The SeniorCare Investor: Light In The M&A Tunnel?
A Small Deal May Help Clarify Pricing In Today’s Market
It has not been an easy acquisition market these past 18 months or so. That is an understatement. A month doesn’t pass without some whisper of hope, some breakthrough, small as it may seem, that everyone wishes will translate into a more vibrant market with sellers waking up from a hibernation that has lasted a few winter seasons. There are sellers, of course, but as we have come to know, most of them have been need-driven, not market-driven, and very few portfolios of any size or reasonable quality have been brought on the market. And when the good ones do make a showing, too often the buyers will not pay the asking price, which has been a common theme these days.
How many times have we heard, whether at conferences or earnings conference calls, any number of senior industry executives say they are looking at a lot of deals, but they don’t really know where “market” cap rates are because of the dearth of decent transactions? Either the quality of properties sold was not so great, or they were non-stabilized, or the seller was forced to sell, or there was below-market assumable debt, or the lender was the seller and so on. The reality, however, is that in private almost every one of those potential dealmakers has an opinion about where cap rates are, and a definite opinion on how they would price an acquisition of an “A” property, whether independent living, assisted living or skilled nursing. The point is, there is demand for the “B” properties, and we know what the cap rate range is for them. There is also strong demand for the “A” properties, and while everyone seems to know what they will pay for these high quality properties and portfolios, there have not been many sales to use to derive reasonable market cap rates. That may be changing.
Three years ago, a portfolio of four assisted living properties in New England was sold to a group where Connecticut-based Westport Capital Partners had the controlling interest, with minority positions held by Kaplan Development Group and Capital Health Group. The purchase price was $65.7 million, or $171,100 per unit, and came with a stabilized cap rate of 6.6% (three of the properties were above 90% but one was still leasing up). At the time, the four properties were three to seven years old, and although the majority of units were assisted living, there was also a mix of independent living (85 units) and Alzheimer’s (84 units). At the height of the market, this was a reasonable deal given the location, quality, census and rates, although some people thought it was a little on the rich side. As it turns out, the buyers knew what they were doing, even with a weak market that was approaching.
For whatever reason, the partnership decided to test the market with this high-end portfolio. Although the initial price-thinking may have been a bit aggressive, demand was certainly strong. One of the problems, however, was that one of the facilities had a recently opened dementia unit that was still filling, and buyers did not want to pay for that future stabilization. Three years ago? Not a problem. Consequently, the two communities in Massachusetts, just outside Boston, were split off from the portfolio and sold separately. The current purchase price is $43.0 million, or $222,800 per unit, and the two properties include 139 assisted living units, 44 Alzheimer’s units and 20 independent living units. Average occupancy last year was a very healthy 97% and they were built in 1999 and 2000. This transaction, even though it is not large (but makes it into the top 10 of the past 12 months), may help in establishing where the market really is for higher-quality properties. Chris Hyldahl and Mike Pardoll of Marcus & Millichap represented the seller in the transaction.
Not to sound overly giddy, but this transaction just seems to be good for the buyer, AEW Capital, the seller and the manager, Kaplan Development, who will stay on as the manager. When the four properties were purchased three years ago, the allocated price for the two Massachusetts properties was about $34.5 million, or $178,700 per unit. So, a relatively high price was paid at the peak of the market with a reasonable but somewhat low cap rate based on stabilized cash flow, followed by the Great Recession and the housing market crash, and still the seller makes a healthy profit on the sale. Our guess is that kudos should go to Kaplan Development for increasing the occupancy and keeping it high, which may have factored into AEW’s decision to retain their services, and kudos should go to the original developer for picking what must be good locations. Now, if interest rates were not so low, we are not sure if AEW would have been able to pay the price they paid. But as long as Fannie Mae and Freddie Mac are putting out money at aggressive rates, especially on the floating rate side, strong prices and relatively low cap rates will be paid, especially by funds with money to invest.
In this transaction, the $43.0 million price translates into an 8.0% cap rate based on in-place combined EBITDA of about $3.44 million (before replacement reserves). The forecasts are for cash flow to grow by about 3% a year, which obviously assumes occupancy remains high and is probably a good assumption since it remained strong with the worst of the economic crisis behind us (we all hope). It also assumes maintaining the 35% EBITDA margin, which should be doable. There is one hidden benefit, however, as one of the facilities has a restriction on it to have a certain number of units at below market rates that is tied to an old financing. Apparently, up to 20 residents are paying just $2,500 per month on average, which is significantly below the market rents. Once they are able to bring these to market rates, in several years, it could result in an increase in value of more than $4.0 million.
Obviously, all of the increased value over three years came from the increase in cash flow, overcoming the increase in market cap rates. So, is 8% the market cap rate for newer, higher quality assisted living facilities? It seems that this may be the case, as long as the debt markets cooperate, or as long as Fannie and Freddie are lending until more of the other lenders return to the market. In the past, similar quality independent living would trade for 25 to 50 basis points below assisted living, but not necessarily in this market, where the move into independent living is not as need-driven as assisted living and very dependent on selling the house. Despite these caveats, we will be waiting for cap rate confirmation with another sale or two in the coming months, and then maybe people can start to tell investors where cap rates are.