Senior Living Business: Small Borrower Financing Issues-
Capital markets have grown over the last two decades and are currently "vibrant," according to Daniel J. Hermann, managing director and group head of Ziegler’s Senior Living Finance Group. "That’s very good news for not-for-profit senior living organizations," he says, "as access to the tax-exempt bond markets is readily acceptable — whether the borrower is large or small."
Generally, small borrowers tend to be single-site operations. And while the financing for a brand-new, single-site CCRC campus can reach as high as $250 million, the typical small, single-site borrower — many times one that’s located outside a major metropolitan area — is often looking to access capital in the $3 million to $25 million range. "Borrowers usually don’t bother with tax-exempt issues below $3 million," says Hermann, "but the majority of projects that not-for-profits are pursuing are at least that large."
Small borrowers may simply be looking at refinancing or recapitalizing existing debt such as older tax-exempt issues, a high-interest bank loan, or some other form of debt. "Average rates for not-for-profits are currently ranging from 4.50 to 5.50 percent," he says, "and while they may, over time, creep up to the 5.00 to 6.00 percent range, we expect them to remain relatively low. It’s a great time to be capitalizing a balance sheet."
Tighten your belt and prepare for lending
Before looking for financing, it’s important to do a little legwork, which involves assembling a team of qualified, experienced professionals that fit the style of the project, and also a little paperwork, which means putting your assets in order. This is critical for all borrowers, whether first-time or repeat and whether the financing is for recapitalizing debt, acquiring or building a facility, remodeling, renovating, or repositioning.
Financing simply is easier when the borrower is prepared and organized, according to Hermann, who suggests the following strategies:
1. Assess your credit standing. Is your existing operation credit worthy? The biggest mistake that small borrowers make — borrowers that have not frequently accessed the capital markets — is that their operation may be weak or their balance sheet may have very little liquidity. The banker is looking for an operation that reflects good management, high occupancy, reasonable margins, and decent liquidity in the form of 120 to 200 days of cash on hand, which is typical for CCRCs, or 75 to 125 days of cash on hand for organizations that are heavier in nursing, which some single-site operations tend to be. Those minimums ensure that enough revenue is being generated from operations to cover debt.
2. Prepare a financial forecast. An organization that is reinvesting in an existing physical plant (renovation, remodeling, repositioning, or expanding) needs to prepare a financial forecast in order to see whether available revenues will provide adequate debt service coverage upon completion of the project. The minimum debt service coverage that credit markets currently expect to see on the not-for-profit side is 1.30x — and 1.35x to 1.40x if the facility is exclusively nursing due to a perceived higher risk. If the project is big enough, the financial forecast may turn out to be a feasibility study that would be published in an offering document.
Organizations that are unable to do a financial forecast simply because of management depth should not hesitate to outsource that exercise to any number of financial firms that specialize in senior living. It could also be one of the larger public accounting firms or an individual consultant. In any case, it’s money well spent. A common pitfall for small organizations is either to wait too long to do a forecast or to do one that isn’t professional, accurate, or conservative enough.
3. Do a market study. Projects that involve adding units call for some type of market study. Many marketing firms, from individual shops to major marketing firms, are highly qualified to do a marketing assessment for senior living; and a market study is not particularly expensive. For acquisitions, a market study is common if occupancy is weak. And for expansions, which depend on the potential upside, a market study is critical. A market study is less important for renovations, unless the unit mix will fundamentally change – e.g., dropping nursing from 120 beds to 60 beds and using the extra space to create 30 dementia units. Experience might indicate that the dementia market is there and 30 units are enough, but a market study would make the case.
4. Engage an architect. It’s important to engage an architect experienced in similar-size senior living projects. That said, don’t get too far along on any architectural work and payments for that work without simultaneously running the financial forecast. Organizations that are doing construction projects for the first time commonly spend too much time on design and design plans and then learn that the financial side doesn’t work. Then, without access to capital, they’re out a fair amount of dollars for the architectural work.
