Senior Living Business: Managing Historically High Negative Arbitrage--
Creative Financing And Phasing Keep Projects Moving Forward
When a provider finances a construction project with a direct taxable loan from a bank, the funds are drawn down in stages, as needed, and interest starts to accrue only when those funds are accessed. When a provider finances a construction project with tax-exempt bonds, those funds are almost always drawn down at once, and interest starts to accrue immediately upon closing the deal. To mitigate the interest cost, that provider may reinvest the proceeds until needed. The difference between the interest owed and the interest earned is the negative (or positive) arbitrage.
The issue facing borrowers today is a historically high level of negative arbitrage. Interest rates on low-rated or unrated tax-exempt financings are hovering around 8.5% (around 6% for rated organizations), while the interest earned on reinvested funds may be less than 1%—a negative arbitrage of 7.5%. In the recent past, the negative arbitrage was closer to 1.25% to 2%, which was acceptable over the course of a two- or three-year construction project.
Are there solutions?
“To the extent that they can, borrowers should try to structure short-term debt during construction as they need it and not in advance,” advised Bill Pomeranz, Managing Director of Cain Brothers in San Francisco. “Right now, taxable debt may be an even better choice than tax-exempt. The problem is, though, that a bank will not lend greater than 75-80% loan to value for short-term financing. In the early part of the last decade, banks were willing to lend 100% of the value of the project to senior living organizations. We don’t expect that to happen again for a long time.”
As a result, projects are being put on hold—about 25 new CCRC projects around the country were tabled, postponed, or shut down in 2009—or, if possible, providers are moving forward in incremental steps to bring the cost of debt down. Instead of doing a $100 million project, for example, they’re subdividing the project and proceeding with, say, a $25-30 million portion that they can finance through banks or other sources.
For example, skilled nursing, assisted living and dementia units may qualify for an FHA program’s lower interest rates, with funds drawn down as needed. “The deals we’re doing right now are a mix of taxable and bank-qualified, with both fixed and variable rates,” noted Pomeranz. “We’re doing taxable FHA deals at 5% for 35 years and Fannie Mae deals at 6%. We’re also doing deals through CalMortgage, a state program, in the upper fives.”
Another possibility is to layer some short-term, fixed-rate bank debt—three-year paper at 6%, five-year paper at 7%, eight-year paper at 7.5%, and so on. The debt is repaid with entrance fees. “The interest rate goes down with the shorter duration,” Pomeranz explained, “with the result that the entire debt isn’t outstanding for 30 years at 8.5%.”
At this point, short-term debt is generally available to quality operators that have a good relationship with their local or regional banks and also to existing multi-site systems that are financially strong and are able to secure, from local banks, small construction loans that are guaranteed by the organization or its obligated group.
Structuring the deal
Whether the high levels of negative arbitrage are significantly affecting borrowers depends on how the deal is structured, according to Tanya Hahn, Senior Vice President at Lancaster Pollard. “If the deal is structured to earn 2.5% in interest over the construction period to help pay for the project, and the borrower is earning less than 1%, that’s a problem,” she explained. “Most of the time, we recommend gross-funding the project fund at 100% of what the borrower needs, and any interest earnings are then gravy. Some investment bankers will net-fund the project fund, with the assumption that the earned interest over the construction period will help pay the construction cost. The risk is, if you assume too high an interest rate, you may fall short and not have enough funds to complete your project.”
The other component of a bond structure is the draw schedule of the project fund. “You’ve got to proactively manage the investment of your construction funds to match your draw schedules,” she advised. “Work with your bond trustee or hire an outside firm to manage those funds in conjunction with the trustee.”
If your existing organization is capable of paying the construction period interest, this can reduce the borrowed amount and help to minimize negative arbitrage on the core project fund. “You’re still paying the high interest rate (say 8.5%), but you haven’t compounded the problem by increasing the borrowed amount,” said Hahn.
“Negative arbitrage obviously impacts the financing,” she continued, “but the key is to manage it. Borrowers who can afford only a certain amount of debt have to figure out how to get the project to that point—perhaps phasing the project or making it smaller. But regardless of whether we’re in today’s environment or where we were three years ago, every project should make economic sense to the organization—and the ability to afford the project going forward should be a big part of that discussion.”
Phasing the project
Even though it may cost more in the long run, phasing the project is a way to work around the problem of high levels of negative arbitrage, providing that the project is able to be broken up and that there is demand for phase one.
“Phasing is a common trend, given the amount of risk organizations want to absorb in a changeable market,” said Dan Hermann, Senior Managing Director and Group Head at Ziegler Capital Markets. “We’re also seeing phase one reduced down to the smallest financially feasible size that can meet minimum financial hurdles and also set up future phases. It’s not always possible, particularly in landlocked situations where the land cost is relatively high or in urban settings where the project is a high-rise building; but most of the time, you can phase.”
Whitney Center in Hamden, Connecticut, for example, planned to replace its health care center and, at the same time, add new independent living units and expand the community center. Because of high interest rates in 2009 and the negative arbitrage, the project was divided into two phases. “We advised Whitney Center to finance the new independent living units and community center first,” explained Rod Rolett, Executive Vice President at Herbert J. Sims, “because that portion of the project would produce a significant amount of incremental revenues through new entrance fees and monthly fees.
