As variable-rate loans reach their maturity, higher interest rates are making refinancing difficult — or impossible — and leading to distressed properties hitting the market.
By Jeff Shaw
The challenge is well known by now. Interest rates saw an unprecedented rise in the last two years. To combat inflation, the Federal Reserve aggressively raised the federal funds rate 11 times from near zero percent in March 2022 to a target range of 5.25 to 5.5 percent as of mid-
January, leading to higher borrowing costs across the board in the seniors housing industry.
Those with variable interest rates saw a sudden and massive increase in their loan payments. While lenders have been largely patient with seniors housing borrowers since the COVID-19 pandemic, the question has now become: Have we kicked the can as far down the road as we can?
For many, the answer is unfortunately “yes.” And distressed seniors housing properties, encumbered by overwhelming debt, are hitting the market.
The news reports are reflecting this in the deals getting done. As two examples, KIRCO acquired Brookmeadow at Blue Hills, a 91-unit assisted living and memory care community in the Boston suburb of Stoughton. The community was built in 2009 and was acquired at 45 percent of replacement cost in a high-income, underserved market, according to KIRCO.
Another opportunistic pair of investors, Kandu Capital and Bloom Senior Living, acquired two senior living communities in Indianapolis out of a Fannie Mae receivership.
The words “distressed” and “value-add” seem more prevalent than ever in properties for sale.
“It’s been happening for a while and it will continue to happen,” says Talya Nevo-Hacohen, chief investment officer at Sabra Health Care REIT.
She notes that in the pre-COVID building boom, many construction loans were written using floating-rate debt to save money. Those loans are maturing now, but the interest rates have swung high and refinancing into a permanent loan is not the easy proposition it was in 2019.
“Your loan-to-value ratio is upside down, your debt-service coverage doesn’t work. If you want to refinance that loan, you can’t refinance the whole principal balance. Many fell into this trap. They didn’t plan on 8-plus percent debt.”
While the 10-year Treasury yield — used as a benchmark for long-term, permanent, fixed-rate financing — fell about 100 basis points between Oct. 19 and the end of 2023, the rates for permanent loans are significantly higher than 18 months ago.
Fannie Mae even noted that seniors housing specifically way driving up its delinquency rate, writing in its third-quarter 2023 report: “The multifamily serious delinquency rate increased to 0.54 percent as of Sept. 30, 2023, compared with 0.37 percent as of June 30, 2023, largely driven by seniors housing portfolios.”
Sabra’s CEO Rick Matros adds that the company converted all its variable-rate debt to fixed-rate debt in the last year, which is saving the REIT approximately $15 million a year at current rates.
“You have really smart people who stopped being proactive because you had years of zero interest,” says Matros. “[Cheap capital is] like a drug.”
That being said, the federal funds rate increased much faster than anyone predicted, even in their most pessimistic of outlooks.
“The 500-basis-point interest rate rise since early 2022 was well outside of most underwritten scenarios,” says Don Kelly III, senior managing director of Locust Point Capital. “With the speed of the rate increases combined with inflationary pressures on operating costs, the debt-service coverages are impacted, causing a strain on borrower liquidity.”
Alex Florea, managing director of Blueprint Healthcare Real Estate Advisors, provided an example to illustrate the impact of the rate hikes: If a company took on a loan in 2021, a good variable rate would’ve been 275 basis points over the Secured Overnight Financing Rate (SOFR).
That loan would’ve had a rate of 3.75 percent at the time, but it has since risen to 8.1 percent. The borrower’s debt costs more than doubled in just two years.
“When you think of it that way, it’s not surprising to hear of widespread distress,” says Florea. “There’s no reasonable underwriting that accounted for that kind of rate jump. And if you had predicted this and underwritten that kind of rate growth, you wouldn’t have won a single deal.”
(SOFR was around 0.5 percent for nearly all of 2021, but opened 2024 at 5.4 percent on Jan. 2.)
Opportunity from distress
Of course, one man’s distressed property becomes another man’s great deal. The flip side of the coin is that for every debt-encumbered property that has to be sold, there’s an opportunistic investor snapping up a property at a discount.
In a property sector with depressed transaction volumes in recent years (volume fell 38 percent from $20.2 billion in 2021 to $12.4 billion in 2022), and a bid-ask spread that has remained wide, buyers and sellers may finally be coming to terms.
“There are phenomenal buying opportunities across the risk spectrum now, ranging from core-plus to opportunistic and everything in between,” says Aron Will, vice chairman and co-head of seniors housing at CBRE Capital Markets. “We are finally starting to see the dams break loose with respect to product trading on account of debt maturities, debt paydowns and fund life issues. Investors will simply need to trade assets in 2024 and 2025. We have just about as large of an investment sales pipeline heading into 2024 as ever.”
Nevo-Hacohen says more distress is on the horizon because “banks are being patient for the moment, but that patience will wear thin.” She also is seeing quality, performing assets hit the market that wouldn’t normally be on sale in a buyer’s market.
“Now is not the time anybody sells assets unless you have to,” she says. “It’s hard, and the prices aren’t great. I would venture to say there are assets being sold today to get cash to save other situations where owners are at risk. They’re selling performing assets to save other assets elsewhere.”
It’s important for buyers to have strong operator partners lined up in order to execute a turnaround strategy, she adds.
Matros predicts that capitalization rates will return to much higher levels similar to the 2012 to 2016 time period when Sabra was extremely active in acquisitions. “For folks like us, there will be some really nice opportunities to expand our presence in the seniors housing space.”
