a deep-dive on housing forecasts is not only beyond the scope of this write-up, it is also unnecessary aside from underwriting more aggressive (reasonable?) upside scenarios. Housing prices have already ascended significantly, and housing-levered equities generally have already risen in tandem. 

We believe senior housing will eventually be one of the most direct housing market beneficiaries, yet one of the least discussed to date. In addition to incremental care (the intensity of which varies by facility types), senior housing is fundamentally a place for seniors to live. It would arguably be an understatement to say senior housing is competitive with housing; more fundamentally, senior housing is housing. Despite this seemingly obvious intuition, the housing market strength’s eventual benefit to the senior housing market has not been discussed or focused on. 

Why have analysts and the market not made this seemingly obvious connection? The recent COVID-driven disarray in senior housing has seemingly led analysts and the market to myopically focus on COVID and the COVID-driven rebound: a combination of larger fires/focus areas earlier in the pandemic and incremental thinking currently. When the occupancy rate recovery matures, which we believe will occur this year, we believe the market will reposition its view of this asset class to a play on the under-supplied and rapidly appreciating housing market. More specifically, the subset of that red-hot, structurally undersupplied housing market that is levered to the fastest growing demography.  

The implications of these emerging dynamics remain significantly underappreciated by the broader market

While most elements of the foregoing fact pattern are not wholly unappreciated, we believe the market has yet to put all the pieces together, and price-in the earnings power implications across Senior Housing exposed equities and particularly Brookdale. 

There are a number of reasons why this is the case. Investors who bet on Senior Housing as a play on aging demographic trends were generally burned by the pre-COVID oversupply, and may continue to have a negative bias against the industry. Additionally, as a hybrid healthcare / real estate asset class, the sector, and Brookdale in particular as a non-REIT, is thinly covered by analysts and investors. Finally, there seems to be a dynamic at play, where making a bet on a recovery to pre-pandemic levels is “enough” to underwrite attractive returns, leaving investors to defer allocating the time to diligence the longer-term ramifications of the forces at play.

However, for those willing to consider what the industry could look like 3-4 years out, we believe the likely conclusion is that the industry as a whole, and Brookdale with it, will be headed to all-time high occupancies, while still driving pricing at above inflation levels, resulting in significant improvements in NOI / unit, and equity values that will be headed much higher

Thesis Point 2: Brookdale is the best way to get exposure to this bullish industry backdrop

Asset sales, lease restructurings and refinancings have substantially repaired a previously challenging balance sheet, and left Brookdale in a robust liquidity position

Over the last 18+ months Brookdale has undertaken significant work to essentially transform its balance sheet, previously a significant source of investor angst, including:

• Monetizing a material “hidden asset” by selling 80% of its Home Health business in an attractive transaction with HCA which left BKD with an equity stake in the business and ~$300m of net cash proceeds (~20% of current market cap)

• Refinanced near-term maturities and replaced prior credit facility with Freddie Mac mortgage debt; while leverage remains somewhat high, long-dated maturities and attractive terms (~3.6% average cost of debt) mean the balance sheet is in a very comfortable position in our view and material discretionary debt paydown is unlikely to be a major call on cash

• Agreed to major lease restructuring with landlords Ventas and Healthpeak resulting in significant go-forward lease expense savings, and eliminating change of control provisions which had previously posed a significant obstacle to a sale (note that we do not view the leased book as a material source of value, but there is no longer risk that it is an effective liability due to these restructurings)

As a result, we estimate Brookdale will exit 2021 with close to $600m of cash on the balance sheet, about 35% of the current market cap, leaving the business with significant excess liquidity and possible capacity to return cash to shareholders (we’d expect via buybacks), something we do not believe the market is currently anticipating

Significant capital and operating investments undertaken in 2019 should address issues which caused Brookdale to underperform operationally pre-COVID

A significant amount has been written on VIC and elsewhere about Brookdale’s operating challenges in the wake of the Emeritus acquisition. While the industry-wide oversupply contributed to the company’s disappointing performance, a key factor was years of apparent underinvestment in the acquired properties, compounded by the increased complexity of the enlarged organization. Three years of investments in labor costs, and a significant capex program undertaken in 2019 (community level capex per unit from $2k in 2018 to $3.6k in 2019) were shocks to the market when undertaken, but now should leave the company in a much improved position. Our research suggests these investments have already yielded material benefits which aren’t obvious in the financials given pandemic-related disruption, but should leave Brookdale in a much improved competitive position moving forward.

Pure-play Senior Housing exposure plus financial and operating leverage provide the most upside “torque” to attractive industry dynamics

Unlike the publicly traded REITs, Brookdale offers pure-play exposure to Senior Housing, and significantly more financial and operating leverage. Clearly, leverage cuts both ways, but given the powerful cyclical dynamics at play, we believe more is better at present, especially given the aforementioned superfluous liquidity situation at Brookdale. Brookdale’s market cap is just ~⅓ of TEV at present, which means returns to the equity of 4x in a doubling of EV (which we think is a reasonable outcome).

Takeout candidate

We won’t belabor the point given that a takeout has been a key component of the Brookdale bull case for years, but we do believe there is a real chance of a takeout at a significant premium over the next ~24 months. M&A activity across the space has been picking up, as REIT management teams, in particular, seek to capitalize on the industry dynamics we have described. Many of the key actions undertaken by management over the last 2-3 years seem to be specifically aimed at addressing the issues which have stymied sale attempts in the past, including change of control provisions in Master Leases with REIT partners, and historical underinvestment in both labor and capital. Should the company revisit a sale, we think there are a number of strategic and financial buyers that would be in hot pursuit. 

Valuation framing

We’ll use two constructs to frame potential outcomes for the equity: value in a relatively near-term sale, and longer-term outcomes driven by tightening industry supply / demand dynamics.

Despite the significant disruption to industry occupancy during the pandemic, Senior Housing assets have continued to trade at valuations that provide very constructive comps for Brookdale. Most recently, Welltower’s acquisition of the Holiday portfolio and Ventas’ acquisition of New Senior (SNR) were announced at per-unit valuations of $165k and $185k (when adjusting the Welltower deal for excess capex commitments) and ~6% cap rates on near-term NOI (in-place NOI in the case of WELL / Holiday, based on 76% current occupancy, and 2022 NOI in the case of VTR / SNR). At $165k / owned unit (the lower of these two comps), we estimate Brookdale’s equity is worth $12-13 / share, or +50% from current levels. Applying a 6-7% cap rate to our estimate of 2022 owned portfolio NOI implies an equity value in the range of $14-19 / share, more than double the current price at the higher end. Moreover, a number of large transactions completed in 2020 were struck on <6% pre-COVID cap rates, suggesting these two comps may be conservative. However, using these more recent deals, our best guess is that Brookdale could fetch $13-17 / share in a near-term sale or a 50-100% premium. 

This math illustrates the margin of safety in the situation, and the effective put option (at higher prices) we believe we have as buyers today. However, if we are right about the medium-term prospects for the industry, we would much rather see Brookdale continue as a publicly traded company. At 90% occupancy we believe Brookdale’s owned portfolio could generate >$700m of NOI, or ~$650m including G&A in 2025. At a 7% cap rate this suggests the owned portfolio is worth $9.3bn, or $5.4bn net of debt, good for close to $27 / share. Including cash currently on the balance sheet and modest valuation for the leased business, this equates to ~$34 / share all-in, or >4x current levels, realizable within 3-4 years. Sensitizing the cap rate to 6% suggests the business is worth about $42 / share or a 4.2x MoM.

Catalyst

Continued Occupancy Recovery

M&A