Dealmakers discuss pullback by REITs on M&A volume, skilled nursing’s challenges, plus the ripple effects of low interest rates
Roundtable participants
Dan Baker
Vice President of Seniors Housing
Avison Young
Kenneth Carriero
National Director and
Senior Vice President
National Seniors
Housing Group
Colliers International
Jim Hazzard
Senior Vice President
JCH Consulting Group
Adam Heavenrich
Managing Director
Heavenrich & Co.
Joshua Jandris
Senior Director
Institutional
Property Advisors
Joel Mendes
Senior Vice President
JLL
Ryan Saul
Managing Director
Senior Living
Investment Brokerage
Rick Swartz
Executive Managing Director
Cushman & Wakefield
By Jeff Shaw and Matt Valley
After the feverish pace set in 2014 and 2015, mergers and acquisitions were bound to slow down in seniors housing. That slowdown came mostly from the REITs, which saw stock prices slump from late 2015 into early 2016.
Smaller buyers did manage to pick up a good deal of the slack, however, and REITs have managed to lower their cost of capital through recovered stock prices and a variety of other means.
Seniors Housing Business asked veteran brokers to share their insights on the current state and future of seniors housing. What follows are the edited responses:
REITs take a breather
Seniors Housing Business: What’s the most compelling trend or biggest surprise so far this year in seniors housing property and portfolio sales?
Jim Hazzard: The most compelling trend we have seen this year is the public REITs’ willingness to sell assets, particularly in the skilled nursing arena. Owner-operators acquiring the real estate of their existing facilities are particularly attractive transactions, because the operator is able to drastically change the complexion of their portfolio.
Dan Baker: REIT structure and investment thesis dictates they are long-term holders for the most part, yet many are actively disposing of non-core, non-strategic assets. Most non-REIT investors consider an asset “gone forever” after a REIT buys it, but that’s not necessarily true.
Ryan Saul: We’ve seen a substantial slowdown from the public REITs. For the last couple of years, they were the most aggressive and most active acquiring both portfolios and individual assets. This year, they have been extremely quiet.
The REIT pullback provides an opportunity for owner-operator investors to acquire and increase their portfolios. With an abundance of capital still available, the market continues to be strong.
Joshua Jandris: The stabilization of transaction velocity and valuations caught many owners and potential sellers by surprise. Now is the time to sell, versus a year or two from now.
SHB: What caused the REITs to slow their seniors housing M&A activity over the past 12 months? Do you see the pace picking back up anytime soon?
Kenneth Carriero: The slowdown of M&A activity with REITs is primarily due to the aggressive pricing within the seniors housing asset group. I do not see the REITs coming back in the market with the same fervor as in the past. They seem to be looking and analyzing each opportunity on an individual basis.
Rick Swartz: The dip in share values last year resulted in an adjustment to REIT pricing hurdles. This, in conjunction with a preference for lease structures (rather than RIDEA), has made REITs less competitive in the market. On the other hand, cap rates for non-premier assets (i.e. older product/non-prime metro areas) have risen, making the corresponding pricing a better fit for the REITs. This should result in a higher level of REIT acquisition activity in the latter part of the year.
Hazzard: One main driver was the difficulty in raising funds due to devalued stock prices. This also played a role in their willingness to divest of skilled nursing assets as another avenue to raise capital. Another cause was the need to digest current assisted living acquisitions and monitor pricing and tenant performance. There were also several large splits of portfolios that occurred, which likely diluted the REITs’ ability to acquire during these time periods.
Baker: The cause was overall market frothiness, a lack of product to purchase and battered stock prices. We do see the pace picking up because of share price recovery and new deliveries, but they are still being highly selective. If the acquisition opportunity is with an existing or otherwise highly qualified operator, their interest and available capital remains deep.
Joel Mendes: This year health-care REITs’ cost of capital has come back down, with stock prices rebounding near their first-quarter 2015 levels. REIT acquisition interest has started to rebound as well.
SHB: Compare and contrast the rate of acquisitions right now to this time last year. What does that tell you about where the market is?
