The government goes on hiatus, deal size grows, and ORIX shows its dominance.
By Matt Valley
Despite enduring a federal government shutdown for 35 days that temporarily put a crimp in loan processing, the HUD/FHA Section 232 mortgage insurance program used to finance seniors housing properties rallied to post a solid performance in fiscal year 2019. The volume of loans closed during the 12-month period that started Oct. 1, 2018 and ended Sept. 30, 2019 totaled $3.7 billion. That’s up from $3.6 billion the prior fiscal year.
The HUD/FHA Section 232 program — more commonly referred to as the HUD Lean program — helps finance nursing homes and assisted living facilities, as well as board and care facilities. The Lean process developed by HUD in 2008 is a methodology based on the Toyota model to increase efficiency by reducing waste. In short, the goal is to eliminate historical inefficiencies in the processing and approval of HUD loan applications.
Dissecting the data
Although the government shutdown that occurred in late December 2018 and January 2019 resulted in the program’s loan count dropping from 317 to 288 on a year-over-year basis, the average loan amount increased 14 percent during the same period to reach a record high of nearly $13 million.
“This was driven not only by some larger, single-asset deals in the New York City/Long Island market, but also by strong-performing portfolios for which it was time to take out the bridge financing with a HUD loan,” says Michael Gehl, chief investment officer for North Bethesda, Maryland-based Housing & Healthcare Finance, which has closed $750 million in HUD Lean loans over the past three years.
Erik Howard, managing director of real estate finance for Baltimore-based Capital Funding Group, believes that “block trades” helped boost the total loan volume in the HUD Lean program during fiscal 2019 even as the number of transactions declined as a result of the government shutdown.
For example, Genesis HealthCare (NYSE: GEN), one of the largest post-acute care providers in the country, has sold off bunches of underperforming skilled nursing facilities in what it calls “non-strategic markets,” including Texas, over the past few years.
“We’re seeing larger clusters of deals, if you will, both from the large national operators as well as the REITs. The REITs have continued to divest assets in bulk size. You may have one transaction that’s worth $200 million as an example. We believe that’s going to continue going forward,” says Howard, whose firm has closed $1.2 billion in loans through the HUD Lean program over a three-year period.
There’s perhaps another factor at play. A growing number of larger care providers are gravitating toward HUD because over time the agency has become more consistent in its underwriting, says Jason Dopoulos, senior managing director with Columbus, Ohio-based ORIX Real Estate Capital. This emerging group of borrowers is helping to boost the average loan amount, he points out. “If you finance a couple large portfolios in California and New York, the average loan amount is going to go up. The other part of it is just the normal valuation growth of cash flows.”
King of the hill
ORIX Real Estate Capital, through its Lancaster Pollard division, was by far the most dominant producer in the HUD Lean program during fiscal year 2019. ORIX closed 78 loans for a record-setting total of $903.9 million. ORIX also led all lenders in construction loan closings, completing seven transactions totaling $112 million, over 50 percent of the program’s total construction volume.
How strong of a performance did ORIX turn in during fiscal year 2019? Well, the 78 loans it closed exceeded the next two lenders combined. Dopoulos cites two primary reasons for ORIX’s success: The firm spends a lot of time educating both current and prospective clients about HUD’s loan program for seniors housing, and important rule changes by HUD over time have helped make it more accessible to bigger entities such as REITs.
“It’s part HUD being friendly, and just part us,” says Dopoulos, who is based in ORIX’s Cleveland’s office and has managed the firm’s healthcare bankers in the Southwest since 2013.
A Plum portfolio
A vibrant mergers-and-acquisitions market coupled with some significant recapitalizations of companies have given a lift to HUD’s overall deal volume, says Dopoulos. Case in point: Over the past 18 months, ORIX has recapitalized Plum Healthcare Group LLC, an owner-operator based in California. Specifically, ORIX structured a bridge loan to take out all of Plum’s bank debt. As part of the recapitalization, 27 of Plum’s properties are gradually being refinanced through HUD in a multi-tier process. This portfolio of HUD loans is valued at $400 million.
“Now the owner has fixed-rate debt in place for 30 to 35 years. It doesn’t have to worry and ask, ‘Is my bank going to lend to me in two years if there is some headline risk in the nursing home industry?’ It can now focus on worrying about other issues facing operators: staffing, labor and PDPM (the Patient-Driven Payment Model),” says Dopoulos.
The ORIX team was talking with Plum management for years about the merits of the HUD program and showing the company how its peers had successfully used this financing vehicle, says Dopoulos. “My team got them comfortable with the program. It’s great for HUD because Plum is a best-in-class operator in California.”
Dopoulos anticipates loan volume for ORIX in fiscal year 2020 will remain healthy due to a strong deal pipeline. But because large portfolio transactions like the recapitalization of the Plum portfolio “don’t happen all the time,” he envisions total annual volume for ORIX will range from $700 million to $800 million in fiscal year 2020.
New York City-based Greystone, the second most active HUD lender by loan volume during fiscal year 2019, closed $606.5 million in loans. That’s up from $298.5 million the prior year. Greystone’s annual loan count also rose from 20 to 36.
“It was a big year for us,” says Scott Thurman, senior managing director and chief credit officer for Greystone’s FHA program. “We’re very dedicated to the healthcare platform and have been building it up over the last couple of years. I believe that in 2020 we’ll double our loan volume and use of the FHA product for skilled nursing.”
Before the first quarter of fiscal year 2020 even came to a close in December, Greystone had already closed 13 deals for $317 million. Commitments for twice that amount are expected to close in the next few months.
Thurman’s intentions are clear. “We want to be the No. 1 HUD lender.”
