If you want to find out what really happened in the seniors housing and care merger and acquisition market in 2016, and the prospects for this year, this is the article for you. Every year, The SeniorCare Investor releases the initial statistics for skilled nursing, assisted living finance and independent living in this interview based on our proprietary database of transactions. Steve Monroe, Editor, The SeniorCare Investor, poses topical questions to Alan Plush, CEO, HealthTrust, Bill Mulligan, President, Ziegler Financing Corp., & Managing Director, Corporate Finance, Senior Living, Ziegler, and Arnold Whitman, Chairman, Formation Capital. Some topics include: what happened in the market in 2016 and what can be expected in 2017; Stagnant interest rates and how they affect cap rates, equity markets, and investor decisions; REITs divesting their skilled nursing facility assets and what that means; And how private equity firms and foreign capital will impact the seniors housing market.
Introduction: The 2016 Results
M&A in the seniors housing market experienced a slight dip in 2016, following a record year of 357 deals in 2015. If capital remains available, is there any reason that this high level of activity won’t continue?
Arnold Whitman believes that seniors housing is poised to keep up the pace. Although event risks, specifically in the capital market, are always a significant concern, there is no reason to expect a lull in deal making. Although, the types of deals that are happening are apt to change.
Is the big deal dead, or just rare? Do you think the market will get back to having multiple $2- to $6-billion deals?
Bill Mulligan believes that mega-deals aren’t dead, but they will start to occur fewer and farther between. A lot of that slowdown can be attributed to the less-than-desirable outcome of the Brookdale and Emeritus combination, which demonstrated that economies of scale have a limit. “I think those economies of scale reverse themselves, where you just lose touch of what’s happening in the markets when you have hundreds and hundreds of facilities. So, I doubt that we’re going to see more combinations of operators getting to the 1,000-facility level, but I could be wrong.”
What would it take to bring those mega-deals back?
In 2014, a busy time for large deals, the market opportunities were unique. It was driven by easy access to capital, low cost of capital, and opportunities that were still available in large purchases. But, in 2017, Arnold Whitman believes it would take more than favorable market dynamics. Arnold speculates that it would take some element of the risk paradigm around population health management to drive a large enough appetite in the market; whether it be payers, risk takers, or managed care companies that decide they want to be a part of this market in a big way.
The average price per bed for skilled nursing facilities has nearly doubled in the past five years. Isn’t the 15% increase in average price per bed last year remarkable given all the reimbursement pressures, Medicare Advantage cuts, LOS lowering, and labor pressures?
“Yeah, absolutely. But I think the challenge we always run into with sales data is that we’re parsing away what’s really selling,” states Alan Plush. He goes on to mention that different types of properties are more active than others, such transitional care, or post-acute rehab facilities. These types of skilled nursing facilities have attracted a lot of investor interest, and they are higher dollar-per-bed transactions, which will skew the numbers. While there have been winners and losers when it comes to reimbursement pressures, Alan Plush says that, overall, the changes he’s seen have been higher-dollar transitional care sales.
Throughout all of this, cap rates have been remarkably stable over the past 10 years, so that has not been the driver for higher prices. Why haven’t they come down when the cost of debt has become so low for several years?
Alan Plush explains that as far as cap rates are considered in valuations, 11 ½% to 14% is the range used to indicate how active a market is. At 11 ½%, the market is considered frothy, and at 14%, the market is slowing down. If current cap rates are in the 12 ½% to 14% range now, then cap rates haven’t changed much, meaning they are not the drivers of higher prices.
So, the valuations are purely driven by economics on a facility basis. The industry has had such an impressive run that the lower cost of funds that are available, or have been available, are slightly offset by the risk of the asset class. “So I think that partially I would suggest, and that’s all I’m doing is suggesting, is that the reason the cap rate stays the same with that lowering cost of capital has to do with sort of an adjustment of risk perspective.”
So what has been driving the rising values has, of course, been the increased cash flow per bed that these SNFs are producing. You can see that it has been steadily increasing, but it declined a bit last year. However, if you weight these numbers by beds, the 2016 NOI per bed continues to rise to just over $12,000. With all the pressure points, can this continue to go up?
