Seniors housing investment brokers weigh in on the top seniors housing issues for 2018 and beyond.
Vice President, Seniors Housing Group
Cushman & Wakefield
Senior Living Investment Brokerage
Evans Senior Investments
Heavenrich & Co.
JCH Senior Housing Investment Brokerage
Founding Partner, Senior Managing Director
Blueprint Healthcare Real Estate Advisors
Senior Managing Director of Investments
Institutional Property Advisors
Managing Director, Senior Housing &
Healthcare Investment Sales Lead
By Jeff Shaw
Seniors housing is a turbulent industry.
In addition to the market factors that affect all of commercial real estate, seniors housing owners and operators have to deal with strict government regulations, massive labor concerns and competition from other forms of care such as home health.
But the upside is undeniable. The sector has proven to be resistant to many of the ebbs and flows of the economy and offers strong returns. Throw in the future demographic wave of aging baby boomers, and many investors salivate.
Seniors Housing Business spoke to a panel of top transaction brokers within the seniors housing sector to see where we stand today, and where we’re heading tomorrow, as an industry.
Seniors Housing Business: What’s the most compelling trend so far this year?
Cobb: The biggest surprise is the Welltower acquisition of QCP — the surprise being the plan to integrate the healthcare system with the skilled nursing operations. Several others are also looking at similar arrangements. It is very forward-thinking to get in front of bundled payments and managed care.
McMurtry: The biggest trend I see is the continued divestiture of assets from the REITs. In the last several years, we have seen them transitioning from net acquirers to net sellers, which has been impactful on the market.
Lowes: We continue to be surprised by the number of smaller, regional buyers who have filled in the vacuum from the REITs’ pullback from the acquisition market. It seems like every week we talk to a new group that is trying to grow and aggressively look at deals. The rise of these regional buyers demonstrates that the acquisition market continues to be very healthy and in balance from a buyer-seller standpoint.
Firestone: Values have held up in light of headwinds, both in the private-pay and skilled nursing markets. New capital coming into the space has clearly supported valuations.
Clousing: It has long been the rumor that staffing would be the largest challenge for our industry. The labor crisis has now landed front and center in the discussion and consideration of operators and even capital providers in the industry.
Secondarily, the quick fall from favor of stand-alone memory care has been surprising. This asset class was in high demand in the capital markets just a few years ago. The higher acuity of residents in memory care right now and significant development in many markets created shorter resident stays, inconsistent census, and difficulty keeping staff.
SHB: After a feverish pace in 2014-2015, the REITs slowed down their acquisitions/dispositions majorly over the last few years. What’s driving this trend? Do you expect it to continue?
Jandris: The slowdown is likely to continue as many REITs simply did too many sale-leaseback deals and are now weighed down with rent escalations and occupancy issues. Seniors housing is a cash-flow business and consumer-demand business. Despite portions of the market that are experiencing stagnation, well-located properties with strong cash flow or justifiable upside continue to draw interest from investors.
McMurtry: The trend of dispositions in the REITs started mostly in the skilled nursing sector and has now carried over into the private-pay seniors housing sector. Driving these trends is a desire to lessen the exposure to the lower-margin, lower-growth and higher-regulation skilled nursing markets.
The REITs have also been trying to diversify their portfolios from a tenant perspective and not have too much concentration with any one tenant. I do expect this trend to continue in the near future.
Cobb: REITs have been impacted by share prices driving up cost of capital. As such, REITs are not as competitive against the vast amount of other institutional and private capital.
Firestone: A large shift in desired investment structures (away from triple-net leases) is the biggest driver. Also, many of the most desirable regional operators found lasting partnerships several years ago.
Mooney: The combination of increased foreign capital and private equity investment has, to some extent, displaced REITs on the acquisition side. These alternative equity sources offer a lower cost of capital and are better positioned to take on value-add deals and new development.
We anticipate that REIT disposition activity will continue and potentially increase as lease coverage ratios decrease and annual lease rate increases outpace revenue growth. As the pendulum swings, and as the supply of foreign capital and private equity capital contracts, the REITs will be in a better position to pursue acquisitions.
Lowes: Many of the REITs have had idiosyncratic issues (such as tenant restructuring or mergers) not necessarily related to the overall market that have slowed down their acquisition activity. Many of the REITs are also simply targeting larger transaction sizes that are becoming less and less available in the market due to consolidation. Obviously, many of the value-add opportunities on the market don’t work under the typical tenant lease acquisition model of a REIT.
