Private Equity Flexes its Muscles

Funds are reshaping the business of buying and building seniors housing.

By Bendix Anderson

In July, Bridge Seniors Housing Fund II acquired the Village at Keizer Ridge, an assisted living and memory care community in Keizer, Oregon. 

“Irreplaceable real estate and strong operator performance” drew Bridge to invest in the property’s 104 units of assisted living and 22 units of memory care, says Robb Chapin, CEO of Orlando-based Bridge Investment Group, a private equity fund manager. The value of seniors housing properties like the Village at Keizer Ridge helped Chapin attract investors to Bridge’s $1 billion Fund II.

Despite the overbuilding taking place in some markets, investors with a strong appetite for seniors housing continue to plow billions of dollars into private equity funds, which these days are dominating the business of buying and building seniors housing.

As real estate investment trusts (REITs) continue to struggle with low share prices, private equity fund managers are taking over as leading buyers of seniors housing. They are also investing in new ways, such as creating funds that can hold properties for longer periods than the typical five years.

“Private equity is currently the most influential capital source in the seniors housing space,” says Matthew Whitlock, vice chairman and partner at the CBRE National Senior Housing Group. Quite simply, private equity buyers are more likely than any other kind of investor to lead the bidding in today’s market, he says.

Active fundraising period

As of August, Bridge Investment Group had already deployed roughly one-third of the $1 billion raised in Bridge Seniors Housing Fund II, which closed its fundraising in 2017.

Private equity fund Kayne Anderson also announced May 30 that it had closed the fundraising for its fifth opportunistic private equity fund with $1.85 billion — a big number even for the world of private equity real estate. The fund will focus on seniors housing properties, medical office and student housing, with seniors housing accounting for roughly one-third of its investments. 

“The $1.85 billion raised for Kayne Anderson’s opportunistic Real Estate Partners V is evidence of experienced firms’ ability to capture the attention of investors,” says Oliver Senchal, head of real estate products in the London office of Preqin, a data firm focused on private equity. 

Closed-end private equity funds focused on real estate raised record-breaking totals of $40 billion in the fourth quarter of 2017 and $38 billion in the first quarter of 2018. Fundraising slowed down in the in the second quarter of 2018 to just $23 billion, according to preliminary numbers tabulated by Preqin, which notes that figure could rise by around 10 percent as more information becomes available.

“[The second quarter] was by no means a bad quarter so much as it was a return to more typical levels,” says Senchal. He also expects fundraising to increase later this year.

Armed with these billions of dollars, private equity funds now have to find appropriate deals to invest in. “Many funds are sitting on record levels of dry powder,” says Senchal. 

Having that much cash on hand puts pressure on private equity funds to buy properties, even if prices are high.

“This, in turn, creates a more competitive bidding environment and keeps pricing aggressive,” says Whitlock.

The average capitalization rate for property and portfolio sales in seniors housing, not including skilled nursing, was 6.4 percent during the 12-month period that ended June 30, according to New York-based Real Capital Analytics (RCA), based on sales of properties and portfolios worth more than $2.5 million.

That’s slightly higher than the 6.1 percent recorded in the year that ended in first-quarter 2016, when cap rates hit their most recent low. 

By comparison, the average 12-month trailing cap rate prior to 2015 was more than 7 percent, according to RCA, which includes assisted living, independent living and memory care — but not skilled nursing — in that calculation.

Private equity establishes pricing 

With ready cash and an urgency to invest, private equity buyers can set their own terms.

“Not only can they act quickly, but they also can effectively drive negotiations for attractive assets,” says Senchal. Private equity has taken over this leading role from the REITs, which historically have been top buyers of seniors housing.

“The pullback by the REITs has allowed private equity to snap up more market share,” says Max Newland, managing director in the Boca Raton office of Kayne Anderson Real Estate.

The stock prices of leading publicly traded REITs have continued their multi-year slide in 2018, effectively raising the cost of capital for the REITs. For example, shares of Welltower traded for $66 per share at press time, down from $74 the year before. Ventas traded at $59, down from $67. HCP Inc. traded at $27, down from $29.

At the same time, falling occupancy rates and slower rent growth this year have reduced the income generated by seniors housing properties. That makes it harder for REITs to make the numbers pencil out when it comes to acquisitions.

If the share prices of REITs rebound, that could pose a competitive threat to private equity funds looking to buy properties. “If REITs return to fair valuation… that could shrink private equity’s share of the market,” says Andrew Rybczynski, senior consultant at research firm CoStar Group. 

A few large acquisitions by REITs have accounted for the lion’s share of their activity this year. Welltower, for example, closed a $1.95 billion deal to acquire Quality Care Properties, also a publicly traded REIT.

Largely because of portfolio transactions such as this one, REITs still accounted for 45 percent of the dollars spent on seniors housing acquisition year-to-date through early August, according to RCA. If not for the Quality Care Properties transaction, that figure would drop to 30 percent. By comparison, REITs accounted for roughly 25 percent of the total dollars spent to acquire seniors housing in 2016 and 2017.

“The story on REIT acquisitions is boosted by portfolio transactions,” says James Costello, senior vice president for RCA.

The activity of private equity funds is best represented by the “Institutional” category in RCA’s data. That category shows private equity accounted for 33 percent of the dollar volume of closed deals in 2017, up dramatically from 6 percent in 2016. 

Year to date through July, that percentage dropped to 14 percent. But once again, that number is artificially depressed by a few large portfolio deals like the giant Welltower transaction, says Costello. 

