I caught up with analyst Frank Morgan  of Jefferies & Company recently and asked him about the market forces that sparked the volatility in seniors housing stocks this year, and what he thinks lies ahead for the industry.

You can click here to listen to the interview (9 minutes) or read the transcript below.
Steve Monroe
We’re here today with Frank Morgan, managing director and healthcare equity analyst with Jefferies & Company.

Good morning, Frank.  Most of the seniors housing stocks got whacked earlier this year. Were investors justified or did they just overreact to economic news?

Frank Morgan
Well, you’re certainly right about the “whack” part.  From the 2007 yearly highs until the end of the third quarter, the average stock was down about 26% with the worst one down about 32%.  The best performer was down only 16%.  Now, fortunately, the stocks have bounced off those lows recently, so you’re definitely correct in terms of the stocks got hit and were very volatile.

Was a correction justifiable?  Correction probably justified to some degree, but as usual, things usually get overdone.  Don’t forget, we’ve actually been in a multi-year bull market in these stocks and the two factors that have been driving the stocks were and still are what’s happening with real estate values and then the fact that you’ve had very good positive operating trends in terms of occupancy and rates, so I would certainly attribute this weakness and volatility to a couple of things.  I think there was, once again, something quietly going on that a lot of investors on my side of the world, on the operator side, really weren’t paying attention to, was this big sell-off that you saw with REITs.  And certainly those stocks peaked out about two months, really back in February, about two months before you saw the operators start to roll over.  So, if part of the reason the stocks went up was rising real estate values, then certainly you would expect the opposite to occur if there is a decline and certainly looking at what’s happening in the healthcare REIT market, it certainly looks like the valuations have declined.

And, certainly, the operating trends in the first and second quarter, you know, spooked people.  A little bit of soft occupancy numbers and people started worrying about the housing market and construction and a lot of other things.  So, to some degree, I think it was justified and probably was actually a little bit—was healthy.

Steve Monroe
It also seemed that investors really did not differentiate that much among the various companies and threw them all together.  Was that a bit of a herd mentality?

Frank Morgan
Yes, I mentioned earlier, when the mood on Wall Street turns, it usually is not very discerning.  They all went down and it wasn’t like the trends of an individual company were stronger than the industry outflows that we saw.  You look at individual stocks – Assisted Living Concepts [ALC], Brookdale, Emeritus and Five Star – group averages all reached yearly lows within two weeks of each other.  So we did look at correlation in terms of asset ownership, leased portfolios, strong or weak earnings visibility and cash flow.  Basically, nothing really conclusive there; they basically all went down.  Sunrise was probably the anomaly.  Obviously, for some different reasons, it was down, but certainly I think takeout talk there probably helped that one.

Steve Monroe
And we’ve been hearing talk about maybe a little over-building in the seniors housing market.  Of all the publicly traded companies, do you know of any that are seeing new construction in their markets that is at all worrisome?

Frank Morgan
Well, you know, we went back and looked at all our second quarter calls and then we’ve actually talked to a lot of people here at the NIC [National Investment Center for the Seniors Housing and Care Industry] conference.  And, you know, we just really don’t see anything that’s alarming.  I know that Five Star is seeing construction in three out of their 162 markets; Capital Senior Living is seeing it in one market.  The other guys really, from Brookdale, ALC, Sunrise, nothing that’s alarming that we see out there.

And, interestingly, here at the NIC there seems to be a lot of people, the people that we talked to or out in the field basically say there’s a lot of people talking about what they’re going to do, but nobody’s really doing it and, certainly, with what’s happened in the markets here, the credit markets, it might actually make it more difficult.

Steve Monroe
Well, speaking of the credit markets, with the problems we’ve had in the debt markets combined with the residential housing market slowdown, do you think seniors housing companies will focus more on organic growth next year?

Frank Morgan
Well, you know, it’s interesting, most of the providers actually were emphasizing organic growth.  Now, I do count expansions as part of that story.  It just doesn’t look like there’s a significant amount of new construction, de novo construction going on.  So the biggest acquirer in the business certainly stopped late last year.  And, yeah, there is certainly focus on things like ancillary services and really just focus on improving occupancies.  ALC has a couple of expansions, about 400 units underway, Brookdale has a good expansion program.  But you’re right, I think it’s more focused really on the organic side and there’s a big opportunity left for all the companies with what they have today and it’s probably a safe and healthy thing to do to really not go out too much and particularly with what might be changing in the acquisition market with valuations.