SHB: Compare and contrast the last 12 months with previous years.
Heavenrich: The biggest change in senior housing has been an aggressive movement to capture residents earlier and allow them to age in place within a community through the addition of independent living or active adult units.
The marketing approach has been drastically modified from care (needs) to lifestyle (wants). Location, build-out, amenities and adjacencies are a key focus. Additionally, the marketing is directed more to the future resident than the oldest daughter. By targeting a younger demographic (75 instead of 85) with few or no care needs, the market size has more than tripled.
While there will always be opportunities for strong operators of boutique assisted living and memory care communities, the larger continuum-of-care projects will put additional competitive pressure on traditional assisted living. This trend has also significantly increased the capital needs for developing these new projects.
Mooney: Over the past decade, interest rates have remained at historical lows, and capitalization rates for senior housing properties have declined steadily from an average of 9.8 percent in 2009 to 7.5 percent in 2017. Investors have remained bullish in spite of overbuilding in many markets and compression of capitalization rates.
It is difficult to determine if this is another example of “irrational exuberance.” However, we saw a similar pattern prior to the Great Recession with average capitalization rates declining from 10.8 percent in 2003 to 8.3 percent in 2007. We suspect that eventually there will be a “price correction” and some resulting shakeout.
Jandris: Several years back, REITs went on a tear acquiring properties with long-term leases. Occupancy and rates have not kept up, leading to a shift in investment strategy. Rather than triple-net leases being the primary investment vehicle, private equity buyers are putting together joint ventures with operators to handle management. There’s a smaller pool of buyers now, but the market is seeing a lot more capital and easier access to debt despite higher interest rates.
Clousing: The past 12 months we have seen a sharper focus on competition, labor markets and stricter underwriting standards. About 12 to 18 months ago, the buying community was willing to look forward on operations. In-place cash flow and the performance of the competing assets in the market are part of every decision now. Additionally, most financing has been either bridge-to HUD or Fannie/Freddie as buyers look to control inflationary risk on the debt side of their capital stack. Pricing has been relatively level, but for certain asset classes pricing has slightly decreased. This includes more rural, smaller and older assets.
Firestone: We are in a similar spot as interest rates have remained relatively constant, debt and equity markets flush, and new construction continues to charge ahead despite underlying occupancy rates. This tells me that market believes in long-term absorption and demand drivers.
Carriero: I still see a lot of activity in the market. However, I also notice that buyers are drilling down to every detail in the financials and arriving at their own value.
Cobb: There are a lot of older, broken deals in the market. It feels like last year’s great purge has gained momentum this year.
Lowes: The last 12 months seem to have seen more high-profile mergers, corporate restructurings and spin-offs. Although it appears a bit like musical chairs, it shows that the major players are becoming more focused on specific asset types and unwinding relationships with some large operators. This trend will bode well for the health of the acquisitions market in future years as these buyers return to the market with a renewed focus on growing their platform. This shift has also allowed smaller, regional buyers the opportunity to step into the acquisitions market.
The SNF challenge
SHB: The skilled nursing segment is facing a number of regulatory, reimbursement and operational issues. How is that backdrop affecting acquisitions and dispositions?
Lowes: The skilled nursing industry is undergoing a sea change in 2018 due to several large-scale disruptive forces impacting all players. The labor shortage is affecting the broader healthcare market, and skilled nursing most acutely. The widespread adoption of managed care (Medicare and Medicaid) continues to place downward reimbursement pressure on skilled nursing revenues.
We continue to see more and more skilled nursing facilities come to market as turnaround or value-add opportunities due to the inability of both independent and institutional operators to get ahead of these changes. The most active buyers in the space continue to be regional groups that can see the opportunity of these distressed facilities and have the financial backing to secure financing for turnaround deals.
Cobb: The skilled nursing segment continues to have a significant number of buyers. However, price expectations have been greatly reset. This has occurred primarily because the people buying nursing homes three or four years ago at the highest prices are finding themselves in financial and regulatory trouble.
Jandris: It’s true this segment is in a tough spot. What we’re seeing now after three to five years of a pretty frothy market is a divestment by REITs and other multi-state owners.
Buyers today tend to be private, regional owner-operators. These companies have a better skill set for taking on the various challenges of these need-driven assets, including a new Medicare reimbursement system, the privatization of Medicaid to managed care, hospital discharge lengths of stay, general declines in private pay, and difficulties in managing and maintaining staff.