Impact of pension funds felt

Private equity funds are also now sometimes able to hold the seniors housing properties they invest in for longer periods than the typical five years. That’s because a significant number of private equity funds have raised money from institutional investors with varied investment needs.

“There has been more interest from pension funds than there has been in the past,” says Beth Burnham Mace, chief economist for the National Investment Center for Seniors Housing & Care (NIC), a nonprofit data and analytics organization based in Annapolis, Md.

Some private equity funds now raise upwards of 70 percent of their capital from pension fund investors, says Joel Mendes, senior vice president for JLL’s seniors housing capital markets team.

Pension funds are especially interested in seniors housing properties because they become better investments as people live longer on average. As demand for seniors housing increases in the coming years, that is likely to help counteract the strain on pension funds as their pension holders age and draw on benefits. 

Fueled by pension money, these private equity funds could potentially hold onto properties indefinitely — with no set date when the fund will have to sell its properties. That would be a relief for some operators that have gotten used to being sold and resold by private equity funds with short-term plans.

“Private equity vehicles with long-term investment horizons provide a great alternative for operators,” says Susan Barlow, co-founder and managing partner of Blue Moon Capital Partners, a private equity fund manager based in Boston. 

Her firm is now fundraising for its second seniors housing fund, focused on new development and value-added redevelopment, Blue Moon Seniors Housing II. The new fund is expected to close its first round of fundraising early in the fourth quarter. Blue Moon’s first seniors housing fund raised $175 million.

Fundamentals sag

Private equity funds have to balance their eagerness to acquire properties against worries that many seniors housing markets are overbuilt.

“We need to be more cautious today than a few years ago,” says NIC’s Mace.

The percentage of occupied apartments at assisted living and independent living properties fell to 87.9 percent in the second quarter in the top 31 markets for seniors housing, according to NIC. That’s the lowest occupancy rate in seven years. 

“Changes in occupancy and, more generally, operating performance could translate to less-than-expected returns,” says CBRE’s Whitlock. 

Most private equity funds target leveraged returns between 12 percent and 20 percent for their clients, but shrinking rent growth could cut into that.

However, the basic health of the seniors housing business from a consumer perspective is not likely to be harmed too badly by overbuilding or even a potential economic downturn, says Whitlock.

“The demographic shift the U.S. will undergo over the next 20 years will provide demand for the seniors housing segment,” says CoStar’s Rybczynski. “The basic case for investors getting into seniors housing will not disappear anytime soon.”

However, the overall occupancy rates for seniors housing are not likely to improve until the long-awaited demand from aging baby boomers arrives in 2025 or 2026, says Aron Will, vice chairman and co-head of National Senior Housing Debt & Structured Finance for CBRE Capital Markets. The oldest baby boomers (born in 1946) are now 72 years old.

Funds scrutinize deals

Private equity funds have become a little more cautious in their investment approach as an increasing number of seniors housing units stand vacant.

“Private equity investors continue to gain more experience in their portfolios amid the current market conditions,” says Richard Swartz, vice chairman of equity, debt and structured finance of the National Seniors Housing Capital Markets Group at Cushman & Wakefield. “These lessons are reflected in their underwriting of new deals.”

For example, many fund managers experimented with renovating properties that were not originally built as seniors housing. They now understand how much it really costs to physically convert these properties and add services. Many also experimented with seniors housing apartments that were too large or small to be competitive in their market, and were punished by renters.

Funds have also learned that properties are more efficient to manage if they have a certain number of units. At least 80 or 90 units is the minimum size to achieve optimal operations, according to Chapin.

However, even with higher standards, private equity funds still need to invest. Fund managers sometimes have to put their money into a less-than-perfect property rather than wait for an ideal opportunity to come along.

The need for strong operators

For private equity funds to succeed with the properties that they acquire or build, they will need to partner with strong operators. That’s especially true for funds that attempt value-added renovations of properties.

As a result, the relatively few private equity funds that buy and renovate older properties tend to have strong property management teams either on staff or as equity partners.

For example, Palatine Capital Partners, a real estate investment firm based in New York and Miami, created its own seniors housing management platform in order to provide better operational oversight. 

“It requires significant operational expertise to underwrite and implement a turnaround strategy,” says Brian Benson, a real estate investment professional with Palatine.

Bridge Investment Group also assembled an asset management team to support the operation of its seniors housing properties and communicate with its operators. “We have a fully built-out team of 40 professionals that speaks the operator’s language,” says Chapin.

Bridge plans to use the $1 billion size of its new Seniors Housing Fund II to recapitalize large and medium-sized portfolios. The new fund is nearly one-third larger than Bridge’s first fund.

Many private equity funds have also learned not to bother with third-party operators that do not have an ownership stake in the properties that they operate. 

For example, Harrison Street Real Estate Capital, a private equity fund manager based in Chicago, now makes sure that every property acquired by its funds comes with an operator that has an equity stake in the asset. The fund manager has longstanding relationships with operators in various regions, such as The Engel Burman Group in Long Island, N.Y., and The Shelter Group in the Mid-Atlantic. 

The skepticism between private equity funds and third-party managers can sometimes be mutual. Third-party managers may look at a private equity fund as an entity that is likely to sell the property in a few years and allow the operator to be replaced.

Many private equity funds are also having an increasingly difficult time finding properties that are suitable candidates for value-added redevelopment. 

Property prices for these deals have become inflated and often already include some of the potential upside of renovation, says Mendes.

Owners also point out that it’s increasingly challenging to raise rents at a renovated seniors housing property due to the new supply hitting the market, according to Swartz. 

“You can’t always count on the same rent bump that you would see five years ago.”