“Once those fees were collected,” he continued, “the organization’s financial health, balance sheet and cash flow statement would improve significantly. Then, in three or four years when the construction and occupancy of the new independent living expansion is complete, Whitney Center will be in a good position to finance the replacement of its health care center.”
For Presby’s Inspired Life just outside Philadelphia, Pennsylvania, however, each phase of its project was dependent on completion of a previous one—but financing had to be in place to ensure that all three phases could be completed. “They needed to build a replacement medical center first,” said Aaron Rulnick, Executive Vice President at Sims. “For phase two, they will renovate the existing medical center to provide larger and more efficient assisted living units. And in the last phase, they’ll renovate the old assisted living units into independent living apartments.”
That project was financed in October 2009 and is expected to take three years to complete. To minimize the negative arbitrage they would have otherwise incurred over the three-year construction period, the $54 million deal was structured as a taxable construction loan through three banks. And even though last fall was a difficult time to secure bank financing, the three banks were willing to make the loans, because the sponsoring organization was strong, the project was strong and the market was strong—all critical elements for success.
Drawing from a line of credit can be another efficient way to mitigate negative arbitrage when a project can be split up into small parts. For a 10-cottage component of a project, for example, it may be feasible to build two clusters of five at a time. Once the first five are completed and entrance fees are collected, you repay the line of credit and then draw on it again to build the remaining cottages. In that scenario, where it may have cost $20 million to construct all of the cottages, you may be borrowing only $10-11 million at a time.
“We’ve been very creative in helping our clients evaluate ways to combine multiple sources of financing for separate elements of a project located on one campus,” said Rolett.
Historically, investment bankers looked at all the components of a project, aggregated them, and then issued a bond financing for it. Now, they’re looking for the most efficient way to finance each component. “In some cases, you can bifurcate the financing,” Rulnick suggested. “In other cases, that’s difficult. But if you have the opportunity to combine different financing vehicles in order to get a project done, that can be much more efficient at this time.”
Bank-qualified debt on a variable-rate structure, which can be refinanced in three or five years, is one way to manage the negative arbitrage for smaller projects. It’s an attractive, low-cost financing vehicle with an all-in cost of capital similar to letter-of-credit deals. Each tax-exempt organization can borrow up to $30 million in 2010.
“We ask the bank to submit a direct loan proposal in the form of a tax-exempt bond rather than a taxable structure,” said Rolett. “That reduces the cost for the borrower. And unlike letters of credit, the bank’s investment grade rating is not important. That helps widen the pool of potential banks that can work with the borrower—regional banks or even larger banks that don’t have a high enough rating to issue a letter of credit. But because of the $30 million per-borrower limit and the required bank involvement, bank-qualified debt doesn’t work for every project.”
The bright side
As the financial markets have started to thaw and the housing markets are beginning to improve, deals that were in the pipeline are being brought to market, “but adjustments have been made given what we’ve learned through the financial crisis,” said Rulnick. “If the entrance fee pricing was above-market, for example, the organization may be looking at ways to develop a more affordable project. Or if they had a $200 million financing planned, that may be phased down to $100 million or $150 million. So the lessons learned and the realities in terms of where interest rates are—and the issue of negative arbitrage—have helped people frame a rethinking of their development project.”
In the midst of the frozen financial markets, of course, it was difficult to continue financial planning. People didn’t know when the markets would return or what the conditions would be. Now, at least, the market has become fairly stabilized, and there’s a context in which to redefine a project. In addition, market factors such as lower asking prices for land, lower architect fees, and lower construction costs can mitigate the effects of high negative arbitrage.
“We’re seeing cost reductions of 5-20%,” observed Hermann. “People have also been successful at achieving post-financing savings due to the very competitive subcontractor market and the ability to buy materials at prices lower than those laid out in the guaranteed maximum price contracts. Subcontractors are also fully staffed, which is leading to faster timeframes and greater efficiency.”
Through the economic stagnation of 2009, contractors were working off backlogs. But as the months marched on, commercial and condo construction wasn’t moving forward, the backlog was worked off and contractor bidding became much more aggressive. Now, any major project gets their attention. “Basically, the elasticity and lack of demand in the construction market is leading to incremental savings and very good execution,” Hermann suggested. It’s the market at work.
Projects that did make it through the gauntlet of 2008-09 share some common attributes. The sponsors were committed, the markets were strong and the projects were strategically important. “Those are the common threads that gave the organizations the confidence to move forward with their projects,” said Hermann. “Many projects that weren’t strategically critical to the health of the organization or that were located in areas where the market wasn’t responding in a healthy way were tabled during that period,” he said. “It wasn’t worth going through the time and effort of the refinement process or placing additional risk on the organization.”
When putting together a plan of finance for their clients, the approaches that investment bankers are recommending are certainly influenced by the high levels of negative arbitrage, but it’s not necessarily the driving factor. Long-term borrowing costs, construction costs, investment bond proceed rates, more working capital due to longer fill-up time, pricing issues—and, of course, the negative arbitrage—are all considerations that determine whether a project will work.
“No one wants high levels of negative arbitrage,” said Rulnick, “but that, in and of itself, may not cause a project to be unfeasible.”