Capital markets have ‘no margin for error’

by Jeff Shaw

New supply combined with the prospect of higher interest rates in an uneven economy raise the stakes for developers and lenders

By Bendix Anderson

After years of relatively easy money for seniors housing, the capital markets are becoming more tentative.

“We are going to see tightening in lending,” predicts Charles Turner, president of seniors housing developer PinPoint Senior Living based in Houston.

Although interest rates are still near all-time lows, which is great news for borrowers, and the pricing of assets is near or at peak levels in many cases, investors from both the debt and equity sides of the aisle are proceeding more carefully before buying or lending on a property. They are demanding more information on the property and the market. 

Overbuilding is threatening some markets, while frothy prices are relegating a few leading buyers to the sidelines. The prospect of higher interest rates this year in the wake of the Federal Reserve’s decision in December to raise a key short-term interest rate a quarter percentage point only adds to the uneasiness about where market conditions are headed.


Irrational exuberance?

Seniors housing experts are worried about overbuilding — especially as the global economy continues to wobble.

Seniors housing developers are expected to deliver 36,000 new seniors housing units per year over the next two years within the largest 99 metropolitan areas in the U.S., based on the number of starts at year-end 2015. That’s more than a 2 percent annual increase in inventory, twice as fast as in 2011.

Developers are now building nearly as much seniors housing as they completed annually during the late 1990s, a building boom that ended with many vacant housing units and failed communities. 

“With an increasingly unsteady economy, there is no margin for error in our sector,” says Mel Gamzon, principal for Miami-based Seniors Housing Global Advisors. The wrong submarket, the wrong offering or simply the wrong operator could lead a project into the weeds. 

But many industry experts predict a softer landing this time around compared with the downturn in the late 1990s. 

“An improving economy will be strong enough to largely meet supply,” says Beth Burnham Mace, chief economist for the National Investment Center for Seniors Housing & Care (NIC). Healthy demographics will also continue to support demand for seniors housing. 

For assisted living, NIC forecasts the occupancy rate in 2016 to range between 88 and 89 percent. That would be on par with the fourth quarter of 2015 when the occupancy rate averaged 88.4 percent in the top 31 markets for seniors housing, according to NIC.

For independent living sector, NIC forecasts the occupancy rate will range from 91 percent to 92 percent in 2016. Once again, that’s about the same as the 91.4 percent occupancy rate recorded in the fourth quarter of 2015.

A few submarkets in major metros may have more serious problems. That’s because a lot of construction is concentrated in a small number of places. In 15 of the 99 property markets tracked by NIC, seniors housing developers are planning construction projects that amount to more than 10 percent of the existing seniors housing inventory. 

Even in overbuilt markets, there may be healthy submarkets, however.

“You can have lots of construction, but if it’s not near you it doesn’t matter,” says Noah Levy, managing director for Prudential Real Estate Investors. “There are still seniors housing properties doing very well in Dallas or Houston or Atlanta. It’s a very local business.”

The upshot is that banks have become much more cautious about providing construction financing for ground-up seniors housing projects, but many are still making loans. 

“There is a lot more scrutiny on the project itself,” says PinPoint’s Turner.

PinPoint Senior Living has five new seniors housing properties under development, including several in Texas. The developer recently closed on construction financing for several of the projects and is shopping for the rest, and Pinpoint does not anticipate any problems.

Banks still offer developers like PinPoint relatively generous terms, including loans that often cover 75 percent of the cost to develop. However, lenders are taking more time to study the specifics of the planned development and the market. 

“Banks are slightly more stringent from an underwriting perspective,” says Turner.

Lenders are also likely to carefully review the history and the experience of their borrowers. 

“Banks and equity are being a little more discerning about who we do business with,” says Mark Cotsakis, executive vice president and business head of Wells Fargo Seniors Housing Finance. “We want to do business with people who are going to be around.” 


A potential fly in the ointment

Construction lenders have also become more cautious as a result of new financial regulations that effectively limit how much risk they can absorb on their balance sheets. 

The international Basel III banking standards and the Dodd-Frank Financial Reform and Consumer Financial Protection Act were created after the financial crisis, but many of their provisions have recently come into full effect. 

Among other things, the rules require banks to hold capital in reserve to cover potential losses on investments, including loans to commercial real estate. 

“These regulations could be a constraining factor, especially for smaller banks,” says Prudential’s Levy.

Some small banks have already taken a break from making construction loans to seniors housing. “Several smaller banks are not doing any construction lending,” says Turner. “They have shut that down altogether.”

It will take time for the long-term impact of the rules to become clear. “No two institutions view this exactly the same,” says Aron Will, executive vice president of CBRE Capital Markets’ National Senior Housing Group in Houston, Texas. “Every single lending institution has interpreted the rules differently.”


Ripple effects of volatility

Other worries hang over the property and portfolio sales market. The biggest buyers of seniors housing properties have curbed their appetite, largely because of volatility in the global capital markets.

“There was a slowdown in transaction dollar volume in the second half of 2015,” says Mace. “There weren’t as many big deals being done [over the last year], just two or three deals over $1 billion in size.” 

Investors bought $4 billion in seniors housing properties in the second half of 2015, less than half of the $8.3 billion they bought in the first half, according to Real Capital Analytics (RCA).

Since the middle of last year, worries about world economies like China and the collapse of the price of oil have shaken the global capital markets. Year-to-date through Feb. 18, the Dow Jones industrial average was down 1,011 points, or 5.8 percent.

Publicly traded real estate investment trusts haven’t been immune to the global selloff. The FTSE NAREIT Index was down 10 percent year-to-date through mid-February.

Welltower, the giant healthcare REIT, traded for less than $60 a share in mid-February, down from over $80 at the beginning of 2015. Brookdale traded at less than $15 per share, down from more than $35 a year ago.