Steve Monroe
What do you think has happened to acquisition values and cap rates, given the problems this summer?

Frank Morgan
Well, I think certainly if you look at what’s happened in the healthcare REIT stocks, it would tell you that cap rates are going up, that underlying asset valuations are declining.  But it’s really interesting, as we’ve walked around the conference here, we don’t see a lot of transactions that have actually occurred and you probably have a better handle on that than me, but it does seem like the offer side of the market is kind of holding, the bid side’s dropping, so there’s a widening gap between bid and asked on transactions.  But it looks like most people are sitting tight.

But, I would have to think valuations, when transactions start to occur again, you’ll start to see a little bit higher cap rates.  And, by the way,  I think that’s probably a healthy thing.  Certainly you could argue that as valuations retreat here a little bit, it probably takes a little bit of the luster out of actually going out and doing new capacity growth.

Steve Monroe
And then looking at the skilled nursing market, are you concerned at all about Medicare reimbursement changes in 2008 and beyond?

Frank Morgan
Well, you know, it’s one of those yes-and-no answers.  It’s always a relative thing.  But not overly concerned.  You had CMS [Centers for Medicare and Medicaid Services] come out with their final market basket update for fiscal ’08, but certainly most of us expect to see at some point, if we get some additional Medicare legislation passed, probably you will see a haircut to that market basket.  So they may get one quarter, they may get the fourth calendar quarter of this year at this full market basket update, but I think most people are certainly anticipating that they’ll have to give a little bit of that back, as Congress comes up with a doctor fix and some other pieces of legislation related to Medicare they have to fund.

So, you know, I think that’s probably the biggest thing.  Certainly Congress, we think, will get around to also fixing this Part B doctor fix, we think that definitely will end up happening, so I’d say a slight haircut to the market basket probably doesn’t freak out investors.  I think if you had a freeze like you saw in the CHAMP act, certainly that would probably catch folks off-guard.

I think there are some other good trends, though.  You always worry about reimbursement, but I do think that there are some very good operating trends in terms of Medicare census growth.  SNFs continue to pick up incremental Medicare volume from the impact of what you’re seeing going on in the rehab industry and in the LTAC industry.  On the Medicaid side, it’s state-by-state analysis, but in general I’d say things are pretty much okay in that world.

Steve Monroe
Do you, and when you talk to Jefferies’ investing clients, do investors ever, in the senior housing and care space, do investors ever target companies known for higher quality care?  Is that a concern for them?

Frank Morgan
Well, yeah, sure.  Health care investing is already difficult enough and just trying to stay ahead of the reimbursement environment, like you were asking about, that’s a full-time job and given all the bad things that can happen if there are quality issues, like investigations or decertifications, the headline noise and the financial consequences of that, you certainly try to focus on what you perceive as higher-quality names.  And you look at, Manor Care is a perfect example of that, certainly perceived as the best-in-class from an asset standpoint and as an operator. And that stock, by the way, has always been rewarded with a nice premium valuation, so certainly investors want to look at that.

Steve Monroe
Do you think landlords will ever be held accountable, legally or financially, for the quality of care provided by their tenants?

Frank Morgan
You know, I’m not a lawyer here, but it certainly doesn’t make sense.  I have talked to lawyers about this topic and the legal theory there is a real stretch to happen.  I know obviously there’s a lot of concern about what’s been written with New York Times articles and some concerns there, but I think, absent any kind of change in law, it probably is hard to do, but I’m probably not your best source there.  But the people I’ve spoken with think that it’s a very hard leap to make.  You start opening up the door to things like, well, medical liability that occurs when a physician practices, is that the responsibility of a REIT that owns the M.O.B.[medical office building]?  So I think you just opened the door for a lot of things that are very difficult.

Steve Monroe
Right, I agree, I don’t think it’ll ever come to pass, but people may be trying to.  All right, thank you, Frank, for your time and we’ll catch up again soon.

Frank Morgan
Thanks, Steve.