The Health Care M&A Monthly: What’s Happening With Cap Rates?
The Nuances of Not-For-Profit vs. For-Profit Entities
In the for-profit world, cap rates are treated the same, scrutinized the same, and viewed the same by Wall Street. It’s more complicated in the not-for-profit sector, but there’s more opportunity, as well.
“I prefer to use the same cap rate regardless of tax status and underwrite the cash flows differently,” says Alan Plush, senior partner at HealthTrust, LLC. “If an investment-grade sponsor is involved, I think you could argue for a lower cap rate. We sometimes do that when we do letter-of-credit appraisals. And we can adjust for real estate taxes.
“Probably 80-90% of transactions in the senior-living sector involve for-profit organizations,” he says. “Let’s say that independent living rates are 6% to 7.5%, assisted living rates are 7.5% to 9%, and skilled nursing is 11.5% to 13%. Not-for-profits really can’t afford to pay more than those cap rates. If they could afford to pay more — and assuming that the seller wants to sell for the highest price — you’d see a lot more sales to not-for-profits.”
In the end, cap rates are cap rates. They’re market-driven — although the income stream for not-for-profits is a little different from for-profits. Not-for-profits have a lower cost of capital, and lower cap rates sometimes reflect that. Also, the availability of better financing and the possibility of saving money on liability insurance premiums and real estate taxes exists uniquely for not-for-profits.
Customarily, cap rates are determined by either of two methods:
(1) Market-extracted cap rates, considered the most accurate method, are based on actual transactions; divide net income into the purchase price.
(2) The “build-up” method, an arithmetic approach, is always affected by the assumptions involved. Assuming an equity return at 20% vs. 12%, for example, materially impacts the cap rate.
The “build-up” method isolates the impact when below-market financing is available. For that to apply, the organization must be a “credit-worthy not-for-profit” — one with sufficient resources to secure investment-grade, tax-exempt debt.
“A lot of not-for-profits don’t fit that category,” notes Plush, “so a slightly lower cap rate based on cost of funds and possibly some savings in property taxes are about the only reasons to apply different metrics to not-for-profit vs. for-profit transactions.”
The property tax exemption is a negotiated item,” suggests Bill Pomeranz, managing director at Cain Brothers. “Some appraisers will include it, and some won’t — and it can be a big number. Apply a 6.5% to 7.5% cap rate to $300,000 or $400,000 in real estate taxes, and that’s a lot of money.”
Occasionally, discounting may be involved, as well. A provider making a bid on a not-for-profit facility, for example, may pay as much attention to operational benchmarks as to an appraisal. “The assumption that not-for-profits have fat that can be cut,” Pomeranz explains, “would improve the appraisal over time. So the buyer will benchmark various line items to see how the expenditures could be decreased over two, three, or four years. That will enhance both the cap rate and the value.”
Favorable financing treatment may apply when a not-for-profit organization is the purchaser. For example, if the cap rate is 7.5% for a purchase with conventional financing and a not-for-profit will instead pay 5%, some appraisers will take the 2.5% differential, create a 30-year income stream, net present value the difference, and add that to the purchaser’s value. That would apply whether the seller is a for-profit or a not-for-profit entity. The favorable financing treatment applies only to not-for-profit purchasers, since they can use tax-exempt bonds with lower interest rates. “Not every appraiser will do it,” says Pomeranz, “but it can be an addendum to an appraisal.”
Factors that influence cap rates
“Not-for-profits tend to be a really good option when the market for conventional lenders is soft and there’s not a lot of liquidity,” says Plush. “If the cost of funds is tight and liquidity is thin, then more equity is required and the investor premium goes up. Right now, there’s so much liquidity and so much institutional capital that I honestly think the not-for-profit sector is at a bit of a disadvantage.”
Risk influences cap rates, and the lowest — or perceived as the lowest — risk is for independent living facilities. “Ideally” says Plush, “the appropriate risk factor would be worked into the cap rate by extracting it from market transactions.”
Deals being made by hedge funds and the financial fortresses of the world also affect cap rates. These entities may be willing to pay 5% on their money in year one, with the belief that every year thereafter they’ll jack up their return 1-2% and, ultimately, sell it 50-100% higher.
