Senior Living Business: Dealing With The Increasing Odds Of Default--

Transparency Can Mitigate Much Of The Stakeholder Blowback


Of the 1,861 CCRCs operating in this country as of July this year (based on recent reporting from Ziegler Capital Markets), the number of communities known to be in payment default or to have filed for bankruptcy is relatively few. Collapsing housing values, the primary impetus for the financial uncertainty over the last year or so, appear to be leveling off, if not improving. And as a result, CCRC occupancy levels are creeping back up.

Nevertheless, the odds of default are still increasing for a number of providers. According to Attorney Elizabeth McKennon, a senior partner at McKennon Shelton & Henn, LLP, in Baltimore, Maryland, providers have been caught up in a perfect storm: the collapse of the real estate market, creating a situation or perception that prospective residents cannot sell their homes and move into a CCRC; the concomitant downturn in the stock market, resulting in prospective residents losing a good portion of their net worth; and, in many cases, the CCRC itself losing a significant portion of its invested funds, resulting in less flexibility to respond to the reduced number of new entrance fees.

"Facilities such as the Erickson communities that were in the fill-up stage of development were hit particularly hard," McKennon stated, "whereas established facilities are encountering technical default issues associated with meeting their bond covenants—which are actually much more manageable situations."

Dan Gray, President of Continuum Development Services in Signal Mountain, Tennessee, agrees with the "perfect storm" description but describes it slightly differently. "For years, not-for-profits have tolerated significant operational shortfalls that they covered with investment income and donations to their foundations," he said. "They focused on ensuring quality but not on financial stability, because they were carrying 350 days cash on hand." Gray views the "triple whammy" this way: 

1.Organizations had to reposition their investment portfolios and, as a result, experienced significant realized losses that count against debt service coverage.

2. For many communities, donations to their foundations—and the value of those donations—have declined.

3. Despite the extremely creative marketing moves undertaken by some communities, the housing crisis has virtually closed the front doors of many CCRCs.

The underlying situation that has brought the three legs of this perfect storm to a critical point is simply that not-for-profit CCRCs have not been operating efficiently, according to Gray. They raised monthly fees for new residents but were reluctant to raise them for current residents, whom they are actually more likely to retain. They didn’t increase entrance fees significantly and are now in the difficult position of having to discount those fees to attract new residents. They haven’t managed their human resources effectively in terms of better scheduling, limiting overtime, reducing turnover, and limiting agency use in the health-care setting. They overlooked all those inefficiencies and now are finding them very difficult to handle in today’s economic environment.

It is extremely important for stakeholders to have confidence in management’s ability to handle any problems that arise, and ongoing communication is an effective way to reassure them. Well-managed CCRCs, along with their investment bankers, conduct regular quarterly conference calls for their investors that are based on the financial reports for the immediately preceding quarter. Beyond those regular updates, any extraordinary financial event should be communicated right away—certainly prior to an actual covenant violation. The key, though, is to talk to investors while the organization is still healthy. And as problems arise, talk more often and in greater detail.

"The earlier you communicate any problem, the better," added McKennon, "and that means to all constituencies—the board, the bondholders, the residents, and any state regulators. If you proactively explain what you’re doing to solve a problem, you’re more likely to instill confidence in your ability to deal with the situation." The good news is that, in this current economic climate, CCRCs are not the only organizations having problems, so bondholders are not inordinately surprised when problems arise.

Avoiding technical defaults
A technical default occurs when a covenant other than one requiring the repayment of interest or principal is violated. About one-third to one-half of the recent covenant violations that Gray currently sees in his consulting practice are technical defaults, up from about 25% a year ago.

Basically, a technical default is "a hiccup," according to McKennon. "Facilities with fixed-rate, tax-exempt bonds that were financed commercially with private banking arrangements usually can work out an arrangement with the banker that may be as simple as a waiver or an increase in the interest rate or fees. Facilities that don’t have private bank financing and fail to meet a covenant will usually be all right if they follow the recommendations detailed in the required management consultant’s report."

Operating measures such as debt-service coverage, occupancy levels, marketing efforts, and days cash on hand are used to evaluate trends and to send a signal to the board, management, and creditors that the business is either doing well or a problem could occur down the road. The basic bond covenant structure sets up a hierarchy of procedures that must be followed in order to correct a problem before it becomes a default event. When a covenant is missed, the organization is required to call in an approved management consultant to analyze the situation and prepare a report explaining why the default occurred and what needs to be done in order to correct it. In most cases, the board and management are required to follow the recommendations of the consultant and correct the problem(s) within a given a period of time.

Some facilities that realize they might fail a covenant act proactively, electing to hire a consultant early to do a full-blown operational review while they focus on repositioning their equity investments in safer fixed-interest bonds and get potential realized losses off the books. The resulting consultant’s report can then explain to investors that the organization’s only difficulty—the downturn in the stock market—has been addressed.

Keep in mind, however, that the consultant hired to do the work early must be approved by the bond trustee and, if one exists, the letter of credit bank to ensure that the report generated is in compliance with the management consultant report required in the bond covenant documents.

