The SeniorCare Investor: Senior Care Acquisition Market--
Deals Are In Hibernation Amid Market Confusion
Two months ago we made the case that the acquisition market had peaked and cap rates had hit bottom and would start to rise. There was little empirical evidence that this had occurred, and was based more on a sense that many market participants were getting nervous about where deals were being priced, who was being priced out of transactions, what the pricing was based on, where the financing was coming from and how it was often structured. Since everyone was making money, demand for the product remained strong, occupancy had been increasing for several years, monthly rates were rising and capital was abundant, there was little cause for concern. But then the credit markets constricted, and the world as we knew it changed, at least for now.
Despite the problems in the credit markets since the beginning of August, cementing the market peak in seniors housing, the average price per unit sold for assisted and independent living facilities may very well hit record levels in 2007. Based on our statistics for the first half of this year, average prices have increased significantly for both property types, well above the records set in 2005 and 2006. The market was still driven by the higher quality properties and portfolios. Average cap rates for the first six months of the year were also lower than the record lows set in 2006 for both independent and assisted living sales.
In the skilled nursing facility market, the average price per bed in the first half of the year dropped a bit from last year’s record, but was still higher than any other full year prior to 2006. Demand remains strong in this sector, especially for properties built in the past 15 to 20 years, but it is unlikely we will see cap rates declining in the future. For the first six months, the average dropped 20 basis points while the median increased 20 basis points from last year’s record lows of 12.5% and 12.3%, respectively.
The reason why we may still be at a record level of average prices paid for the full year in 2007 is because the acquisition market appears to have slipped into hibernation as if a sudden frost hit the buyers, sellers and lenders all at once. And it did. Despite one seniors housing brokerage firm with a backlog of at least 25 transactions currently under contract or letter of intent, the market in the past six weeks has been as quiet as it was in the 2001 to 2002 period when lenders disappeared amid the rash of bankruptcy filings. While bankruptcy filings are certainly not in the cards this time around, buyers and sellers appear to be in a state of mild confusion, with the bid/ask spread widening enough to make it hard to get deals done. We have heard that in several transactions the buyers "due diligenced" themselves out of the deal rather than making the mistake of paying too much, borrowing at too high a cost, or both. In any case, today’s sellers are living in yesterday’s world and today’s buyers are afraid of overpaying if they no longer have to.
So where does that leave us? First of all, it is necessary to distinguish between the big deals and the smaller ones, and by big we mean anything over $250 million, but perhaps over $500 million. While these have been the minority in terms of number of transactions, they have dominated the headlines and represent close to 75% of the actual dollar volume. If any of the billion-dollar deals that have closed so far this year (Holiday Retirement and Genesis HealthCare) or soon will be closed (Manor Care: NYSE: HCR), had come to market after August 1, there is close to certainty that their pricing would have been lower, certainty that the cost of debt would have been higher and some uncertainty whether the debt would have even been available.
In the case of Manor Care, with the banks trying to syndicate more than $4.5 billion of total debt, we assume that the paper loss on the unsold debt has to total at least $250 million for the three banks that made the commitment prior to the market collapse. In the case of one of them, Credit Suisse, the fallout has been the closing of the bank’s entire health care real estate finance and securitization group and the dismissal of the employees. We assume that someone in senior management decided that their basic business had dried up for at least the next year or two, but Wall Street has a way of responding very quickly to problems, and losses, by laying people off.
One Wall Street competitor was quite disturbed by the news, because it doesn’t bode well for the rest of the industry. It has to be understood, however, that Credit Suisse focused on the mega-deals, having financed the Mariner Health acquisition a few years ago ($918.6 million of CMBS debt), as well as the Beverly Enterprises acquisition last year ($1.4 billion of debt) and its participation in the current Manor Care deal, which is still expected to close, but you never know. The point is that, at least for now, these deals are a thing of the past. While that may not make much of a difference for the average buyer or seller in the market, these deals (and others like them), and the capital provided to complete them, were in many ways responsible for the bull market in seniors housing, the declining cap rates and a much-changed market perception of risk and expected return. Their absence will, in the reverse, change the direction of cap rates as well as the market perception of risk and expected return. It’s not necessarily a bad thing, but more on that later.
Most people are in agreement that the very large deals are temporarily a thing of the past, but that may have happened without the summer’s credit market disruption anyway because most of the targets are already gone, with an exception or two (without sounding redundant, more on that later, too). What is unclear is whether the smaller portfolios, but those at the high-end of the market, will take themselves out of the market because of pricing uncertainty. As of today, from what we are hearing cap rates for assisted and independent living are up at least 50 basis points from earlier this year, but no one really knows because of the dearth of deals to base that on. It is basically an assumption as a result of the cost of capital going up, as debt spreads have increased by 50 basis points and more, depending on the type of loan.
CLW Health Care Services Group completed a survey with 68 respondents (53% were owners/operators), and 75% believed that recent events impacted cap rates. Of those, 50% believe cap rates have increased by 25 to 50 basis points, while 24% think the new level is an increase of 75 basis points or more. A little more than half of the respondents believe that current market conditions are temporary, while the rest believe it will be an ongoing trend. When determining value in the acquisition market, 65% said they will use trailing net operating income while 35% will use projected net operating income. Six months ago these were probably reversed.
The high-end properties and portfolios that do come to market in the next 12 months will still get premium pricing, but a premium over what? Any premiums will be in the context of a market with higher cap rates and perhaps fewer buyers. Consequently, we expect to see average per-unit prices in 2008 to decline from the 2005 - 2007 levels, based on higher cap rates and lower quality properties, in general, sold. There will still be those $300,000 per unit or higher transactions, but they just won’t be very common. In the nursing facility sector, even though cap rates declined to record lows, there is less of an expectation that pricing will get whacked as much. With an average 12.5% cap rate last year, there is still plenty of room for attractive returns with interest rates as low as they are.
The bottom line is that while the credit markets had a bit of a meltdown this summer (to put it mildly), the seniors housing and care market is going through what we believe will be a much-needed market correction. While this may be mildly painful to some in the short term, in the long term it will benefit the industry and bring more stability. If prices continued to soar, the risk of not performing would have increased, and the punishment would have been more severe. Plus, many strategic buyers have grumbled that they were often priced out of the market by financial buyers, and in almost any industry when strategic buyers don’t understand how financial buyers can pay that price, there is usually a disconnect between perceived business risk and actual risk. Not always, as there are obviously some acquisitions that are way too large for strategic buyers to contemplate, but enough times for some concern. The result is that strategic buyers may be able to take a new look at the market and pay what they believe is a fair price, not one dictated by the capital markets. This will be healthy for everyone except, perhaps, the bankers at Credit Suisse. But they will be back.
In the meantime, the acquisition market almost came to a halt in September. We know of some deals that just got delayed for a variety of reasons, but the past month was unusually quiet. Small deals should not be impacted by what happened in the credit markets, other than a slightly higher borrowing cost, but it is eerily reminiscent of five years ago, but for very different reasons. The mood at the recent NIC Conference was cautiously upbeat, with operators mostly happy with how things were going, but the big lenders more nervous about the future.