Seniors housing property owners need to prepare by finding ways to grow EBITDA
By Kenneth Carriero
The real estate fundamentals of the seniors housing industry have enjoyed a nice bounce over the past few years. Rents at assisted living communities increased 5 percent on average from the fourth quarter of 2012 through the second quarter of 2015, according to New York-based real estate research firm Reis.
During the same period, rents at independent living communities rose 4.3 percent, followed by skilled nursing at 3.1 percent and memory care at 3 percent.
While rents have been on the rise, cap rates have compressed.
I recently brokered a portfolio sale of assisted living facilities in the Southeast. These facilities were built between the late 1970s to mid-1980s. They were Class C properties, all in need of significant capital expenditures.
At any other point in time, these facilities would have traded at an 11 percent-plus cap rate. However, a bidding war to own these facilities compressed the cap rate to an astounding 7.9 percent.
This was not a unique situation. In upstate New York, I brokered another transaction, the sale of a 40-year-old facility that also had a considerable amount of deferred maintenance. The transaction closed at a 7.6 percent cap rate.
These cap rates may work at today’s interest rates, but what happens when those interest rates start climbing? Over the next several years, are we going to see owners of seniors housing facilities going underwater on their mortgages as we saw with residential property owners?
Can the facility operators outpace the rise in cap rates, keeping the market value of their facilities at a breakeven point, or even show a slight appreciation by increasing their EBITDA (earnings before interest, taxes, depreciation and amortization)?
Growing EBITDA is paramount
We know there are two ways to increase EBITDA: increase rents or decrease expenses. As noted above, rents have increased nationally throughout all sectors of seniors housing. Another way to improve the bottom line is to boost occupancy.
The occupancy rate at independent living communities increased 230 basis points from the last quarter of 2012 through the second quarter of 2015, rising from 89.3 percent to 91.6 percent, according to Reis.
During the same period, the occupancy rate at assisted living communities rose 170 basis points, climbing from 88.8 percent to 91.5 percent. Meanwhile, the occupancy rate at skilled nursing facilities rose by 160 basis points, from 90.8 percent to 92.4 percent.
The memory care segment experienced the least significant change in the occupancy rate, rising from 90.8 percent to 91.5 percent, a change of 70 basis points.
This relatively small change in occupancy in the memory care sector may be due to the fact that many memory care residents do not necessarily have the option to remain in their homes, even with family support.
Increased occupancy does help to maintain a stable EBITDA. However, in many cases rents may still need to be adjusted upward. The astute seniors housing operator realizes that the ability to increase rents is inextricably linked to the disposable income of its residents.
The second approach to increasing EBITDA is to cut expenses, which usually results in eliminating certain services or amenities, or charging residents for services that previously were in the residents’ basic rental package. This approach is frequently frowned upon by residents.
Retrading a deal all but disappears
There are a couple of sure signs that point to an asset group catapulting to the top of the food chain. The first indicator, which I immediately notice, occurs when a buyer discovers a problem during due diligence that negatively affects the value of the asset.
This discovery would normally trigger the buyer to renegotiate the contract price. We call this retrading. The fact that the buyer doesn’t try to retrade the contract price indicates that the asset is highly sought after.
In a recent transaction, during the due diligence period an inspection report revealed some significant deferred maintenance at a property. The buyer wanted to retrade the purchase price, but the seller realized that the current market frenzy for a seniors housing asset would easily enable the property to go back under contract in a short period of time. Therefore, the seller stood firm on the original offering price. The buyer immediately retracted its request to retrade the price.
Influencing factors on market values
When there is an increase of 50 basis points in the cap rate, there is a decrease in the market value by 62.5 basis points. Therefore, the market value drops at a faster rate than the increase in the cap rate.
Another factor to consider is the influence that interest rates have on cap rates. Although the spread between the interest rate and the cap rate is subjective, based on a specific buyer’s goals and objectives, a simple formula shows how an increase in the interest rate of 50 basis points will increase the cap rate by approximately 80 basis points. Exactly what does that do to the market value?
A facility with an EBITDA of $2.2 million with a cap rate of 7.5 percent has an approximate market value of $29 million. If the interest rate rises from 5 percent to 5.5 percent and everything else stays constant (debt-service coverage ratios, amortization, annual debt service, for example), the market value will change to $27.5 million. The cap rate has now risen to 8 percent.
Operators need to remain nimble
Over the last few years, occupancy has risen in all sectors of seniors housing along with an increase in rents. While deal velocity is still high, based on my observations it has not exceeded the velocity in 2014.
This asset type may either be approaching or at a peak. Cap rates have compressed to such a point that even older facilities with deferred maintenance have demanded astonishing cap rates and are trading at values previously reserved for newer Class A facilities.
What affect will increased interest rates have on cap rates and on a facility’s market value? If the cap rate rises, in order for the market value to at least maintain its previous value, operators may have to make adjustments to their bottom line.
Regardless of the forthcoming tsunami of aging Baby Boomers and the corresponding surge down the road in demand for seniors housing, today’s frothy appetite for seniors housing investments has to settle down at some point.