EXPERT OPINION: A Conversation with Dan Hermann
February 17, 2013
In this "Expert Opinion" interview, Dan Hermann, Senior Managing Director and Head of Investment Banking, Ziegler, discusses CCRCs, differences in the current economy and 2008's recession, the interest rate market, bonds, and more....
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Daniel Hermann joined Ziegler in 1987 and is the head of Ziegler’s investment banking practice and a member of the Board of Directors. In addition, he directly manages Ziegler’s senior living practice nationwide. During his tenure Dan has become a leading investment banker in the senior living industry and has far-ranging experience in the management, structuring and financial analysis of every type of senior living financing. In his 25 years with Ziegler, Dan has structured and managed more than 185 senior living financings exceeding $5 billion. He has utilized his expertise to create financing structures for a large clientele — from stand-alone nursing homes to multi-facility, multi-state systems including start-up campuses, and campuses undergoing major renovation projects. He has previously been named to the Contemporary Long Term Care 2005 CLTC Power & Influence Top 25 listing, the magazine’s selection of today’s decision makers “who hold the reins and help shape the path” for senior living. Dan has lectured at Harvard and internationally on senior living finance (its historical trends, strategic positioning issues, growth potential and other), served as a member of the CARF-Continuing Care Accreditation Commission’s Financial Advisory Panel.
Daniel J. Hermann
Senior Managing Director
Head of Investment Banking
200 South Wacker Drive
Chicago, IL 60606
P: 312 596 1509
F: 312 263 5217
M: 312 623 9588
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The CCRC market is on its way of coming out of its doldrums of the Great Recession. I'm sitting here with Dan Hermann, he's the senior managing director and head of investment banking at Ziegler. He has probably underwritten more CCRC projects than anyone in the country.
With the collapse of the housing market, it was a bit of a rocky road for some CCRCs, especially some that were still in fill-up or were just opening up when the recession hit. How much better or more stable is the CCRC market today?
Steve, it's much more stable today than, obviously it was in 2008 by a large factor. Folks have been working very, very hard to fill up around the country. There are a number of high quality marketing firms in this sector and many of our clients have reached out to those folks or, if they happen to be multi-facility systems, they might have a pretty deep marketing department. They've been using a number of tactics, marketing tactics, sales tactics, sales training efforts to put themselves in a position of marketing to today’s senior. There have been a lot of programs around home sales and home staging to facilitate the senior moving in.
So we've seen average occupancy continue to grow around the country. There's no question there were a number that were in a challenged state coming out of the 2008-2009 financial crisis.
Some bond investors back then took some sizeable losses on some defaulted projects. But we've seen, in the last 12, 18 months, a lot of new developments on the not-for-profit side, the CCRC market, some in the $100 million or more area. Is all forgotten with the bond investors in terms of four years ago?
No, not all's forgotten. It's clearly a lesson learned. But the sector had been very rewarding for the high yield investor, both institutional and retail, for years, recognizing they could buy the debt of quality not-for-profit organizations that were in the senior living space, both CCRC and otherwise. These organizations ranged from large multi-facility systems down to single-site organizations.
There were a number of defaults in this sector. Some of those were unenhanced bonds and some of those were LOC-backed bonds. Investors understand what caused those. They looked and reported back to us or asked us to correct or try and adjust our underwriting to address that and a lot of it has to do with liquidity to get through longer fills, and we've done that.
When they looked at their overall portfolios, they generally fared well from a long-run perspective and in the high yield market, the high yield mutual funds have anywhere from 5 to 20%, usually around 10% for the typical high yield fund, in the not-for-profit senior living space. Relative to other high yield spaces, this actually performed overall very well. Most owned multiple names, so while they didn't appreciate the defaults, the recovery rates have been reasonable, although some were poor, and blended together with everything they owned in the portfolio. They will tell us their senior living portfolio actually performed relatively well compared to other high yield spaces, which include land deals which didn't perform well at all, the healthcare sector, tobacco bonds and so on.
So that's why they're coming back into the market, as the CCRC market starts ramping up again. They're, like, hey, it wasn't as bad as it seemed.
It wasn't as bad and the merits of the quality providers—so, there definitely was a lot of news around certain defaults, no question about that. There's numerous quality providers that have performed very well and a typical investor, again, might have 15, 20, 25, 50, 75 different names in the portfolio. And the majority of those have performed well and rewarded them in their high yield funds.
Some of these new bonds, the bond amounts are $500, $600,000 per unit, what happens if we have another big shot to the economy, another major housing market downturn, if we have the Decade of Japan this decade?
Right. "Post-crisis"—we use that phrase a lot, so coming out of Spring of 2009, the question was, what modifications to the underwriting of new campuses? So, isolated, new campuses, whether it was a multi-facility provider or a new single site. Although, let me say that prior to the crisis, the vast majority of developments were by existing sponsors. But then you had some religious orders, some universities and some hospitals. But the vast majority were existing senior living providers.
Post-crisis, it's essentially all existing senior living providers growing, going forward. So that's one of the modifications that you're generally going to see, it's going to be the existing providers deciding to grow.
Secondly, collectively by the sponsors, the developers and the underwriters said we need more liquidity to allow for a longer fill period. If you looked at the average fill periods, it had been 24 months. That allowed room for a short recession, but not a one-year recession. If you look at the new campuses that have been financed post-crisis, the average fill period is 36 months. And that's basically budgeting for a recession, or planning for it, because they're also 70 to 75% presold. If you follow the old fill patterns of 24 months, you'd have substantial liquidity left over from planning for a 36-month fill.