5. Negotiate the construction contract. The borrower must have construction estimates for the project, as evidenced by a construction contract, in order to get financing. Firming up the construction project by having a guaranteed maximum-price construction contract with a reputable contractor is particularly important prior to seeking financing but sometimes overlooked by prospective small borrowers. The contract typically includes payment and performance bonds and liquidated damages, which ensures that debt service is paid in the event of any delay. Also, in this volatile construction market, writing a five percent project contingency into the contract has become the norm.
6. Bring in a construction consultant. An owner’s rep — or construction consultant — will act as the liaison between the architect and the contractor.
7. Hire a development adviser. Somebody has to be the quarterback on the project, and some providers are skilled enough to coordinate all the tasks internally. Others feel the need to bring in a development adviser to play that role. Hiring a full-service developer is an expensive alternative that, in today’s market, is usually reserved for projects costing $25 million and up.
8. Have an investment banker on board. Add an investment banker to the team early in the process to provide expert guidance and to be a sounding board while working through the project. The investment banker does not get paid, and the feedback can be a tremendous help in determining whether the project is: a) on the right track, and b) finance worthy.
Prepared and poised for financing...
If all the preparations are complete and the project is deemed financeable, the vast majority of not-for-profits with projects costing $3 million or more will borrow in the tax-exempt bond markets. Below $3 million, particularly in a state such as New York where the tax-exempt issuing process is expensive, the borrower commonly looks to a local bank as a convenient source of capital. While those loans are not tax-exempt and the rates are higher, the local banks are usually familiar with the borrower, eager to lend, and the fees associated with the loan are lower. On the other hand, in states such as Kansas, where a lot of underwriters do small tax-exempt issues, it’s rare for people to bother with a bank loan.
Today, not-for-profit small borrowers have a multitude of financing alternatives, ranging from 100 percent fixed-rate to 100 percent floating-rate options and everything in between. The investment banker will walk the client through the full spectrum of alternatives to determine the most appropriate mix of debt based on the then-current market. "At Ziegler, we look at the cost, the expected interest rate, the expected cost of issuance, the debt-related covenants, the risk tolerance for a floating rate, and whether one wants to hedge with a swap," explains Hermann, "and then we pick the right mix."
Currently, for example, long-term fixed rates are extremely low, and floating-rate debt, including the letter of credit (LOC) fees that are required when pursuing floating rates, is actually close to the fixed rates. The vast majority of borrowers, therefore, are choosing fixed rates or a combination of fixed and floating. Two years ago, according to Hermann, half of Ziegler’s clients were choosing floating rates, because those rates were materially below the fixed rates. "But the LOC banks have been educated on the business and are as active as ever," he says, "so assuming our borrowers have truly managed their development process and made sure that the project is financeable, they have more options than ever.
Limitations on borrowed funds
Virtually everything on a new project is tax-exempt eligible except for certain working capital needs such as marketing expenditures after the new building opens. State laws may vary with respect to what’s deemed to be working capital on a new project.
The borrower must also represent that 95 percent of the tax-exempt proceeds will be spent within three years. Most small senior living expansions fall in the range of 9 to 15 months. Larger projects involving newly constructed buildings typically take 18 to 21 months.
"The vast majority of our clients have projects that fit nicely within the three-year limitation," says Hermann. "A complex renovation/remodeling or demolition/rebuilding can get a little challenging, though, so the borrower must be careful about the timeline." For bank loans, borrowers work out the drawdown with the bank.
The issuer of tax-exempt bonds must be eligible to issue bonds for senior living communities. "That’s the case in virtually all states now," he says, "but the particular requirements differ from state to state. They may require, for example, the creation of a certain number of new jobs or certain conditions in the construction contract such as meeting the prevailing wage requirements of the Davis-Bacon Act."
Funds may be used for land acquisition if the owner plans to develop the site simultaneously and not simply use the funds to bank the land, but the use of the tax-exempt bonds must be reviewed, case by case, with the bond counsel. "This is generally not an issue for small borrowers," Hermann notes, "because they usually can’t afford to buy without putting a revenue-generating facility on the property."
Once again, a not-for-profit organization should reach out to the investment banking community as early as possible to learn about the tax-exempt financing process and any specific state lending regulations. The banker knows the issuer framework in each state, which is a tremendous help to the small borrower — especially a first-time small borrower.