“Think about it,” says Pomeranz. “Buy a building for $20 million with $1 million of free cash flow — a 5% return for a for-profit organization. For not-for-profits that are used to financing 90-100% cash to debt, that’s a serious problem. It’s difficult to do 100% financing on $20 million with only $1 million of free cash flow, because that only carries $7-8 million worth of debt. So a not-for-profit cannot pay what a for-profit can pay.
“The for-profit entity uses a different return matrix and is looking for lower returns,” he continues. “So in sales where the owner wants the most money, you don’t see many not-for-profit bidders in the final go-round.”
The playing field
Not-for-profit facilities are often sold because they’re struggling, according to Pomeranz. And they’re usually struggling because they’re outmoded and/or don’t have the right mix of unit types.
“If the transaction is between two arm’s length entities paying market prices, the owner is either under financial duress or wants to raise capital,” he says. “That happens, for example, when senior housing is not the main line of business or the owner wants to drop a product line that isn’t fully developed. In those cases, the cap rates have been very low, because the properties tend to be over-designed and overstaffed. They’re in good locations and have reputations for quality care. When a not-for-profit has that kind of tremendous value locked up in its product, we call it a ‘halo effect.’”
Skilled-care nursing homes, particularly solely skilled nursing campuses, have seen the highest volume of not-for-profit sales. These facilities have become Medicare-oriented and rehab-oriented businesses that, in many states, can no longer make ends meet on state reimbursements. The skilled-care facility doesn’t disappear. A for-profit nursing home chain buys it — and, in fact, the level of care often improves. “Not many traditional not-for-profits provide skilled nursing or are entering into it,” says Pomeranz, “because they never geared up to take Medicare, which requires rehab care and taking in patients seven days a week, for example. And many not-for-profit facilities that currently offer skilled nursing are closing out those beds.”
Instead, not-for-profits are focused on retirement communities for middle- and upper middle-income people. Some put mission on the back burner; others try to balance mission but not necessarily at the same site. They may do an upscale CCRC in one location, for example, and a low-income housing project ten miles away. “That tends to be the trend in capital markets, as well,” says Pomeranz.
“The moderate income population is difficult to serve without being a really good operator,” he adds. “These folks are unable to afford the CCRCs, because CCRCs are not designed as cost-efficient products. They offer too many amenities. As a result, operators such as Sunrise Senior Living pick up that population for the last couple of years of life, when those people spend down.”
A particular concern for purchasers of not-for-profit CCRCs with a high percentage of entrance fees with care obligations, is that appraisers don’t normally value the outstanding care obligation. Sometimes those future obligations are underfunded, which will have a huge impact on the balance sheet. Cash flows may say that a project is worth $20 million with almost no money on the balance sheet — which is typically true and the reason the property is on the block — but the purchaser will have to meet the $6, $7, or $8 million underfunded actuarial liability.
The best strategy for not-for-profit organizations to improve their marketability is to get all zoning approvals for expansion while it’s still a not-for-profit organization, according to Pomeranz. “Land-use regulations are increasingly more stringent in many communities, and a not-for-profit entity is more likely to get zoning approval to build an expansion than a for-profit developer buying the same property,” he says. “We advise our clients to get all the necessary approvals before putting the property up for sale. The incremental expansion represents incremental revenue, and that creates desirable value. And the cash flow for an expansion is better for a functioning operation than for a start-up.” The risk, of course, is that the seller’s ideas aren’t the same as the buyer’s, so zoning approval for a generic expansion makes the most sense.
Finally, while the not-for-profit sector has tremendous value locked up in its products, owners don’t tend to sell even when it’s strategic. Let’s say an operator has five or six facilities and could sell one, raise a lot of money, and use it as seed capital to build four new facilities. Some consider that a betrayal of mission. Others aren’t willing to take the risk on new development. Instead, the not-for-profit sector turns to third-party developers, which can be both good and bad. The good part: The administrator transfers the risk to someone else. The bad part: It jacks up the price dramatically and suppresses the market.