Broker Q&A: Are we in a pricing bubble about to burst?

Based on the latest data of U.S. property and portfolio sales in seniors housing, 2015 is shaping up to be another strong year on the transactions front. According to Real Capital Analytics, deal volume year to date through August was up 32 percent compared with the same period in 2014, which also was considered a banner year.

But is this a sign of lasting prosperity, or is a bubble waiting to burst? 

Seniors Housing Business asked veteran brokers to share their insights on the state and future of seniors housing. An edited transcript follows:

Roundtable Participants:

Bradley Clousing, Managing Director, Senior Living Investment Brokerage

Bruce Gibson, Principal, Senior Capital Advisors

Allen McMurtry, Executive Managing Director, DTZ

Mark Myers, Executive Director, Institutional Property Advisors, a division of Marcus & Millichap

Nick Stahler, Senior Vice President, JCH Consulting Group

Jason Stroiman, President, Evans Senior Investments

Richard Swartz, Executive Managing Director, Capital Markets, Cushman & Wakefield

Industry trends

Seniors Housing Business: What has been the most compelling trend or biggest surprise so far this year in seniors housing property and portfolio sales? 

Jason Stroiman: We’ve seen several interesting trends in the seniors housing market so far in 2015. In particular, we’ve noticed a continued compression in cap rates and a rising level of interest from buyers not currently in the industry. We’ve also noticed a continuation of high levels of occupancy, which is impressive considering the growing supply of new seniors housing properties across the country. With that being said, we have also noted how quickly interested buyers and large REITs are absorbing these new properties.

Richard Swartz: The most compelling trend has been the prices per unit paid for premier and high-quality assets. Until recently, per-unit values in excess of $400,000 were very limited. Consequently, it was often difficult to justify such higher exit values for new development projects in high-density, more expensive markets. These recent higher per-unit price points have thus helped to substantiate these newer higher-end development projects, further fueling the supply side of the market.

Bradley Clousing:  By far the most significant surprise is the creativity in which both REITs and institutional capital are demonstrating flexibility in structuring transactions to control quality inventory across all different stages of the asset life cycle. While this buyer pool has traditionally focused on core, stabilized products, many of our recent turnaround portfolios have been funded by institutional capital under a creative arrangement with the operating partners. 

We have also worked on a number of portfolio transactions where there were developments and assets in lease-up included with core cash-flowing assets. Many buyers have realized how difficult and lengthy the timeline has been to build new assets in quality locations. Flexibility from the institutional players has become increasingly evident to allow them to control these locations through acquisitions rather than just development.

Transactions hit new high

SHB: The data shows that acquisition prices and volume have reached record highs during the last year or two. How does this change your approach to the market? What advice do you give buyers and sellers in today’s frothy market?

Allen McMurtry: My approach is to take full advantage of this seller’s market while it continues. Having been through a number of real estate cycles, I am a big believer in the inevitability of a market correction. This has been one of the longest seller’s markets I have seen, and sellers should be careful trying to time market cycles precisely.

Bruce Gibson: Potential sellers must consider how they will redeploy capital gained from the sale of properties. Investors should carefully consider whether it makes the most sense for them to purchase an existing property or develop a new property. Replacement cost is well below market value in most instances, but some markets are already saturated and in danger of being overbuilt if some or all of the planned projects come to fruition. It can be much more lucrative to build, but doing so must be done with caution as market and operator selection is the key.

Stroiman: Without question, the best piece of advice we offer our clients is to go to market without a listing price. Our marketing approach presents an opportunity for a buyer to come in post-underwriting and make an offer potentially exceeding our client’s expectations.

How much activity is too much?

SHB: How long do you think the market can sustain the feverish activity? Is there any concern that the market is creating a bubble that could burst?

Swartz: While the long-term threat to the market is overbuilding, to date the capital markets have pursued development in a disciplined manner to the extent that most regional markets are not showing signs of overbuilding. That said, further loosening of underwriting standards among construction lenders could threaten performance and related values of existing assets given the growing number of new entrants in the development space.

Stroiman: We believe that we’re currently in the fifth inning of this game. There is plenty more to come in the future. Because of the cap rate spread between seniors housing and multifamily, this market is lucrative for a lot of investors. At the end of the day, this is a story of demand, and demand is still at a serious high.