Arnold finds it highly unlikely that NOI per bed will continue to increase at this pace. Whether it’s the uncertainty of the Trump administration, labor, or just the changing, different profiles and different programs that are in their early stages of testing under the value-based healthcare approach, it wouldn’t be surprising if it went down next year. But, it all depends on what gets sold.
Moving to seniors housing, when you look at the combined IL/AL market, yes we almost hit another record average price last year, but the price movement has been nothing like that of skilled nursing. If this is where we have seen so much investor interest, why haven’t prices increased even more?
Alan believes that a lack of price increase may be the result of investors’ concerns about competition, new supply, and even oversupply in seniors housing as opposed to nursing. Also, there are fewer and fewer trophy properties available, and when those properties dry up there are only more second-tier properties on the market.
Is there some sort of ceiling that might be keeping prices in a certain range where people started getting a little nervous about averages over $200,000 a unit?
Bill responds, “I don’t know if there’s a magic ceiling. I think people that have been in the business for a while probably sweat a little bit when it’s over $200, $300. In our HUD financing business, we deal with regional providers that are doing a lot of the development, and you show those guys an acquisition and it’s $200,000 a bed, and they say I can build it for $180.” For this reason, many people who have been in the business for a while use construction cost replacement cost, especially if they already have experience in doing so.
When you break the market out between majority IL and majority AL, you can see that the IL transactions have had a major impact on the total market average price. With values so high, are you surprised that there has not been a lot of new development in the sector, at least compared with assisted living?
Arnold explains that, from his perspective, lack of IL development is a surprise. This is because advances in technology make it easier for higher acuity residents to remain in independent living settings longer, creating a good market opportunity for development of this type of asset. But slow development may be due to overall concerns about the demand of IL properties since it is not a need-based asset, relative to AL and memory care.
We all know that most IL communities have been adding AL and often MC units. What impact is this having on acquisition demand, and what impact does it have on those communities that stay with just the IL model? Are you seeing buyers shying away from those?
Bill believes that having the ability to add multiple levels of care to an independent living facility enhances the value of your assets. “Having been in the job where I used to develop, I developed independent living and 10 years later I’d have to convert it to assisted living.”
Residents generally want to stay in place, and when a community offers multiple levels of care it can retain its residents as their care needs grow overtime. On the other hand, standalone independent living communities will lose residents as their needs grow, putting these communities in a position of trying to refill their departures.
Assisted living hit a record average price per unit for the third year in a row, despite fears that there is too much new development in some markets. From our data, we know that some of these new developments are having a positive impact on the higher prices, but will there come a time when some troubled ones that don’t fill up put downward pricing pressure on the market?
Alan believes that 2017 will be the year when the impact of oversupply will become relevant and begin affecting individual assets. He then breaks down the development cycle into three stages. The first stage includes the people who got in before everybody else could, filled their properties very fast, and then sold them at a premium because there was a large investor appetite. By the second stage, construction and land costs were higher, and there was existing competition. And although the third stage hasn’t consummated quite yet, Alan says he has started to see smarter operators backing off and lenders tightening things up. For this reason, he expects this trend to manifest in 2017. “So as a long way of answering your question, Steve, I think, yes; my opinion is we’re probably at the top for these numbers. I don’t know if they’ll go down dramatically, but they’ll probably plateau for a while.”
Assisted living is a very popular asset class for investors. Who is doing the buying and how high can prices go?
Arnold responds, “It seems like everybody is. I think assisted living is the sweetheart of the senior care industry from an investment perspective.” Assisted living has evolved to become a commodity, and about ten years ago this wasn’t the case. Due to the large demographic changes that are going to occur in the next few years, there is a universal perspective that assisted living is positioned to extend different types of services that can play into the whole continuum of healthcare, while still delivering a good yield to investors.
