Senior Living Business: Perspectives On The Tax-Exempt Bond Market--

Bankers See Issues Coming To Market And Investors Ready To Buy

The scarcity of new capital has made the past 14 months difficult for not-for-profit senior living providers, many of whom have also had to devote a tremendous amount of resources to maintaining their existing debt. “A lot of organizations have experienced technical covenant violations,” observed T. Brian Pollard, Senior Managing Director of Lancaster Pollard & Co. “And there has been a lack of marketability for many of the letter-of-credit (LOC) banks that support senior living bond transactions. We’ve closed about a half-dozen deals this year, but it takes an exceptional credit profile for a bank to agree to issue an LOC; and the pricing is probably 200% of what it was before the financial meltdown.”

In fact, the comparative volume of senior living tax-exempt debt in recent months and years is both startling and fascinating:

                       2007     2008     2009

Jan-Jun              -        $1.4B    $0.4B
Jan-Oct              -        $2.2B    $0.9B
Jan-Dec          $7.4B     $2.5B    $2.0B

2007 was a record year.
Volume dropped precipitously in 4Q 2008.
Volume in 3Q 2009 nearly matched 1H 2009.
Jan-Dec 2009 volume is estimated.

But there’s light at the end of the tunnel. Some capital has been available to strong providers—primarily organizations with an investment-grade rating (BBB or better)—for renovations and moderate expansions, but those who have successfully secured new development funding have had to be especially creative—working with nontraditional funding mechanisms such as community banks with FHLB wraps, for example, and with various government insurance programs through the FHA. The temporary increase in the bank-qualification rule, part of the federal stimulus plan, has also helped.

A glimmer of hope
The demand for tax-exempt bonds was virtually nonexistent for the senior living sector through the second quarter and much of the third quarter of this year but is starting to pick up for strong organizations. “We saw some movement beginning in August,” said Pollard. “For the non-rated or less strong organizations, demand continues to be relatively weak unless the deal has some compelling qualitative attributes.”

For those organizations that have focused on operations, those improvements should pay dividends for them as the economy rebounds. Also, many of the larger not-for-profit communities with sizable investments have seen a significant improvement in their balance sheet liquidity since March, when the stock market hit bottom. All that improves the credit characteristics of the organization and will make its debt more marketable down the road.

One headwind that investors have to negotiate is the high number of distressed properties, according to Pollard. “At least 10 not-for-profit CCRCs have defaulted in the last several months,” he noted, “and the recent troubles at Erickson, whose complex structure involved not-for-profit entities, could impact an estimated half-billion dollars worth of tax-exempt debt. That could curtail the appetite for buying more tax-exempt debt by institutional investors that take a rather significant hit on those investments.”

So there’s a glimmer of hope, but considerably less financing than in a typical year. “Once the banking sector returns to some sense of normalcy and banks are willing to start credit-enhancing more deals, I think we’ll see a lot of activity,” Pollard said. “We have been able to get credit enhancement for strong non-rated organizations, and that has sold very well on the market; but non-rated organizations are still paying a very large credit spread to get tax-exempt debt sold on their behalf. So high-grade debt, whether it’s credit-enhanced or issued on an investment-grade organization, is getting sold at relatively reasonable levels.”

Dealing with a bifurcated market
Big banks that got caught up in developer-driven projects are now holding huge amounts of troubled credit, and that has bifurcated the market, according to Bill Pomeranz, Managing Director of Cain Brothers in San Francisco. Those major players in the banking industry have hundreds of millions of dollars to work off and now are in the market only on a very selective basis. “Unrated debt seems to be available for the upper half of the market,” he said, “and traditional construction loans are available for expansions. But national banks are unpredictable from region to region. They may be willing to do a deal in Michigan but not in California, for example.”

The active banks tend to be regional banks that are interested in relatively solid community providers with multiple lines of business—particularly CCRCs with considerable assisted living and skilled nursing, because they generate more revenue. And if the organization can show a good or improving balance sheet, that it has completed successful projects in the past, and that occupancy never took a huge hit, that’s even better. “A key factor, though, is the relationship of entrance fees to local housing prices,” Pomeranz said. “If the fees are above the new normal for housing prices, that’s a negative. Also, regional banks usually limit their deals to $25-30 million, forcing providers to phase larger projects.” And the banks expect borrowers to turn over their commercial business in exchange for providing the credit.

