Finding the Fairway
by Colleen Blumenthal, MAI, COO
Despite the gray hairs accumulated over 30+ years of appraising seniors housing and care communities, we find it has never been so difficult to mirror a buyer’s anticipation of value. 

On the one hand, the much anticipated “silver tsunami” is arriving with nearly three million more Americans reaching 85 years of age or older between 2020 and 2030 per US Census Bureau projections, or nearly 80% of the existing inventory of seniors housing and care units/beds (NIC MAP® Data Service, AHCA). This mismatch of supply and demand as well as the industry’s ability to generate returns even in recessions has attracted tremendous amounts of capital – debt and equity, private and public and domestic and foreign. 

However, leading into the pandemic, the amount of new construction in seniors housing caused margins to decrease due to lower occupancy, softer rate growth and increased competition for staff while in skilled nursing the transition from RUGS to PDPM proved to be lucrative, rather than budget neutral, as CMS had expected. Then, during the worst of pandemic, the entire industry suffered in varying degrees: occupancy drops, wage and benefit increases, and reliance on agency nurses on top of 40-year-high inflationary rises in everything else. In order to tame what can no longer be called transitory inflation, the Federal Reserve has implemented increases of 425 basis points in 2022, the highest level in 15 years with more expected in 2023, and the sharpest increase since 1980.

Following the Year of Heroes Work Here and the Year of the Vaccine, we find that 2022 is proving to be the Year of Where’s My Money? According to the 2Q 2022 NIC Lending Trends Report, nearly 20% of unpaid loan balances are in construction, mini-perm and bridge loans. According to our discussions with the agencies, Fannie/Freddie loan volume has plummeted from over $7.0 billion in 2019 to an estimated year-end of $2.3 billion in 2022. Further, HUD’s volume fell from $4.2 billion (with no 223a7s) in FY 2019 to $3.3 billion in 2022 when 223a7s comprised more than one-third the total volume. Anecdotally, most balance sheet lenders laid down their pencils in the second half of the year; construction financing is nearly non-existent; and non-bank lenders are getting inquiries on Class A assets that they rarely see. 

As capital becomes tighter and the cost of it rises, we have seen every pending transaction in seniors housing that did not have assumable, fixed rate debt get re-traded in the latter half of 2022 at 3-20% discounts, with implied increases in capitalization rates of 25 to 75 basis points. Although we have not seen the same with skilled nursing, brokers active in the space expect it will follow, especially in states that saw the greatest escalation.

As the pandemic dies down and the era of “extend and pretend” – or for those who prefer the more classical, A Rolling Loan Gathers No Loss, what is the right way to think about valuations as capital is undeniably tight and rates continue to rise while operations are likely still a couple years away from pre-pandemic margins? Rather than the usual appraiser “it depends” we suggest the following:

Class A, Core Assets: These communities offer a continuum of care, often located in barrier-to-entry areas and have the greatest appeal to institutional investors, who generally have a lower cost of capital than most. Operationally, these communities are back or close to stabilized occupancy and are poised to implement sizable rate increases to return pre-pandemic performance. While capitalization rates may be up 25 to 75 basis points, these communities are poised to generate high returns and values are down only slightly, if at all. In some cases where performance has been strong, values may be even higher than before the pandemic despite higher rates.

Fail-to-Thrive Assets: These properties opened between 2017 and 2020 and have yet to reach stabilized occupancy or cash flows envisioned when under development. Most opened in markets awash with new supply while others had 20-year-old unit mixes and designs out of sync with market demand. None anticipated the pandemic or a fill process years longer than expected. These assets started trading in 2021 at prices above replacement cost with little to no return to equity. Increasingly in 2022, we are seeing more transactions of these properties below construction cost, wiping out equity and causing some lenders to write down loans. Demand for these properties is strong – especially at a cost basis below replacement – but values are dependent on the timing and optimism of the “stabilized” cash flows. Equity investors view these opportunities in terms of yield rather than cap rates. Moreover, there is potential for this group of failures to infect otherwise healthy assets: in desperation to fill, some operators offer deep discounts that impact the ability of others in a market to implement increases and sustain their occupancy levels. Further, at a lower cost basis, new owners can implement more permanent rate reductions. A lower rate will not entice a resident or family to leave home and move to a holistically safer environment, but it may attract someone who has already made the decision and is now choosing among communities.

Class A of Yesteryear/Older Seniors Communities: When these communities opened in the 1990s and 2000s, they were the nicest from a consumer perspective and the most desirable from an investor perspective. Today, most these communities look tired, feature too many studio and one-bedroom units and offer unit sizes much smaller than newly developed communities. While there has been much talk about some of these buildings ultimately serving the middle market, it will be years before the gap between seniors housing demand and supply is so great that Baby Boomers will accept a studio at any cost. Ultimately, the ability of these communities to generate cash flow will depend on location within their market, the strength of on-site management, capital investment and barriers to entry. Since the onset of the pandemic, the spread in cap rates between Class A assets and other classes has widened from 100-200 basis points to 250-400 basis points. 
Source: HealthTrust
With the number of opportunities likely to hit the market in the fail-to-thrive group, we expect that this spread will increase in 2023, as the appetite for this group will be weaker and the return requirements higher.

Skilled Nursing: Since 1992, the federal funds rate has varied from 0.25% to 6.50% and capitalization rates for skilled nursing facilities have been stable between 12.00% and 14.00%. We remember the sense of daring when the first portfolio of assisted living assets sold at a cap rate below 10.00% in 1995, but that level of compression never happened in skilled nursing because investors view reimbursement risk a primary concern. However, the federal government’s distribution of over $10 billion during the first two years of the pandemic has changed investor perspective on that risk and led to some of the highest prices paid for facilities. At this point, we have seen the volume of transactions decline but prices – even while frothy relative to historical levels – remain well below replacement cost and may not fall as far as we are seeing for seniors housing. While CMS has clawed back some of the excess PDPM payments, states have largely compensated with higher Medicaid rates. Nonetheless, while we expect more deals in the bridge-to-HUD pipeline to become stabilized enough for a HUD exit, we note that HUD remains notoriously conservative about “frothy” valuations. Perhaps the biggest question in these valuations is what cash flow is one capping? Comparing the implied capitalization rates of nearly 100 seniors housing and care sales for which we have both the historical net operating income and the buyer’s proforma, we noted the following:
Source: HealthTrust
When the property is stable, the difference in a capitalization rate derived from historical versus prospective cash flows is about 75 basis points, but when the buyer anticipates a strong improvement in margin, the capitalization rate spread grows to 500 basis points.

The conjunction of communities still pulling out of the operating nosedive that was the pandemic while having little runway left to maneuver with their increasingly impatient lenders and investors will lead to some crashes in the year ahead. Admittedly, neither the industry nor the economy may be stabilized until 2026 or 2027. 

Hence, for operators, lenders and investors on the seniors housing and care course in 2023, we know that those landing in the rough may hold a very dim outlook. But we also see sufficient fairway and greens for those who aim to avoid the hazards and remained focused on the flagstick.
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Colleen Blumenthal, MAI - COO

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Colleen Blumenthal, MAI - COO

David Salinas, MAI - Partner

Samantha Medred, MAI - Partner

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