For this reason, money and capital will be readily available in assisted living, and foreign buyers and private equity firms will continue to be attracted to the market. Assisted living also has a better reputation than skilled nursing facilities from a consumer perspective, while still having the need-driven demand that independent living lacks, making it a very stable niche of the seniors housing market.
Let’s move on to cap rates. We had been hearing all year that cap rates were spiking up, that buyers were being more conservative in forecasts, that lenders were tightening up a bit. And here, average IL cap rates bumped up by 20 basis points. Surprised?
Bill doesn’t think that 20 basis points is significant enough to cause any sort of overreaction. “I think the sampling, the number of transactions, who they were, how many, could easily explain that bump up. I could easily see that come back down 20 or 30 basis points next year, even in supposedly a rising interest rate environment.”
And then look at the average AL cap rate. This is what shocked us, and even when it is weighted by units sold, it still jumped. But a 70-basis point increase, back above 8% which we hadn’t seen in three years, was a real surprise. Agree?
Arnold says that although the increase was a surprise, it can be partially explained by a slowdown in REIT activity which causes bank lending to drive the day.
Are we maybe at an inflection point? Prices are at highs, cap rates have bottomed out, demand is coming from other buyers, capital may be changing. But the demographic story remains. Are we heading into new territory?
Alan says that during the Great Recession he had a chance to talk to Arnold Whitman who quoted, “Its always the same, and its always different.” To back up that statement, he goes on to say that although the market may have reached an inflection point, it is one that was expected. The last time the market was at an inflection point like this, the Australians were the big foreign buyers. Now, the Chinese are the big foreign buyers. “So a lot of things look and feel the same, but of course as Arnie pointed out, it’s always different. I believe we are [at an inflection point], but an artificially and arbitrarily low interest rate climate has kept us here longer than we otherwise should have been.”
Interest Rates and the Supply of Capital
Everyone has been talking about the time when interest rates start to rise. It almost sounds like a broken record, because we have had declining or flat rates for eight years. While none of us are economists, hasn’t the time finally arrived, given the economy and the indications from the Fed?
Arnold responds, “I would say absolutely. But then again, I’ve been wrong for several years.” To back up his point, he says that the new administration will presumably do everything they can to stimulate the economy, and that comes with rising rates as well.
Bill points out that he doesn’t expect long-term rates to increase materially. On the other hand, short-term rates may increase but overall rates will experience a flatter yield curve.
There are people on the investing and lending side who have not been in the senior care market when rates have risen. How do you think they will react to this new territory?
Bill references the tendency of a “herd mentality” when it comes to interest rate fluctuations. When interest rates rise, it usually ripples through to valuations, causing a herd mentality reaction. People who have experience in the industry are unlikely to overreact, and not have these increases materially impact what is a long-term investment or a long-term loan.
People with less experience may overreact a bit and have more conservative underwriting. Some banks are already being more conservative with their capital in terms of where they place it, and want to be paid a fair spread for investing in this sector.
“On the not-for-profit side, we did 40 or 50 bank placements last year. Banks are crawling all over themselves to provide capital to not-for-profits. So it’s a big world out there, and a lot of different banks have different views of this sector and the future of interest rates.”
Interest rate changes have had little impact on skilled nursing cap rates over the years, so do you expect that to also be the case for seniors housing? Why or why not?
Alan agrees that, while anything can happen, he doesn’t expect interest rates to increase materially. In the event of material increases, debt costs would be affected and equity would be unwilling to accept a lower return, resulting in fewer transactions. But the rates that he expects to see should be inconsequential, having no impact on seniors housing.
However, the real danger may be troubled assets, such as facilities that are poorly positioned or not operating well. “We’ve already started to see volume coming across our desks. Not a large number yet, so I don’t want to be alarmist, but we’re definitely seeing some fraying around the edges. I think that’s going to be a bigger influencer.”
And then you have the equity side of the equation. Let’s forget the public markets for now. Where is all the equity coming from to drive the acquisition market to new highs?
Arnold responds that equity is coming into the seniors housing market from all angles. In addition to new players entering the market, there are the original players who have stuck around. Private equity’s interest continues to grow, particularly in growth-type investment opportunities, and foreign capital continues to find its way in.
