After any airplane accident, investigators turn to the "black box" as they search for clues about what went wrong. They hope the box holds answers to some of their questions.
In the world of assisted living, another type of "black box" might hold some answers for executives: It's an increasingly popular off-balance-sheet financing tool for publicly traded companies.
In financial parlance, the black box, so named because it basically hides losses of the operating company, is typically a developer or privately held company that finances the building and capital project while the assisted-living operator focuses on management and operations of the communities.
The black box typically receives lease payments from the operator. Once the facility is built, the black box pays a management fee that's usually equal to about 5% of the facility's annual revenues.
With off-balance-sheet financing, debt isn't carried as a liability, so it doesn't impair borrowing capacity. Companies are doing off-balance-sheet financing in a variety of ways, including sale-leaseback arrangements and "synthetic leases" (Oct. 7, 1996, p. 71). Vencor, a Louisville, Ky.-based long-term-care chain, has chosen another route. It plans to spin off its real estate into a separate company, a real estate investment trust that will be publicly traded. Vencor will make lease payments to the REIT.
"Assisted living is very capital intensive, so more companies are looking at the black box as a way to generate earnings during a period that they would otherwise lose money," says Andrew Gitkin, an analyst at Salomon Smith Barney in New York.
During the development phase of assisted-living projects, companies still need to generate earnings to grow. Project development expenses can amount to hefty sums, dragging down earnings.
Assisted-living facilities with 60 units or more can cost more than $10 million to develop and build, according to industry estimates.
"It takes 11/2 to 2 years to zone and build some projects," Gitkin says. "They also carry a lot of liabilities, like debt on the balance sheet."
So finance executives have been looking for ways to neutralize some of those liabilities, leading more assisted-living companies to use the black box strategy.
The graying of the U.S. population has made assisted living a hot investment vehicle for real estate firms and healthcare companies. Assisted living, which combines senior housing and a healthcare component, caters to a more affluent and ambulatory clientele than nursing homes do. Practically all assisted-living residents are private pay.
Needham, Mass.-based CareMatrix had planned to add six assisted-living facilities in the third quarter of 1997 but ended up building 17. Most of CareMatrix's facilities are owned and financed through privately held Chancellor Senior Housing Group, which is principally owned by healthcare mogul Abraham Gosman, who's also chairman of the nation's largest publicly traded healthcare REIT, Meditrust. Chancellor is the black box in CareMatrix's case. Gosman's sons, Andrew and Michael, are executives at CareMatrix. Andrew is president, and Michael is vice chairman of the board and executive vice president of acquisitions and development.
In exchange for financing the buildings, Chancellor receives lease payments. It also is entitled to write-offs such as depreciation.
Terms of the CareMatrix deals weren't disclosed, but analysts say the company wouldn't have been able to finance as many facilities if their development was on the balance sheet. Thus, the 11 additional projects might have been put off if they had to be financed more conventionally.
"If a company were to develop and own the real estate, and development losses are $500,000 to $1 million per project, you're talking as much as $11 million in losses," says Sheryl Skolnick, an analyst at BancAmerica Robertson Stephens in New York.
About one-third of the nation's 15 publicly traded assisted-living firms are using a black box, and more are looking to try the strategy as a way to boost earnings.
"We will be looking into the black box," says Howard Phanstiel, chairman and chief executive officer of Costa Mesa, Calif.-based ARV Assisted Living. ARV operates 49 assisted-living facilities in 10 states. None has used a black box thus far.
Founded in 1980, ARV could use a boost in quarterly earnings. Since the company went public in October 1995, it has yet to turn a profit. Despite a 51% increase in quarterly revenues to $28.8 million in its second quarter ended Sept. 30, 1997, the company posted a loss of $4.1 million. It will report its third-quarter results later this month.
ARV isn't the only assisted-living company looking for ways to boost earnings.
The 15 publicly traded assisted-living companies lost $31 million on $488 million in revenues in 1996, according to Hilton Head, S.C.-based WDI Capital Markets. Most, like ARV, blame start-up losses from new developments.
WDI hasn't tallied 1997 results for all assisted-living operators, but CareMatrix is one of only a few expected to report a profit. For 1997 it reported net income of $6.6 million, or 38 cents per share, on $73.2 million in revenues. In the previous year, the company posted a net loss of $485,000, or 3 cents per share, on $8.7 million in revenues.
ARV's strategy hinges on the future success of an affiliation with Kapson Senior Quarters Corp. of Woodbury, N.Y., a privately held firm that develops assisted-living facilities and will play the role of the black box.
"We would leverage the Kapson alliance to get off-balance-sheet financing," Phanstiel says. "We want to aggressively grow the number of facilities we operate."
The two companies also share a bond with New York-based Lazard Freres Real Estate Investors, which owns a 92% stake in Kapson and a 48% stake in ARV. "ARV is the operating company, Kapson is the development company, and Lazard is the principal owner of both companies," Phanstiel says.
But off-balance-sheet financing has its drawbacks.
By using the black box technique, the operating company could make higher lease payments because they often include project development fees.
The black box method also means the operating company isn't as valuable if it would be put up for sale.
"Companies when they are sold have bigger valuations if they have buildings on the balance sheet," Skolnick says. "If they lease the buildings, they're not as valuable."
Firms taking on the black box role are banking on assisted-living properties appreciating in value so they can earn a healthy return if they sell the property.