The SeniorCare Investor: Looming Liquidity Crisis

 
As Debt Markets Contract, M&A Market Follows

We all read the daily headlines, with well-respected economists and senior Wall Street executives saying they have never seen "it" as bad as "it" is today, that the markets are in the worst shape they have ever been in since the Great Depression, and—this is where we start to stiffen up—we are just at the tip of the iceberg and things are going to get a lot worse than they are today. While we aren’t sure about this last point, we have heard it from enough people with what can be called an intimate knowledge of what is really going on behind closed doors on Wall Street and understand just how shaky some of the recently created markets and financial products really are (such as the credit default swap market). From the sound of it, it appears that the Wall Street whiz kids (aka MIT quant jocks) got way ahead of themselves and their quantitative programs did not have built into them $140 oil and 20% year-over-year housing price declines and the subsequent surge in defaults.

While it is too late to cry over spilled milk, it is very apparent that the shrinking debt markets are having an impact on our industry in more ways than one. The most obvious, of course, is the volume of publicly announced seniors housing and care mergers and acquisitions. Deal volume hit bottom in the years 2000 through 2002, when the dollar value of publicly announced transactions ranged from $1.5 billion to $1.6 billion in each of those years, down from $8.8 billion in both 1997 and 1998. The recovery was gradual, with $2.5 billion of transactions in 2003 and increasing to $6.9 billion in 2005. The break-out year was 2006 with $22.6 billion of announced deals. This volume was more than three times the level in 2005 and more than double the annual volume in the last market peak in the late 1990s. It is likely that the record set in 2006 will last quite a while, and by 2007 activity had already dropped by 25% to $16.6 billion. As for 2008, if one of the major transactions in the market we have been writing about for the past few months does not get signed up this year, we may not even reach the low of $1.5 billion in the last down cycle. What is peculiar is that the industry fundamentals remain much better than seven years ago, despite the housing market crunch.

When looking at the transaction volume in 2008, the first quarter saw a nearly 90% plunge, compared with the first quarter of 2007, to just $376 million of announced deals, and the second quarter isn’t looking much better. Pricing, however, has held up reasonably well for the first half of the year. Based on our preliminary half-year data, the average price paid for skilled nursing facilities was just over $45,000 per bed, which represents a drop from both 2006 and 2007, but is above the years prior to 2006 and we still have the rest of 2008 to go. The average cap rate of 12.2% was just 20 basis points above 2007 full-year results (which were a record low), which tells us that the decline in the average price paid per bed was because the overall quality of nursing facilities sold had declined, and there weren’t many portfolio sales either.

In the assisted living market, the average price per unit in the first half of the year was just over $136,000, which is down from the record $159,100 set in 2007 but right in the middle of the levels in 2005 and 2006. Given market conditions and a dearth of the high-quality portfolios this year that dominated the market in the past few year, this result is not surprising. As far as cap rates are concerned, for the first half of 2008 the average assisted living cap rate was about 8.7%, or 40 basis points above the record low in 2007. By the end of the year that may rise even further depending on what happens to the credit markets.

Debt is available for transactions, or so we are told, but the cost is higher in terms of interest rates as well as terms, including a higher equity portion than in the recent bull market. If the returns on an acquisition don’t pencil out because of the financing part of it, the deal just won’t get done because so far, in most cases sellers are not willing to drop their prices because of the credit markets. The two most active lenders are probably Fannie Mae and Freddie Mac, despite their corporate problems from the residential housing mess and the potential need for a federal bailout. They just keep putting out money at rates that are quite attractive in today’s market. But what happens to the senior care market if, as part of a bailout, both agencies are forced to support the residential housing market and curtail their multifamily lending, which includes seniors housing, or stop it entirely? Not only would that be a disaster for the M&A market, the entire credit markets for seniors housing would deteriorate significantly and we are not sure who would step into the void in this environment. We are not even sure who would want to step into that void.

And now we get to the meat of the matter, or the F word, which is Fear. Liquidity and fear can go hand in hand, because as providers get more concerned about the future (fear), they have to ensure they can maintain sufficient liquidity to weather the storm, no matter how long that may be. Recent media reports indicate that we may have passed the peak in residential housing mortgage defaults, but that this is just the peak of the first wave of defaults and 2009 may be much worse than 2008 as more interest rate resets take place (at higher rates, of course) amid what may be a continually deteriorating economy. If that happens, no one really can quantify what the impact will be on seniors housing occupancy rates, other than not good. Achieving those 5% to 8% rate increases will be much more difficult, however, and combined with any further weakness in occupancy rates we could start seeing some liquidity issues.

Sunrise Senior Living (NYSE: SRZ) has already announced it will be cutting its development pipeline by up to 50% (see story on page 1) because of market conditions, and in May it financed some previously unencumbered properties with $106.7 million of debt, half of which was used to pay off bank lines and the rest, we assume, is to be used for future liquidity needs. One company that has raised some eyebrows with investors is Brookdale Senior Living (NYSE: BKD). It has already cut its dividend in half, and we may see another cut by year-end as well, which would make sense to us. But investors are wondering why, after a nearly 50% drop in its share price since the end of last year (on top of a 41% drop in 2007), and a stock buyback program in place, the company isn’t repurchasing shares at what some perceive to be incredibly cheap values? The only logical answer is that they want, and perhaps need, to maintain liquidity for what will be a difficult period over the next 12 months or more. And while that is the prudent course right now, it also has investors worried about the occupancy trends Brookdale will release the first week of August, which may be one reason why its shares have not bounced back somewhat the way shares of Emeritus Corporation (AMEX: ESC) did in the last two weeks of July.

Speaking of occupancy, Australia-based GPT Group (ASX: GPT) spooked seniors housing investors when, several weeks ago, the company revealed its forecast that occupancy at its Benchmark Assisted Living portfolio company would decline significantly in the second half of the year. Combined with some other problems, GPT has lowered its earnings forecast and its share price has dropped by half since the beginning of the year. We don’t know what GPT was basing that forecast on, other than the housing market, but since Benchmark is mainly an assisted living and Alzheimer’s company, which are supposed to be need-driven, there was fear that soft occupancy was going to spread well into the assisted living sector, and not just primarily independent living and assisted living "lite."

Liquidity is not just a concern for seniors housing companies, and as each new negative economic statistic hits the wires, there will be at least one more pessimistic lender who will pull in the reins even tighter, or pull the plug entirely. Fortunately, there is not a lot of debt maturing in the next 12 to 18 months at the major companies, and some companies, such as Capital Senior Living (NYSE: CSU), spent the past year or so refinancing debt and fixing the term and rate. Nevertheless, cash is needed for working capital, ongoing capital improvements and opportunistic acquisitions and to pay off maturing debt. The only thing worse than an illiquid company would be an illiquid industry, and that is in nobody’s interests.