Peak, Plateau or More? - A Bipolar Market Tries To Figure Out What’s Next

It is generally agreed that the entire senior care market hit rock bottom in 2003, most likely in the summer, after overbuilding and over-leverage almost killed the assisted living industry, and reimbursement changes coupled with unsustainable acquisition pricing wiped out most of the public equity value in the skilled nursing sector in the previous three years or so. While investors and operators rummaged around the bottom during 2003, people began to realize that the worst was behind them and, more importantly, the fundamentals were actually quite strong. Combined with declining interest rates, an investment market flush with cash and returns in general, but for real estate investments in particular, dropping, the table was set for a robust rally in senior care.

After the bottom was reached, it took a while to build up some investment momentum, but by 2004 the market rally took off and it hasn’t taken a rest since then (perhaps). Asset prices are at record high levels, cap rates are at historically low levels, public equity prices are up with some very high earnings multiples, and there is more institutional equity in the market looking at properties, especially portfolios, than at any time in the past….ever. One thing this has done is make everyone who has invested in almost anything in the past three years look very smart, not to mention very wealthy. The question we posed to the panelists in our audio conference (Are We Hitting The Peak?) last month was, Will it last, and if so, for how long, and if not, what would cause the weakness? In other words, have we reached a peak and how will we know?

Regarding the assisted and independent living markets, the panelists believed we will be in a stable period for a while, with little or no decrease in cap rates from current levels, with one panelist stating that assisted living had peaked and another believing there was still some room to go. In the skilled nursing side of the business, it was nearly unanimous that there still was room for upward movement in values (and corresponding downward movement in cap rates), as investors are finding the potential returns there attractive in this market environment.

In our mid-year look at the acquisition market, we found that for the first half of 2006 skilled nursing per-bed prices, both the average and the median, had topped the high set in 2004 for the average and 2005 for the median, and this does not include the complicated (with a variety of assets and terms) Tandem Healthcare sale and the GE Healthcare Financial Services purchase of Formation Capital’s six SNF portfolios at values well above any previous yearly high in the market. In addition, average skilled nursing cap rates so far this year have dropped by more than 100 basis points from the 13.3% average in 2005, and may be heading even lower.

In the assisted living market this year, average per-unit prices have dropped significantly, not because of a deterioration in the market, but because we are not seeing the large supply of high-quality facilities and portfolios that came on the market in late 2004 and into 2005. Despite the lower volume, average cap rates have appeared to drop by 40 to 50 basis points from the record low of 9.7% set in 2005. While a lot of people talk about a 7.0% to 8.0% market cap rate environment for assisted living (and even lower), this is usually associated with the higher-end properties or portfolios, and the B and C properties are usually (but not always) above that level, bringing the average up.

There is no question that the senior care market is hot right now, as evidenced by the fact that in the first six months of 2006 there were 12 announced acquisitions of senior care assets worth a total of more than $10.3 billion. This is more than any full year for all announced transactions, ever, and we may reach $15 billion by the end of the year. That demonstrates the high demand in the market, but it is doubtful the supply will be able to keep up.

The atmosphere and state of the industry at the recent NIC Conference was characterized by Jefferies & Co. analyst Frank Morgan as "rationally exuberant," and while we agree, we also suspect that a bipolar diagnosis could be made as well. Obviously, everyone is exuberant that the industry is performing so well, but in the corridors and meeting rooms there was also a certain level of nervousness about the prices being paid, the implied cap rates and when it will all end. We were hard pressed to find someone who thought it was going to get even better than this current environment; but we were almost equally as hard pressed to find someone who would predict the end of the party. That tells us that while "last call" may have been announced, no one is getting ready to leave the party. And for rational reasons.

In the assisted and independent living arena, occupancy rates continue to rise, rental rates are increasing anywhere from 5% to 10%, and cash flow is increasing at the facility level and for the larger corporations. All of this should mean that the development market is poised to start heating up, but this is not the case, which causes our feeling of rational exuberance to move up a bit. And, many operators have stated that they would welcome new development in their local markets, because with high construction costs, the new kid on the block would have to charge rents that may have to be 15% to 25% higher than in-place rents, making the existing facility look like a bargain. In a recent lender survey by CLW Health Care Services Group, although new construction loan volume as a percentage of entire seniors housing lending dropped from 7.4% in 2005 to 4.6% in 2006, every respondent stated that new construction lending volume would increase next year. We don’t know whether that is wishful thinking or projects on the books ready to go, but it is still not going to compare with the 1990s building binge.

Higher construction costs are the primary culprit for slower-than-expected development growth, with quality site identification a close second. But with acquisition prices so high, one might think that the build vs. buy decision would be shifting to build. According to Rob Mains of Ryan Beck, this has already occurred for Healthcare Realty (NYSE: HR) in the medical office building (MOB) market, where the REIT is shifting from acquisitions to development, as the current MOB acquisition market does not offer a sufficient spread between invested returns and its cost of capital. When this rationale will hit the senior care market is anyone’s guess, but a few years of 5% to 10% rental rate increases, combined with strengthening occupancy, might do it.

Despite this period of rational exuberance, there are some risks in today’s environment (yes, there always has to be a party pooper) other than a 300 basis point increase in interest rates. While we suspect it will be short-lived (12 to 18 months), the current decline in the housing market will take its toll on any development that is already in the ground, at least for CCRCs and independent living. And as a by-product, we may see more developers crashing the senior care party as it is viewed as a long-term growth opportunity with great fundamentals. No one is predicting a period of over-building again, but bad things can happen.

Something that is infrequently addressed, probably because no one has a good answer for it, is the supply, cost and quality of labor. The industry just does not have enough high quality people to run their communities, and little is being done to fix the problem. Turnover is high and we hear that training is not sufficient for what is not an easy business. And with acuity levels rising in assisted living facilities, ancillary services are becoming popular again. The problem is that it is easier to find a good property to buy than a physical therapist to hire (and keep). The supply of therapists seems to have diminished much like the nursing shortage of the past decade, and no one knows what to do about it. This is the industry’s Achilles heel.

The other risk is that the capital markets (equity) lose their interest in the senior care market and find other places to park their cash horde. This won’t happen soon, but it may occur nonetheless. It may be when investors start to pay "A" prices (and cap rates) for "B" and "C+" properties that the yellow flags go up; some would argue that this is already occurring. The best comment we heard was, How is it that an investor is buying an "A" property when I am selling him my "B" property? Beauty is in the eye of the beholder (or buyer).

In conclusion, the common theme is that assisted and independent living cap rates in 2006 will have dropped about as low as possible, but few people see them rising in 2007. Skilled nursing cap rates, on the other hand, are expected to drop by an unprecedented 100 to 200 basis points by 2007, if not already in 2006. With little SNF new construction, no major reimbursement issues on the horizon and a more strict Medicaid eligibility now in force, the industry fundamentals are stronger than they have been in years. Frank Morgan reported that most everyone he talked with at the conference prayed every night for Brookdale Senior Living’s (NYSE: BKD) continued success. Perhaps it goes something like this:

Now I lay me down to sleep
Is Brookdale’s stock the one to keep?
I pray that Fortress ups its stake
So I, too, can then partake