This trend was reflected in CBRE’s October survey of seniors housing investors. Skilled nursing capitalization rates increased by 71 basis points (bps) between April and October, after falling by 34 bps between CBRE’s previous two surveys. The average cap rate for active adult communities increased by 68 bps between April and October. Cap rates for independent living, assisted living and memory care facilities increased by 73 bps on average over the past six months.
However, Florea still urges caution. In choppy financial waters, today’s opportunistic buyers could simply become tomorrow’s distressed sellers themselves.
“It comes down to capital for the buyers as well. Buyers have to make sure they’re buying with a capital stack that’s sustainable, provides some flexibility and won’t just put them in the same situation a year or two later,” says Florea.
Will NOI save us?
The increased interest rates are the most recent of a long line of challenges for seniors housing owners and operators. Occupancy still hasn’t recovered to pre-pandemic norms and expenses have increased across the board.
But on the bright side, occupancy has increased consistently over the last few years with no signs of slowing down, while rent rates have increased greatly with little resident push-back.
The occupancy rate for private-pay seniors housing rose 80 basis points to 85.1 percent in the fourth quarter of 2023, according to data from NIC MAP Vision. It’s the 10th consecutive quarterly increase in occupancy as the industry continues to recover from impacts of the COVID-19 pandemic.
The occupancy figure marks an increase of 660 basis points from the pandemic low of 77.8 percent in second-quarter 2021, but still short of the pre-pandemic mark of 87.1 percent in first-quarter 2020.
Annual rent growth was 5.4 percent in the third quarter of 2023.
Whether borrowers can afford to wait for net operating income (NOI) to be fully restored to pre-pandemic levels, though, depends on how much leeway they have with their loans.
“With the change in the supply-demand dynamic, occupancy will surpass pre-pandemic levels, which is what needs to happen to restore margins because other costs have gone up so much,” says Matros. “But that’s not in the next 12 months either. It’s going to take longer than that. If you’ve got a two- to three-year outlook, then it looks really great. But I’m not sure how many folks have that much breathing room.”
Andrew Smith, senior managing director and head of real estate debt at Kayne Anderson, doesn’t mince words when providing borrowers with looming debt maturities the range of options: Work with lenders to modify debt, seek equity infusions from partners/investors, sell properties for a loss, or default on debt and risk foreclosure.
“If borrowers can work with lenders to get extensions or relief to give them more time, this could allow them to successfully grow their way out of the problem,” says Smith. “For the properties that were financed aggressively, it probably will take years.”
“I don’t think increased NOI is enough, but it’s absolutely the foundation of any recovery. Without that, there is no way out,” says Florea. “There’s realistically not enough NOI growth to make up for debt costs doubling. There has to be some component of rate reductions and/or material deleveraging.”
Kelly agrees that increased income is ideal, but says it needs to come with a matching reduction in expenses to get owners out of this financial squeeze.
“Revenue improvement in the form of higher rents and improved occupancy is certainly helpful,” he says. “There will need to be normalization in expenses such as labor, insurance, food and other categories for NOI margins to gravitate toward historical norms. That said, underlying interest rates are the other part of the challenge that may persist.”
Can we avoid a freeze-up?
Distressed assets selling at a discount following a long period of depressed transaction volume could be viewed as a natural part of a cycle. But is it possible we’re heading for even tougher times? What if the amount of distress is larger than the investment appetites of opportunistic buyers?
“I don’t think industry-wide that will be the case,” says Matros, “though it will be for certain assets in certain markets.”
Matros expects to see many sidelined buyers returning to the fold as pricing continues to come down, particularly private equity investors.
“A lot of private equity on the development side walked away. At some point, they’ll be back in. They have mandates to fulfill. They also have a lot of vintage, closed-end funds they’re stuck with and losing returns on.”
CBRE’s Will shares the belief that the transaction market won’t lock up for seniors housing.
“We’re starting to see more liquidity enter the market, generally speaking, and those with capital who aren’t too inundated with legacy challenges are seeing the great opportunities at hand.”
Florea says that pricing will continue to come down “until sidelined buyers are confident enough to re-enter despite the heightened carry costs and overall risk.” But he also suggests the possibility exists for more distressed seniors housing properties being converted to other uses.
“It’s not crazy to say that there’s a subset of these distressed assets that are in markets that are too overbuilt, or that have an obsolete physical plant (or both), and can’t go on as seniors housing,” says Florea. “At some point there really is value to the sticks and bricks, even if you need to move them around some.”
Smith believes more capital markets pain is on the way as a result of continuing struggles among banks.
Although the Fed has indicated it plans to begin lowering interest rates in 2024, that’s cold comfort to both a borrower that’s underwater today and the bank holding the loan.
“With the commercial real estate loan exposure held by banks, even in a scenario where the distress is muted, we expect to see significant bank failures and consolidation over the next several years as many banks have significant concentrations of loans that will experience stress while maintaining limited liquidity,” says Smith. “In addition, many owners will lose properties to their lenders (or the entities that absorb a failed lender) and will go bankrupt.”
But Kelly puts a more optimistic face on the issue, noting that this isn’t our first or last down cycle in seniors housing — and we’ve always survived before.
“With distress comes opportunity. There are typically ample sources of opportunistic capital chasing each of the product and care types and various asset qualities to absorb what is on the market.
“The seniors housing and care model has proven durable and resilient during past capital cycles supported by continued growth in the senior demographic.”