Ben Swett, the Editor of The SeniorCare Investor, sits down with Don Kelly, Managing Director of Locust Point Capital, to discuss the current state of the seniors housing and care lending environment.
Ben Swett, Editor of The SeniorCare Investor – Don Kelly is the Managing Director of Locust Point Capital where he is responsible for loan originations and structuring. Don has more than 25 years of experience in the seniors housing and skilled nursing industry and he’s also been involved in the originating, structuring and underwriting of approximately $5 billion in transactions. So, Don, you seem like the right person to turn to for all our lending questions!
Don Kelly, Managing Director of Locust Point Capital – Thanks for having me this morning, Ben. Always good to connect with you and The SeniorCare Investor.
BS – I’ll start with a simple question, but I’m sure it has quite a complex answer. How has the lending environment changed from this summer?
DK – So, we saw positive cases on the rise from March up until May, and then cases dropped up until approximately June. I think people liked a little bit of positive news and felt a bit better about what this virus was confronting us with. So, we saw a little bit of activity once we got to late summer. Then, there were some ups and downs, and over the past three months, we’ve seen positive cases just go up and up and up.
From this summer, where maybe, as an industry, we didn’t feel like it was going to be quite as bad, we then saw this second wave. And it was probably a lot bigger than I even anticipated, with almost 200,000 cases across United States in a couple of days. One major difference between the summer and today is that perspective. There is some good news with the vaccine, and I think that’s providing some level of clarity. I think we have better data, better empirical evidence and better perspective about maybe where the finish line is. That may be a lot further then many of us thought it would be. In the lending environment, people are still waiting to see right now and struggling to understand how best to underwrite transactions.
BS – Have you noticed a specific shift in lender sentiment following the vaccine announcements from Pfizer and Moderna? And also from the CDC’s recommendation that the first to get the vaccine would be the frontline workers and also nursing home and assisted living residents?
DK – Yes, I think that’s really positive news. Lenders are confronted with a couple different things right now. One concerns what else is in their portfolio or book. If you’ve got hotels and corporate finance loans and office and retail, you’re confronted with some challenging loans. A lot of lenders in the healthcare space also lend in those spaces and so the decisions being made from a lender perspective across the industry aren’t necessarily only tied just to our industry by itself, but rather all the decisions that have to be made internally. it’s just kind of all the other decisions that have to be made internally.
Number two is what is each lender’s perspective, what are cash flows going to look like, and what occupancies are going to look like. In March or even over the summer, we were at higher levels than today, but industry wide on the seniors housing side, back in February and March, we were at around 88% nationally. Today, we’re probably 10 points lower than that, so the starting point from an industry perspective is much lower than we had anticipated. Understanding what the implications are with census at the facilities, but also what it means for the cash flow and from a coverage perspective point of view. They’re all things that lenders have taken into consideration. The biggest challenge is knowing how long the headwinds are going to last and when we think we can get back to whatever normal is.
BS – Can you tell us how Locust Point has been underwriting for both the census and cash flow recovery, and has it changed throughout 2020?
DK – As you know, we’re pretty pragmatic. We’re a relationship lender, we’re focused on supporting operators that provide really good care. In order to give them the best opportunity to do that, we as lenders have to be pretty patient and reasonable with how we lay out our underwriting, our projections and also our covenants. In loans we’ve closed over the past three or four months, we’re really tracking a very lenient and forgiving path with respect to what the cash flow projections are and what the census is supposed to look like. The last thing we need is borrowers tripping over covenants, so we want to be as accommodating as possible. We want to make sure there’s enough liquidity on the balance sheet, give them plenty of room to operate and track a path over the next two years that’s reasonable.
BS – Does your approach change when working with a skilled nursing facility versus an assisted living or independent living community?
DK – No it doesn’t really change. The same latitude is required and the same patience is required at this time in the market, and we want to be the best business and lending partner that we can. Having reasonable expectations of how folks are going to operate is the best that we can do.
BS – I know it is tough to put a date on it, but do you have any kind of projection for when we return to some kind of normal occupancy for the senior care industry?
DK – Yes, so when you think back to 2010 when we had some occupancy softness and some challenges back then, it took from 2010 to 2018 to improve five points or six points of occupancy. We’re now down about 10 points of occupancy from just a year ago, so I’m not so sure how long that will take to return to normal.
I’m also not sure the new will be 80 to 90%. I think in every given market it will be totally different, and there’s different market factors in each locale. And it’s also different by skilled versus assisted versus independent. So, in terms of getting to a point where facilities, especially assisted and independent, can have normal marketing traffic, that’s all going to be dependent on vaccinations and other factors. Talking with a number of operators over the past week, they’re definitely encouraged by the news from the CDC, but application and matriculation of the vaccine to nursing home and assisted living residents and also the employees will take a while. Just asking a couple of our operators for their opinion, it looks like it can take six months to really process through fully.
