Occupancy issues create underwriting headaches, slower approval process, but pipeline remains active.
By Matt Valley
The emerging consensus among lenders in HUD’s Section 232 mortgage insurance program for healthcare properties is that total deal volume in fiscal year (FY) 2021 will fall short of the nearly $4.4 billion in loan closings recorded the prior year. In fact, some lenders expect the total dollar amount of loans closed will decrease 10 to 20 percent on a year-over-year basis.
Despite low interest rates, lenders cite an extremely challenging operating environment for skilled nursing and assisted living facilities due to the COVID-19 pandemic that struck in early 2020 and whose lingering effects are still hobbling the industry.
The average occupancy rate at skilled nursing facilities plummeted from 83.8 percent in the fourth quarter of 2019 to 70.7 percent in January 2021 before rebounding slightly, according to the National Investment Center for Seniors Housing & Care.
Such a dramatic drop in occupancy rates has led to cash flow problems for many operators, underwriting challenges for lenders and generally slowed the loan approval process overall at HUD. Understandably, the agency wants to be certain the loans it is insuring are on solid footing.
Still, not every finance professional is convinced that deal volume generated by the mortgage insurance program in FY 2021 will fall short of last year’s total. Scott Thurman, chief credit officer for FHA lending at Greystone, points to a healthy number of loan commitments made by HUD that are close to crossing the finish line. He also cites HUD’s strong track record of being able to ramp up its efforts as necessary to process loan applications in the queue.
“We could definitely end up with a higher volume than last year, but there is a lot going on that could undermine those commitments of HUD,” acknowledges Thurman. If, for example, the agency feels uncomfortable with the occupancy situation at a particular facility, or someone at a facility tests positive for COVID-19, that loan could be put on hold.
“Also, the later in the year that we get, there starts to become a bandwidth issue of how many deals HUD can process [in a compressed time period],” adds Thurman.
Dissecting the data
Through the first six months of FY 2021, HUD provided mortgage insurance on 191 projects totaling $1.8 billion in closed loans, according to Jason Smeck, a director at Lument. “That is off the pace of the prior year by about 15 to 20 percent.” (HUD’s fiscal year runs from Oct. 1 to Sept. 30.)
“Interestingly, the number of applications received by HUD in the first six months of the year has been much higher than prior years. This is likely a byproduct of the low interest rate environment, which has made note modifications and 223(a)(7) applications very attractive,” says Smeck.
“It’s also likely a sign that application review has been challenging over the course of the pandemic. Most communities in the seniors housing and healthcare industry have suffered greater volatility in census, payor mix and financial performance, and it’s incredibly challenging to underwrite and/or review the underwriting of projects in the face of this volatility,” adds Smeck.
The 223 (a)(7) loan program Smeck refers to is used to refinance existing HUD-insured debt on healthcare properties, and it’s a popular vehicle for borrowers to take advantage of amid today’s choppy market conditions. Through May 21 of FY 2021, lenders closed 76 (a)(7) loans compared with just seven during the same period a year ago.
“As opposed to a loan modification, where all you can do as a borrower is reduce the interest rate, an (a)(7) allows you to both lower the rate and extend the loan maturity term. The net impact is typically twice the savings for deals we have looked at versus a modification,” explains Michael Gehl, chief investment officer at Housing & Healthcare Finance LLC.
“In a challenging environment for many owner/operators, achieving savings through their existing HUD-financed portfolio can provide much needed assistance as we slowly return to normalcy,” adds Gehl. “As a result, the (a)(7) program is up dramatically, and the modification program is tracking within 10 percent of its record last year.”
To Gehl’s point, lenders in the HUD healthcare mortgage insurance program completed 186 loan modifications through the first 33 weeks of fiscal year 2021, up from 38 during the same period a year ago.
The “tremendous increase” in loan modifications on a year-over year basis, as well as the big uptick in the number of (a)(7) loans, reflects the dramatic swing in the interest rate environment over the past year, says Erik Howard, executive managing director for Capital Funding Group (CFG).
The 10-year Treasury yield, a benchmark for fixed-rate permanent financing, began 2020 at 1.8 percent, but dropped to 0.5 percent by the end of July before steadily climbing again. As of June 2, the 10-year yield stood just shy of 1.6 percent.
“The (a)(7) volume trended relatively consistently with the dip in the 10-year yield that we saw. My suspicion is that those (a)(7) loans will start to trail off. Since the start of 2021, the 10-year yield is up about 60 basis points,” says Howard.
The lesson for borrowers and lenders is to react quickly to any shocks in the system that might result in dramatic interest rate swings, advises Smeck. “Throughout this time, we focused heavily on making sure our clients understood their options to reduce interest rates on their HUD-insured loans and how quickly they needed to act.”
Although the 10-year yield has trended upward for the past several months, credit spreads have tightened, and not just for Ginnie Mae securities, notes John Randolph, senior vice president with KeyBank Real Estate Capital. “It’s across the board: Fannie Mae, Freddie Mac, CMBS — everybody’s spreads have come in. And they’ve tightened probably 50 basis points (from a year ago).” Tightening spreads don’t shield borrowers from rising interest rates, but they can help soften their impact, he notes.
While the volume of (a)(7) loans has been surging, the opposite is true of the FHA/HUD Section 232/223(f) program designed for the acquisition or refinancing of healthcare properties. Through the first seven months of FY 2021, the volume of loans closed through the 223(f) loan program decreased by about $841 million compared with the same period in FY 2020, according to Gehl. Conversely, the volume of (a)(7) loans closed by lenders during the same period increased by $614 million year-over-year.
