With REITs temporarily sidelined, several funds take center stage in pursuit of high-yielding assets.
By Bendix Anderson
On Aug. 31, Kayne Anderson Real Estate Advisors acquired Sentio Healthcare Properties Inc. for $825 million, including all assets and liabilities. The portfolio of 34 properties includes seniors housing communities and medical office buildings in 16 states.
What made this deal unusual wasn’t the properties or price tag, but rather the roles of the players involved. Kayne Anderson (KAREA) is a private equity fund manager, while Sentio is a public, non-listed healthcare real estate investment trust (REIT).
In the past, big REITs often purchased portfolios of properties acquired over time by private equity funds. This time the transaction worked in reverse.
In markets across the country, private equity funds have been buying more seniors housing properties as other types of investors buy fewer.
Investors overall spent half as much on seniors housing in the first half of 2017 compared to the peak year of 2015. For REITs and other buyers, the cost of capital has gone up. The yield on seniors housing investments is currently near historic lows, and uncertainty about overbuilding, interest rates and public policy have kept some seniors housing buyers on the sidelines.
But private equity funds like KAREA still have access to ready capital and opportunistic strategies to use it — whether that means turning around troubled properties, building new communities from the ground up or buying whole portfolios from REITs on the rocks.
“That created opportunities to transact at very good prices,” says Max Newland, managing director of healthcare real estate for KAREA.
Private equity funds are even sometimes buying relatively vanilla, stabilized, Class-A seniors properties to balance out the risk of investments like new developments.
“If you’re selling Class A, private-pay seniors housing, private equity is likely going to win that bid, which is a stark contrast to the buyer landscape in 2014 and 2015, when a REIT would have likely won,” says Joel Mendes, senior vice president for JLL's seniors housing capital markets team in Dublin, Ohio.
Private equity funds flush with cash
KAREA is now raising funds for its fifth private equity fund to invest in seniors housing: Kayne Anderson Real Estate Partners V.
KAREA’s Fund IV raised $1 billion. The new fund, which is on schedule to finish its capital raise shortly, is likely to raise up to $1.8 billion, according to experts familiar with the fundraising effort.
Over the last two years, private equity fundraising for real estate has increased dramatically.
“Currently, private equity fund capital available for investment, or ‘dry powder,’ is at its highest level on record,” says Mendes.
Investors are especially eager to put their money into higher-yielding funds focused on niche property types like seniors housing. Closed-end, niche private equity real estate funds raised $4.8 billion in 2015, according to Preqin. That’s more than double the fundraising in any other year going back to 2006.
“There has been increased capital raised for seniors housing,” confirms Mathew Whitlock, executive vice president with CBRE National Senior Housing Group.
Bridge Investment Group, the private equity fund manager formerly known as ROC Seniors Housing, is now raising capital for its second seniors housing fund, Bridge Seniors II.
Its first fund, Bridge Seniors I, formerly known as ROC Seniors Housing & Medical Properties Fund, closed its fundraising in 2015 with $740 million and finished investing the last of that money this year. With the use of debt financing, the fund was able to purchase $2 billion in seniors housing properties.
Bridge’s second fund is clearly on track to raise more than the first, according to sources familiar with the fundraising.
Like KAREA, Bridge is already investing in the capital raised for its second fund. Together, its two funds are on track to invest between $600 million and $650 million in seniors housing properties this year.
REITs leave an opening
At a time when private equity funds are finding more eager investors, REITs have less money to spend on seniors housing,
“Since 2015, we’ve seen a significant decrease in the buying activity of public companies, especially the big three real estate investment trusts,” says Bill Kauffman, senior principal at the National Investment Center for Seniors Housing & Care (NIC).
REITs bought $3.9 billion of seniors housing assets in 2016. That’s a fraction of the $11.6 billion REITs spent in 2015, according to NIC.
“This seems to be the year that private equity funds are more prominent,” says Susan J. Barlow, co-founder and managing partner of Blue Moon Capital Partners, whose Blue Moon Seniors Housing I fund recently finished investing its $250 million. The investments include four acquisitions and eight new developments.
Stock market volatility is part of the reason that REITs have pulled back on acquisitions. “REIT stock prices declined, increasing their cost of capital,” says JLL’s Mendes.
Ventas Inc. (NYSE: VTR) is a prime example. The REIT’s stock price closed at $80.43 per share on Jan. 23, 2015. By Feb. 12, 2016, the price per share had fallen to $48.43. The stock has been on a roller coaster ride since then, peaking in the mid-$70s in July 2016 before tumbling significantly and rising again. VTR’s stock price closed at $68.78 per share on Sept. 1, 2017.
As their stock prices rise again, REITs will become more active buyers, Newland predicts.
“This fall you’ll see quality opportunities hit the market and the REITs will be back to bid on them.” However, REITs are unlikely to spend as much they once did on acquisitions, he says.
Meanwhile, pension and sovereign wealth funds have become more active buyers. Institutions spent $4.4 billion on seniors housing properties in 2016. That’s up sharply from $3.2 billion in 2015 and just $1.9 billion in 2014, according to NIC.
Much of this institutional money has been raised by private equity real estate funds.
Why is deal volume slumping?
Investors of all types spent just $6 billion on seniors housing properties during the first half of 2017, according to NIC and Real Capital Analytics. That’s the slowest start to the year since 2013, and a fraction of the more than $13 billion traded during the first half of 2015.
“Where you might have had 12 potential buyers 12 months ago, you might have six now,” says Mark Myers, executive managing director of Marcus & Millichap’s National Seniors Housing Group.
The current malaise in property sales is affecting commercial real estate overall.
For example, across the U.S., investors spent roughly half as much to buy office properties during the first half of 2017 as they did the year before, according to Marcus & Millichap.