So, we’re talking June to get to a point where operators feel like they’ve been able to get everyone taken care of. Hopefully it goes faster than that.
BS – Hopefully census doesn’t continue to fall too drastically, but it almost surely can’t get worse. Although, knock on wood.
DK – Many operators are doing the best job they can using kind of alternate technologies and techniques where they can do zoom calls and their marketing and a lot of this in unconventional ways. The challenge is the operator having a tough time getting the same level of traffic in the doors, but we have the normal rates of mortality in the industry or even higher now. It’s depending on the location or the market you’re in.
BS – I like point that you made earlier that the new normal for a stabilized facility is not going to be the same in a couple years where 88% is considered to be stabilized. It’s going to change market to market and based on what’s happening on the ground, so it seems like the pragmatic approach is the right one for financing those communities.
DK – We’re never going to know what the new normal is until we get there. But having reasonable expectations on operating margins and cost structure is important with underwriting, plus PPE and staffing needs will have to be determined.
BS – Turning to the short-term debt market, how have the terms, requirements and covenants changed for deals like that?
DK – There’s a number of things that really stick out to me as I’ve observed transactions in the last three or four months. It seems like anything with a 1.0x debt service coverage or better has a chance of getting done. Deals below that struggle to attract debt financing in today’s market. It’s not that they can’t, but the choices are significantly less. That’s number one. Number two, requirements to have debt service reserves, capitalized interest or a cushion in the liquidity of the borrowers is really important. Also, non-recourse is tougher and tougher to come by. Personal recourse for smaller middle market companies or corporate recourse for larger transactions is pretty important and pretty commonplace in terms of deals getting done over the past three or four months.
BS – Are we at the same place today underwriting-wise as we were back in March, April and May?
DK – Probably not. In March and April as we were just trying to figure out what this was, there might have been some level of optimism that this might be a shorter-term issue than it is. Most were trying to figure out what this virus actually was, and how will it impact us. At the time, occupancy hadn’t really started falling yet in February or even March. But as we got to April or May, we started gathering more empirical evidence. I think as we’ve seen how challenging this virus has made the operating environment for operators, I think we’re in a much different spot now. We’re all, as lenders, a lot more educated on what the challenges are for operators and what it’s going to take from a liquidity perspective. We now have quite a number of months of actual real data in terms of what the expense loads are relative to where the censuses are. That’s helpful and allows us to better project and track what it’s going to look like in the months to come. I think we’re smarter now that we have more data that allows us to project a little bit better and work with our operators on tracking a good path for them over the next few years.
BS – Have you heard of any lenders getting out of the business or taking a year-long pause?
DK – I’ve heard of different perspectives of how some wanted to approach this market, and there are a couple of things. Number one, credit is super important. Number two, taking care of existing relationships seems to be a theme. And also, just being judicious with the opportunities they take is important. If you’re a bank lender, preserving this 2-1 capital is pretty important for banks. Some bank lenders could give you other considerations, but it just seems like right now credit is king, and so is taking care of existing clients, trying to be conservative in this environment, and preserving some capital.
BS – Last question, Don, but it’s a doozy. How will the lending market change in 2021, in terms of activity, terms, rates, the distressed debt market?
DK – Well, in the distressed debt market, I think many felt like at some point in time there will be some distressed debt opportunities. But as time has gone on, it has just never quite arrived. I think that’s a positive because it means we have a resilient industry. If a property is seeing challenges and needs to be sold, and even if there’s limited cash flow, there seems to be buyers for the properties. There also seem to be lenders that will refinance other lenders with new structures, maybe better collateral in terms of liquidity and other covenant requirements.
But I haven’t really seen true distress in the debt market at this point in time. Distressed debt provides opportunity for some folks, but I’m glad from our industry’s perspective that we’re not seeing a lot of it right now because it means we have a pretty strong industry.
For 2021 in terms of what I see for the financing market, a lot of lenders are optimistic that they’d like to do a lot of business next year. That will all depend on where we are in terms of occupancies, EBITDAR margins and how we start creeping back to where normal is. Also, when will lenders feel a little more comfortable having a line of sight towards when normal occupancies and margins will return. I think once the vaccination starts being administered, that will provide a lot more clarity as to when people can feel confident extending more credit or capital to operators. And maybe that will help the M&A market rebound a little bit. You’ll see a little more transaction activity, which obviously provides more opportunities to us lenders.
BS – You would think that with each deal that closes, lenders, buyers, everyone just gets that much more comfortable with getting deals done right now. So hopefully that results in a very, very active 2021 for everyone.
DK – I think everyone would be pleasantly surprised if that happened, and probably relieved.
BS – Thank you so much, Don, you for your insight, and good luck to you in the New Year!
DK – Thanks to you too, I appreciate you having me on.