Mid-Year Analysis of LTC Financing

There’s no question that the credit crisis has affected the lending and investing environment for seniors housing and care. There is also no doubt that investors are concerned that the economic slowdown and residential housing market downturn will spill over into industry fundamentals. What specifically is the data telling us with regard to potential impacts? And what is the expected fallout of external economic events on seniors housing and care for the remainder of 2008 and into 2009?

To help answer these questions, the National Investment Center for the Seniors Housing & Care Industry (NIC) conducted a conference call with top industry leaders in mid-July as part of its Executive Circle service. Speakers represented those from the operations, debt lending, and equity investment sectors: Thilo Best, chairman and chief executive officer, Horizon Bay Senior Communities; Noah Levy, managing director, PREI® (Prudential Real Estate Investors); and Angela Mago, senior vice president and national manager, Key Bank Real Estate Capital. The following are highlights from that call, as moderated by Michael Hargrave, vice president, NIC MAP.

Hargrave: How are fundamentals holding up for Horizon Bay?

Best: As we look at our portfolio of 12,000 units during the first and second quarters of 2008, our move-in rate was actually up, but our move-out rate was up proportionally. So our blended occupancy rate for independent living stood at 94.3% at the end of 2007 and is 93.3% today. For assisted living, our occupancy level has stayed relatively level at 95%. So it’s a little hard to characterize the market as anything other than pretty resilient, given some of the macroeconomic factors that everybody’s facing.

Hargrave: Has the credit crisis impacted your ability to make acquisitions?

Best: The challenge today seems to be more on the debt side of the equation. And then you have to bifurcate that further into whether you are looking for construction debt or a more permanent-type debt. Fortunately, in our current business, we don’t have a significant amount of near-term maturities, which we feel very good about given the state of the markets and refinance options. However, there’s no question that, essentially, due to the debt markets, we won’t be able to grow as quickly as we have in the past. In the last two years, we’ve basically doubled units under management.

Hargrave: Are financing terms still favorable? Do you see deals getting done?

Best: The difficulty is on the underwriting side. If a portfolio comes up for sale, we’re clearly not underwriting them at 95% levels anymore. There are more conservative guidelines across the board. In looking at acquisitions, people are starting to look more and more at trailing 12-month numbers and then maybe trailing one-quarter numbers as they approach their underwriting. When you combine that more conservative approach to underwriting with the more difficult capital markets and higher capitalization rates, there doesn’t appear to be a lot of acquisitions getting done in the short run, as potential sellers are adjusting to the new market reality.

Hargrave: Let’s switch to construction financing. How is Key Bank’s appetite, as one of the largest construction lenders to the industry, for construction financing right now?

Mago: In terms of our deal flow, we’ve begun to do less construction lending. We did see the impact from the housing market pretty early on. We’ve got a large homebuilder portfolio, so we began to focus on areas in the portfolio sub-ject to market risk. Right now, we’ve got about $150 million in seniors housing projects in lease up. We’re going to have several more projects that will come out of construction and into lease up during the next 18 months. Therefore, we’re being very selective about continuing to make new construction dollars available today.

Hargrave: How would you describe the current financing situation?

Mago: Of course, each market is a little different, but we do feel that the housing market overall will continue to deteriorate and probably won’t reach its lowest point until 2009. Also, there will be a lot of adjustable rate mortgages that will be resetting in the second half of this year. I believe around $300 billion. So there’s going to be more foreclosure activity and supply on the market. We’re watching the potential impact of the housing market on our portfolio very carefully and are managing it, with our clients, very proactively. Also, I do think that lenders have tightened up. For example, we syndicated a couple of large construction projects earlier this year and they were definitely more difficult to get done. Pricing increased and terms were a little tighter than in the past, and these projects involved excellent sponsors with very solid track records.

Hargrave: Do you think that there will be a drop-off in construction activity in the second half of 2008?