And, although long-term interest rates are unlikely to increase, short-term rates are going up because the economy is improving. A strengthening economy means more available capital. These market conditions become a cycle, because as more money continues to come in, the market becomes increasingly attractive to new investors.
“At what point do we get to that place where too much money has come in and we’ve overdone it? I just personally don’t think we’re there yet.”
If you had to look back 3-5 years, what kind of return were equity investors expecting compared with today?
Bill says that 3-5 years ago, equity investors were shooting for 20% or higher. There are still people today who claim that’s what they’re aiming for, but whether they’re going to find it or not is another matter. In a business that deals with a lot of government reimbursement, especially on the skilled nursing side, it’s hard to get that kind of growth.
“If I sold a group of assets and the private equity investor got a 20% return over a five-year period, I would probably say I should have sold it for a higher number, given their requirements.”
All in all, investors who are looking to put their money in this market have probably dialed down their expectations.
But Arnie, you’re one of the biggest private equity investors in the sector. I’m curious how you would respond to that.
Arnold claims that the private equity perspective is always based on the creation of value proposition that leads them to the return they would like to get. Typically, they don’t view their investments as a traditional real estate investment firm. Although real estate is a component, it is a broader view of the investment opportunity, such as having some sort of strategic advantage or ability to consolidate, that leads to getting those 20% returns.
If expected equity returns are lower, is that why with rising debt costs, cap rates may not increase as much as some of us are expecting?
Alan agrees with the moderator’s theory, and he points out that debt costs have also been affected by lower loan-to-value ratios on some recent loans and transactions.
A significant challenge is that the answers are not always formulaic. Other influences such as the asset quality, operational performance and investor appetite at a given time, also come into play. There is no foolproof algorithm that can accurately account for every factor and produce perfect cap rates or valuations, and for this reason there will always be a large gray area.
When looking at the universe of equity capital out there interested in our sector, what percentage do you think is interested in the private pay seniors housing market vs. skilled nursing?
Arnold responds, “I’ll go with 80/20, because that’s what feels kind of right.” Skilled nursing, from the institutional perspective, still has a stigma and a challenge, as well as reimbursement and regulatory risks that can typically be challenging for a non-educated private equity firm.
However, there is still great opportunity in the field when partnerships and relationships are developed. Whether it’s an operating business with a private equity firm, or Formation Capital with another private equity firm, bringing together both expertise and capital can create an investment structure with a lot of potential and merit. But, as a standalone investment private equity firm, looking at it objectively from their criteria and their risk profile, you’re going to get a lot more interest on the IL/AL side.
But if expected equity returns in seniors housing are declining, aren’t they still quite high in skilled nursing? With 4% HUD debt and 12% cap rates, that is a lot of return and a lot of margin for error. What am I, and the investors, missing?
Bill argues that, for the same reason that some lenders have red-lined government-reimbursed business, you always have that uncertainty associated with a reimbursement event. Whether it’s Medicaid block grants, Medicare and the shorter length of stay, or dialing down drug reimbursement, investors expect to be paid a little bit more for that government-funding risk.
Alan agrees that most people who’ve been in the business for a long time would say that maintaining a skilled nursing facility to market or above-market standards would cost more per bed and more per unit, than an assisted living or an independent living facility. “So on an apples-to-apples basis, I think you need some of that higher cap rate to deal with the higher recurring cap ex.’
The REIT Pullback and What It Means
The Big Three REITs, at various points in the past year, have talked about taking a breather from this sector, other than maybe for their current customers. These three alone have accounted for several billion of acquisitions in most years, and now they have accounted for several billion of divestitures in 2016 alone. What is the current impact on the acquisition market? Less competition for PE firms wanting to make a big play?
Arnold believes that the recent REIT divestitures may just be a natural stage of the investment cycle. When REITs were especially active, around 2014, their strategy was to target as many high-quality providers as possible, invest in them, see a growth path and then experience a good yield. Arnold says that, as a result, a “land grab of quality” took place.
