With bank balance sheets improving and real estate fundamentals strengthening, developers enjoy more choices as borrowers.
By Bendix Anderson
The seniors housing industry finds itself squarely in Phase II of the real estate cycle — the expansion phase.
It is now possible to get money to build new seniors housing properties, though developers have to prove that they have a solid business plan and the experience to carry it out.
“If you have the equity, the site and good demographics, you should be able to get the money to build,” says Richard Lynn, director in the Oak Brook, Ill., office of Marcus & Millichap Capital Corp. (MMCC).
Drawn by solid property fundamentals and strong returns, a broad range of capital providers now compete to invest in seniors housing properties.
Simply stated, “The seniors housing sector has arrived,” says Beth Burnham Mace, who recently became the first chief economist for the National Investment Center for the Seniors Housing & Care Industry (NIC).
Currently, the seniors housing industry finds itself in a harmonious state of equilibrium. Seniors housing borrowers are finding willing lenders. Owners and investors are finding equity partners. And sellers are finding willing buyers.
Banks’ improving health is good sign for borrowers
Most construction loans still come from the balance sheets of commercial banks, and banks are now much more able and willing to lend.
The majority of senior loan managers consistently say they are easing standards for commercial real estate borrowers, according to the Senior Loan Officer Opinion Survey on Bank Lending Practices, released monthly by the Federal Reserve.
In part, that’s because bank balance sheets are stronger overall. As of March, there were 411 banks remaining on the Federal Deposit Insurance Corp.’s problem bank list, down from 884 troubled banks in 2010.
Banks have also emerged from the financial crisis and years of a slow recovery in which bank lenders were less-than eager to lend to new construction real estate projects, experts say.
The vital signs of the seniors housing industry also are strong — though experts are keeping a close eye on real estate fundamentals as new construction increases.
Independent and assistant living seniors housing properties posted an average occupancy rate of
89.8 percent during the first quarter of 2014 in the top 31 U.S. metropolitan areas, according to NIC. That’s not far from the previous peak of 91.5 percent in early 2007.
Independent and assisted living properties also performed well during the Great Recession. The average occupancy rate dipped to a low point of 86.9 percent in the first quarter of 2010. From the top of the market to the bottom, that’s a range of less than five percentage points.
Average rents also continued to grow throughout the entire period. “Seniors housing is one of the only sectors that did not show rent declines,” points out Mace.
Borrowers will need to carefully prove that demand will be strong in the geographic area around their planned development and that their property is likely to capture this demand.
Among seniors housing projects in which the majority of units will be independent living, developers started less than 4,000 units in 2013, less than half the rate of construction during the boom.
The rate of new development for assisted living was more impressive. Among projects in which the majority of units will be assisted living, developers started more than 8,000 units in 2013. However, in most markets demand is still expected to be strong enough to more than soak up the new supply.
“There is now pretty good balance between supply and demand,” says NIC’s Mace. NIC forecasts that demand for seniors housing will stay well ahead of supply through the first quarter of 2015.
Proven developers enjoy attractive financing terms
Borrowers still benefit from historically low interest rates. Banks now offer construction loans at floating rates ranging from 250 to 300 basis points over the 30-day London Interbank Offered Rate (LIBOR), which was less than 0.2 percent in May.
Banks are especially concerned with the track record of the borrowers who they consider for construction loans.
“Gone are the days when people assumed an apartment operator could do seniors housing,” says Mark Myers, executive director for Institutional Property Advisors (IPA). “Before the crash, you could be a single-family developer and get a loan in seniors housing.”
Construction lenders typically demand recourse debt. They also want borrowers to demonstrate that they have a plan to transition to permanent financing. “A firm commitment would be ideal,” says Myers.
Much-needed equity available
Borrowers of all types will probably need to bring a significant amount of equity to the table to finance seniors housing properties.
Most lenders are unwilling to make loans that cover more than 70 percent of a property’s value — if they are willing to go that far.
Lenders are also much less willing to accept aggressive estimates of a property’s future value than they were during the boom years when lenders sometimes appraised the likely value of an acquisition at up to 120 percent of the purchase price.
“You could effectively have 100 percent financing,” recalls IPA’s Myers. “Those days are really gone.”
Fortunately for borrowers who don’t have their own cash, private equity funds and pension funds are willing to enter into joint venture agreements.
“Equity is virtually unlimited for seniors housing,” says IPA’s Myers. Like other capital provides, equity partners are drawn to seniors housing by strong fundamentals and relatively attractive returns.
Permanent lenders compete heavily
Lenders are especially eager to make permanent loans to stabilized seniors housing properties.
