Q3 2023 CareTrust REIT Inc Earnings Call

Participants

David M. Sedgwick; CEO, President & Director; CareTrust REIT, Inc.

James B. Callister; CIO & Secretary; CareTrust REIT, Inc.

Lauren Beale; Senior VP & Controller; CareTrust REIT, Inc.

William M. Wagner; CFO & Treasurer; CareTrust REIT, Inc.

Austin Todd Wurschmidt; VP; KeyBanc Capital Markets Inc., Research Division

Connor Serge Siversky; Equity Analyst; Wells Fargo Securities, LLC, Research Division

Juan Carlos Sanabria; MD & Senior U.S. Real Estate Analyst; BMO Capital Markets Equity Research

Michael Albert Carroll; Analyst; RBC Capital Markets, Research Division

Unidentified Analyst

Presentation

Operator

Good day, everyone, and welcome to the CareTrust REIT Announces Third Quarter 2023 Operating Results. Today's call is being recorded. (Operator Instructions) I would now like to turn the call over to Lauren Beale, Senior Vice President and Controller. Please go ahead.

Lauren Beale

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 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 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?

David M. Sedgwick

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 '25, 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 2.5x 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 2 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 2 loans.
Investments since Q2 also included 2 acquisitions, consisting of 3 skilled nursing facilities in California. We added 1 skilled nursing facility at a yield of 9.7%. The second deal was for 2 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 1.43x. 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 2 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 nurses aids with no mention of LPN hours nor adjustment for acuity. Even with the delayed and 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 4 to 5x 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. James?

James B. Callister

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 seniors 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 that 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 nonstrategic assets, the regional owner operators or mom-and-pops who are fatigue 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 to 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 how 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 scouting for some time. Please remember that when we quote our pipe, we only quote deals we are actively pursuing under our current underwriting standards. And then 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.

William M. Wagner

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 at an all-time low with a net debt to normalized EBITDA ratio of 2.5x, which is well below our stated range of 4 to 5x. Our net debt to enterprise value was 16.8% as of quarter end, and we achieved a fixed charge coverage ratio of 4.5x. 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.

David M. Sedgwick

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

Question and Answer Session

Operator

(Operator Instructions) We'll take our first question from Connor Siversky with Wells Fargo.

Connor Serge Siversky

A 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?

James B. Callister

Yes. This is James. There is a smaller buyer pool, I would say of the time (inaudible) 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 most -- the 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.

Connor Serge Siversky

Okay. And then when we take 2024 into consideration, should we be expecting maybe 2, 3 asset deals? Or are there some portfolios out there that can make a big dent at 1 time?

David M. Sedgwick

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.

Connor Serge Siversky

Okay. And then very quickly for Bill, it's great job with the balance sheet. It looks like this 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 on to the revolver? Or could we still see some equity issuance to balance it out?

William M. Wagner

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.

Operator

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

Austin Todd Wurschmidt

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?

David M. Sedgwick

Yes, I'll start and then James can clean up after me. High level, when we talk about our pipe, we really want to -- I mean different people talk about their pipes in different ways. We certainly don't talk about everything that is on our screen that we're taking a look at. We really narrow it down to things that are either at least under LOI or very close to it that we have a lot of confidence that we can close. The timing on closing our pipe when we announce it, generally, is anywhere from imminently in a month to 9 months or longer depending on how a particular transaction develops.
So that's how you should -- in terms of the timing of it, if we say $175 million, you should not expect that to happen by year-end. And you should have kind of some grace period of 1 to 9 months, give or take. And sometimes stuff falls out of that pipe that we announce. But because of the activity that we're seeing right now, we're pretty confident that if something does fall out of that, we'll be able to replace it pretty quickly. James?

James B. Callister

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're -- what we would usually be underwriting it 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.

Austin Todd Wurschmidt

That's helpful. And then can you just discuss or confirm, I guess, the terms on the 11 property portfolio you mentioned just 1 under contract. And then did you collect any rent from those assets in the third quarter?

David M. Sedgwick

Well, in terms of the terms of the deal, I'm going to demur on that just because if -- 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 out at this point. And in terms of rent, yes, we did receive rents in the quarter from that operator.

Austin Todd Wurschmidt

And then just last -- okay, 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 1x 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.

David M. Sedgwick

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 2, we have seen 3 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 received from -- unsolicited interest from operators to take on those assets. And so having these 2 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, we're excited about that acquisition.