Firestone: The buyers are nimble private equity and regional operators. Larger operators (and related investors) have been net sellers. This can be largely explained by the operating risk and claims environment. This also signals that the optimal size of a firm in the space may be shifting smaller.
SHB: Which segment(s) of seniors housing are you most bullish and bearish on and why?
Carriero: I am most bullish on skilled nursing. It has been a segment of the asset group that for years has not had a large investment pool. I feel that is because of the government regulations. I am somewhat bearish on assisted living, mainly because of new construction within the asset class. I feel this has generated an increased interest in skilled nursing.
Clousing: The rental campuses with multiple levels of care in strong secondary markets with little or older competition look to be the best performing assets with initial lease-up this year.
Additionally, some of the trophy assets in very urban markets should do very well as they are almost exclusively shielded from competition and close to a large labor pool. The higher rates also shield an owner from fluctuations in the labor costs given the higher margins.
Cobb: While not traditionally considered seniors housing, I am most bullish on market-rate, 55-plus senior apartments (lifestyle communities). I am also very bullish on affordable independent living with a la carte services.
I am pretty bearish on low-
barrier-to-entry tertiary and secondary markets for assisted living and independent living.
Jandris: There’s an allure in brand-new, well-located infill properties — typically large assets with 100 to 120 units that offer a mix of independent living, assisted living and memory care. Active-adult communities are becoming more popular now given the demand from a demographic of people who are a bit younger.
On the bearish side, older facilities that are smaller, typically with 25 to 40 units and located in tertiary or rural locations, are harder to sell in the current market.
Mooney: We are bullish on stabilized assisted living/memory care and skilled nursing properties in high-barrier-to-entry markets such as Seattle and coastal California. This has been a bulletproof segment of the seniors housing market, and we think this will continue.
We are bearish on senior living communities, particularly stand-alone memory care communities, in oversaturated markets with low barriers to entry such as Phoenix and Dallas areas.
Ripples of overbuilding
SHB: The high rate of new construction is finally slowing down, but not before driving occupancy rates to record lows. How has this trend affected the acquisitions side of the sector? Why do we still have so many pockets of overbuilding?
Mooney: A large part of the acquisitions market has been focused on acquiring value-add opportunities, including acquisition of underperforming assets in overbuilt markets. Overbuilding results from overly optimistic developers and aggressive lending practices coupled with insufficient knowledge of seniors housing.
However, in markets with high population growth rates, demand will eventually catch up to supply assuming future development is limited. We continue to see new development in even the most saturated markets because developers are fundamentally optimistic, and frequently their interests are not in alignment with providers of capital and operator entities.
Lowes: For better or worse, this real estate asset class suffers from a long development cycle. Decisions are often made 18 to 24 months ahead of actual development, before perfect market data is available. Development activity is often more heavily correlated with construction financing conditions than with market data. I think all buyers in today’s market have been more cautious in evaluating the barriers to entry in a market and evaluating replacement costs in their pricing.
McMurtry: Investors are more cautious today on occupancy fill-up projections. Understanding the strength of the market, and potential new competition, is a big factor in determining stabilized occupancy and fill projections.
Not all developers have access to good market data and demographics. Many developers have a piece of property they are trying to find a use for, rather than determining where there is a need. Fortunately, there are fewer developers like this today than there were in the past.
Firestone: The aggregate belief is that baby boomers equal demand over time. As investment structures become more aligned and flexible with respect to fixed payments, we are witnessing continued investment activity in light of occupancy challenges in the short run.
Clousing: Most feedback has been that the demographics will really begin to take hold and favor our industry between 2023 and 2025. Market-by-market occupancy could stall for a time until then. More conservative occupancy targets and rate growth have been a focus in the acquisition and lending market. It is going to continue to be a challenge in certain markets.
Lastly, many new groups have entered the market that did not have previous experience, but had the capital and lender relationships to build an asset. Most overbuilt markets that we observe have at least one project that was built by a new entrant into the market, typically from a developer coming from another asset class outside seniors housing (often multifamily or hospitality).
The finance puzzle
SHB: After years near record lows, interest rates have started to creep up. One theory holds that as interest rates rise, eventually so too do cap rates. Is that currently the case industry-wide?
Mooney: Theoretically, capitalization rates increase with interest rates. However, the availability of capital from private equity groups has resulted in a compression of expected returns on equity, resulting in relatively flat capitalization rates.
Capitalization rates have remained low in spite of modest increases in interest rates. Cap rate compression has resulted lower yields. Ultimately the higher prices do not fully reflect the additional risk of a business-intensive real estate investment relative to other real estate asset classes.
