By Michael Okaty and Mark Scimeca, Foley & Lardner
The private equity investment landscape for seniors housing has, like so many things this year, been profoundly disrupted by the ongoing COVID-19 pandemic.
From 2016 through the third quarter of 2019, private buyers, including private equity, have consistently provided the greatest investment in the seniors housing industry, outpacing public, institutional and cross-border investment and averaging $1.5 billion per quarter.
The outlook early this year was bright for private equity investment generally. With investors seeking higher returns, private equity funds going into 2020 had accumulated a record $1.5 trillion in unspent capital. At the outset of 2020, private equity was predicted to again be the top investor in seniors housing.
With the advent of the COVID-19 pandemic hitting the U.S. this spring, followed by the associated economic lockdowns, huge amounts of uncertainty were injected into the outlook for the seniors housing industry, giving investors pause as preserving liquidity became paramount over new investment. By all accounts, seniors housing transaction deal flow is down considerably this year.
Yet, despite the near-term headwinds, seniors housing industry fundamentals remain strong and medium- and long-term prospects robust. Moreover, near-term opportunities for acquiring distressed seniors housing communities or their debt are there for prudent investors who take the right due diligence, contractual and insurance precautions to protect against downside risks while waiting for the industry to rebound.
Headwinds for the seniors housing industry due to the pandemic include reduced profitability as operators have been squeezed by declining demand and increasing regulatory, infection control and staffing costs.
Reduced demand for seniors housing in 2020 reflects a “perfect storm” of challenges facing the industry, with no clear end in sight. These challenges include the fears of many seniors to leave their homes to enter more institutional settings with a potentially elevated risk of contracting COVID-19, with assisted living communities nationwide experiencing COVID-19 outbreaks and thousands of COVID-19-related deaths. Compounding these fears have been seniors and their families not being able to do in-person tours of senior living communities before making a decision whether to leave home, concerns about potentially being cut off from having visitors as a result of more stringent infection control protocols, and concerns that such safety measures will indefinitely prevent the group activities and social life that are often a major selling point for many senior living communities.
Practical challenges have also taken a toll on seniors housing transactional activity, such as COVID-19 travel and access restrictions interfering with the ability of investors to do their due diligence at a time when more diligence is needed. And even when due diligence can proceed, investors are encountering challenging financials. This reflects the declining occupancy due to increases in deaths, combined with decreases and delays in new admissions and move-ins, in part due to government-mandated moratoriums which began to ease over the summer.
Lenders in the space have also imposed hurdles to closing deals. For example, Freddie Mac, as a condition to extending financing, has required that seniors housing communities must have no active cases of COVID-19, be open to accepting new residents and provide pandemic-related policies that align with best practices as identified by Freddie Mac.
Potential residents in holding pattern
Further dampening demand for seniors housing have been the economic effects of the COVID-19-related lockdowns, which have adversely impacted housing prices in many urban markets. Low home prices reduce the funds available to pay for seniors housing for those seniors counting on the sale of their primary residence.
With the decision whether, and particularly when, to enter seniors housing for most being more discretionary, other than for those requiring more acute care, the trend in 2020 has been for an increasing number of seniors to delay the sale of their homes and the move into seniors housing communities. This is reflected in substantial declines in the annual absorption rate for seniors housing inventory and occupancy in primary and secondary markets, down from about 4 percent and 86 percent respectively at the beginning of this year to near 0 percent and 83 percent in the second quarter.
Despite these near-term challenges, seniors housing industry fundamentals and the aging demographics underlying them remain compelling over the medium and long term. The number of Americans age 65 and older is expected to grow from 52 million in 2018 and 16 percent of the total U.S. population, to 95 million by 2060 and 23 percent of the total U.S. population. A Joint Center for Housing Studies of Harvard University report projects that the 80-and-over population, those most likely to use seniors housing, will double from 12 million to 24 million between 2015 and 2035.
It is projected that there will be an average deficit of 96,209 seniors housing units per year between 2020 and 2030 assuming that the current rate of seniors housing usage remains flat at 12.55 percent of households with seniors age 75 and older.
There are several trends as the ongoing wave of baby boomers enters and moves through their retirement years:
- Higher divorce rates leave many seniors without a spouse to help care for them.
- Many seniors live longer and need more care to do so.
- Adult children of seniors often live away from their parents and are unable to easily care for them.
As a result, the need for seniors housing is expected to grow over the medium- and long-term future. For many, aging in place at home while delaying sale of a primary residence is a viable short–term solution, but not sustainable over the medium and long term and may only delay the inevitable need to move into seniors housing.
Like other sectors of the economy that have experienced short-term dips in usage such as mass transportation, the expectation is that demand for these necessary services will return as Americans adjust to the “new normal” of going on with life amidst a pandemic.
Wider trends offer openings
Opportunities for consolidation in the seniors housing industry, which is still relatively fragmented, abound. Mom-and-pop and smaller regional operators are at the margins of profitability, being squeezed by pandemic-related declines in census and higher operational costs associated with ever-increasing regulatory oversight and compliance requirements. Careful investors are identifying distressed acquisition targets in the industry that would benefit from the economies of scale and systems that larger, multi-facility and multi-state seniors housing operators offer.
The COVID-19 pandemic has helped to separate the stronger, better-prepared operators from weaker, less-prepared operators, and thereby raised opportunities for acquiring the latter.
Governmental intervention is offering hope to the seniors housing industry, which is lobbying hard for state and federal immunity for COVID-19-related liabilities. The U.S. Department of Housing and Urban and Development for the first time extended access to Phase 3 distributions of Provider Relief Fund assistance to assisted living facilities, offering a lifeline to the beleaguered industry beyond the aid already given to skilled nursing facilities earlier this year.
The current economic realities of the industry are also pushing an overdue reset downward of valuation expectations in what many last year viewed as an overpriced market flooded with private equity buyers that were often willing to overpay. While the sting of overpaying no doubt remains for some investors who made seniors housing acquisitions when the industry was stronger, lower pricing now should nonetheless lure private equity investors back for opportunistic strategic acquisitions that are available in the current, more distressed market.
Sophisticated private equity investors in the age of COVID-19 are certainly asking more questions and conducting more robust due diligence regarding infection control, staffing levels and marketing strategies, among a myriad of other things. Legal counsel is helping to overcome some of the headwinds through careful drafting of contractual representations, warranties, indemnities, purchase price holdbacks, earnouts and post-closing obligation provisions designed to mitigate and allocate COVID-19 related risks, tying valuations and purchase price to performance.
These efforts have helped to create greater certainty regarding responsibility for COVID-19-related liabilities and net operating income shortfalls from post-closing performance that fails to meet expectations. In addition, the representations and warranty insurance industry continues to aggressively court parties and their counsel in the seniors housing industry in an effort to increase market penetration, which historically has lagged behind other industries for use of such insurance.
Whether it is in the context of purchasing distressed seniors housing communities or acquiring their debt, these contractual and insurance trends are helping investors to achieve greater certainty at the individual deal level and less uncompensated risk. This offers hope for a rebounding of private equity investment in the future as the industry’s fundamentals begin to drive demand again.
Deals are still happening, and private equity plays that offer promising returns over the medium and long term are out there for the astute and careful investor that takes the right steps to protect its investment.
Michael Okaty is partner and Mark Scimeca is special counsel for Foley & Lardner LLP, a law firm that serves the seniors housing industry among others.