Borrowers’ strong appetite for financing helps capital providers overcome headwinds.
By Matt Valley
Despite nagging concerns of oversupply, the impact of banking regulations and uncertainty surrounding government reimbursement in the skilled nursing sector, seniors housing lenders believe it’s a great time to be in the business. Apparently strong borrower demand trumps all obstacles.
“For skilled nursing, the common theme continues to be increased competition for Medicare and private pay residents,” says Donald Clark, senior vice president with Chicago-based MB Financial Bank. “As a result, there have been a number of requests to finance renovations or include a Capex (capital expenditure) component for an acquisition or turnaround financing.”
MB Financial has been lending to skilled nursing operators in the Midwest for over 30 years. “We continue to be bullish on the skilled nursing sector due to our experience working with established operators and the limited supply of facilities as a result of the certificate of need requirements,” says Clark. (Approximately 35 states have certificate of need laws in place that regulate the number of beds in order to avoid overbuilding.)
MB Financial recently expanded its scope by developing relationships across the country with established operators in assisted living, memory care and other services that support the growing senior population.
A number of first-time operators with backgrounds in multifamily or other property types are seeking opportunities in the assisted living and independent living sectors, observes Clark. “There also seems to be an increased demand across the industry for bridge loans that ultimately get refinanced with the U.S. Department of Housing and Urban Development or other agency debt.”
The market equilibrium challenge
The industry is better positioned now than in the past to avoid the volume of new construction from getting completely out of hand, says Jim Sherman, senior vice president of seniors housing with Minneapolis-based Dougherty Mortgage LLC.
“There is a lot of supply coming on board,” acknowledges Sherman. “But if you read the market studies and you see the aging population, it seems like there is a much better chance for absorption than there was in the mid-1990s up until the early 2000s. That’s when there was so much building occurring, but there wasn’t a market for it,” he explains. “Now people are more familiar with the product. Operators are more knowledgeable and professional about how they are going into the projects.”
Sherman tries to avoid making blanket statements about a particular market. “Everybody says Houston is overbuilt,” he says. “I’m working with a sponsor in the Houston market that opened two assisted living buildings during 2016, and one broke even [financially] in 90 days, which is amazing.”
Seniors housing accounts for 25 percent of Dougherty Mortgage’s overall lending business, which also includes multifamily and affordable housing, hospitals, healthcare and student housing. The deals Dougherty enters into in the seniors housing space are typically $45 million or less.
Sherman is bullish on independent living primarily because most of the construction that’s occurred over the past several years has been in the assisted living and memory care segments of the industry.
“Right now there seems to be room in a number of markets for new independent living, especially if an operator has a presence and a good reputation in the market,” says Sherman. For example, the owner and operator of a successful assisted living facility might see a need to add independent living units in response to consumer demand.
One segment of seniors housing that is possibly overbuilt and “a segment which makes a lot of people nervous” is freestanding memory care, says Sherman. “Memory care needs to be part of assisted living in a lot of cases unless you really understand the business.”
Sherman cites Irvine, Calif.-based Silverado Senior Living as a leader in freestanding memory care because of its highly regarded programming that incorporates the latest in clinical research to benefit residents. He questions whether operators new to the space understand the specialized levels of care needed to successfully operate a memory care facility and achieve positive resident outcomes.
“If you are a Silverado, you know exactly what you are doing. There are not a lot of companies like Silverado that can really run a memory care facility freestanding and replicate it one after another,” says Sherman.
Lancaster Pollard likes stand-alone memory care, says Steve Kennedy, senior managing director at the Columbus, Ohio-based firm. Lancaster Pollard is most widely recognized as the top-producing lender in the HUD Lean 232 mortgage insurance program with 60 transactions closed in fiscal 2016 totaling $554.4 million.
“Only a few years ago, most of our memory care project financings were additions to existing facilities,” says Kennedy. “But stand-alone memory care has proven to work in a lot of different markets, and it’s not just one or two operators We’re funding the facilities in a bunch of different ways.”
Indeed, Lancaster Pollard has funded stand-alone memory care facilities through Fannie Mae, the U.S. Department of Housing and Urban Development’s Lean 232 program, and its Propero Seniors Housing Equity Fund.
A growth vehicle for operators
The Propero Seniors Housing Equity Fund, one of the fastest-growing parts of Lancaster Pollard’s business, is essentially a lease-to-own program for operators. The private equity fund partners with proven operators of any scale to finance the new development and acquisition of independent living, assisted living, memory care and skilled nursing facilities. Operators have the option to purchase the properties between years two and five at a pre-determined price.
