REAL ESTATE

As of September 30, 2016, we owned 196 health care real estate properties located in 32 states and consisting of 124 senior housing communities, 67 skilled nursing facilities, 3 hospitals and 2 medical office buildings. Our senior housing properties include assisted living facilities, senior living campuses, independent living facilities, and entrance-fee communities. These investments (excluding our corporate office of $1,152,000) consisted of properties with an original cost of approximately $2,392,524,000, rented under triple-net leases to 27 lessees.

During the nine months ended September 30, 2016, we made investments and commitments related to real estate as described below (dollars in thousands):



Operator	Properties	Asset Class	Amount
The Ensign Group	8	SNF	$	118,500
Bickford Senior Living	5	SHO	89,900
Watermark Retirement Communities / East Lake Capital Mgmt.	2	SHO	66,300
Chancellor Health Care	2	SHO	36,650
Marathon/Village Concepts	1	SHO	9,813
			$	321,163

Bickford

On September 30, 2016, NHI and Sycamore Street, LLC (“Sycamore”), an affiliate of Bickford Senior Living (“Bickford”), entered into a definitive agreement terminating their joint venture consisting of the ownership and operation of 32 stabilized properties and converting Bickford’s participation to a triple-net tenancy with assumption of existing leases and terms. During the period ended September 30, 2016, we owned an 85% equity interest and Sycamore owned a 15% equity interest in our consolidated subsidiary (“PropCo”) which owns 32 assisted living/memory care facilities, one new facility and four facilities in development. The facilities have been leased to an operating company (“OpCo”), in which we previously held a non-controlling 85% ownership interest. The facilities are managed by Bickford. Our joint venture was structured to comply with the provisions of RIDEA.

According to provisions of the unwinding, NHI agreed to redeem Bickford’s 15% interest in the real estate underlying the joint venture (PropCo) for a distribution to Bickford of $25,100,000, before the offset by Bickford of $8,100,000 payable to NHI in acquisition of our non-controlling 85% interest in senior housing operations (OpCo), which we have carried on our balance sheet as an equity-method investment through September 30, 2016. A remaining distribution of $10,546,000 related to the unwinding transaction is recorded in our accounts payable at September 30, 2016. See Note 3 for discussion of the disposition of our equity-method investment in OpCo in conjunction with the unwinding.

No gain or loss was recognized on our acquisition of Bickford’s 15% interest in PropCo, which has previously been consolidated. Rather, Bickford’s non-controlling interest was de-recognized, and the difference between the fair value of NHI’s cost allocated to the redemption and the carrying amount for Bickford’s non-controlling interest was recorded as an adjustment to equity through additional-paid-in capital.

Provisions governing details of the unwinding reach to our various arrangements with Bickford and include, but are not limited to, the following:


•	For the 32 stabilized facilities previously owned by the joint venture, forward annual contractual rent is unchanged at $26,260,000 plus annual escalators of 3%.

•

For the five additional facilities under development owned by NHI, of which one opened in July 2016, two opened in October 2016, and two are planned to open in the first half of 2017, funded amounts will be added to the lease basis during construction and up to the first six months after opening; thereafter, base rent will be charged to Bickford at a 9% annual rate. Once the facilities are stabilized, rent will be reset to fair market value.


•	Future development projects between the parties will be funded through a construction loan at 9% annual interest. NHI has a purchase option at stabilization, whereby rent will be set based on our total investment with a floor of 9.55% on NHI’s total investment.


•	On current and future development projects, Bickford as the operator will be entitled to incentive payments based on the achievement of predetermined operational milestones, the funding of which will increase the investment base for determining the NHI lease payment.

On June 1, 2016, in an asset acquisition, we acquired five assisted living and memory care facilities owned by Sycamore and operated by Bickford for $87,500,000, including $77,747,000 in cash and cancellation of notes and accrued interest receivable totaling $9,753,000 (Note 4). Additionally, we have committed $2,400,000 for capital expenditures and expansion of the existing facilities, the funding of which will be added to the lease base. The lease provides for an initial rate of 7.25% and term of 15 years plus two five-year renewal options. The annual lease escalator is 3%. NHI’s purchase option on an additional Bickford facility was relinquished. The facilities, consisting of 277 total units, are located in Iowa (2), Missouri, Illinois, and Nebraska. The facilities were not included in the RIDEA joint venture between the parties.

Of our total revenues, $8,528,000 (13%) and $6,150,000 (11%) were recognized as rental income from Bickford for the three months ended September 30, 2016 and 2015, respectively, and $21,999,000 (12%) and $17,844,000 (10%) for the nine months ended September 30, 2016 and 2015, respectively.