“It’s a tremendous time to be a borrower,” says Christopher Honn, director of Fannie Mae’s seniors housing group.
Seniors housing borrowers have a range of choices — from portfolio lenders such as banks and life companies to Fannie Mae and Freddie Mac lenders.
Even conduit lenders, which securitize mortgages that are bundled together and sold to Wall Street bond investors, have begun to come back to the seniors housing business, though the interest rates they offer are often not yet competitive, experts say.
Interest rates vary based on the type of seniors housing property and the level of services required. Life insurance companies often offer the most competitive interest rates, followed by banks and Fannie Mae and Freddie Mac lenders.
Life companies recently began making seniors housing loans on Class A properties in the strongest markets. “They are new to the seniors housing sector, having entered the market in the last year or two,” says NIC’s Mace.
Their loans are typically low leverage, covering less than 60 percent of the property’s value. Because these lenders hold the loans on their own balance sheets, the mortgages come without prepayment penalties and other restrictions charged by securitized lenders.
Banks of all sizes have also gotten into the business of making fixed-rate, permanent loans from their own balance sheets to seniors housing properties.
It’s a relatively new business for banks, which traditionally have focused on making shorter-term, floating-rate construction loans.
However, banks now have such a low cost of capital that they are willing to commit to longer-term loans at fixed rates. Even if interest rates eventually rise, the money made over the first years of a loan is likely to make up for it.
“Their cost of capital is effectively zero,” says MMCC’s Lynn. Banks can also use interest rate swaps to help protect themselves from the risk of rising interest rates.
Experts like Lynn expect banks to continue to make permanent loans on seniors housing properties for the foreseeable future. “I don’t think that they’ll lose appetite,” he says.
Regional banks now regularly offer fixed-rate loans with five-year terms and local community banks often lend as long as seven years at fixed rates.
Some banks are even willing to make 10-year permanent loans, with an interest rate reset at the fifth year, says Lynn.
“You are seeing more regional players lending to smaller deals,” adds NIC’s Mace.
Agencies lose volume
Fannie Mae and Freddie Mac are also eager to make permanent loans on seniors housing properties by offering the lowest rates they can, plus faster service.
But competition from portfolio lenders such as insurance companies and banks is still cutting into the volume of Fannie and Freddie’s multifamily lending business.
Last year federal regulators ordered the government-spon-sored enterprises to shrink their volume of lending to multifamily properties by 10 percent — arguing that agency lenders were too dominant in the apartment lending business.
However, seniors housing is an extremely attractive part of the multifamily lending business for Fannie Mae and Freddie Mac. Their portfolio of seniors housing loans has effectively no defaults. So, they expanded their seniors housing lending practice even as they made fewer loans to multifamily properties overall in 2013.
This year, federal regulators aren’t demanding that the agencies trim their lending volume further, but competitive pressure has picked up where the regulators left off.
Fannie Mae closed and sold $6 billion in apartment loans during the first five months of 2014. That’s less than half the $13.6 billion that the agency closed during the same period last year.
“The market has gotten a lot more competitive. A lot more lenders are out there looking to do debt,” says Dan Dresser, director of multifamily capital markets for Fannie Mae.
Competing for limited supply
Fannie Mae and Freddie Mac’s shrinking share of the lending market has had a surprising side effect — helping to lower interest rates for their apartment loans. They now have fewer multifamily loans to turn into bonds. That means bond investors must compete for the limited supply, paying higher prices and accepting lower yields.
It also helps that Barclays Bank now includes commercial mortgage-backed securities (CMBS) in its securities index, increasing demand for the bonds. “Mutual funds that track the index have to buy the bonds,” says Dresser.
The difference between the typical investment yield on Fannie Mae delegated underwriting service bonds and the yield on Treasury bonds has shrunk by 25 basis points since the beginning of the year.
Agency lenders have pushed their interest rates even lower to try to be more competitive with banks and insurance companies.
The interest rates offered by Fannie Mae apartment lenders have dropped by about 50 basis points on average since the beginning of the year, experts say. That includes the effect of lower bonds yields plus the effect of Fannie Mae and its lenders squeezing their own fees.
Fannie Mae and Freddie Mae offer a variety of terms, including fixed- and floating-rate loans. The maximum loan-to-value is 75 percent and debt-service coverage ratios are also higher, at about 1.50. (A debt-service coverage ratio over 1.0 means that the property generates enough cash flow for the borrower to pay its debt obligations.)
Says Honn: “It’s a blessing to be able to accommodate a variety of borrower types.”