In addition, additional working capital has been set aside. And then the operating reserve fund, which is meant to be an additional reserve, was expanded and the replenishment features of that operating reserve are more expanded. So, in the stress testing that we did at Ziegler, these new campuses could literally afford a five-year fill without even tapping the operating or reserve fund.
And, in addition to that, there's a marketed underwriting requirement of a liquidity support feature from these sponsors backstopping the working capital fund, the operating reserve fund, to provide that worst-case liquidity in the event of a recession and those liquidity reserves have ranged from $3-to-$10 million. On a typical $100 million issue that you mentioned, it would typically be about $5 million. That's being put up by the sponsor and held in an account or set aside on their balance sheet in a special reserve.
So, much more of a conservative structure, which is good. Now, when CCRC's work, they really work.
They really work, they're really popular. During the Great Recession, even some of the good ones stayed at 95%-plus occupancy, which surprised a lot of people. For a new development, what makes for a good or successful CCRC in today's market?
It's what everyone wants in any type of good development, any type of real estate development, a great location in a good market. So you're able to get positioned where there's adequate to a substantial number of age-and-income-qualified seniors. And so finding a parcel that fits that is difficult. Some really successful ones have been replacements of old hospitals in first- and second-ring suburbs, where it's logical to zone them for senior living. Those have really done well.
But then let me back up to the sponsor. Having a high quality, committed, not-for-profit sponsor is the number one attribute of the good projects. That understands the business, that wants to be in the business and are committed to seeing the project through with either, if they're developing it themselves or with their various development advisors and partners. Then you add in a good market. And then the underwriting structure that allows for the liquidity to see through an extended fill, in fact, if we have a recession.
And, as you said, most CCRCs are full. If you study them in history, and in fact, the average before the crisis was 94 to 95%. That meant half of those were above 95%. Today, the average in the country, especially if you focus on the not-for-profit providers, is about 90%.
They've offset that 5% drop, and it had been a 7% drop, so they've made up about 20 to 30% of the lost ILU occupancy. But they also made up the revenues on the healthcare side. So the good CCRCs today also have vibrant—when I say "healthcare," healthcare businesses that include nursing, assisted living, memory support, possibly even some home- and community-based businesses or services, and they've generated meaningful additional revenue from that to offset the drop in the independent living revenue.
So, if we measure by ratings, the average bond rating has not dropped. There have been an equal number of upgrades to downgrades since the crisis. In fact, here's a stat you and I haven't talked about. Of the 1,900 CCRCs in the country, about 1,500 are not-for-profit. Many of those are in multi-facility systems. There are about 150 rated senior living organizations—not all of those are CCRC. But when you do the math for how many CCRCs are within a system that have rated debt, plus the single-site rated CCRCs, about 400 of the 1,500 have a bond rating. So we're up to over 25% that, where their debt is rated.
That's not bad. So, a lot of people have been critical of the not-for-profit model, myself included, of not having enough equity. So, basically you're saying with how you are now structuring these deals, with the liquidity support agreements and everything else, basically the need to have that kind of equity, cash equity backstop is, I don't want to say gone, but it's been significantly mitigated.
Correct. Prior to the crisis, the model was premised around the preselling to subjects—the range has been 65% to 75% for 30 years, with 70 as the midpoint, executing properly on construction, on time and on budget. That came under strain in the '05 to '07 period in the United States, where a handful of these projects actually went over their contingencies for a number of different reasons. But assume that a lot of time and effort that gets put into executing on time and on budget, then the intent is to fill ahead of plan, collect entry fees and pay down temporary debt, leaving the asset with permanent debt that's somewhere between 40 and 75% of debt-to-asset value, clearly you still have your entry fee liability, so the model's premised on staying full—that model has worked for years, assuming you have adequate liquidity to fill in a backstop if fill-up goes longer than expected. And today's backstops are essentially belt, suspendered and bootstrapped to literally allow for up to a seven-year fill. On our end, we both did stress-testing, feasibility consultants did stress-testing, developer, sponsor and the investors. We have a number of investors that ask for special sensitivity analyses to look at different slow fills, if we had a different recession or if we had another recession.
2010 was probably not a great year for the bond market. 2011, you started seeing a lot more activity. I've been seeing a lot more; in 2012 did you outpace 2011?
Absolutely, because the long-term interest rate market is excellent right now, so the market has tailwinds behind it. So, Ziegler will end up doing a billion and a quarter of not-for-profit public debt.
Not-for-profit senior housing. We'll do another $250 million of FHA-related debt on the for-profit side. But on our not-for-profit side, we'll probably do $750…somewhere between a half a billion and a billion, probably $750 million of bank-related activity that's not showing up as public debt. So, essentially, $2 billion of senior living activity, which is about half of the market.
What's your forecast for your not-for-profit senior housing tax-exempt debt for this year? It should be a big pipeline.
Big pipeline, should be about the same. Interest rates are exceptionally attractive, so a lot of these providers, many of them are multi-facility with large portfolios, have been replacing or reducing their variable rate exposure with fixed-rate debt that ranges from right now, 4.25%, if you're in the A category, average rate; up to 6% if you're a moderate, unrated—but let's just call it with an average of 5% for the whole industry. That's phenomenally attractive to eliminate the risk associated with variable rate debt or with the bank, the risk of the bank market, future regulation and possible downgrade of banks.
Now, for our bank friends out there, we work with dozens of banks around the country and they continue to get up to speed on the sector, so there's plenty of opportunity for them. But prior to this fixed rate movement, I'd say the industry probably had, say, 60% fixed and 40% bank, if you looked across the whole not-for-profit industry. And in this fixed-rate wave, it's probably shifted to 75-25.
Well, I think low rates are definitely helping stability and capital costs for the not-for-profit world. Good luck this year and hope we'll see a lot of successful projects.
Great. Thanks, Steve.