There are several reasons that investors have pulled the reins in on acquisitions.
“Investor surveys suggest that the dip in commercial real estate sales activity can be attributed to challenges surrounding high valuations, ongoing volatility and uncertainty in global markets,” says Steve Blazejewski, a managing director at PGIM Real Estate.
Interest rates also play a role. Both short- and long-term interest rates rose sharply at the end of 2016 and early 2017, without a corresponding increase in cap rates. “That contributed to a gap between what sellers were willing to pay and what buyers expected to receive,” says JLL’s Mendes.
Since the first quarter, interest rates stopped rising and started falling again, but are still significantly higher than they were a year ago.
Lenders are also becoming more conservative, which can limit how much potential buyers can afford to pay.
“It’s not unusual for lenders to reduce the loan-to-value ratio [they’re willing to allow] — 70 percent is not a given anymore. It’s no longer automatic,” says Myers. That’s particularly true for smaller properties or for product types and markets threatened by competition from an oversupply of other seniors housing properties, he adds.
Private equity funds continue to invest hundreds of millions of dollars in seniors housing, despite these challenges.
“We’ve seen some of the largest deals this year going to private equity funds,” says JLL’s Mendes. “Private equity, not beholden to public shareholder scrutiny, has been able to adjust and still buy in this environment, particularly in the seniors housing space.”
Undaunted by building spree
Even though some markets are arguably overbuilt, private equity funds can see potential upside in seniors housing investments.
Developers have started construction on a tremendous amount of seniors housing in many parts of the country. The number of new units of independent living and assisted living under construction may have peaked in 2016 at about 37,000 in the top 31 markets tracked by NIC.
The percentage of independent and assisted living units that are vacant is likely to rise slightly in 2017 as those units open their doors and compete for residents.
However, developers are expected to open fewer seniors housing properties in 2018, and even fewer than that in 2019. At the same time, the consumer demand for seniors housing is projected to increase over the next few years.
“The demand imperative tells you that the new construction is really not enough,” says Robb Chapin, CEO of Bridge Investment Group.
Private equity funds may even benefit from a little softness in the market if they are able to buy properties at a discount and find an opportunity to improve the income produced by the property.
High yields entice investors
Private equity funds are drawn to buy seniors housing assets in part because the sector can provide a yield that matches the promises the fund managers have made to their investors. Often those yield targets are as high as an 18 percent internal rate of return.
Seniors housing properties typically provide a higher yield than multifamily properties, getting fund managers a little closer to their yield targets. They also typically choose investments that they can transform while adding value in the process.
“Private equity funds have historically played in a value-
oriented investment role, looking for returns in the mid to high teens,” says Aron Will, vice chairman and co-head of the National Senior Housing Debt & Structured Finance practice for CBRE Capital Markets.
For example, even KAREA’s purchase of Sentio’s stabilized portfolio provides a substantial potential upside: “a compelling opportunity for KAREA to create value through property renovations, facility expansions and other operational enhancements,” says David Selznick, chief investment officer for KAREA.
Roughly 90 to 95 percent of the seniors housing investments in Bridge I and Bridge II are value-added investments.
The added value can be created by adding new services, or by renovating old, outdated apartments, or both.
For example, Bridge I just finished its capital expenditures at Thunderbird Senior Living, an independent living community in Glendale, Arizona. Built in the 1980s, more than a quarter of its housing units were empty.
“The community was losing its resident base out the back door because of acuity,” says Chapin.
Bridge saw an opportunity to create value by converting one-third of the units at Thunderbird to assisted living and memory care. “It has gone extremely well. A lot of independent living residents have already moved into the higher-acuity units,” says Chapin. The property also benefited from renovations to the apartments and common areas.
Thunderbird’s story is not unique. Roughly 60 percent of the seniors housing inventory that exists today was built before 1999, and 80 percent was built before 2006. “There is a lot of functional obsolescence,” says Chapin.
Private equity funds often focus on creating long-term partnerships with local operators who can turn around seniors housing properties.
“Private equity funds are almost always looking to build a business platform,” says Myers.
Relationships often help private equity funds avoid the frenetic bidding that can take place for seniors housing properties available for sale.
“The majority of our deal flow is off-market or very limited-market transactions,” says Chapin. In these transactions, the property is marketed to just one or a limited number of potential buyers.
New development challenges
Private equity funds are also developing new seniors housing.
For example, in June, Capitol Seniors Housing (CSH) opened 82 new units of assisted living and memory care at Arbor Terrace Morris Plains, a new community in Morris Plains, N.J.
CSH currently has 15 seniors housing projects in various stages of the development pipeline. The private equity fund is not worried about competition from other new seniors housing projects because its developments are mostly located in affluent suburbs where development sites are hard to find and the process of development is difficult.
For example, CSH met with local residents and town officials numerous of times over the 18 months leading up to securing the necessary zoning and approvals needed to build in Morris Plains.
“We go through a very tough local approvals process. We don’t want to constantly be looking over our shoulder,” says Scott Stewart, founder and managing partner of CSH.
KAREA has also recently broken ground on several new construction projects, in places like Mount Pleasant, Calif.; Raleigh-Durham, N.C.; and Napa County, Calif.
Construction financing is also a challenge. In the past, Kayne Anderson might have relationships with five lenders interested in providing financing for a new development. “Now maybe two will be in the market for any particular deal,” says Newland.
A few private equity funds are also balancing riskier investments like new development, which often provides a return on investment above 15 percent, with safer investments like stabilized, Class A properties, which typically provide returns in the single digits.
“Private equity funds are also actively investing in construction projects, oftentimes offsetting these higher-risk, back-end loaded returns by acquiring core or core-plus assets with current yield,” says JLL’s Mendes.