Extendicare: a REIT in a rare rough spot

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It's rare to see a Canadian real estate investment trust hurting these days, but health care focused Extendicare is one of the exceptions.

Hit by a sudden cut to U.S. Medicare reimbursement rates, as well as a spike in lawsuit liabilities – in Kentucky of all places – Extendicare has taken a nose dive.

From its peak over the past year, Extendicare is down more than 30 per cent. By contrast, the S&P/TSX Capped REIT Index is up about 25 per cent since bottoming out when the broad market tumbled last August – and has even risen in the past few days despite the new bout of global economic turmoil.

Most poignantly, Extendicare was hit by an 11.1 per cent reduction to Medicare rates, a cut that is expected to send earnings before interest, taxes, depreciation and amortization lower by about $64-million a year. This rate change was announced last July, right before the entire market crumbled around the U.S. debt ceiling deadline, and Extendicare just hasn't recovered since.

(In fairness, it's worth noting that the medicare cuts were announced because reimbursements were unintentionally overpaid after a new rate classification system was put in place in 2010. So the big picture isn't as clear cut.)

For its part, the company has tried to offset the drop by lowering costs – to the tune of $24-million less each year – but no word yet on how much that will impact the services it provides. The company says it will operate just fine.

All in, the net hit to EBITDA should be about $40-million annually, the company figures.

Extendicare has also been troubled by a nagging law firm in Kentucky that has brought forward a number of lawsuits, forcing the REIT to put more money aside for settlements. Last November, the REIT said that the "increase in claims received has generally resulted from aggressive advertising by a certain law firm in Kentucky well known for soliciting liability claims against long-term care providers."

At the time Extendicare said it would review its options in the state. On Monday the REIT announced that it is exiting the market by leasing all 21 of its skilled nursing centres to a third-party.

To combat its problems, Extendicare has aggressively renegotiated its U.S. mortgages, bringing its weighted-average all-in rate down to 4.3 per cent, with a term of 33 years. (Note: the company has sizable Canadian operations, but the U.S. division is much bigger.)

Extendicare has also decided to convert to a corporation, and which was just approved by unitholders. The REIT has already been subject to the SIFT tax since 2007, so it promises that its distribution will be the same, and as a corporation its limits on foreign ownership will be relaxed. (Canadian REITs are capped at 49 per cent foreign ownership.) Extendicare also hopes that a corporate structure will give it favourable tax treatment on future deals.

Given the circumstances, Extendicare has managed the past year well. But there's nothing its executives can do about the extremely unfortunate timing of rate changes right when REITs are hot.