Whether the triple-net leasing model can remain viable in the long term in the senior living space has been the topic of much debate over the last few years. The greater prevalence of RIDEA structures and real estate joint venture ownerships, the provision of additional capital through preferred equity and mezzanine debt, and the increased use of management arrangements, have cast into doubt the long-term utility of the triple-net lease. For premium assets in desirable markets, alternatives such as a RIDEA structure and management arrangements, which can more closely align the interests of the landlord and the operator, might in fact be superior to the typical net lease structure. While such alternatives are now established and may become increasingly common in the market, it seems unlikely the triple-net lease will disappear in the foreseeable future.
A typical triple-net lease in the senior living space often involves a pooling of multiple properties by a single property owner, which are then leased to an independent operator, with set annual rent escalators that apply regardless of performance or market conditions. Opponents of the triple-net lease raise the following objections with respect to the arrangement:
- When faced with weak occupancy, rising operational expenses and flat or declining reimbursement rates, the challenges faced by a tenant with an annual rent escalator are obvious.
- Structural constraints can oftentimes compound market issues—where a REIT is the landlord, restrictions on what a REIT can or cannot agree to, even if the landlord were willing to provide relief or restructure a lease, can rule out creative workarounds aimed at achieving long-term stability.
- The presence of a mortgage lender, whose timeline and priorities are generally not the same as a landlord's or operator's, can inhibit restructuring and often only result in short-term solutions for what are long-term problems.
Despite these issues, it seems unlikely the use of the triple-net lease will be abandoned altogether. Also, given the long-term nature of many existing leases in the market, landlords and operators will have no choice, but to live with existing lease arrangements and restructure them to the extent necessary and possible. Below are a few matters that (a) investors in this space should consider when making an investment in either an operator or landlord that is a party to a triple-net lease, and (b) that landlords and operators will likely need to take into consideration when assessing the entry into, or restructuring of, a triple-net lease:
- Coverage requirements: Minimum coverage requirements are a common feature of long-term triple-net leases in the senior living space. Tenants under master leases with numerous properties that are burdened with facility-specific coverage covenants will necessarily be at a disadvantage to those that are able to negotiate covenant testing on a portfolio basis. Using a portfolio coverage test and including extended cure rights will mitigate issues that might otherwise arise when a subset of facilities underperforms due to market or other reasons, but the overall portfolio is otherwise financially robust.
- Capex requirements: It is typical for a triple-net lease in the senior living space to impose minimum capital expenditure requirements on an operator, in addition to a general covenant to maintain the premises. Mostly, this requirement takes the form of a covenant to spend a minimum amount per annum, per bed. Just as testing coverage covenants on a facility level basis creates issues for an operator, so too does the imposition of a capex bed spend by facility. Facilities don’t age equally and the demands of the market may warrant sinking a disproportionate amount of capital into certain facilities. The use of a portfolio-level capital expenditure requirement will afford an operator greater flexibility in this regard. For a landlord and its lender, whether to permit such flexibility does not need to be binary. Requiring a reduced minimum spend per facility and a higher overall spend across the portfolio is one way to balance the needs of both the operator and the landlord.
- Financing: Agency lenders such as HUD, Fannie Mae and Freddie Mac, have been a considerable source of financing for landlords in the senior living space. The ability to negotiate loan terms mandated by their programs can be less flexible than commercial lenders; however, taken overall, the terms can be more favorable. The lending requirements to be satisfied in order to access agency programs are well-known. A landlord should consider requiring, and a tenant can expect to see, provisions requiring a tenant to cooperate in complying with agency requirements (many of which will be applied to the tenant and licensed operators).
On the operator side, the use of accounts receivable financing is extremely common. Ordinarily, a tenant will grant a lien in its assets to the landlord to secure its obligations under the lease. A well-crafted lease will allow an operator to grant a priority security interest in its account receivables and related assets to its lender, and provide for the entry into a mutually agreeable intercreditor agreement.
- Cross-defaults: For a landlord or operator, cross-defaulting the lease and its financing can be fraught with peril. In particular, both landlords and tenants should take care not to allow minor defaults under the lease to cross-default either financing.
As noted above, it seems unlikely the triple-net lease will cease being a feature of the senior loving space anytime soon. Reducing rent and eliminating rent escalators is an instant, but unrealistic solution for operators struggling in the current environment. However, for existing operators and landlords, as well as new investors in senior living assets, approaching certain key lease terms in a creative way may alleviate some of the pressure created by a downturn in market conditions.
Peter Mair serves as counsel in the real estate practice of Skadden, Arps, Slate, Meagher & Flom LLP.