Baker: While the pace has cooled, it’s all relative — the market went from red hot to just hot. The overall market is past peak, but not in a dive at all. It is more of a gradual slowing and plateauing. Deals are still happening, and tremendous liquidity and appetite to purchase seniors housing remains.
Saul: We haven’t seen a slowdown in transaction volume; in fact, our total transactions are up slightly. That said, total dollar volume is down. With fewer portfolios on the market and the REITs on the sidelines, that is to be expected.
This tells me that the market is still strong. There is an abundance of low-cost capital. Buyers are anxious to acquire properties before interest rates increase. Individual assets and smaller portfolios continue to be well received. We see the most opportunities coming out of the tertiary markets as major metropolitan statistical areas (MSAs) face more competition, increased development and higher pricing.
Jandris: Seniors housing is still very much a niche market. There are only so many assets that can trade, and with 2015 being a record year, it is hard to continue to put up those numbers. Transaction activity in the third quarter of this year has been quite strong thus far. Despite a plateau lasting nearly a year, market fundamentals should remain favorable for the near future.
Swartz: Sales volume is down year over year with the notable absence of the public players. The market is still healthy and there are great opportunities out there, but it’s a far cry from the flood of deals that were out there in third-quarter 2015.
Certain regions, sectors more active
SHB: What subsectors of seniors housing and geographic areas have been the hottest for investment sales this year?
Swartz: Geographically, California has been super hot this year. From a segment perspective, there is continued strong interest in buildings that offer a continuum of care as well as standard assisted living/memory care buildings.
Carriero: This past year I saw an appetite for assisted living, skilled nursing and memory care on a national level. I have noticed interest in independent living
to be in the Southeast and Southwest. I think CCRCs still need
to rebound.
Baker: Skilled nursing facilities in particular have tremendous demand. Despite the obvious risks inherent in skilled nursing and well-documented challenges facing the space, the enormous returns outweigh those risks and challenges for certain investors, especially in certificate-of-need states.
Jandris: Skilled nursing facilities were the only asset class to see compression in average cap rates from 2015 to 2016, ranging from 20 to 40 basis points, according to Senior Living Valuation Services. All other asset classes saw either no change, or an increase of at least 20 basis points. Overall, there has been more seniors housing transaction activity, but skilled nursing sales have recently seen better returns for sellers.
Per NIC MAP, from January 2015 to July 2016, the West and Southeast regions of the country experienced the largest dollar volume of transactions. The Midwest had the highest total number of transactions and units during that time period, with 512 closings comprising 49,232 units across all asset types. From the standpoint of the total number of units, the Southeast had the most independent living, assisted living and memory care units trade, at 20,328 units, while the Midwest had the most skilled nursing beds trade, at 32,151 beds.
SHB: As the skilled nursing segment undergoes dramatic changes to its goals and reimbursement structures, who are the buyers and sellers in that niche and why?
Hazzard: Sellers in the skilled nursing segment range from single-asset, mom-and-pop operators to institutional investors and operators divesting multiple properties.
The sale of a mom-and-pop typically happens for two reasons in today’s market. First, the market is still experiencing historically high pricing, so now is as good of time as ever to exit and capture a high valuation. Secondly, many are unable to compete going forward as a single-asset operator.
For the institutional players, we have seen a lot of bearish sentiment toward the skilled nursing sector. With ever-increasing expenses and no major increases on the top line in the near future, there isn’t much to be bullish about. The buyers we see in today’s market are existing operators/ investors, typically mid-sized, looking to add beds to stay competitive, especially with managed care providers.
Baker: The buyers are generally the same few REITs that have been exposed to the space for a while, as well as private, regional owner-operators. For the regional players, the opportunity to scale their operations and be a force when MCOs (managed care organizations) and ACOs (accountable care organizations) inevitably impact their bottom line is a key motive to amass a portfolio.
The sellers are still nonprofits, mom-and-pops and larger
owners divesting non-strategic assets due to an increasingly difficult operating environment, or because they can achieve high pricing today on their assets.
Saul: Regulatory and reimbursement changes force private, mom-and-pop owners to sell and exit the business. An owner of a single skilled nursing facility does not have the resources to adapt to the constant regulatory and reimbursement changes. This puts financial pressure on those operations. In addition, REITs and national owners are sellers in certain instances. They are pruning their portfolios, selling older, less desirable communities while the market is still strong.
