Capital still flows to seniors housing developments, though overbuilding concerns have led to stricter underwriting.
By Bendix Anderson
Many lenders are more cautious than they were just a few years ago when it comes to construction of new seniors housing. But determined developers can still find the capital to build — they just have to work a little harder.
Many of the largest, most experienced lenders are making smaller loans and focusing on experienced developers and operators. At the same time, however, some local and regional banks are still bidding aggressively to finance new construction. Debt funds, often run by private equity fund managers, offer extra leverage to developers.
The result is that developers may have far fewer financing options for their projects, but choices nonetheless.
“The construction market has changed in the last 12 to 18 months,” says Aron Will, vice chairman and co-head of national senior housing debt and structured finance in the Houston office of CBRE Capital Markets.
“It is now a three-term-sheet market,” he says.
In other words, a developer today might get three serious offers — term sheets — from lenders to finance a construction project. “That’s compared to the eight-term-sheet market back in 2013,” says Will.
Pressure rises on borrowers
Some lenders have become more wary as developers deliver more new properties than the market can immediately absorb in some of the biggest seniors housing markets (see sidebar).
Overbuilding has hurt the odds that a new seniors housing property will be able to increase its rents. In addition, the cost of hiring qualified staff is also rising. These factors cut into the net operating income produced by a property and shrink the pot of gold that investors and developers hope to get at the end of a successful construction project.
Long-term interest rates are also likely to eventually rise. The higher cost of capital will also cut into the yield that equity investors receive from their investments in seniors housing.
The yield on the benchmark 10-year Treasury bond has already inched higher in early 2018. From Jan. 2 to Feb. 2, the 10-year Treasury yield climbed from 2.46 percent to 2.84 percent, nearly 40 basis points.
“Eventually rising interest rates are going to make deals harder to buy,” says Ari Adlerstein, managing director for Meridian Capital Group, based in New York City.
Worries like these are making some lenders cautious as they make more construction loans. But so far developers are still finding financing to build new projects.
Lenders are paying close attention to both market supply and the experience of the sponsors, “but there is definitely financing available for experienced developers and operators with a quality opportunity,” says Russ Dey, a vice president with Walker & Dunlop headquartered in Bethesda, Md. Dey is responsible for the origination of new seniors housing debt and equity opportunities at the firm.
Lower leverage, higher rates
Not every large lender has become more conservative about financing seniors housing projects, but enough have stepped back to make a difference.
“Banks are becoming more conservative with respect to loan to cost,” says Christopher Fenton, managing director of seniors housing for Berkadia. Fenton is based in the firm’s office in Lenox, Mass.
In part, smaller loans relative to the cost of development can give cautious lenders some security that even if rent projections fall short, the lender will still be able to recoup the money it lent on the project.
Government regulations implemented in the wake of the Great Recession have also begun to slow down the commercial banks that issue many construction loans. The Dodd-Frank Wall Street Reform and Consumer Protection Act and the international Basel III banking regulations have begun to take effect.
These rules often require banks to hold money in reserve to offset the risk of investments like real estate loans. Federal regulations pertaining to high-velocity commercial real estate (HVCRE) mandate that development partners put equity into projects equal to at least 15 percent of the value of the deal.
That has not been a difficult standard for most seniors housing lenders and developers to meet. However, ambiguity about the HVCRE standard has still created confusion.
“Different lenders have vastly different interpretations of HVCRE,” says Adlerstein.
Today, a typical construction loan provided by a large bank might cover 65 percent of the cost. By comparison, earlier in the recovery banks regularly offered construction loans that covered 75 percent of development costs or more for a seniors housing facility. “Four or five years ago, 75 percent was out there,” says Will.
Interest rates typically float from 275 to 375 basis points over the 30-day London Interbank Offered Rate (LIBOR) for construction loans from commercial banks. Most offers are clustered between 300 and 350 basis points over LIBOR for loans that cover 65 percent of the development cost, experts say.
Credit spreads are above 400 basis points over LIBOR for high- leverage construction loans. For some lower-leverage loans, interest rates are significantly lower, with credit spreads as low as 275 basis points over LIBOR, according to Will.
Staying the course
Not all of the big banks have pulled back on the leverage they offer.
“We have not changed our approach to structuring or pricing,” says Erin Peart, a senior vice president with Wells Fargo Bank who manages the Northeast Region for the firm’s Senior Housing Finance Group from the firm’s Washington, D.C. office.
Wells Fargo regularly offers loans that cover 65 percent of
the cost of a seniors housing development, with interest rates ranging from 275 to 325 basis points over LIBOR.
Banks may also provide higher-leverage loans to developers with stronger track records — especially if those potential borrowers have a good track record with the bank.
“For the tried and true sponsors, we can still find them more typical leverage,” says Joe Munhall, senior vice president and director of syndicated credit at Lancaster Pollard headquartered in Columbus, Ohio.
Some regional bank lenders make loans that cover much more of the cost of development. “We can get you to 80 percent,” said Richard Thomas, senior vice president in the Seniors Housing & Healthcare Finance Group of Grandbridge Real Estate Capital, a subsidiary of BB&T Bank. Grandbridge has branches in 15 states and Washington, D.C.