In 2015, REITs accounted for $10.8 billion of the $12.4 billion in seniors housing and care properties and portfolios that traded hands, according to RCA. 

REITs were not as active in the second half of 2015 as they were in the first half, says Mace. Lower prices for REIT stocks make it much more difficult for REITs to raise money to buy properties. 

“In the second half of 2015, volatility in the equity markets led to higher cost of capital for REITs and a noticeable pullback in their appetite,” says Kass Matt, president of Columbus, Ohio-based Lancaster Pollard.

However, even with a higher cost of capital, REITs are still finding ways to invest. 

Soon after stock prices fell last summer, Welltower, formerly known as Health Care REIT, partnered with the Canadian Pension Plan Investment Board to invest in a portfolio of Southern California medical office buildings. 

The seller traded a 50.5 percent interest in the $449 million portfolio in exchange for a mix of operating partnership units and cash. Offering operating partnership units enabled the REIT to put off paying in cash for the full price of the property. 


Near-term outlook

Private equity funds may also have less money to invest in seniors housing in the short term. “It might be a more difficult fund-raising environment,” says Prudential’s Levy. 

That’s because many of the institutional investors that contribute to private equity funds may have lost a significant amount of money in the stock market over the last year. That reduces the amount these institutions have to invest overall. 

Even if they still plan to allocate the same percentage to commercial real estate, the dollar amount they have to invest has shrunk. “All of a sudden, the size of the investment pool shrinks because stock values are down,” says Levy.

In the long run, volatility in other asset classes only makes the relatively stable business of seniors housing more attractive. Institutional investors continue to increase their allocations to commercial real estate in general. 

“If they used to allocate 3 percent to 5 percent, they now might allocate 8 percent to 10 percent,” says Levy.

Seniors housing continues to be a magnet for investors. “The number of people who have gotten comfortable with seniors housing has grown,” says Levy. “There are more private equity players and the like getting in the game. There is no shortage of capital out there.”

But in the short term, the ups and downs of the stock market are giving many investors heartburn.


Property prices still high 

So far, the volatility in the stock markets and worries about overbuilding haven’t driven down the prices for seniors housing properties. While the volume of property and portfolio sales tailed off somewhat in the second half of 2015, the capitalization rates, which fall as prices rise, also remained low.

Cap rates for seniors housing properties averaged 7.7 percent over the 12 months that ended in the fourth quarter of 2015, up slightly from 7.5 percent over the 12 months that ended in the fourth quarter of 2014.

Seasoned dealmakers have been waiting for cap rates for seniors housing properties to rise along with interest rates. 

“There is some concern that there could be valuation adjustments if higher interest rates occur,” says Mace.

The Fed has signaled its plans to raise interest rates for a very long time.

“Most organizations had anticipated higher interest rates for 2016,” says Mace. “Although there isn’t always a one-to-one correlation between interest rates and cap rates.”

With prices still high but the volume of transactions slowing, investors are spending more time carefully poring over the details of potential deals before they decide to buy. 

“Six months ago, a lazy broker could get tons and tons of offers and people weren’t really underwriting deals,” says Lisa Widmier, executive vice president for CBRE Capital Markets’ National Senior Housing Group. “Now you can’t be lazy and expect offers to come in without any effort.”


Low interest rates defy expectations

Volatile financial markets overshadowed the event capital markets have waited for since the end of the financial crisis.

If the economy continues to improve, the central bank plans to increase the Fed funds rate as many as three times this year for a total of 100 basis points over the course of a year.

Seniors housing borrowers would feel the difference if interest rates for permanent loans to seniors housing properties rose that much. Long-term rates could increase 100 to 125 basis points over the next 12 months if federal officials stick to their plan — though that seems increasingly unlikely, experts say.

So far mortgage rates offered by lenders have moved in the opposite direction — falling as investors around the world worry about declining stock markets, the low price of oil and instability in the Chinese economy.

“All of a sudden a lot of deflationary forces are going on at the same time,” says Levy. “The capital markets are having a hard time seeing clearly into the future.”

Uncertainty is likely to slow down the Federal Reserve’s plan for rate hikes. “We expect a very gradual increase from the Fed in 2016,” says Lancaster Pollard’s Matt.

For now, long-term interest rates are once again near their all-time lows. The yield on the 10-year Treasury bond, the basis for many long-term interest rates and investment yields, fell below 2 percent at the start of 2016. 

As of press time, the benchmark bond yield was at 1.75 percent, not far from its record low point of 1.49 percent set in June 2012.

Experts still expect long-term rates to eventually rise by as much as 55 basis points by the end of 2016. But for now, lenders continue to offer lower rates. 

“You never know how long these windows are going to stay open,” says Levy. The central banks of several countries have set their interest rate targets far below historical norms. “Interest rates are below zero percent in a lot of places.” 

A growing number of lenders also offer permanent financing in the seniors housing sector, even though these lenders are also cautious in their underwriting. The money is available, even if deals take time to close. 

For example, the number of insurance companies that offer permanent financing to seniors housing properties has more than tripled. “There are now six or eight [insurance companies] that are actively quoting deals and have dedicated staff for seniors housing,” says CBRE’s Will. 

Many of the banks that offer construction financing to seniors housing properties also offer longer-term financing from their balance sheets.

Both Freddie Mac and Fannie Mae lenders also have a new capacity to provide capital to seniors housing properties. In 2015, the federal regulators who watch over Freddie Mac and Fannie Mae loosened the limits on how much they can lend. 

Now Fannie Mae and Freddie Mac can provide an unlimited amount of capital in loans to affordable housing properties. That frees up billions of dollars that Fannie Mae and Freddie Mac can lend to other multifamily properties, including seniors housing.

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