Let’s say a proven operator wants to develop three or four projects over the next 18 to 24 months, but doesn’t want to use up all its equity on one project and wait two years for it to be built and leased up. The Propero fund offers operators an attractive option.
“It acts like high-leverage lending for the operator, which can minimize the amount of equity it’s putting into the deal,” explains Kennedy. “Ultimately, the operator secures ownership and the majority of the value creation over the long term.”
Brian Pollard, the firm’s founder, coined the name Propero, which in Latin means “to accelerate.” The Propero fund helps accelerate the growth of seniors housing operators.
The first Propero fund included more than $100 million of projects. The second fund will end up with over $200 million of projects, according to Kennedy. A capital raise for a third fund is currently underway.
“We’re still seeing a lot of capital flow into the space on the equity side,” says KeyBank Real Estate Capital Market Executive Kevin Murray, who leads the marketing efforts for the bank’s healthcare finance group. Much of that capital is targeting core and core-plus properties. Core properties are stable, fully leased assets whereas core-plus properties are in need of some enhancement or value-added element.
“A lot of the capital continues to be interested in independent living, assisted living and memory care,” according to Murray. “We’re also seeing some interest in the skilled nursing space. However, the skilled space is obviously very operator intensive.”
Ultimately, the preferences of institutional investors will vary depending on the yield or return they are seeking and the various stages of life their portfolios are currently in, he emphasizes.
Murray sees his role as a consultant that begins with understanding the goals of his investor clients, finding out how long they want to hold the properties they purchase, and then matching the client’s strategic goals with the bank’s finance capabilities. In short, it’s a one-stop shop at KeyBank.
“We actively use our balance sheet with most of our clients as well as utilize the permanent debt solutions. Oftentimes when you acquire a property, it’s not quite ready to go to a permanent debt solution. We’re more than happy to utilize our balance sheet to bridge those transactions,” says Murray.
Banking regs under review
The Dodd-Frank Wall Street Reform and Consumer Protection Act and the Basel III accord taken together have placed more regulatory burdens on commercial real estate lenders, says Sherman of Dougherty Mortgage.
Basel III requires banks to set aside much higher capital reserves for high-volatility commercial real estate (HVCRE) loans. For example, a loan that previously required $1 million to be held in reserves will now require $1.5 million to be held in reserves if it’s classified as HVCRE, according to an impact study conducted by the CRE Finance Council.
The study concludes that the net effect of these regulations will be to increase the banks’ cost of capital and decrease the availability of financing.
Dougherty Mortgage, which syndicates many of its loans to the banks, is feeling the impact of the regulations, says Sherman. “We have a multi-billion portfolio of balance sheet loans.”
Murray of KeyBank Real Estate Capital says the regulations have had some impact on how the bank conducts its business day to day in the seniors housing sector, but has worked hard to ensure the impact on clients is limited. He adds, however, that “the regulations have definitely impacted all the banks as it relates to the cost of capital.”
With the Trump administration now settling in at the White House, the business community anticipates that regulation may decrease over the next couple of years, according to Murray. That’s reflected in the rising stock prices of banks in recent months. “Obviously, we haven’t seen anything very specific as of yet. Clarity of regulation is of benefit to many lenders as it allows them to put more capital to work.”
Possible wild cards
Lenders continue to pay close attention to the strength of the U.S. economy — particularly the housing market — as well as the interest rate environment because they are the main drivers of debt financing in the seniors housing industry, according to Clark of MB Financial. If interest rates rise, the expectation is that cap rates will follow suit.
“More specifically, new construction and the impact on market census will continue to influence the assisted living market, while skilled nursing operators need to be aware of changes to Medicare and Medicaid reimbursement,” cautions Clark.
Another wild card is availability of labor. “The potential shortage for qualified caregivers and the ability for employers to retain high-caliber employees will continue to be issues across the industry moving forward,” says Clark.
Kennedy of Lancaster Pollard believes the Trump administration is a wild card because skilled nursing facilities are extremely dependent on government policy and regulation, whether the issue concerns licensing or Medicaid reimbursement.
“Finance folks and business owners just want to have some relative certainty what the landscape looks like going forward,” says Kennedy. “In the short time Trump has been in office, his administration has not clearly forecast what it’s going to do in a variety of areas, so that inherently creates a little bit of consternation.”