Regional and national skilled nursing owners with personnel and technology resources are the buyers for these opportunities. This is a great way for larger companies to grow in their existing footprint.
Mendes: For stabilized assets with a triple-net lease to a solid operator, the REITs are still very active buyers. If the asset is not stabilized, as is often the case, the buyers vary depending on the state and circumstances. For larger, value-add acquisitions, private-capital-backed operators based out of the tri-state area have been active. The smaller deals tend to be bought by local operators with intimate knowledge of a given state’s reimbursement system.
The revenues and expenses are so high in skilled nursing that relatively small changes in census mix, occupancy, payroll or vender contracts can significantly improve the bottom line, which attracts buyers despite the uncertainty in payment models.
Jandris: The thing that is interesting and oftentimes troubling about the skilled nursing facility segment is the volatility. Well-capitalized, private, strategic buyers from California, the East Coast and Chicago continue to be the most active buyers in the space. They are agile and typically depend on a deep bench of operators that have regional and local expertise, who are not spread too thin. With each state having different reimbursement structures, labor laws and licensing regulations, you need regional expertise.
Adam Heavenrich: There is definitely a big shift going on in the skilled nursing segment. The buyers are often those providers that have built the infrastructure and relationships to grow their managed care business. Those operators must scale up to accommodate the needs of the insurance companies and the hospitals. At the same time, the small players are being left off the preferred provider lists and Medicare census is dropping. They may not survive in the managed care environment.
Private equity and REITs are the logical financial backers to accommodate the growth of the preferred providers. While the spinoff REITs that specialize in skilled nursing are a step in the right direction, private equity has not yet fully filled the void and there is a need for more capital for growth with the skilled nursing providers. The best acquisition model includes an experienced operating company coupled with a strong equity source with ready capital for both acquisitions and capital improvements on those acquisitions.
Gauging the impact of new product, players
SHB: The rate of development in seniors housing has been brisk in recent years, and now we’re starting to see a lot of deliveries coming to fruition. How do the new communities coming on line affect the acquisitions side of the sector?
Saul: Acquisitions and pricing haven’t been affected due to development in a majority of markets across the country yet. Most development — some might call it overdevelopment — is in the top MSA markets.
Communities in those markets are forced to lower rents in order to compete. Lowering rents drives down net operating income and values. While most buyers are apprehensive to purchase communities in markets where there is significant development because of the risk, some find opportunities.
New units coming into a certain market can scare owners to want to sell due to the uncertainty of what those new units will do to their community. Buyers that have a long-hold look for these situations can acquire communities for below replacement cost, weather any potential storms, and let the market absorb the units. Development creates opportunity for both buyers and sellers.
Jandris: It could have an adverse effect on the sector over the course of the next three to five years. Many of our traditional seniors housing owner or operator clients don’t think demand will catch up to supply until 2020 or 2021, when a greater concentration of our population reaches their mid-80s. Many of our clients are underwriting 36- to 48-month lease-up periods, which is an increase over historical levels.
Occupancy drives revenue, and revenue drives cash flow. Increased supply will have a direct effect on competition among providers, which could hurt occupancy and rents.
Heavenrich: Buyers have shown concern that their target facilities may quickly become outdated and struggle to maintain occupancy as new product continues to come on line. One strategy to attract or maintain residents is to drop pricing in order to compete with new product. The problem with that strategy in seniors housing is that there is a limit as to how much you can drop pricing and still provide needed levels of care. Unlike multifamily, nearly 60 percent of seniors housing operating costs are tied to staffing. New product can have an outsized impact on the pricing of existing product, especially if the market gets overbuilt.
SHB: We often hear veteran industry experts express concern about how the strong real estate fundamentals of seniors housing are attracting new, inexperienced buyers from outside the sector.How do you as brokers advise these newcomers in their quest for acquisitions?
Heavenrich: We steer clear of newcomers. In this strong market, there are so many qualified buyers out there for good product who will pay a premium. We look for buyers that have the following: 1) a strategic reason for an acquisition and therefore can afford to pay a premium; and 2) a good track record for closing on acquisitions and not re-trading a deal. With newcomers, you can never be sure if their equity is lined up, their lenders are lined up or if they will get cold feet midway through the process.