Operator

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

Michael Albert Carroll

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 underwriting where EBITDARM is trending or where it could potentially stabilize?

James B. Callister

Yes, Mike, I think that it's a combination of factors. I guess I'd say, I think that you see a number of -- more than usual institutional groups now that they've got positive cash flow in buildings, trying to take advantage of being there and exiting, putting those up for sale. And if they've got any kind of interest rate risk or maturity date risk, they're just a little more -- wanting to be a little more reasonable to get the deal done quicker. I think also they really want to attract the all-cash or quick buyer. So they're willing to get a little more -- you kind of -- they take a little less on the proceeds side to get more certainty of execution and timing. And so I think that's why they've come down a little bit.
I think also just if you put a deal out there right now at a stabilized number and it's not, you're just not going to get the interest, you're not going to get the buyer of a quality that you want to be able to close quickly. And I think that feels like it's finally started to really be taken into account and narrowing the bid-ask gap a little bit to kind of ensure that certainty of closing with a quality buyer.

Michael Albert Carroll

Okay. And then can you kind of provide some color on who are these 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?

James B. Callister

On the 2 Covenant Care deals, it's a third-party family kind of owned, family office, third-party landlord. They were not particularly heavy investors in skilled nursing. This is just an asset they've held for a very long time, and they felt like it was the right time to get a price that they could sell at. So I can't speak entirely for them, but I think that's pretty consistent right now, whether it's institutional or mom-and-pops or whoever that -- either fatigue for what it's been like for a few years or really are facing down the barrel of having to try to refinance or figure out their maturity date risk, and so they're putting up properties for sale.
And you still see some institutions and REIT selling non-core assets because the buyer pool is more -- a little more -- you get that certainty that, hey, if I put it up now, I'm getting a cash buyer, and so they try to take advantage of that, now the cash flow is positive for the most part.

Michael Albert Carroll

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

David M. Sedgwick

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.

Operator

(Operator Instructions) We will take our next question from Juan Sanabria with BMO Capital Markets.

Juan Carlos Sanabria

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, who's big in the state. If you could just bifurcate where your assets account for and who those operators are broadly as well.

David M. Sedgwick

Yes. Juan, thank you for that. We've got -- I'd say probably our strongest group of operators in our entire portfolio are in California. And we are really not overly concerned with the mandate there. As you may know, the skilled nursing sector was excluded from the mandate generally speaking. And yet there will be some upward pressure just from competition from other health care settings.
The reason we're not terribly concerned about it is because it has quite a long implementation schedule ahead several years of getting to that number. And in the meantime, that's going to correspond with several years of continued recovery, and from the occupancy perspective, we think continued recovery on the agency staffing perspective. And we've got increased Medicaid and Medicare rates that I think we would expect also over the course of the next 5 years that you throw all of that together, and we think it will be definitely manageable by particularly our strong core of operators in California.

Juan Carlos Sanabria

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?

David M. Sedgwick

Yes. 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.

Juan Carlos Sanabria

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

David M. Sedgwick

Sequential decline from last quarter to -- from Q2 to Q3.

Juan Carlos Sanabria

And then just a follow-up, the rent that was booked in the third quarter for the 11 SNF portfolio, was that just to think from a modeling perspective, what -- how much rent or NOI goes away?

William M. Wagner

Their annual rent is -- their monthly rent is around $400,000.

Juan Carlos Sanabria

And all that was captured in the third quarter?

William M. Wagner

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.

David M. Sedgwick

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.

Operator

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

Unidentified Analyst

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.

David M. Sedgwick

Yes, what's your question?

Unidentified Analyst

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

David M. Sedgwick

So yes, they vary deal by deal. In some cases, they will be -- it depends on whether or not we provide any sort of ramp in rent. In some cases, like James talked about, a lot of what we are underwriting and bidding on today have some form of value-add turnaround or stabilization required. And so in order to make that really a better chance of success for our operators, we will occasionally give a ramp where needed anywhere from 2 to 3 months and in an extreme case, maybe a 1- or 2-year ramp. And so generally speaking, that initial yield is going to be for SNFs in the 9s, if you sort of adjust for the ramps.

Unidentified Analyst

Okay. That's helpful. 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?

David M. Sedgwick

Yes. 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.

Operator

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.

David M. Sedgwick

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

Operator

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