The SeniorCare Investor: Mixed M&A Results In 2009--
SNF Bed Prices Up In 2009, ALF Unit Prices Down
Throughout 2009, health care reform was supposed to caste a pall over the entire health care acquisition market, but someone forgot to tell that to the buyers and investors. Yes, certain areas, such as managed care and hospitals, not to mention seniors housing, felt the brunt of uncertainty on transaction volume, but overall it was a very active year. In fact, from a dollar value perspective, 2009 ranks as the second most active year ever in the overall health care merger and acquisition market, helped along by a few very large transactions in the pharmaceutical sector. Based on the number of actual transactions, it makes it into the top five years.
Despite plunging equity values, which would result in bargain-hunters coming into the market, the rest of the M&A market suffered in 2009 while the health care market continued on its usual pace of activity. The lack of debt financing obviously kept many of the private equity firms from making major acquisitions for most the year, but by the fourth quarter of 2009, “financial buyers” of all types represented 8% of the health care M&A transaction volume and 21% of the dollar volume. This compares with 2% and less than 1%, respectively, during the first half of 2009, so there was obviously a big change in market psychology as the year was coming to an end. There is no question that this phenomenon was occurring in seniors housing as well.
In total, there were about 950 publicly announced transactions across all sectors of the health care market in 2009 worth approximately $233.0 billion. This compares with just over 1,000 transactions worth about $227.0 billion in 2008. Even though the 372 health care services transactions represented nearly 40% of the transaction volume in 2009, the dollar value was just $13.8 billion, or less than 6% of the total health care market. The number of health care services transactions has been steadily declining since the peak in 2006, and with just 372 transactions in 2009, this represented the lowest level of activity in the decade. Seniors housing and care has been declining as well.
As the specter of health care reform was looming on the acquisition market during 2009, some areas were hit harder than others, but the transaction volume decline was pretty much across the board in all health care services segments. Although certainly not the lowest of the decade, the hospital sector posted just 53 transactions, a 12% drop from 2008, while the managed care sector was just as quiet as the year before, with just 15 announced transactions compared with 16 in 2008. There was the most uncertainty with these two sectors as to just what the various proposals for health care reform would do to their businesses, but when “health care” reform became health care “insurance” reform, very few investors wanted to make a bet on managed care companies. All sectors experienced lower acquisition volume in 2009, with the rehabilitation sector suffering the largest percentage decline (-55%).
The number of publicly announced seniors housing and care transactions has declined in each of the past few years, from 146 in 2006 to 127 in 2007 and just 96 in 2008. Despite the common belief that the seniors housing acquisition market died in 2009, the relatively small decline in 2009 to 90 publicly announced transactions seems to indicate a potential bottoming out of the market, but it may be too early to confirm that. Another indicator of a potential market turnaround is that the dollar volume of announced seniors housing and care transactions in 2009 more than doubled to about $4.1 billion compared with just $1.8 billion in 2008. The 2009 figure does include some transactions that have not closed yet, and one large deal (the $1.1 billion acquisition of the Sunwest Management portfolio) may not close, or it may close in a different structure which would result in a sharply reduced “price.” These levels are much lower than the transaction volume of $22.6 billion in 2006 and $16.6 billion in 2007 for seniors housing and care. Unlike most of the other sectors of health care, the seniors housing market saw the reemergence of private equity buyers, even though one firm (KKR) actually lost out in a competitive bidding process for one of the largest transactions of the year, and the other (Blackstone) is still waiting to see if it comes out on top. In 2009, there were four announced transactions in excess of $300 million, while in 2008 there was not one above this mark. That would seem to indicate a strengthening in the sector.