McMurtry: The rise in interest rates has not had much of an impact on cap rates — yet. Most of the interest rate rise has been absorbed by the competitive market for acquisitions. In the past, I have always felt that cap rate increases lagged interest rate increases, and the timing of this lag depended on other macro-
Cobb: As interest rates rise, so will the cap rates on other asset classes such as multifamily. As yield becomes stronger for what are perceived to be less risky investments, we will see less money coming into seniors housing. Interest rates will have an impact on seniors housing cap rates, but not directly.
SHB: Has foreign investment in the U.S. seniors housing market increased, decreased or held the same over the past few years?
Jandris: There has been a decline in foreign investor activity. According to NIC, over the last four quarters foreign investors accounted for only 1 percent of the buyer pool composition; whereas over the previous two years they represented 6 percent of buyers. Foreign investors closed $236 million worth of transactions over the last four quarters compared to the previous four quarters that totaled $1.4 billion, a marked decline. Some of the key drivers behind foreign investors pulling back on investment in the space are the current political climate and overbuilding concerns.
Carriero: As a broker in an international company, we have seen an increased interest in the U.S. seniors housing market. Basing my opinion on comments made by some foreign investors, the opportunity for a higher return on investment exists in the U.S.
McMurtry: Foreign capital demand ebbs and flows with macroeconomic factors. Foreign investors like seniors housing in the U.S. for multiple reasons — to gain knowledge to take back to their home markets, portfolio diversification and demographics. Many countries have an even more aggressive aging of their populations than we do.
Firestone: It has remained flat. Overall it’s been more talk than action, especially with growing challenges of investment crossing borders.
Clousing: Chinese investment has been grabbing the headlines lately, with a reduction of 55 percent in real estate investment over 2017 and likely a larger reduction in 2018. This is mainly being driven by the government looking to stabilize its own currency by having these funds invested at home.
While there has been significant investment by foreign funds into our sector, we do not see this as a major risk factor. Out of our pipeline of transactions, this has only affected one.
The EB-5 program has been used in the past as well, but we have not seen that as a significant portion of the market. Investment from other areas of the world appear to continue to be strong, while most of these groups are investing through a U.S.-based sponsor.
Peeking into the future
SHB: Looking into your crystal ball, what do the next 12 months hold for seniors housing?
Clousing: We will likely continue to see a strong market for well-located, well-designed assets. Non-performing or functionally obsolete assets will continue to be more difficult to sell. Additionally, the market for older, rural nursing homes will also continue to be difficult. Pricing will likely start to be more affected by the increasing cost of capital and headwinds for rising labor costs.
Lowes: We believe the acquisitions market will continue to maintain an active pace over the next 12 months due to the availability of capital still present in our space. New buyers and operators continue to emerge on a weekly basis looking to acquire seniors housing assets — the industry is still very much in balance for both buyers and sellers today and we expect that trend to continue. The industry appears very healthy over the near term.
Firestone: We will see more turnover of assets as investors optimize portfolios, and new entrants charging into space uphold pricing — but perhaps with a marginally growing bid/ask spread. Again, the attractive acquisition basis is shaping the build versus buy conversation, especially as the cost of construction continues to escalate
SHB: What issues in our industry keep you up at night?
Lowes: Staffing, staffing, and staffing. With unemployment nationally so low and pay lagging behind other industries, seniors housing and skilled nursing face a disturbing staffing problem with no easy answer in sight. With the industry talk of overdevelopment focused on occupancy and absorption, our main concern has been on the worker shortage.
Who is going to work in all these new buildings? Where are they going to come from? Over time our expectation is that average profit margins will shrink due to higher staffing costs — a trend that may arrive sooner rather than later. We have already observed record usage of overtime pay and agency staffing at facilities in 2018.
Cobb: The lack of progress on market penetration rates. All occupancy issues could be solved if we could pick up 1 or 2 percent market penetration in most markets.
Clousing: High inflation and a collapse of the residential real estate market (given a jump in mortgage costs) would put additional pressure on the occupancy in the industry, which would in turn not provide for rent growth needed to offset the rising capital and labor costs. I believe that is the worst case for our industry. If the interest rates can grow modestly and wage growth follow similarly, the additional costs should hopefully be able to be offset by healthy rate growth for the assets.
McMurtry: Nothing. I sleep like a baby. Well, a baby that sleeps through the night, not one that gets up every few hours.