He credits Greystone’s portfolio lending group — a balance sheet financing platform that provides bridge loans to borrowers — for much of the company’s success in the HUD Lean program. A borrower seeking to turnaround a newly acquired skilled nursing facility can obtain a bridge loan through Greystone. The loan term is one to three years and the loan amount can range from $5 million to $75 million.
Once the loan has seasoned and/or the property has stabilized, the borrower can apply for a HUD-insured loan through Greystone. “To be in this space and grow the way we have, having our bridge loan product is key to that success and growth because it takes pressure off the HUD timing.”
Capital Funding Group, which ranked fourth among the top 10 lenders in the federal mortgage insurance program, closed $394.8 million in loans in fiscal year 2018, down from $502.6 million the prior year. Howard says the year-over-year dip in deal volume needs to be put into perspective.
“For what it’s worth, in fiscal year 2018 we were working through the refinancing of a relatively large portfolio at the time. That’s always a benefit in terms of both the number of transactions and overall deal size,” says Howard. Capital Funding’s total loan count in fiscal year 2018 was 46, but fell to 33 in fiscal year 2019.
“We spent quite a bit of 2019 and even 2018 continuing to fill our bridge pipeline, which has been an extremely important component of our business,” explains Howard, referring to Capital Funding’s program of providing short-term bridge loans to borrowers whose end game is to obtain long-term permanent financing through HUD. “In our bridge program, we have over $1.2 billion in loans outstanding, which will eventually work their way through HUD.”
Capital Funding closed over a half-billion dollars in bridge loans during the 2019 calendar year, according to Howard. “2019 was a fantastic year for us across the portfolio, where we financed in excess of $1 billion in healthcare real estate.”
Housing & Healthcare Finance closed $336.4 million in loans through the HUD Lean program in fiscal year 2019, ranking it fifth in total loan production. That total compares favorably with the prior year, when the company’s loan volume was $172.5 million.
One notable deal for Housing & Healthcare Finance was the $81 million refinancing of a six-property skilled nursing portfolio in Chicago and the surrounding area. The transaction helped transition the portfolio from a higher-rate, short-term loan into the longer-term, HUD-backed financing. The borrower was a Chicago-based investment group and its operating affiliate.
What keeps Dopoulos up at night is what he likes to call “headline risk.” In August 2018, Rosewood Care Centers defaulted on $146 million in government-backed mortgages secured by 13 skilled nursing and assisted living facilities in Illinois and Missouri. According to The New York Times, it was the biggest default in the history of the mortgage insurance program.
“In my opinion this default was not a HUD problem. The operator was just not a good operator,” says Dopoulos, who points to the industry’s low default rate, which stood at 1.76 percent as of October 2019, the most recent data available. (HUD considers a loan to be in default if it is 60 days or more past due.)
The natural tendency for any agency facing negative headlines is to recoil, and with HUD that could potentially lead to a slowing of the entire loan approval process, says Dopoulos.
“I am worried about a newspaper article coming out about a borrower defaulting, everyone reading it and then HUD saying, ‘We’re not doing this or that anymore.’”
Competitive threats to HUD’s Section 232 program are another area of concern, says Dopoulos. For the longest time, the only financing option for skilled nursing operators has been HUD because it offers non-recourse, fixed-rate financing at low rates for a period of 35 years. No other lender can match HUD on all of those terms. The potential does exist, however, for newly emerging competitors to attract borrowers in other ways.
“If someone figures out a way to do a fixed-rate deal at prices similar to HUD, and let’s say it’s only for 10 years with a 30-year amortization, and the lender can close the loan in 90 days, there is going to be a lot of nursing home operators who will listen to that,” says Dopoulos. That’s because it can take six to eight months for a HUD-insured loan to close after work commences on the application.
Thurman keeps a close eye on every move the Centers for Medicare & Medicaid Services (CMS) makes, including any changes to the Five-Star Quality Rating System used to score the performance of nursing homes. Skilled nursing facilities with five stars are considered to have quality well above the average, while those with one star are considered to be well below average.
“What keeps me up at night is that CMS changes the five-star system from time to time — and what I need to go through on the underwriting side,” says Thurman. He recounts how a five-star facility he was underwriting fell to a two-star rating overnight when CMS rolled out its last change. In turn, that made the folks at HUD “very nervous.”
The financial status of state budgets also concerns Thurman, who poses a rhetorical question: “If we do slip into a recession, what happens from a Medicaid standpoint?” The main revenue source at many nursing homes is Medicaid, which is jointly funded by the federal government and the states. The federal government pays states for a specified percentage of program expenditures.
Another wild card is PDPM, which is a new way of calculating reimbursement for skilled nursing facilities. Launched by CMS on Oct. 1, the system aims to ensure appropriate treatment by focusing on the individual patient, rather than the volume of services provided. CMS plans to re-evaluate PDPM this April.
Low interest rates enable Thurman to sleep well. The 10-year Treasury yield, for example, was 1.9 percent as of Dec. 18, down from nearly 2.8 percent a year earlier. What’s the significance? “We can withstand a lot of reduction on the reimbursement rate or increases in expenses,” he says.
HUD’s conservative underwriting parameters also are helpful, says Thurman. What’s more, borrowers in the HUD Lean program pay a mortgage insurance premium: 1 percent of the loan amount due at closing and 0.65 percent annually.
The possibility of future government shutdowns is what keeps Gehl of Housing & Healthcare Finance up at night.
“While government shutdowns have been part of the history of our country, I would say that in this current partisan divide they will be more frequent and last longer than they have in the past. As a result, there will be more times where we have business held up by the fact that HUD will be unable to accept new business during shutdown periods. That will impact loan production going forward.”