The skilled nursing facility industry is not one that is considered to be exciting or sexy, but it has been durable. Over the past 20 years, it has evolved from one characterized by longer-term custodial care stays (with various levels of acuity) to much more of a health care business, with high levels of post-acute care, high patient turnover because so many more patients go home or to an assisted living facility than in the past, and an increasing reliance on Medicare for revenues and profits. This is a bit of a double-edged sword from an investment perspective. First, as the acuity levels rise and rehabilitative care is more dominant, skilled nursing facilities begin to lose their “real estate” appeal and the value becomes increasingly centered on the business model. And maintaining quality of care is crucial for that business model to work. Second, as Medicare becomes more important as a revenue source, it increases the uncertainty for skilled nursing providers as Medicare reimbursement gets caught in the web of health care reform and cost cutting in general.
When the market was peaking in 2006 and 2007, skilled nursing facility values rose above their historical norms, topping $50,000 per bed for the first time in both years. The increase, however, was not astronomical, especially compared with what was happening in the assisted and independent living market. On an inflation-adjusted basis, those record average SNF prices in the 2006 to 2007 period were probably not much higher than the record set in the last bull market in 1996. The point is that even though the skilled nursing industry is not cyclical, it does operate in cyclical environments and is influenced by them. The difference, however, is that the impact of these cycles over the years (and decades) is not as great as one would think. In other words, despite changes in reimbursement, interest rates, capital availability, inflation and general economic strength, the skilled nursing sector is remarkably resilient and steady.
Despite a terrible economy and capital markets environment in 2009, the average price paid per skilled nursing bed actually increased to $47,500 from $45,500 in 2008. This is somewhat counterintuitive given that real estate values in general declined so much from mid-2008 through the end of 2009, and that Medicare and Medicaid were coming under increasing pressure. But well-operated skilled nursing facilities, especially those with a good Medicare census in attractive markets, were still performing well in a bad economic environment. And since there are not any “lower-cost producers” able to do what skilled nursing facilities do, most buyers decided that Medicare will not lower reimbursement rates too much in the future, if at all. Medicaid is a problem, of course, with most state budgets in the red, but few providers make much money on Medicaid patients, so it will be a matter of how much they are willing to lose until the economy strengthens.
As far as cap rates go, during most of 2009 everyone was assuming that cap rates were rising. In the first half of the year, and based on a very small universe of transactions, the average cap rate had actually decreased. Nobody believed that would hold out for the full year, and it didn’t. With most of the transactions closing in the second half of 2009, the average skilled nursing cap rate for the full year was 12.8%, which was just 10 basis points less than 2008. The median cap rate, however, increased by 50 basis points to 13.3%, and many investors will be focusing on this number, especially those who believe a “market” cap rate is closer to the 13.5% to 14.5% range. And there are plenty of deals done at this range; it’s just that there are also transactions done at lower cap rates for a variety of reasons.
Unlike the skilled nursing sector, the seniors housing market (assisted and independent living) is still considered to be much more real estate oriented even though assisted living has seen the acuity levels of its residents rise as lengths of stay decline. The real estate component of value has also been increasing as the newer properties tend to have larger units, more common space and a generally more luxurious design that approaches the look and feel of high-end hotels. The sector has certainly attracted its share of real estate investors and developers, and when the housing market and other real estate sectors began to tumble in 2008, many investors threw the assisted and independent living sector into the same sinking ship. Independent living was thought to have the most exposure to the weak housing market since it is not need-driven, unlike assisted living.
Acquisition volume in independent living during 2009 was as slow as we have ever seen it, partly because the potential sellers did not want to sell into a declining market with rising cap rates, and partly because many buyers were concerned about future census levels as the housing market did not appear to be turning around. What no one counted on, however, was that some of those need-driven elderly chose the less-costly independent living option over the more expensive assisted living option, even though they may have really needed the latter. In some cases they couldn’t afford the higher monthly rates, and made the decision to add services later when they really needed them. The few independent living communities that did sell in 2009 actually turned in better average prices than anyone expected.