These same regional banks also offer interest rates that are significantly lower than the rates offered by large banks relative to the leverage of the loan.
Many of these smaller banks serve developers in multiple ways. They are eager to keep the income flowing from these banking services.
“We’ve seen some regional banks get very aggressive to protect their customers,” says Wells Fargo’s Peart. Those banks often offer lower interest rates than competing larger banks.
“They are not off by 5 basis points, they are off by 25 to 50 basis points.”
Banks demand recourse
Most of these financings are recourse loans, in which the bank will require anything from a completion guarantee to a full repayment guarantee.
That’s especially true for construction loans that cover a greater percentage of development costs.
“At 65 percent loan to cost, it is very difficult to get non-recourse loans,” says Will. “A very small percentage of borrowers can get non-recourse financing at 55 or 60 percent loan to cost — really just best-in-class developers, who for the most part are also fully integrated operators,” he adds.
“It is not the same as construction lending was three or four years ago,” says Berkadia’s Fenton. “The lender will ask for some type of a guarantee.”
Lenders are also paying more attention to the experience that borrowers have in seniors housing. “Lenders ask more questions,” says Meridian’s Adlerstein.
“Larger commercial banks are still lending. They are just a little more cautious,” emphasizes Berkadia’s Fenton. “They are focused on deploying their capital with existing relationships, not new relationships.”
That’s a sea change from three and four years ago when lenders were more carefree. “Lenders knew they should have an experienced sponsor,” says CBRE’s Will, “but they kept making those loans anyway.”
Today more lenders resist the temptation to makes loans to developers who don’t know seniors housing.
“These loans to inexperienced developers still happen, but they are not as prevalent,” says Will.
Interest rates rise
Developers are paying higher interest rates for construction loans as short-term interest rates rise throughout the U.S. economy.
Not only have the credit spreads that banks charge borrowers increased. The underlying interest rates have also risen steadily over the last two years.
Federal Reserve officials continue to gradually increase the benchmark federal funds rate, which is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight.
The Federal Reserve held the federal funds rate near zero during the financial crisis and through most of the long, slow economic recovery. Officials started to inch the federal funds rate higher at the end of 2015.
At the beginning of 2018, the federal funds rate was set to a range between 1.25 and 1.50 percent, after a series of five small bumps of 25 basis points each, which were often announced far in advance and often delayed.
Three more bumps of 25 basis points are expected in 2018 as new leadership comes to the Fed. Jerome Powell has replaced Janet Yellen as the new Federal Reserve chair. Yellen’s term officially ended Feb. 3.
“The Fed is getting more hawkish,” says Beth Burnham Mace, chief economist at the National Investment Center for Seniors Housing & Care (NIC). “Further interest rate increases are expected this year, as Fed policy becomes less accommodative in response to a rising inflationary environment and a strong economy.”
The rising federal funds rate has a direct effect on short-term interest rates.
LIBOR has followed it closely. The 30-day LIBOR rate hovered around 1.57 percent, as of Feb. 2. That’s up from close to zero a few years ago.
In the last year, rising short-term rates have added roughly a full percentage point to the floating interest rates that developers pay for their construction loans. That’s a substantial increase, but seniors housing experts have been expecting interest rates to rise for a long time.
Mezzanine fills the gap
Seniors housing developers are still finding ways to increase their use of debt financing for seniors housing construction projects, even as many banks make smaller loans.
Mezzanine lenders are eager to help developers fill in the gap. The combination of a mezzanine loan and a construction loan often covers up to 85 percent of the cost of development. Mezzanine lenders typically offer interest rates ranging from 10 to 15 percent for their loans.
Several specialty finance companies and real estate investment trusts have created funds to provide this kind of financing, in addition to private equity fund managers.
However, some of the lenders who make primary construction loans will not allow developers to pile on additional mezzanine financing. Mezzanine lenders often claim the right to seize the property in the case of a foreclosure.
“You have to navigate which senior lenders and mezzanine lenders will play nice together,” says Meridian’s Adlerstein. “There are some senior lenders that absolutely will not allow mezzanine debt to go behind them.”
Developers can also take on extra capital structured as preferred equity, which is similar to a mezzanine loan.
Lenders who offer mezzanine debt frequently also offer preferred equity.
The difference is that a preferred equity partner cannot seize the property in the case of a foreclosure.
Also, a preferred equity provider does not receive interest on a loan. Instead the equity provider receives a set yield on its investment that is usually slightly higher by about 100 basis points than the interest rates charged by mezzanine lenders.
Many primary lenders vastly prefer their borrowers to structure the extra financing they receive as preferred equity, instead of as a mezzanine loan.
A contribution of preferred equity is much simpler than a mezzanine loan. The capital from a mezzanine loan to a developer is often provided as the funds are needed, along with the primary construction loan. The provider of the preferred equity often provides the capital upfront.
The private equity funds that also offer mezzanine financing often would rather structure their deals as preferred equity. The transactions are often much less complicated, experts say.
Borrowers are the only ones who seem to prefer mezzanine loans to preferred equity because the interest rate on mezzanine debt is typically 100 basis points lower than the yield on preferred equity.