Now, two years later, REITs must reassess their portfolios to improve them. A plausible plan may be to divest 20% of the lowest performing assets, whereas other REITs will choose to become less heavily-weighted in the skilled nursing sector due to reimbursement and regulatory pressures.
“It’s interesting, we’ve gone through a shift where the majority of the dollars of transactions were being driven by the REITs two years ago, as buyers. They’re now in a position where they’re actually sellers in some cases, and now giving opportunities to smaller operators or turnaround people or opportunistic investors. So I think really, it’s just a shift that’s taken place.”
And what does it mean longer term?
Alan recounts the history of REITs and points out that, traditionally, they have always served a specific purpose in the industry. REITs were essentially born of a low interest rate environment, and became an alternative financing vehicle when banks dried up. Eventually, they became all-encompassing which caused smaller REITs to be formed, and as the sector grew they became dominant.
“We have all focused so much of our efforts and our observations on the REITs, and still it’s a very viable alternative. But I think you’re going to see, longer term, other groups come in. I think the commercial lending market will probably continue to be vibrant. I don’t view this in a negative context at all. It’s just an evolution for the industry.”
So Arnie, we know that the big three REITs are very sophisticated investors. You’ve done business with a lot of them. For them to say they’re going to focus on some of the other markets—life sciences, medical office buildings, one of them in hospitals—what message does this say to the rest of the market when you’ve got—I’m just going to say it—the smartest investors out there—obviously there’s a lot of other smart investors, but the most experienced and driven investors are kind of taking a breather. What message is that?
Arnold responds that the latest moves by the REITs were simply driven by diversification and opportunity. When there was prime opportunity in the seniors housing space, they took advantage of it, similar to what they’re doing today in other markets. Today, REITs are seeking more diversification from an investor’s perspective. He predicts that REITs will remain in seniors housing, but won’t be as prominent, mainly because there just aren’t as many large transactions out there for them to get.
“So I don’t read it as it’s a message, negative or positive. I just think it’s a dynamic of the market and the way they’re positioned.”
And what about RIDEA structures vs. straight purchase/leaseback? The leases give REIT investors comfort in steady cash flow, but providers have cooled off to the 2-3% escalators, especially by years five to seven. Are we going to see any shift in strategy from all the REITs, and what will that mean for their pricing in acquisitions?
Alan states that there’s always an evolution of strategies. Some of the smaller REITs have talked about doing away with those increases and trying to come up with a more hybrid structure. It is the nature of the competition for capital that is going to result in a different dynamic.
The other side of that is the challenge that the REITs are going to face in order to keep their multiples as high as they are, and to keep their costs down. REITs must provide a return if they start doing a lot of flat, no-increase leases, because investors are going to react poorly, causing their stock prices to go down and the cost of equity will go up. There’s only a finite amount of change that REITs can undergo without being dilutive to what they have existing.
“We only have these conversations when margins, and particularly in nursing, come under pressure. Nobody worries about it when margins are growing at or faster than lease rates. So the fact that these are becoming concerns is because the opposite’s happening: margins are under pressure.”
PE Firms and Foreign Capital
First of all, there is a big difference between the large PE firms and the much smaller private real estate equity firms, which tend to do onesie-twosie deals and maybe small portfolios. Are the big PE firms getting too much publicity because of their occasional big deals?
Arnold responds with his theory that larger private equity firms showing interest in the seniors housing market may cause an evolution that shouldn’t be ignored. Since private equity firms are more growth oriented than traditional investment firms, they are looking to be the first to cash in on the changing healthcare industry. As the health system evolves from a reactive to proactive system, PE firms will seek opportunities to establish a proactive preventative wellness, capitated world where there’s opportunity in not only just the centers (skilled, assisted, memory, independent) but the full continuum of care that starts with the individual.
Private equity senses an opportunity that links the growth in home care to the business of hospice, rehabilitation, different services, and palliative care. “I think most of these guys are thinking, look, there’s got to be a real opportunity for creation of value. They’re not coming in like a REIT might, for a yield; they’re coming in for a growth investment strategy.”