Watermark Retirement / East Lake Capital

On June 1, 2016, NHI acquired two entrance fee continuing care retirement communities (“CCRCs”) from funds managed by certain affiliates of East Lake Capital Management (“East Lake”) for $56,300,000 in cash, inclusive of a $4,500,000 regulatory deposit, and entered into a lease transaction with affiliates of East Lake. We accounted for the purchase as an asset acquisition. The CCRCs consist of 460 units and are located in Bridgeport and Southbury, Connecticut. The communities are sub-leased to affiliates of Watermark Retirement Communities (“Watermark”), the current manager. The lease has a term of 15 years, with an initial lease rate to East Lake of 7% with escalators of 3.5% in years two through four, and 3% annually thereafter. NHI has committed up to an additional $10,000,000 for capital improvements and potential expansion of the communities over the next two years, of which $747,000 was drawn at September 30, 2016.

In conjunction with the lease, East Lake acquired a purchase option on the properties as a whole, exercisable beginning in year six of the lease. The option will be based on our initial acquisition cost, our funding of capital improvements and expansions, other additional funding that may then be in place, or further rent escalations during the remaining duration of the option window.

East Lake’s June 2016 lease represents an expansion of its relationship with NHI, which began in July 2015, with our acquisition and lease to East Lake of two senior living campuses and one assisted living/memory care facility. East Lake’s relationship to NHI consists of its leasehold interests and purchase options and is considered a variable interest, analogous to a financing arrangement. East Lake is structured to limit liability for potential damage claims, is capitalized for that purpose and is considered a VIE.

The Ensign Group

On April 1, 2016, we purchased eight skilled nursing facilities in Texas totaling 931 beds for $118,500,000 in cash. The facilities were owned and operated by NHI’s existing tenant, Legend Healthcare (“Legend”), and we accounted for the purchase as an asset acquisition. Concurrent with the acquisition, we amended in-place leases covering the nine existing skilled nursing facilities we leased to Legend, extending their provisions to the new facilities. The amendment also replaced purchase options that provided for equal sharing of any appreciation in value, within a specified range, with purchase options having a price determined at fair value, exercisable at the end of the lease term. Based on our analysis of the in-place rights, benefits and obligations, $6,400,000 of the consideration in the acquisition was allocated to the canceled provisions related to the in-place leases.

On May 1, 2016, Legend and NHI agreed to transition Legend’s skilled nursing operations under it’s lease with NHI to a new operator, and NHI entered into a new 15-year master lease with affiliates of The Ensign Group, Inc. (“Ensign”) on 15 of the former Legend facilities for an initial annual amount of $17,750,000, plus an annual escalator based on inflation. NHI’s total original investment in the 15 facilities leased to Ensign is approximately $211,000,000. The Ensign lease has two 5-year renewal options. Upon entering the new lease, NHI sold to Ensign for $24,600,000 two remaining skilled nursing facilities in Texas totaling 245 beds previously under lease to Legend. The Ensign lease, secured in part by the operator’s corporate guaranty, replaces the amended Legend lease, and, accordingly, the rights, benefits and obligations held by Legend have terminated. In recording the transition of our leases to Ensign, we wrote off the fair value assigned to the former Legend leases and $8,326,000 of accumulated straight-line rent receivable, leaving an allocation of $6,252,000 to land and $105,848,000 to depreciable assets.

As part of this transaction, NHI is committed to purchase, from a developer, four new skilled nursing facilities in Texas for $56,000,000 which are leased to Legend and subleased to Ensign. The purchase window for the first facility is open. The other three facilities are under construction by the developer. The fixed-price nature of the commitment creates a variable interest for NHI in the developer, whom NHI considers to lack sufficient equity to finance its operations without recourse to additional subordinated debt. The presence of these conditions causes the developer to be considered a VIE.

Marathon/Village Concepts

On January 15, 2016, we acquired a 98-unit independent living community, Woodland Village, in Chehalis, Washington, for $9,463,000 in cash inclusive of closing costs of $213,000 plus an additional commitment to fund $350,000 in specified capital improvements, of which $158,000 has been funded at September 30, 2016. We leased the facility to a partnership between Marathon Development and Village Concepts Retirement Communities for an initial lease term of 15 years. The lease provides for an initial annual lease rate of 7.25% plus annual escalators. Because the facility was owner-occupied, the purchase was accounted for as an asset acquisition.

Chancellor

On August 31, 2016, we acquired two facilities consisting of a senior living campus and a memory-care facility in McMinnville, Oregon, for $36,650,000 in cash inclusive of closing costs of $150,000. We leased the facilities to Chancellor Health Care (“Chancellor”) for an initial lease term of 15 years, plus renewal options, at an initial annual lease rate of 7.5% plus annual escalators. Because the facility was owner-occupied, the purchase was accounted for as an asset acquisition.

Holiday

As of September 30, 2016, we leased 25 independent living facilities to an affiliate of Holiday Retirement (“Holiday”). The master lease term of 17 years began in December 2013 and provides for an escalator of 4.5% in 2017 and a minimum of 3.5% each year thereafter.