Mago: Many of our clients have told us they have slowed the pace of their development activity. Availability of financing has also been an issue. So I do expect that we will probably see a slowdown overall in the amount of construction activity going forward. Capital is precious and more expensive for most lenders today. We need to make sure that we are allocating our capital wisely. Relationships are key. We continue to make capital available to organizations where we already have established relationships, although we are certainly open to new, meaningful ones. I think that’s probably a very consistent message with what most operators are hearing across the industry.

Hargrave: What other things are you seeing?

Mago: Interestingly, because there is so much capital sidelined, we’ve had a lot of requests to provide capital for other things: debt refinancings, recapitalizations, helping borrowers buy back some of their portfolios from the REITs (real estate investment trust), helping to capitalize some early stage REITs, things like that. Many of these provide a better risk-return dynamic for our capital right now.

Hargrave: Do you think some of the stress in the debt markets will spill over into some of the debt that exists in the seniors housing market?

Mago: We haven’t seen the need for sponsors to write big checks to carry projects in lease up right now. However, we expect that we are going to have slower lease ups and believe our borrowers are anticipating that. Fortunately, we feel that we have well-capitalized sponsors and projects. So while we expect softness in the lease up portfolio, we don’t anticipate that it’s going to translate into losses or defaults. I’ve heard of a few distressed CCRC projects that have been placed on the market in the last six months. I think those have largely been some non-profit, third-party managed situations. While there may be pockets of stress out there in terms of over-leveraged portfolios, we’ve not heard of a lot that would give us cause for concern. But I think we are in an interesting time right now and what’s going on in the broad capital markets is affecting availability of capital to this sector.

Hargrave: How about on the equity side?

Levy: We’re still adjusting. Fortunately, we tend to use lower amounts of leverage with our funds than perhaps other equity players. I think some private equity players have got to go to the sidelines for the time being until more leverage is available. Also, we’re being more cautious with our underwriting. We’re going back to basics, for example, looking at trailing numbers instead of forward numbers on existing product. We are looking at IRR (internal rate of return) hurdles and capitalization rate kinds of comparisons that might be a bit more aggressive than before. We need to be sure that we’re going to hit our targets at the end of the life of our funds.

Hargrave: How has the credit crisis terms changed the way you look at new deals and new deal flow, among other things?

Levy: It’s important to make a distinction between the impact on transactions for existing projects versus new construction. The lead time for construction projects in our industry is relatively long. Many that have been in the pipeline quite some time are actually coming out of the ground now. And so, when LIBOR (London Interbank Offered Rate, the interest rate indices used by the banking and mortgage industries) comes down as it has, this helps these particular operators and developers do well–or at least hang in there if their fill-ups aren’t quite as long. It’s the new projects that people are trying to put together where, even though LIBOR is down, they will find spreads, or the difference between two interest rates, are up, the amount of equity required may be greater and the underwriting will be more cautious. We haven’t seen that “grab” that’s going to slow down the level of construction quite yet. We may start seeing it now as people try to get their equity today.

In terms of pricing, the market may have been as close to perfection as it was going to be 12 to 18 months ago. And if things didn’t work then, projects are not likely to be done. Also, sellers are probably not under pressure to sell. They have pretty good financing in place. They’ve had a great financing environment for quite some time, so they don’t have guns to their heads. We don’t have a lot of distressed projects. So I think we’re going to have a period of time where the market is going to have to find its level. Then sellers and buyers are going to have to start the negotiation process a little more. But when we get to points of inflection in the marketplace like where we are now, sometimes that process takes a while to sort out. And then a few deals break loose, and people understand where cap rates are or where pricing is, and then the market starts flowing again.

Hargrave: But at some point, these lenders and investors, these equity players, have got to get back into this game and conduct transactions.

Levy: I remember the dislocations in the late 1980s and early 1990s, and even a decade before that, where no matter what you did, there was no cash available for anybody. We’re not in that environment. There is still equity and debt money out there. Mortgage financing, while certainly not as plentiful, is available. Its pricing has moved up quite a bit, but from an historic standpoint, it still remains relatively low compared to the early 90s. So things can pencil, but it is a lot harder. Like many in commercial real estate, the solid operators with good sponsorship and good equity backing and the like are going to get what they need in terms of financing. Those that aren’t, the marginal players, will not.

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