To help skilled nursing operators make it through the pandemic, the federal government provided various forms of financial assistance. For example, $21 billion was earmarked for nursing homes with the passage of the CARES Act in March 2020. The federal government also waived the requirement for a three-day inpatient hospital stay prior to providing Medicare-covered, post-hospital, extended-care service to eligible beneficiaries.
Because a number of these programs are temporary measures, they need to be backed out of any cash flow underwriting analysis, explains Gehl. And when the decrease in occupancies is taken into account, in many cases the underwritten cash flow is lower, resulting in lower valuations and thereby lower loan proceeds.
“As a result, 223(f) loans that would underwrite pre-pandemic are just not there anymore, or turnaround bridge loans that would normally be taken out by HUD once a repositioning occurred, will take longer to achieve the needed cash flow for refinancing,” emphasizes Gehl.
Notable transactions
CFG, which specializes in the long-term care and assisted living industries, provided more than $2 billion in bridge-to-HUD and HUD loans nationwide during a record-setting first half of 2021. This financing included 25 bridge loans and 49 HUD loans. (The $2 billion figure includes loans closed outside of the HUD Lean 232 program.)
Among the first-quarter highlights, CFG executed $285 million in bridge-to-HUD financing for the acquisition of a skilled nursing portfolio, including 16 facilities in the Mid-Atlantic region. CFG also closed an $88.9 million bridge-to-HUD loan that refinanced a 239-bed assisted living community in Queens, New York, and a 184-bed assisted living facility in Brooklyn, New York. Both properties are licensed assisted living program facilities by the State of New York.
“We financed $1.3 billion in bridge loans last year during the worst pandemic in the last 100 years. Once the industry really recognized our commitment to it, [the momentum] has continued into this year,” says Howard.
After closing approximately $400 million in loans through the HUD Section 232 program in FY 2020, CFG is on pace to close between $700 million and $800 million in FY 2021, adds Howard.
Housing & Healthcare Finance, which closed 28 loans for $452.4 million in FY 2020, is on pace to eclipse that figure in FY 2021, according to Gehl, thanks in part to a surge in (a)(7) loans. Additionally, the company completed $404 million in loan modifications through April of FY 2021 compared with $413 million in loan modifications for all of FY 2020.
In February, Housing & Healthcare Finance provided a $21.4 million HUD-insured loan for a skilled nursing facility in Maryland. HHC’s capital advisory team helped arrange the bridge financing. The operating team, which only purchases facilities with a drive time of a few hours from where they live, already had a strong presence in the Maryland market.
Upon acquisition, several management positions were replaced at the facility, while a new admissions director and external marketing person were hired to rebrand the facility and improve relationships in the community.
As a result, the quality mix (higher rate and better margin payors) at the facility improved, going from a low-single-digit EBITDAR margin to a low 20 percent range. The borrower’s bridge financing was replaced with a 35-year, fully amortizing HUD loan at an interest rate in the low 2 percent range, putting the financing to bed for a very long time so that the operator can continue to focus on patient care.
Smeck of Lument says the COVID-19 pandemic illustrates why the HUD Section 232 program is so important and valuable for property owners. “Having a long-term financing structure in place brought tremendous comfort to property owners knowing that they were not facing a pending loan maturity and an anxious lender.”
Earlier this year, Lument helped the Gardens by Morningstar complete an $8.3 million refinancing through HUD’s 223(f) program. The Gardens is a family owned and operated assisted living community located in Oswego, New York. The community, which includes 106 assisted living units, offers select healthcare services and support for its residents.
The property sat vacant until 2016, when current ownership acquired and substantially renovated the building. Lument helped ownership structure a bridge loan in 2017 that consolidated construction debt and positioned the facility to execute the bridge-to-HUD refinancing. The loan, which closed in January 2021, paid off the existing bridge loan and reimbursed the borrower for previous capital expenditures. The loan features a low, fixed interest rate and 35-year term.
Greystone completed 75 loans for $1.32 billion through the HUD Section 232 program in FY 2020. Based on current trends, Thurman projects that Greystone will close approximately 90 loans totaling between $1 billion and $1.2 billion in FY 2021. “It just depends on how COVID affects us,” he says.
The 223 (a)(7) loans accounted for 60 to 70 percent of Greystone’s deal volume in the first part of FY 2021, notes Thurman. “They are now about 20 percent of our volume.” A steady diet of 223(f) loans has taken their place.
Meanwhile, the number of loan modifications, also referred to as IRRs (interest rate reductions), has fallen off, he says. “I think we only have three that are in closing at HUD right now.”
It’s all about labor
Because nearly all operators face significant staffing challenges today, Randolph of KeyBank closely follows the latest employment data. “This is really a local business rather than a national business. It’s national in the sense that one of the program payers is Medicare, the program of the federal government. But the issues operators face are more local, so we want to understand what’s going in your market,” explains Randolph.
“What labor challenges do you have? Is there a competitor coming? Have you had to go out there and find new talent, and do you have to get agency staffing? What’s going on at the state level? What’s going on policy-wise,
regulatory-wise? Is the state considering any adjustments to its Medicaid program?”
Concludes Randolph: “We want to understand the issues operators have so maybe we can provide a comprehensive solution.”