Tenant Struggles Continue, Magnifying Concern for Omega's Dividend Coverage Outlook

Despite a broad economic recovery, the struggles of skilled nursing facilities (SNFs) amplified by the pandemic continue to loom large.

With SNFs accounting for nearly 80% of Omega's portfolio, not much has improved since our note last August. Dividend coverage remains stretched as SNF operators, the REITs tenants, continue to struggle with reduced occupancy rates and labor issues. As such, we are reaffirming Omega's Unsafe Dividend Safety Score.

When Covid became a national concern, occupancy at Omega's properties fell from 84% to a low of 72% in January 2021 and has since only modestly improved to 75%. Further problematic is that occupancy rates before the pandemic were already too low, thanks to an oversupply of SNFs that kept many operators struggling to turn a profit.

On top of reduced revenues from lower occupancy, SNFs have incorporated costly Covid-related safety protocols, which have further eroded operator profitability. To make matters worse, a labor shortage has restrained SNFs from serving more patients, increased staffing costs, and made many necessary jobs hard to fill – further complicated by vaccine mandates.

Thankfully, in 2020 the government created the Provider Relief Fund with $175 billion to aid health care service operators, which has been a lifeline to many SNFs. However, these stimulus funds are temporary and running low.

In the most recent data available on the matter, Omega reported that its operators had received $253 million of government aid in the 12-month period ending in September 2021. That represents about 30% of Omega's annual rent from these tenants.

With the Provider Relief Fund running low, more of Omega's tenants may soon find paying rent difficult. In fact, operators representing about 15% of income had stopped paying rent as of January 2022. 

This figure seems likely to rise since around half of Omega's rent comes from operators with questionable rent coverage ratios below 1.2x. And excluding relief funds, Omega's portfolio-wide rent coverage falls to just 0.88x.

For context, rent coverage of 1x indicates an operator generates just enough cash flow to cover rent and debt service but has no flexibility to invest in other areas such as maintaining its property.

Assuming government aid continues to dwindle and occupancy rates continue stagnating, Omega may need to restructure a large portion of these leases at lower rates, find new operators, or dispose of some properties. Each of these scenarios would at least temporarily reduce cash flow.

This situation is alarming for a highly leveraged REIT whose projected cash flow is already expected to barely cover the dividend.

On Omega's fourth-quarter 2021 earnings call earlier this month, management said they will not change the dividend unless they see "a long-term impact on our cash flows."  

We believe there is a realistic chance cash flow will be disrupted long enough for Omega to reduce the payout this year. If a dividend cut does take place, a 25% reduction would seem reasonable to return Omega's payout ratio to a more sustainable level going forward. Shares would still yield north of 7% in that scenario.

While there is still some optimism for the long-term outlook of SNFs thanks to an aging population and an expected correlated increase in health care spending in the years ahead, the industry lacks a sound foundation to inspire much confidence.

The SNF industry is still trying to find a bottom, suggesting things could get worse before they get better.

With so much of the near-term outlook for SNFs tied to uncertain government aid and intervention, conservative investors may find safer exposure to the health care industry in REITs like Physicians Realty Trust or Medical Properties Trust.

We will continue to monitor for improvements and communicate any changes to Omega's Dividend Safety Score.