Nick Stahler: We believe the market will sustain this level of activity as long as all of the current market conditions remain intact. The fundamentals of seniors housing are continually improving. We believe the low interest rate environment and flood of equity investing in the sector is what we will have to watch closely. The equity infusion into seniors housing will probably hold strong as long as the interest rates remain low and the returns are higher than those of other real estate asset classes. 

With that being said, we are absolutely in a pricing bubble
that could sustain a pricing correction if the raising of interest rates or other economic issues come into play.

 Gibson: I really don’t think there is much to the idea that there is a bubble as the fundamentals are quite solid in most markets. However, the most recent studies from NIC MAP suggest that growth in demand will drop slightly over the next few years before the demand starts to surge in approximately seven years.” The industry should be on solid footing for the foreseeable future.

Mark Myers: Markets always cycle, and this one will do the same. However, if you look at past cycles, you will find that the most highly capitalized companies, such as GE, have grown stronger in down cycles, while smaller, weakly capitalized companies tend to struggle most in down cycles. In down times cash is king, and those with the cash can snap up good deals from those who are financially drowning.

Finding the hot spots

SHB: In which segments of seniors housing are you seeing the most transactions — independent living, assisted living/memory care, skilled nursing, or CCRC? What geographic areas are most active?

McMurtry: With the exception of entry-fee CCRCs, we are seeing large numbers of transactions across the board, and in all regions. Relative to past sale numbers, even the number of entry-fee CCRC transactions is high.

Stahler: The majority of the transactions we have recently completed are in assisted living and skilled nursing. The major metro and coastal markets will always be the most attractive — that’s real estate 101.

With that being said, recently we have seen a lot of attention turn to secondary and tertiary markets for several reasons. For one, typically there is less competition in the bidding process. Secondly, there is much less competition once operating the asset. We work with buyers that specifically seek out the rural markets with only one or two facilities in town. While the barriers to entry remain low and there’s definitely a risk factor, it is much easier to beat out one or two competitors than 10 or more. 

Clousing: As the population of the country continues to shift to core markets, many of our rural cities and counties are experiencing a population decline, which creates a difficult environment to transact. This is particularly true for aged and inefficient skilled nursing assets that have seen their quality mix deteriorate as newer options enter the market. This often comes in the form of high-acuity assisted living attracting the private pay residents.

 Gibson: All segments of the seniors housing market are seeing strong activity, but interest in each segment is fueled for different reasons. Most of the focus for both development and acquisition during the last few years has been in the assisted living/memory care segment. However, numerous groups have switched focus to the independent living segment to pursue yield. This extra yield sometimes comes in the form of an assisted living/memory care expansion to — or conversion of — the existing independent living community. Those communities with the opportunity to push yields via conversion and/or expansion are receiving the most attention.

Myers: Our activity has been balanced across those product types, with a few larger portfolios skewing the balance at times. We also find a balance between transactions in all major geographic regions of the U.S. It seems that there are age- and income-qualified seniors in all markets, a growing knowledge of the various housing options and a desire to stay near adult children and grandchildren. While Florida, Texas, Arizona, Nevada and certain other regions continue to attract seniors due to more favorable winter weather conditions and other factors, it is also a known fact that some of the largest and most successful retirement communities are in New England, Chicago, Boston and Portland. 

Development is in high gear

SHB: In addition to the high acquisition volume, a lot of new development is also underway. Will all the new deliveries over the next year or two balance out supply and demand?

Swartz: While there are certain submarkets that have hit a saturation point, we feel that much of the concern of overbuilding is overblown given the very local dynamic of supply and demand for seniors housing. We still see many underserved market areas where new development is well supported. To the extent that overbuilding impacts a given submarket, we expect that older, less desirable product will bear the brunt of the more distributed demand.

Stahler: We don’t believe we are building fast enough to balance supply and demand long term. While we are starting to see some overdevelopment in certain markets, we think this will only be an issue over the next three to five years. The investor that is looking for a quick return on its capital will likely cause the greatest problems for development. Calculated, tempered, long-term investment into development will pay the highest dividends to the industry as a whole. The age wave we are beginning to see in our facilities will undoubtedly demand a newer product, but oversaturation of new units, especially not well-thought-out units, is our greatest concern for the industry in the short term. 

