There are three interrelated facts that separate skilled nursing facility (SNF) finance from other kinds of commercial real estate lending.
By Joshua Rosen
Capital One Multifamily Finance
There are three interrelated facts that separate skilled nursing facility (SNF) finance from other kinds of commercial real estate lending. The first is that cash flow — not underlying property value — drives the deal. The second is that the vast majority of this cash flow comes from state and federal government programs in the form of Medicaid and Medicare reimbursement. Only a small percentage comes from private pay. And third, almost all SNF financing is insured by the Federal Housing Administration (FHA), an agency of the Department of Housing and Urban Development.
In the fiscal year ending September 30, 2015, the FHA issued commitments for 298 loans totaling $2.8 billion. Increasingly, banks are standing on the sidelines of SNF finance — and when they do provide loans, they tend to shy away from long-term risk. Typically banks provide SNF acquisition or refinance funding with terms no longer than seven years.
What does this mean for SNF borrowers? The first takeaway is that patience is a virtue. With taxpayers on the hook if an SNF defaults, the FHA wants to make sure that it finances strong facilities with staying power. As a result, it can take as long as six months for the agency to approve a transaction. The second related takeaway is that attention to detail is a prerequisite. The documentation that FHA requires is substantial. To mitigate the first two factors, it is essential that SNF borrowers work with lenders who are deeply versed in the HUD process and whose knowledge of FHA priorities can help them shape a more effective, compelling application.
For borrowers willing to put in the effort, the rewards can be substantial. Because the FHA is committed to ensuring that there is an adequate supply of affordable nursing home beds, nursing home borrowers can get terms unheard of in other commercial real estate markets. FHA-insured loans are non-recourse and assumable, offer maturities of up to 35 years, and loan parameters of up to 80 percent loan to value (LTV) and 1.45 debt service ratio coverage. Best of all, they feature low fixed interest rates, which are currently under 3 percent.
This is a great deal by any standard, but it is even more important in an industry where labor remains a high fixed cost, reimbursement rates tend to lag behind inflation, and margins are accordingly thin. Low interest rates made possible through an FHA-insured loan can have a large impact on profitability.
FHA’s Evolving Approach to Its Signature SNF Programs
The FHA insures loans used to refinance or acquire SNFs, as well as assisted living, intermediate care, and board and care facilities, under its Section 232/223(f) program, but it has modified the details to this program over time. In 2008, it introduced its LEAN process for Section 232 applications, an integrated series of measures designed to reduce waste, increase uniformity, and accelerate application review. Only lenders who have been approved to process applications using the FHA’s Multifamily Accelerated Processing and Section 232/LEAN Healthcare processes can take advantage of these tools.
The FHA also has two programs that allow borrowers with an existing FHA loan to lower their interest rate. The original one, Section 232/223(a)(7) is essentially a streamlined refinance program, which also allows borrowers to extend the term of their original loan by up to 12 years and increase the amount of the loan. Typically, minimal documentation is required. In 2014, the FHA began offering an even more accelerated process — taking at most 60 days from submission to closing — that enables lenders to reduce interest rates on their existing FHA-insured loans. Loan modifications under the FHA’s Interest Rate Reduction (IRR) program apply only to the rate, however. Borrowers cannot use the program to change the loan’s term and maturity.1
In one of its more recent refinements, the FHA introduced a change that broadens the field of eligible borrowers by eliminating the waiting period for refinancing after a cash out. Previously, borrowers had to wait 24 months. Now they can refinance immediately, though they are subject to lower LTV constraints than the maximum typically allowed.
The Right Operator is the Decisive Factor
Because the FHA must feel comfortable with an SNF’s prospects of generating long-term cash flow, it is much more concerned with the qualifications of the facility’s licensed operator than those of the borrower. This is another distinctive feature of SNF finance. Operators must be able to demonstrate through state surveys and Centers for Medicare & Medicaid Services (CMS) ratings that they have a clean compliance and care record.
They also must have a track record of successfully operating SNFs. This means they must establish that they are financially stable with an unblemished credit history. They must show that they are good employers — the FHA considers low turnover rates an important factor that contributes to high-quality patient care. And they must demonstrate prudent financial management. Borrowers and operators must devote time and resources to providing a substantial amount of documentation, including three years of operating and financial data and be prepared to address follow-up questions that their lender or the FHA might have.
Because Medicaid plays such a large role in SNF cash flow, the FHA pays particular attention to operators’ budgeting practices. Operators should have sufficient reserves or an accounts receivable (AR) line in place to absorb payment delays due to gridlock in the state appropriations process.
The Elements That Make an Effective Lender
Applying for an FHA-insured loan is a complex and often time-consuming endeavor. Borrowers can reduce this burden by selecting a lender with the experience to avoid delays in the application process. For instance, the FHA requires a master lease when either $15 million or three separate projects (regardless of the total) are submitted within an 18-month window. This window resets whenever a new application is submitted. Having a master lease ensures that if the performance of an individual property suffers, borrowers must use free cash flow from the other properties pay the mortgage. Lenders must know when a master lease is required and how it should be structured to meet the FHA’s requirements.
The best lenders can also bring other financial facilities to the table like treasury management services and accounts receivables (AR) financing. The AR line helps smooth the borrower’s cash flow and ensures reliable payment on the loan. Having a lender that knows how to structure the loan is critical (i.e. among other requirements, the FHA has to be a party to the line) and who can actually provide such line can shave weeks from the application process.
Another desirable financial service that lenders are beginning to offer for acquisitions is a bridge loan to FHA-insured financing. The FHA usually takes six months to close, but there are situations where sellers would like to close sooner. Lenders can offer a balance sheet loan that meets the sellers’ deadline while moving forward with the borrowers’ FHA-insured loan.
For newcomers, the 100-page-plus documentation typically involved in submitting an FHA application can be daunting. But borrowers should have a much higher standard for their lenders, seeking out experienced organizations that are so well versed in the application process that they know how to use it to present the operators’ (and borrowers’) strengths in the best light.
Joshua Rosen is senior vice president of Originations with Capital One Multifamily Finance.
1 Declines in FHA commitments in recent years — from $6.4 billion in FY2013 to $2.8 billion in FY2015 — can be almost entirely attributed to the decline in loans available for refinancing and the switch from the Section 232/223(a)(7) to the IRR program. IRR modifications are not considered new commitments.