Hazzard: We love seeing new buyers, but they need to learn the industry. There is roughly an 18-month learning curve, and most new buyers tend to spend too much in the wrong areas and skimp were they shouldn’t. If they are coming from another real estate asset class, they typically are accustomed to lower capitalization rates and are tempted to pay too much for seniors housing. This makes the ultimate success of the building much more challenging.
We introduce new buyers to the various industry organizations such as NIC and ASHA to build and strengthen their knowledge base as well as the publications that cover the seniors housing industry. Management is always the key. Part of what a good broker does is help match the management company to the property.
Some management groups thrive with high-end properties, but struggle or are ineffective with the properties that appeal to middle America, and vice versa. Others flourish with facilities that are rely mostly on Medicaid reimbursement, while others prefer private-pay models. It really is a matter of putting the right team
in place.
When the new buyers succeed, it is good for the entire industry. They not only bring capital, but also fresh ideas that help all of us do a better job.
Baker: We advise newcomers to partner with quality operators, explore the variety of deal structures out there, and actually visit as many communities as possible. After you’ve been inside enough, you develop a better sense of what works, what doesn’t, what’s sustainable and why.
Carriero: I try to point out the differences between other asset types such as multifamily or retail and a seniors housing asset. Unlike income-producing properties where the value is in the location, curb appeal and amenities, management is the key component to the business value in seniors housing. Therefore, the new investor must realize that the key component to this investment is not just the capability of the real estate to attract tenants, but also the services and care provided to the residents.
What’s ahead?
SHB: With interest rates falling even further this year — the 10-year Treasury yield stood at 1.58 percent at the time we sent you these questions, down from 2.25 percent at the beginning of the year — what impact has this turn of events had on buyer and seller strategies?
Swartz: Buyers are increasingly interested in securing long-term, fixed-rate debt to finance their acquisitions, particularly regarding stabilized assets. Sellers are expediting the disposition of their assets even prior to stabilization to take advantage of the low interest rate environment.
Baker: Qualified, experienced buyers can still find incredibly attractive financing for a variety of needs. Falling interest rates also put pressure on equity yields, further reducing the weighted average cost of capital. This trend helps buyers get deals done, but also affects available income for residents and adult children, which can inhibit rent growth.
SHB: What do the next 12 months hold for the seniors housing industry?
Swartz: 1) New entrants will continue to come to the seniors housing investment market, many of whom will initially focus on
the segments of seniors housing with the lowest acuity levels, including active adult and independent living.
2) More multifamily developers will enter the sector while teaming up with seniors housing operators.
3) There will be a significant increase in age-restricted, active-adult seniors housing development starts.
4) As newly constructed properties fill, successful projects will significantly raise rents, creating greater disparities with respect to older product.
Baker: Barring unforeseen economic events, expect a continuation of the last 12 months: Higher selectivity regarding acquisitions, continued pressure on smaller operators, more new construction and new deliveries, attractive debt and equity, and more newcomers exploring the space.
Saul: The market will remain strong and active for the next 12 months. Buyers continue to look for opportunities to acquire in order to take advantage of the historically low cost of capital. While I believe interest rates will increase slightly toward the end of the year, this will be no surprise to anyone. A slight increase in the cost of capital will have little impact on the market for the next 12 months. We will continue to see small portfolios and individual community sales lead activity in the market.
Jandris: The inventory of deals on the market will remain solid. However, we see the quality of inventory continuing to wane. The largest concentration of available inventory will likely be older skilled nursing portfolios and the older stock of seniors housing. This is a result of public owners looking to cull their portfolios of outmoded, physically obsolete assets and further eliminate exposure to non-private-pay sources of revenue. Quality assets in core markets will continue to garner the most interest and the highest prices.
Heavenrich: Right now is the best time to sell, as occupancy rates are high, capital is plentiful and cap rates are excellent. Since 2010, we have seen a great run-up in pricing and it should remain solid for the next 12 months. Don’t wait until things start weakening or try to time things perfectly. If you’re thinking of selling, now is the time.