The seniors housing market was dominated by assisted living sales, which represented about 86% of the transaction volume. Within the assisted living market, the sales of properties by Sunwest Management dominated the market in 2009, both in closed transactions and pending deals, and so far this year they have been prevalent as well. While some of the properties are above average, because of the distressed situation, combined with a negative market with little debt financing available, the prices achieved were sometimes on the low side. Not to say that they were not “market prices,” but that in a different environment they might have sold at higher prices. Based on our acquisition study results, the average price paid per unit for assisted living declined by 9% to $113,300 per unit in 2009, and this was on top of a 21% decline in 2008. Unlike three years ago, very few buyers have been willing to pay the seller for any upside. Despite the worst economic environment in 60 years, the average price per unit was still higher than it was during the 10 years prior to 2005.
The main difference between the skilled nursing market and the assisted living market in 2009 was what happened to cap rates. Assisted living cap rates increased by 100 basis points in 2009 to an average of 10.0%, an increase that was somewhat expected at the beginning of the year and came on top of a 70 basis point increase in 2008. It was this cap rate increase more than anything else that caused the average price per unit to decline last year, helped along, of course, by some deterioration in the quality of the properties sold. In many of the cases, however, the deterioration was more in the census than in the actual quality of the building. Full details on the 2009 acquisition market are included in our upcoming report, The Senior Care Acquisition Report, 15th Edition, which will be available at the end of the month. In addition, tune into our audio conference on March 25 when we will be going over the 2009 results and talking about the prospects for 2010 and beyond.
The seniors housing and care industry has actually held up quite well during the recent economic upheaval. Occupancy levels did decline at many companies, but these were in the 100 basis points to 350 basis points range, something that all providers can survive. And contrary to popular opinion, some providers did not suffer any decline in census, even at their properties with 95% to 100% occupancy. There were two high-profile bankruptcies/restructurings (Sunwest Management and Erickson Retirement Communities), but these were somewhat isolated situations that came about from a combination of reckless growth and over-leveraged capital structures. For many of the companies that suffered from small occupancy declines, by the summer of 2009 that started to stabilize and in some cases census improved. Throughout it all, however, cash flow was positive and often increasing even when occupancy dropped. That is a resilient market.
The acquisition market is trying to find itself, meaning that buyers and sellers are still trying to establish what the valuation metrics really are in today’s environment. The pricing “disconnect” has been talked about for two years now, and while some buyers still believe sellers are not realistic, the reality may be that if they don’t have to sell, their above-market price merely reflects where they are willing to do business, with a take it or leave it attitude. When a deal has to get done, the equilibrium is found. Sellers know that the world has changed, that cap rates have increased and valuations have declined; that doesn’t mean they have to play in the new game. The deal logjam did start to break up in the fourth quarter of 2009, as there were more publicly announced transactions in the sector than in the second and third quarters combined. In fact, the fourth quarter of 2009 was the most active quarter since the first quarter of 2007, measured by number of announced transactions. There is strong demand for single property sales and, with Blackstone Real Estate Advisors and KKR both making large bids late in 2009, demand for large portfolios may be back.
Our expectation is that 2010 may look a lot like 2009 in terms of deal volume and types of transactions. The two determinants will be the supply of capital, particularly debt, and the inventory of properties for sale. No one expects the lending market to return to the volume and relatively loose underwriting standards of 2006 and 2007, but in 2000 and 2001 after all the bankruptcies and loan defaults, no one thought we would see such a strong lending market, and it took less than five years to overcome the previous market trauma. From an operating perspective, with an improving economy and stabilizing occupancy levels, increases in cash flow at the property level may start to rise significantly, especially as the “move-in deferrals” start to make some decisions, and as the level of new development hits bottom, limiting any future competition. Skilled nursing will still worry about reimbursement, and it is a real concern, but the sector is in much better shape from a health care delivery sophistication perspective than any time in the past, so we do not anticipate any dramatic changes, one way or the other. Whether cap rates have found a new equilibrium may depend on what happens to interest rates, as the entire industry has benefited from historically low rates for a long time. If interest rates start to rise significantly, as some have predicted, the landscape will certainly change as existing loans come due. If that happens, lenders may dominate the selling market, and that will not be fun.