WHERE THE MONEY IS REIT FINANCING IN SENIOR HOUSING ACQUISITIONS

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1 WHERE THE MONEY IS FINANCING IN SENIOR HOUSING ACQUISITIONS Brian J. Maas Senior Vice President and Associate General Counsel Chad C. White Associate General Counsel Long Term Care and the Law February 25 27, 2013 Austin, Texas Where the Money Is Financing in Senior Housing Acquisitions What is a real estate investment trust ( )? Usually referred to as a Mutual fund for real estate Not subject to federal income tax Restrictive income and asset rules patterned loosely on mutual fund rules 1

2 Where the Money Is Financing in Senior Housing Acquisitions Rules in a Nutshell Assets must consist primarily of real estate Must distribute 90% of its annual income Must receive 75% of its income from real estate holdings Must receive 95% of its income from designated passive sources Where the Money Is Financing in Senior Housing Acquisitions Important Milestones in the History of s s Authorized: The Act of 1960 Taxable Subsidiaries: The Modernization Act of 1999 (effective January 1, 2001) Management Arrangements: The Investment Diversification and Empowerment Act (generally effective January 1, 2009) ( RIDEA ) 1 1 The Housing and Economic Recovery Act of 2008 contained all but one of the provisions in the proposed Investment Diversification and Empowerment Act of

3 Where the Money Is Financing in Senior Housing Acquisitions Comparison to Other Financial Institutions Typical Model Debt Broad Investment Strategy Standard Financing Products Focus on Transactional Returns VS. Approach Equity Investments Specialized Asset Class Flexible Financing Strategic Interests Where the Money Is Financing in Senior Housing Acquisitions Typical Healthcare Asset Classes Medical Office Buildings Hospitals Senior Housing Skilled Nursing Facilities Life Science/Biotech Facilities Traditional Financing Structures Sale Leaseback Mortgage Debt Development Initial Public Offering 17% 12% 8% 20% 43% 3

4 Where the Money Is Financing in Senior Housing Acquisitions Things to remember when evaluating a s proposal Motivations Qualification Protect the Dividend Manage Income Volatility Diversification vs. Focused Concentration Expertise Underwriting Structuring Healthcare Regulations Where the Money Is [AHLA Financing Presentation] in Senior Housing Acquisitions Investments in Senior Housing pre RIDEA Prior to the enactment of RIDEA in 2008, healthcare s generally could not participate in the cash flow from operations of a healthcare facility (such as an assisted living community). Healthcare s could only generate qualifying income by leasing their healthcare facilities to unrelated third party operators. Historically, a s principal senior living investment tool: Triple Net (NNN) Lease Structure Fixed rent with typical 2% to 3% escalators Participation in improved performance limited to fair market value rent resets or gross percentage rent clauses Allocates much of the physical maintenance responsibility to the tenant/operator Leases Property Pays Rent Operator Owns operating contracts and licenses Runs day to day operations Increases profits if EBITDAR growth outpaces rent growth Responsible for rent even if facility underperforms Has most responsibility for physical maintenance As lessor, the is higher in the capital structure than the operator and, therefore, is in a less risky position. Traditionally, this has been an important factor for investors. Pre RIDEA, acquisitions in senior housing were often made through a sale leaseback structure in which the acquired the assets and simultaneously leased them to the operator. 4

5 Where the Money Is [AHLA Financing Presentation] in Senior Housing Acquisitions The RIDEA TRS Structure Post RIDEA, a healthcare can now lease facilities to its Taxable Subsidiary ( TRS ), if the TRS hires an unrelated eligible independent contractor ( EIK ) to be the operator and manager. This permits the healthcare to participate in the cash flows from the operations of the facility, as the TRS will earn the facility s net operating cash flow (less the management fees paid to the EIK and the rent paid to the ). Non taxable entity Owns the facility Leases Property TRS Taxable entity Owns operating contracts and licenses EIK Taxable entity Oversees daily operations Independent from Where the Money Is [AHLA Financing Presentation] in Senior Housing Acquisitions The Eligible Independent Contractor ( EIK ) To qualify under RIDEA, the s TRS must enter into a management contract with an independently owned/controlled management company ( EIK ). The EIK: must have sole and exclusive management authority; must be adequately compensated ; typically gets a base fee tied to gross revenue plus an incentive fee tied to a metric such as EBITDARM; cannot enter into new leases with the in the future; cannot have shareholders who own more than 35% of both the and the EIK/management company; and must manage other third party properties at the time the management contract is entered into. Certain affiliates of the EIK may have an ownership stake in the real property and operators. The EIK has less risk and lower potential returns than NNN tenant. 5

6 Where the Money Is [AHLA Financing Presentation] in Senior Housing Acquisitions Comparison of NNN vs. RIDEA TRS Structures NNN Lease Structure Full separation of real estate and operations Master lease agreements are full recourse obligations of tenant Fixed rent, with annual escalators; limited upside for the as Senior Housing Operator / tenant benefits from operational improvement No downside risk unless tenant defaults Tenant responsible for physical maintenance RIDEA TRS Structure The, through lease to its TRS, retains the operations Rent from intercompany lease, interest on intercompany debt and G&A allocations offsets much of taxable income Lease is structured at market rate For, TRS structure may result in: Higher base of earnings Higher growth Higher physical maintenance costs Higher cash flow, but with greater downside operational risk and volatility Operations must be managed by the EIK For Senior Housing Operator/EIK, RIDEA structure may result in less risk (with corresponding lower returns) than traditional NNN lease Opportunity for better alignment of parties Where the Money Is [AHLA Financing Presentation] in Senior Housing Acquisitions Lease Model vs. Management Model Considerations Lease Model Capital Requirements Risk Allocation Operational Control Budget Control Licensing Purchase Option Opportunity Management Model Due Diligence Change in Nature of Operator Relationships Financial Reporting Incentive Structure Joint Venture Opportunity Leverage 6

7 Where the Money Is Financing in Senior Housing Acquisitions Representative Transaction Background Perspective owned 25 communities held in NNN structure Upside opportunity of implementing RIDEA structure with new operator Skilled nursing exposure Fannie Mae financing in place Background Operator Perspective Operator consolidation opportunity Complementary assets Ability to obtain management of additional communities and minority ownership of real estate for modest capital investment Significant capital requirements for communities Where the Money Is Financing in Senior Housing Acquisitions Resulting Hybrid Structure NNN Structure New triple net lease of 4 skilled nursing facilities Operator assumed NNN lease of 8 independent/assisted living communities RIDEA TRS Structure Operator entered into new management contract for 21 independent/assisted living communities Joint Venture: 90% / 10% ownership of real estate and operations by the and Operator, respectively First RIDEA transaction for each of and Operator Operator Perspective: Upside potential from management fees, incentive fees, joint venture interests and NNN leases Less leveraged transaction than pure NNN lease Better alignment of interests through use of RIDEA joint venture Perspective: Opportunity to participate in upside through RIDEA structure Minimize skilled nursing exposure through use of NNN lease for skilled nursing facility assets 7

8 Where the Money Is [AHLA Financing Presentation] in Senior Housing Acquisitions Hypothetical RIDEA Joint Venture Structure 100% 100% 100% Qualified Subsidiary TBD% Landlord Entity (Owns Real Estate) TBD% Senior Housing Operator Subsidiary Senior Housing Operator 100% TRS TBD% Pays Rent Leases Property Senior Housing Tenant Entity (Owns Operations and Holds License) TBD% Operator Subsidiary Management Agreement Management Fees EIK 100% 8