NIC On Financing

BY ROBERT C. KRAMER

What can these indicators tell us about how the skilled nursing sector started the year-and where it is headed for the rest of 2003? In particular, what can we learn about loan volume, loan performance, occupancy rates, move-in rates, and capitalization rates?

Delinquency Rates Up
The loan volume placed in the first quarter was down about $300 million across all property types compared to the fourth quarter of 2002. But this tends to be a normal seasonal decline, because of lenders rushing to close deals by the end of the year.

Loan performance-that is, for loans that are performing, as opposed to those that are restructured, delinquent, or foreclosed-showed improvement for the senior living industry, reaching a level of 96.3% for the first quarter. Compare this to the first quarter of 2002, when loan performance was at 89.3%.

But there are two areas of caution. First, the overall, industry-wide delinquency rate of 2.3% was higher than the 1.75% or lower that the secondary market would like to see for other real estate asset classes. Second, when broken down by property type, skilled nursing still experienced significant delinquencies in both permanent (at 9.75%) and short-term debt (doubling from 3.75 to 7.22% since the previous quarter). These numbers were predominately responsible for driving up the overall industry delinquency rate.

Even for those skilled nursing facilities that are currently covering their debt service, the real issue may be the property’s loan-to-value ratio. Operators with a variable rate loan may not be in loan default because the current low-interest environment is enabling them to survive. But if the loan-to-value ratio, based on the current value of a nursing home, has gone up significantly, and the value of the property does not increase by the time the note comes due, an operator is going to be facing a tough situation. He will either be forced by the lender to put in more equity or possibly lose control of the property.

In comparison, loan performance on permanent debt for congregate care (with zero delinquencies) and assisted living (less than 1%) “stacked up better than virtually all the other real estate asset classes,” according to Anthony J. Mullen, executive-in-residence with the Johns Hopkins/NIC Seniors Housing & Care Program. “This means that Fannie Mae and Freddie Mac-which represented the majority in our sample, but do not underwrite the debt of skilled nursing facilities-were doing an excellent job of underwriting the permanent loans [in these other areas].”

Occupancy Rates Holding Steady
Occupancy rates for skilled nursing held steady in both the mean (from 84.5 to 85%) and the median (from 86 to 86.5%) since the fourth quarter of 2002, based on approximately 1,260 stand-alone skilled nursing properties, representing more than 150,000 units, reporting their data to NIC in the first quarter.

For assisted living, the top quartile of properties showed healthy performance, with occupancy rates at 89% and above. But the overall assisted living sector saw a sizeable drop dur-ing the quarter, with the median occupancy rate declining three percentage points, from 86 to 83%, and the mean drop-ping from 85 to 83.5%.

This drop could be attributed to several factors. The first is seasonal. Although the size of the drop was unprecedented, the Key Financial Indicators have regularly shown a drop in assisted living occupancy rates from the fourth to first quarters since the data have been tracked. Other likely factors were the economy and uncertainties around the war with Iraq, which began during the first quarter. According to Mullen, “These conditions could have meant that people delayed the decision to move mom into an assisted living facility or, in some cases, decided to move mom out.”

Lastly, this drop provides further evidence that there are still a number of distressed assisted living properties pulling down the median. Half of the properties reported occupancy rates below 83%-a number considered inadequate to generate any kind of equity return.

Move-in rates for new assisted living properties open less than 24 months were slightly higher in the first quarter, with an average of 2.4 net (move-ins less move-outs). But at this rate it still will be difficult for operators to realize fill-up within a reasonable enough period of time to avoid financial difficulty.

Capitalization Rates Reflect Investor Anxiety
Not surprisingly, the capitalization rates for skilled nursing facilities during the first quarter reflected the high degree of risk investors still assign to these investments. Not only was there a wide spread between the high and the low cap rates, but also a significant increase of 110 basis points in the average or mean compared to the last quarter, and an increase of 170 basis points compared to the same period in 2002.

Unfortunately, the skilled nursing sector has been hit hard over the past couple of years with what has been called a “Triple Whammy,” i.e., the failure of the government to restore all the Medicare givebacks, the anxiety about Medicaid cuts, and the continuing problem of both litigation costs and increased liability insurance rates. This three-pronged assault has meant a decreasing valuation for many skilled nursing facilities.

Not All Gloom and Doom
Clearly, this is not the time for an inexperienced lender to get involved in the skilled nursing sector. Financiers who want to participate in this sector had better know what they are doing, particularly how to value skilled nursing properties and how to judge good operators.

It is important to remember, though, that the numbers reported here are from the first quarter of the year. Since that time, several significant events have moderated the impact of the Triple Whammy.

First, the Centers for Medicare and Medicaid Services (CMS) implemented a Medicare “market basket” adjustment in May. Amounting to a 2.9% increase in Medicare rates, this will take effect in October (i.e., for federal fiscal year 2004). CMS has also proposed restoring what is known as the “administrative fix” of 3.26%, or about $10 a day to the Medicare rate. This fix is to adjust for the capital cost allocation and nursing salary calculations used in the market basket calculation. Taken together, these two unexpected pieces of reimbursement could add approximately 6% to the rates that operators would get by this fall.

Things are also looking up on the Medicaid front. NIC’s first quarter Key Financial Indicators were gathered at the height of anxiety about state budgets not being balanced and accompanying dire predictions of Medicaid budget cuts. Naturally, astute lenders factored in these concerns at that time. The reality, though, turned out to be not nearly as bad as feared. On average, the cuts were in the 1 to 3% range, rather than 5 to 10%. And some states ended up not cutting rates at all-or even approving slight increases.

As far as liability insurance and litigation are concerned, since the beginning of the year there has been continued momentum by operators pushing for relief at the state and federal levels for both liability reform and caps. Also, a number of operators of national chains have been able to successfully divest themselves of properties in what are considered “high-risk” states. This may not bode well for the consumer in those states, but it shows that many of the nursing home organizations judged to be of the right size by investors have been able to lower their liability exposure.

So, despite the data reported from the first quarter of 2003, things may not necessarily be “gloom and doom” for the skilled nursing industry. Stay tuned for a year-end analysis in an upcoming issue of this magazine. NH