Myers: There is little doubt that there will be some overbuilding in some markets because it’s impossible to nail the exact number of units needed in the next three to five years or how many units are actually planned. In many larger markets, there are projects that are currently only in the mind of an experienced seniors housing provider or home builder, or a deep-pocketed investor with loads of liquidity and a burning desire to put up “the best assisted living or memory care facility in the market.” 

Some of these folks will ignore the telltale signs of overbuilding and will build it anyway, banking on beating out the competition regardless of how stiff it is. It’s these projects that we don’t anticipate, that pop up in the future, that may very well cause excess supply. And, the trouble with seniors housing bubbles is that the recovery time can be long, much like recovering from a large oil spill.

A flood of new capital

SHB: Seniors housing performed well during the Great Recession relative to other property types in terms of total returns, according to the National Council of Real Estate Investment Fiduciaries. From a historical perspective, is there more capital coming into the sector now than in previous up cycles for seniors housing?

Swartz: There is a much broader pool of capital today compared to previous up cycles, which were dominated by several larger public REITs. Today we have additional public companies, private/unlisted REITs, large specialty seniors housing funds, private equity investors and significant interest among the various pension fund advisors who invest on behalf of separate account clients as well as through commingled funds.

McMurtry: Absolutely. The last housing downturn from a long-term perspective was a real benefit to seniors housing. Performance in the sector during this time period caught the attention of many institutional investors and has led to a number of new institutional equity sources for senior living. I see this trend continuing. I used to say that the seniors housing asset class was about 10 years behind the multifamily asset class in terms of institutional acceptance. I now think that gap has narrowed significantly.

Myers: The positive difference in this cycle seems to be the amount of smart money. Investors in seniors housing are some of the brightest, most highly educated investors who have liquidity, operating platforms and financing alternatives to enhance IRR, market knowledge, and so forth. We don’t see buyers making acquisition decisions based on emotions, but rather based on facts. There will always be the cowboy investor who ignores the signs in a given market, and buys or builds something in spite of signals that the region is heading toward an oversupply. But, in general, investors in our space are quite savvy. 

Having said that, it is true that there are macroeconomic factors that can hurt all businesses, including ours. The banking crisis that almost resulted in another economic depression in the late 2000s, and managed care reimbursement for long-term care facilities, are examples of factors that may cause financial tsunamis for which no one can fully prepare.

Ripples from around the world

SHB: Do “wildcard” factors like the economic problems in Greece have any impact on the sector, or is this part of the industry somehow insulated from those outside influences?

Swartz: There is minimal direct impact from such events. However, to the extent that such events drive other economic factors such as interest rates, the stock market and the housing market, these factors could impact investor demand for seniors housing in various ways. For example, a more volatile stock market could result in increased capital flows to real estate, and seniors housing in particular. On the other hand, a depressed economy/housing market could negatively impact more lifestyle-driven facilities such as independent living.

Stroiman: No, the seniors housing market has been pretty resilient during economic downturns, and we’re confident it will continue to be resilient despite outside influences. 

Clousing: At the end of the day, even though the demographics are continuing to move in our favor, our industry still needs a healthy equity market and housing market for the consumers to afford the services provided. Greece is looking like it will not specifically be a factor. However, we are concerned about the health of the pension funds that a significant percentage of seniors rely on to pay for services, specifically in the Rust Belt states. If there is a large state or city default on these pensions, it could create a difficult financial environment for assets located in these markets. 

My larger concern is the impact of the overall debt load our country has taken on nationally and the continued unemployment/underemployment rate and how that will affect the overall credit and financial markets in the long term. In the short term, we expect the status quo, but there could be some challenging times ahead if the economy does not begin to create more jobs and provide for a strong financial base to support an ever growing retired population.

 Gibson: Seniors housing is not fully insulated from outside factors, but the impact can be somewhat muted to the extent that demand is inelastic, as is the case for assisted living and memory care. The impact is felt to the degree that any event influences interest rates or rattles the financial markets. Interest rates are very closely tied to capitalization rates, so any major changes there can have significant and immediate repercussions on value.