Problems with an operating covenant typically do not result in default, as long as the community follows the procedures recommended in the bond documents, according to Walter A. (Skip) Frey, III, Managing Director of the Senior Living Finance Group at Raymond James & Associates, Inc., in St. Petersburg, Florida.

"Bondholders, other creditors, and residents usually react favorably to early notice of any possible financial or covenant problem," he observed. The logical point to communicate bad news, though, is when management and the board are fairly sure that a problem is likely, have had a chance to analyze and understand it, and have at least begun to identify plans for mitigation. Ongoing forecasting, he suggests, is a useful tool that can help management spot a trend or problem long before it occurs.

"Organizations generally get into actual financial default when they miss a debt-service payment," he continued, "or when they call upon the debt-service reserve fund to make a payment under the bond. In the last couple of years, management and boards of CCRCs have taken a much more businesslike approach to managing operations by putting a stronger focus on the bottom line. They’ve made major adjustments that have substantially increased their operating margins without affecting the quality of life for residents."

For new projects or expansions, there’s an emphasis on ensuring sufficient operating reserves—not based on the feasibility study for the project but on what might happen if there’s a slow fill up or reduced occupancy. And down the road, the risk of financial default should be reduced through the tightened credit standards of the capital markets, improved covenant structures, required liquidity support agreements and other outside credit support where that’s available.

Entrance-fee refunds—disclosing the reality
With high investment returns and a more-than-healthy real estate market that ensured a continuing supply of new prospects, that scenario worked just fine. When investment portfolios lost so much of their value, however, providers began to realize that perhaps they should have set those entrance fees aside in some sort of reserve fund.

It’s unlikely that a CCRC could or would ever guarantee an entrance-fee refund, under any circumstances and at any time, and still function financially. The fee structure would become unaffordable for residents, and financing the project in the capital markets would become extremely difficult if not impossible. For their part, residents need to understand that an entrance fee is a type of investment and that there’s really no way to eliminate all investment risk—especially risk related to the market conditions we’ve experienced in the last year or two.

Yet refundable entrance fees continue to be an important marketing strategy for CCRCs, and providers certainly imply that a refund is guaranteed. "That really is not right," said McKennon. "At a minimum, facilities should disclose to people moving in that they can expect to get a refund but, like any other real estate investment, it’s always possible that they won’t."

Also, few contracts address the procedure if the resale value of a vacated unit is significantly less than the unit’s original value. If the contract obligates the provider to refund 90% of the entrance fee, for example, that percentage will be applied to the current value of the unit. This situation has not been a problem historically but certainly is happening in today’s depressed housing market. The point, however, is full disclosure.

Frey predicts that future contracts will include more specific language regarding entrance-fee refunds. "In all their communications with current and prospective residents on this subject, whether written or oral, it is important for CCRCs to disclose that there is risk involved with entrance fees, what the community would do to mitigate the potential loss of the refund in the event that risk occurs, and that there are circumstances under which a refund may not be possible at all," he said.

For new projects, some states require entrance-fee deposits to be held in escrow until the facility opens. In other states, they are treated similar to deposits on a condo under construction; if the developer goes bankrupt, the deposit is lost. Some might argue, of course, that vacating residents of CCRCs (or their heirs) are no worse off than if they bought a condo at the top of the market and the value was lower upon resale.

Nevertheless, a lot of states are thinking about establishing or updating regulations. "In Maryland, for example, regulators are considering ways to modify the state’s current regulatory scheme," said McKennon. "The first thought is to require all entrance fees to be escrowed; but in states with that requirement, entrance-fee CCRCs are not economically viable. So instead, regulators might consider requiring facilities to maintain a certain amount of cash to help sustain operations and provide flexibility."

Happily, bankruptcy is rare
It’s almost never in the interest of those holding the debt to place an existing CCRC into bankruptcy, because there’s usually such a huge discrepancy that exists between the value of the facility’s assets and the amount of its debt. Even secured lenders often don’t get paid in full.

"Normally, one very common criteria for lending requires a certain loan-to-value ratio, generally not more than 80% of the value of the underlying asset," McKennon explained. "In the case of CCRCs, where the cost of construction might be $40-50 million, the borrowing will amount to $60-70 million or more—100% financing that also includes interest during construction. So from Day 1, there’s a negative net worth that may last for years."

That scenario hasn’t been a problem as long as new revenues (entrance fees) continue to come in to pay for debt service and operations. But when the tide turns, as it did during the last 18 months, a very strong incentive to work something out still exists among the bondholders. By working out an arrangement outside of bankruptcy, creditors usually get more for their dollar.

"As it turns out, there have been really relatively few bankruptcies in the industry," McKennon added, "and even those that have occurred were resolved without harm to the residents. Very few lost their entrance fees—and those that did were situations where the facility never really got off the ground. So if CCRCs can withstand this current economic cycle, that’s a sign that maybe the model isn’t so bad."  

The expectation that entrance-fee refunds would always be available, because units would always resell at a higher price than residents originally paid, is now causing difficulties for many organizations. Under a number of contracts currently in place, the CCRC is not required to refund entrance fees when a resident moves through the continuum but only when the person leaves the facility altogether. So providers commonly re-let the apartment and apply the entrance-fee funds to other uses (e.g., investments or operations) until the money is refunded.