Is the Canadian fee-gouger's reign at Vital Healthcare nearly over?

The seemingly innocuous announcement that Vital Healthcare Property Trust's manager was replacing its representative on Vital's board concealed a momentous upheaval at Canada-based Northwest Healthcare Properties Real Estate Investment Trust (REIT).

Paul Dalla Lana not only left Vital's board, but he also stepped down as Northwest's chief executive and executive chair.

At the same time, Northwest announced “a broad-based strategic review to unlock value.”

Long-term investors are likely well-attuned to the fact that “strategic review” is so often corporate-speak for “we're in trouble” and/or “we need to sell something.”

And it does seem as if Northwest is in some trouble and that it does need to sell something.

On June 8, it announced that it expected its British-based joint venture would close that month.

The institutional investor – believed to be Singapore's sovereign wealth fund GIC – had “waived conditions and finalised terms on the previously disclosed UK JV, including an investment into the REIT's existing UK structure, which holds a portfolio of 14 UK hospitals.”

GIC was expected to pay about £165.8 million, or about C$276 million, to take a 70% stake in the JV, leaving Northwest owning the other 30%.

However, by June 21, the deal was off and Northwest had to announce that “the previously referenced institutional investor will no longer be proceeding.”

Amicable parting?

The news of Dalla Lana's ouster had been painted as amicable and that he was leaving “to focus on initiatives at Northwest Value Partners Inc., the REIT's largest shareholder.”

That vehicle owns 9.9% of the REIT and has said it supports the strategic review.

But a glance at Northwest's last financial report for the six months ended June 30 provides an inkling of the difficulties it's in.

It made a net loss of C$196.6 million for the six months after a profit of C$240.1 million in the same six months last year, largely because the value of its properties was written down by almost C$292 million after a C$133.2 million gain in the year-earlier six months.

That loss is unrealised, of course, but what wasn't unrealised was the 88% jump in its mortgage interest bill to C$108.8 million.

As well, its general and administrative expenses jumped by 23.5% to C$28.6 million while transaction costs almost doubled to $23.4 million. Presumably, the latter included the costs of the collapse of the GIC deal.

So, I'd translate that “strategic review” as meaning the remaining directors are looking at Northwest's assets to figure out what is saleable

The notes to the accounts reveal that as at June 30, Northwest had borrowed C$182 million against 185.3 million Vital units, meaning selling them would at least reduce some of the debt.

As of Aug 25, Northwest owned 191.7 million Vital units with a market value yesterday, Monday, Sept 11, of $394.9 million at the $2.06 close.

But since Della Lana's ouster, the value of the units has plunged from $2.32, dropping $49.3 million off the value of Northwest's stake.

That’s the lowest price Vital units have traded at since March 2020 when we were in the first throes of the covid pandemic.

But the low price makes sense – if you think Northwest might be forced to sell, that means a huge overhang and drag on the market for Vital units.

A botched process

But the biggest value in Vital for Northwest over the years has been its ownership of Vital's management contract.

ACC is normally a very astute investor and its investment team has done a fantastic job of stewarding its nest egg, beating its benchmarks almost every single year.

But the saga of how Vital's management contract ended up in Northwest's greedy hands doesn't cover the agency with glory.

Back in 2011, ANZ Bank owned the management contract and offered to sell it to Vital's investors for $14 million.

That was at a time when investors were getting very antsy about how much in fees managers were raking in out of listed and other types of property trusts.

Vital's independent directors managed to beat the price down to $8 million but the riled-up investors, led by ACC, the NZ Superannuation Fund and Westpac, tried to sack ANZ as manager instead.

The vote garnered only 25.2% support and the Northwest swooped in and took the prize from under their noses, paying $11.5 million

Investor unrest quietened down after that – no doubt these major investors were licking their wounds – and didn't re-emerge until 2018 when it gradually unfolded that Northwest was treating Vital as its very own piggybank, even charging Vital fees for giving Vital the “privilege” of lending Northwest money, as it pursued the then ASX-listed hospitals owner Healthscope.

By that time, Northwest had already extracted in gross fees more than 10 times the price it paid for Vital's management contract. That reflected the fact that both its base management fees and its incentive fees were based on Vital's gross assets.

Fee restructuring

Northwest got to pocket up to 1.75% of Vital's gross assets each year with 0.75% of that being the base management fee.

After much argy-bargy, Northwest eventually agreed to restructure its fees.

The result was better than the black box of the previous structure, but it remains undesirable, particularly because it explicitly rewards the manager for gearing up Vital.

Vital's gearing at June 30, as defined in the trust deed, was 36.3%, up from 30% a year earlier.

The actual base management fee now ranges from 0.65% of gross assets for the first $1 billion down to 0.4% of gross assets over $3 billion, while the incentive fee is 10% of the average annual increase in net tangible assets measured over a three-year period.

However, it was far from clear when the change was announced how much difference this would make to the management overhead costs, largely because, at the same time, Northwest started charging fees explicitly for all manner of related activities such as leasing, project management, acquisitions and disposals, and property development fees.

For example, in the year ended June, Northwest pocketed $18.5 million in base fees and almost $15 million as its incentive fee.

All those little extras

But it also charged nearly $2 million in property management fees, $733,000 in disposal fees, $571,000 in acquisition fees, $330,000 in leasing and licensing fees, and $6.8 million in development management fees.

In the four full years since the fee structure was changed, Northwest has collected $109.3 million in base management and incentive fees alone, and another $49.9 million in all these extra fees.

The big question now, is what is the Vital management contract worth now?

The gross value of Vital's properties has risen from $570 million 10 years ago to $3.4 billion at June 30, so it's clear, especially if the current fee structure remains in place, it's worth many multiples of the $11.5 million Northwest paid for it in 2011.

But there's a certain odure attached to the management contract, given how rapacious Northwest has been during its tenure of ownership, which has to translate to some kind of discount.

It seems pretty clear that Northwest is going to have to sell something and sellers with their backs to the wall don't tend to get the best prices.

What's the bet it can get a reasonable price for those British assets GIC rejected?

Selling in a difficult market

One clue is Vital's own track record of “recycling capital” in a difficult market.

It sold about $100 million of assets in the last financial year at an average 8.4% discount to book value and it has another $55 million of assets sold or under contract since June 30 at a 7.1% discount to book value (and remember that book value is after $208.6 million of writedowns of the value of its properties).

Management is planning to sell another about $100 million of non-core assets through the current year.

Analysts' valuations of Vital units carry implied hefty discounts, no doubt reflecting the impost of the onerous management contract.

Of the three I've seen, Forsyth Barr's Rohan Koreman-Smit's 12-month target price is the most generous at $2.55 while Craigs Investment Partners' Nicholas Hill's is $2.23 and Jarden's Arie Dekker's is the lowest at $2.08.

And yet Northwest says the net asset backing of Vital's units was $2.96 at June 30, down from $3.34 a year earlier.

Incidentally, one slide Northwest left out of its presentation of Vital's latest results and that it usually includes, was of Vital's comparative returns.

The slide in the 2022 presentation showed that while it produced a negative total return of 10.2% that year, that was 3.5 percentage points better that the S&P/NZX All Real Estate Index and 3.9 points better than the benchmark top 50 index.

Between June 2022 and June 30 this year, the unit price fell from $2.695 to $2.34 while distributions were 1.3% higher at 9.75 cents per unit. Northwest's guidance is for a flat payout this year.