The smaller firms are doing a lot of the buying, and partnering with operating providers, often with multiple providers. Is this kind of changing the operating landscape, with much more of a management focus and not ownership?
Bill responds that the regional providers that have great market share in a regional area can afford to develop some of those ancillary services. The PE companies struggle to compete for the real estate because of the options available to finance real estate.
He says that firms may begin acquiring operating entities and banking on strong regional management teams that can do the things that Arnie just referenced. But for that to work, there must be a certain amount of scale. A five-facility chain probably can’t pull that off in many markets. Instead, it needs to be super-regional of some scale, in a decent market concentration where they can drive contracts with referral providers with their outcome statistics, etc.
“But having said that, I probably couldn’t give you a lot of examples where private equity has indeed partnered with these super-regionals.”
And how committed do you think both the large PE firms and the small private equity real estate firms really are to this space? Aren’t they more opportunistic?
Alan claims that some equity firms have proved their commitment to the industry, but many of the newer firms are simply chasing yield and opportunity. As far as opportunities go, they’ll stick around if they remain, but they aren’t wedded to the industry like a Formation Capital might be. “They’re a three- to five-year hold. Once they hit their number, they’re out and that’s just their model. So that’s my perspective.”
And what about foreign capital that we hear so much about. How much of it is interested in direct investments as opposed to providing their equity to a U.S. investment partner doing their bidding, so we may never really know the ultimate source of the capital?
Arnold agrees that foreign capital sources are more interested in partnering than they are in direct investments. They seek out reliable partners that understand the industry and are willing to take risks with them, versus coming in and trying to understand a foreign market. There are also concerns about tax issues, structure issues, and currency risk issues that can prove problematic for foreign investors.
“We’ve got some investments in the U.K. and some investments in China. We’re not going to go in there and think we know what we’re doing. We’re going to try to find the best partner we can to partner with strategically to build our business. I think the same thing holds true here.”
Are these foreign equity sources working from a different investment thesis, meaning their return parameters, time line and exit strategies may be very different from what we are used to?
Arnold responds with, “The only way I can answer that is to say the investment model that we’ve built has been attractive to international investors. So I don’t really know the answer to the broad market of institutional investors as far as what they look for.”
He goes on to say that his company has always built its thesis on a hybrid between a fixed return, real estate-based investment with a growth combination, and its been successful with foreign investors buying into that strategy. Oftentimes they like having a fixed return yield involved, and growth upside.
Are private equity buyers willing to pay a higher price, or lower cap rate, for deals that in the short term might look expensive but, because they can do things “in private,” may have longer-term benefits that we can’t see? How much of an advantage is that?
Willian responds, “We’ve all been in business long enough to have stories of private equity companies overpaying and regretting it later.” But, private equity firms have several advantages, the first being patience. The typical cycle might be five to seven years, and private equity can allow management the proper time and capital without having to answer analyst questions each quarter. Second, there is an advantage from a liability standpoint, and that is the lack of transparency of their financial statements which means less investigations and cost reports that must be filed.
Conclusions and Forecasts
Do you expect 2017 to look just like 2016 from an M&A perspective?
“I think very similar,” Arnold replies.
Will a slow rise in interest rates impact values and the acquisition demand very much?
“I think it will be a small bump. I think the bigger impact, as I’ve said several times, is going to be operational fundamentals across the entire sector” Alan replies.
Do you see development slowing, and if so, how favorable an impact will that have on acquisition demand and values?
Bill predicts that development will slow in the AL/memory care areas. On the other hand, there is a chance that there might be a pickup in new development on the skilled nursing side, now that Florida has been flirting with removing the CON process for skilled nursing and hospice.
“As far as its impact on the acquisition market, every time we’ve gone through a market cycle where somebody has overdone it, there are always distressed assets and somebody lacking enough capital to see it through.” In 2017, there could be a small level of distressed assets where people bail out because they can’t afford to eat the operating losses and the fill-up. But still, there’s a chance that there will be more development on the SNF side than on the memory/AL side.