Of our total revenues, $10,954,000 (17%) and $10,954,000 (19%) were derived from Holiday for the three months ended September 30, 2016 and 2015, including $2,241,000 and $2,616,000 in straight-line rent, respectively. Of our total revenues, $32,863,000 (18%) and $32,863,000 (19%) were derived from Holiday for the nine months ended September 30, 2016 and 2015, including $6,724,000 and $7,849,000 in straight-line rent, respectively. Our tenant operates the facilities pursuant to a management agreement with a Holiday-affiliated manager.

NHC

As of September 30, 2016, we leased 42 facilities under two master leases to National HealthCare Corporation (“NHC”), a publicly-held company and the lessee of our legacy properties. The facilities leased to NHC consist of 3 independent living facilities and 39 skilled nursing facilities (4 of which are subleased to other parties for whom the lease payments are guaranteed to us by NHC). These facilities are leased to NHC under the terms of an amended master lease agreement originally dated October 17, 1991 (“the 1991 lease”) which includes our 35 remaining legacy properties and a master lease agreement dated August 30, 2013 (“the 2013 lease”) which includes 7 skilled nursing facilities acquired from a third party.

The 1991 lease has been amended to extend the lease expiration to December 31, 2026. There are two additional 5-year renewal options, each at fair rental value of such leased property as negotiated between the parties and determined without including the value attributable to any improvements to the leased property voluntarily made by NHC at its expense. Under the terms of the lease, the base annual rental is $30,750,000 and rent escalates by 4% of the increase, if any, in each facility’s revenue over a 2007 base year. The 2013 lease provides for a base annual rental of $3,450,000 and has a lease expiration of August 2028. Under the terms of the 2013 lease, rent escalates 4% of the increase in each facility’s revenue over the 2014 base year. For both the 1991 lease and the 2013 lease, we refer to this additional rent component as “percentage rent.” During the last three years of the 2013 lease, NHC will have the option to purchase the facilities for $49,000,000.

The following table summarizes the percentage rent income from NHC (in thousands):



	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2016		2015		2016		2015
Current year	$	733	$	596	$	2,199	$	1,788
Prior year final certification¹	—		—		547		94
Total percentage rent income	$	733	$	596	$	2,746	$	1,882

¹For purposes of the percentage rent calculation described in the master lease Agreement, NHC’s annual revenue by facility for a given year is certified to NHI by March 31st of the following year.

Of our total revenues, $9,270,000 (15%) and $9,133,000 (16%) were derived from NHC for the three months ended September 30, 2016 and 2015, respectively and $28,357,000 (15%) and $27,492,000 (16%) for the nine months ended September 30, 2016 and 2015, respectively.

The chairman of our board of directors is also a director on NHC’s board of directors. As of September 30, 2016, NHC owned 1,630,462 shares of our common stock.

Senior Living Communities

As of September 30, 2016, we leased eight retirement communities with 1,671 units to Senior Living Communities, LLC (“Senior Living”). The 15-year master lease contains two 5-year renewal options and provides for annual escalators of 4% in 2017 and 2018 and 3% thereafter.

Of our total revenue, $9,855,000 (16%) and $9,855,000 (17%) in lease revenues were derived from Senior Living for the three months ended September 30, 2016 and 2015, respectively, including $1,795,000 and $2,105,000, respectively, in straight-line rent. For the nine months ended September 30, 2016 and 2015, of our total revenues, $29,566,000 (16%) and $29,566,000 (17%) were derived from Senior Living including $5,386,000 and $6,316,000, respectively, in straight-line rent.

Other Lease Activity

As a result of material noncompliance with lease terms, we began exploratory measures to effect either transitioning the lease of a 126-unit assisted living portfolio from the current tenant or the marketing of the underlying properties. Either of these courses of action result in recording a reserve, for accounting purposes, at September 30, 2016, of $1,131,000 related to straight-line rent receivables. While straight-line receivables represent the effects of recognizing future escalations under terms of the lease using the straight-line method, we anticipate full recovery of all amounts billed to date under the lease. We have made no provision for any legal or other costs associated with the transition, as these amounts are neither estimable nor, in the opinion of management, material to our financial position or results of operations. Contractual rent received through August 2016 was $1,491,000.

Disposition of Assets

On March 22, 2016, we sold a skilled nursing facility in Idaho for cash consideration of $3,000,000. The carrying value of the facility was $1,346,000, and we recorded a gain of $1,654,000. As discussed above in connection with The Ensign Group, we sold two skilled nursing facilities in May 2016 for total consideration of $24,600,000 and realized a gain of $2,805,000 on the disposal. In June 2016, we recognized a gain of $123,000 on the sale of a vacant land parcel.