“At first, investors were just chasing the yield and didn’t distinguish between good credits and bad,” he added. “Since mid-October, they appear to be more discerning about high-risk or speculative financing vs. more manageable-risk financing such as an existing community doing an appropriate expansion. So while the market is still very tough, I’m actually heartened by the better banking that’s going on.”

Understanding market drivers
As interest rates on tax-exempt bonds went down from January 2009 through the end of September, market liquidity went up, according to William B. Sims, CEO of Herbert J. Sims & Co. Then, interest rates began to increase in the last few weeks of October, but the money isn’t flowing into the bond funds as it did over the summer. Nevertheless, Sims believes the tax-exempt bond market is much better than it was a year ago.

“The senior living industry has held up very well relative to other industries,” he said. “A lot of projects that were put on hold because of market conditions are now queued up and ready to go. In the longer run, as the real estate market stabilizes, we will see more activity. The difference going forward will be that the credit criteria will be stiffer than it used to be, and I expect that will continue for a long time. So the credit quality of new bond issues will be much higher than in the past.”

So what’s driving the market? The tax-exempt bond market’s appeal to investors relative to other markets continues to grow. As taxes increase, tax-free income will become more valuable. The equity market, while it has recovered quite a bit, is still a rather scary place to invest. And as the huge population of baby boomers gets older and their investments become more conservative, they’re more likely to buy tax-exempt bonds than equity. “All of those things bode well for the not-for-profit senior living industry relative to the for-profit side and to other credit markets,” Sims said.

Focus on fixed-rate debt
The availability of capital for variable-rate debt has been dramatically reduced to 10-20% of the level in fall 2008, according to Dan Hermann, Senior Managing Partner at Ziegler Capital Markets. He expects that volume to gradually increase over time but suggests it may never get back to previous levels. “People will pursue variable-rate debt very judiciously and selectively,” he said. “While floaters have been productive economically, we warn our clients about the risk—not the variable-rate risk as much as the uncertainty about many financial institutions. Unless the borrower has significant cash reserves to sustain the risk, we recommend having a portion of the capital structure in fixed-rate debt, especially for large amounts of long-term debt.”

Fixed-rate fiancing has been available since the beginning of the second quarter 2009, but borrowers weren’t willing to accept the high interest rates. Once the dust settled from the markets crashing, construction costs came down considerably—from 3-5% on the low end to 15-20% on the high end. Borrowers could then afford interest rates in the 7-8% range, since they were looking for less debt and didn’t need an LOC enhancement, and pending projects began to move forward. That created a dramatic improvement in the fixed-rate market in the third quarter.

“We saw levels rated A to BBB drop a full point and unrated levels come down 1.5 to 2 points,” said Herman. “That, combined with the uncertainty surrounding some financial institutions, caused many borrowers to reduce their exposure by replacing some of their floating-rate LOC bank debt with fixed-rate debt.”

By the close of 2009, Ziegler expects to bring to market 15 fixed-rate issues—for both new campuses and expansions—with a total value of approximately $1 billion. All the projects in the queue were planned for years but put on hold because of the tight credit markets. One of those, The Stayton at Museum Way in Fort Worth, a new SQLC campus, was about 60% presold when the economy began to fall apart in late 2008. The project was put on the back burner, but preselling continued. When it went to market this month, it was 75% sold. The $165 million financing is expected to be the biggest deal of the year in senior living.

“Folks that were well beyond planning and were into presales by the beginning of last year had three choices,” Hermann explained. “They could continue on, postpone, or cancel the project altogether. About two-thirds of the projects that were at least 25-30% sold and getting a good response continued, and those are coming to market now. Projects that hadn’t begun presales waited to see, and some of those are now preselling. Those that either didn’t get a good initial response or didn’t have sufficient seed capital to deal with the extended premarketing time cancelled.”

Add to that activity about $300 million in refinancings, principally LOC replacements at major rated systems, coming on stream. “There are markets for those, because it’s all fixed-rate debt,” Hermann said.

Ziegler has projected a total volume of at least $2 billion in not-for-profit senior living financings for 2009—which works out to more than $1 billion expected in the fourth quarter alone (see chart above). “We were conservative in our projection,” Herman noted. “If we get all our planned deals done and our competitors get their deals done, the total for the year might even exceed our projection. The key has been the opening up of the fixed-rate market, because it’s an attractive investment at current levels. Investors will buy high-quality senior living or health care in the sixes, sevens, or eights. And the expectation that taxes will increase has also fueled the tax-exempt market.”

So the tax-exempt market is absolutely open. Interest rates coming down have brought more issuers to the market, and the market is holding. “Deals are getting done,” Hermann said.