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March 2007 issue
What’s Happening With Cap Rates?
What are the nuances of cap rates, what factors influence them and how do
they affect the playing field?
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Novel Renovation, Novel Financing
Good Samaritan Home restructured its existing debt, financed a unique new
project, and saved money, too.
...
Q&A With Stan Thurston
The former CEO of Life Care Services comments on his early days in the
industry, the Return of Capital™ plan, and changes he’s observed over the
years.
...
SNF Beds Hit Record,
IL Price/Unit Strong
SNF price per bed hit a record in 2006, and IL price per unit as strong as
2005.
...
NFP Financing Parity
Bill Sims comments on the new age of financing for not-for-profit providers
and the senior living sector overall.
...
Not-for-Profit
Acquisitions in 2006
Who acquired what facility, where, for how much, and more.
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Steve's BLOG on Senior Care
Companies Mentioned in this issue:
March 2007
American Seniors Housing Association p2
Cain Brothers p4
HealthTrust, LLC p1
Lancaster Pollard & Co. p1
Life Care Services LLC p2
Sunrise Senior Living p5
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What’s Happening With Cap Rates?
The Nuances of Not-For-Profit vs. For-Profit Entities
Email Editor
In the for-profit world, cap rates are
treated the same, scrutinized the same, and viewed the same by Wall
Street. It’s more complicated in the not-for-profit sector, but there’s
more opportunity, as well.
“I prefer to use the same cap rate
regardless of tax status and underwrite the cash flows differently,” says
Alan Plush, senior partner at HealthTrust, LLC. “If an investment-grade
sponsor is involved, I think you could argue for a lower cap rate. We
sometimes do that when we do letter-of-credit appraisals. And we can
adjust for real estate taxes.
“Probably 80-90% of transactions in the
senior-living sector involve for-profit organizations,” he says. “Let’s
say that independent living rates are 6% to 7.5%, assisted living rates
are 7.5% to 9%, and skilled nursing is 11.5% to 13%. Not-for-profits
really can’t afford to pay more than those cap rates. If they could afford
to pay more — and assuming that the seller wants to sell for the highest
price — you’d see a lot more sales to not-for-profits.”
In the end, cap rates are cap rates.
They’re market-driven — although the income stream for not-for-profits is
a little different from for-profits. Not-for-profits have a lower cost of
capital, and lower cap rates sometimes reflect that. Also, the
availability of better financing and the possibility of saving money on
liability insurance premiums and real estate taxes exists uniquely for
not-for-profits.
Customarily, cap rates are determined by
either of two methods:
(1) Market-extracted cap rates,
considered the most accurate method, are based on actual transactions;
divide net income into the purchase price.
(2) The “build-up” method, an arithmetic
approach, is always affected by the assumptions involved. Assuming an
equity return at 20% vs. 12%, for example, materially impacts the cap
rate.
The “build-up” method isolates the impact
when below-market financing is available. For that to apply, the
organization must be a “credit-worthy not-for-profit” — one with
sufficient resources to secure investment-grade, tax-exempt debt.
“A lot of not-for-profits don’t fit that
category,” notes Plush, “so a slightly lower cap rate based on cost of
funds and possibly some savings in property taxes are about the only
reasons to apply different metrics to not-for-profit vs. for-profit
transactions.”
The property tax exemption is a
negotiated item,” suggests Bill Pomeranz, managing director at Cain
Brothers. “Some appraisers will include it, and some won’t — and it can be
a big number. Apply a 6.5% to 7.5% cap rate to $300,000 or $400,000 in
real estate taxes, and that’s a lot of money.”
Occasionally, discounting may be
involved, as well. A provider making a bid on a not-for-profit facility,
for example, may pay as much attention to operational benchmarks as to an
appraisal. “The assumption that not-for-profits have fat that can be cut,”
Pomeranz explains, “would improve the appraisal over time. So the buyer
will benchmark various line items to see how the expenditures could be
decreased over two, three, or four years. That will enhance both the cap
rate and the value.”
Favorable financing treatment may apply
when a not-for-profit organization is the purchaser. For example, if the
cap rate is 7.5% for a purchase with conventional financing and a
not-for-profit will instead pay 5%, some appraisers will take the 2.5%
differential, create a 30-year income stream, net present value the
difference, and add that to the purchaser’s value. That would apply
whether the seller is a for-profit or a not-for-profit entity. The
favorable financing treatment applies only to not-for-profit purchasers,
since they can use tax-exempt bonds with lower interest rates. “Not every
appraiser will do it,” says Pomeranz, “but it can be an addendum to an
appraisal.”
Factors that influence cap rates
“Not-for-profits tend to be a really good option when the market for
conventional lenders is soft and there’s not a lot of liquidity,” says
Plush. “If the cost of funds is tight and liquidity is thin, then more
equity is required and the investor premium goes up. Right now, there’s so
much liquidity and so much institutional capital that I honestly think the
not-for-profit sector is at a bit of a disadvantage.”
Risk influences cap rates, and the lowest
— or perceived as the lowest — risk is for independent living facilities.
“Ideally” says Plush, “the appropriate risk factor would be worked into
the cap rate by extracting it from market transactions.”
Deals being made by hedge funds and the
financial fortresses of the world also affect cap rates. These entities
may be willing to pay 5% on their money in year one, with the belief that
every year thereafter they’ll jack up their return 1-2% and, ultimately,
sell it 50-100% higher.
“Think about it,” says Pomeranz. “Buy a
building for $20 million with $1 million of free cash flow — a 5% return
for a for-profit organization. For not-for-profits that are used to
financing 90-100% cash to debt, that’s a serious problem. It’s difficult
to do 100% financing on $20 million with only $1 million of free cash
flow, because that only carries $7-8 million worth of debt. So a
not-for-profit cannot pay what a for-profit can pay.
“The for-profit entity uses a different
return matrix and is looking for lower returns,” he continues. “So in
sales where the owner wants the most money, you don’t see many
not-for-profit bidders in the final go-round.”
The playing field
Not-for-profit facilities are often sold because they’re struggling,
according to Pomeranz. And they’re usually struggling because they’re
outmoded and/or don’t have the right mix of unit types.
“If the transaction is between two arm’s
length entities paying market prices, the owner is either under financial
duress or wants to raise capital,” he says. “That happens, for example,
when senior housing is not the main line of business or the owner wants to
drop a product line that isn’t fully developed. In those cases, the cap
rates have been very low, because the properties tend to be over-designed
and overstaffed. They’re in good locations and have reputations for
quality care. When a not-for-profit has that kind of tremendous value
locked up in its product, we call it a ‘halo effect.’”
Skilled-care nursing homes, particularly
solely skilled nursing campuses, have seen the highest volume of
not-for-profit sales. These facilities have become Medicare-oriented and
rehab-oriented businesses that, in many states, can no longer make ends
meet on state reimbursements. The skilled-care facility doesn’t disappear.
A for-profit nursing home chain buys it — and, in fact, the level of care
often improves. “Not many traditional not-for-profits provide skilled
nursing or are entering into it,” says Pomeranz, “because they never
geared up to take Medicare, which requires rehab care and taking in
patients seven days a week, for example. And many not-for-profit
facilities that currently offer skilled nursing are closing out those
beds.”
Instead, not-for-profits are focused on
retirement communities for middle- and upper middle-income people. Some
put mission on the back burner; others try to balance mission but not
necessarily at the same site. They may do an upscale CCRC in one location,
for example, and a low-income housing project ten miles away. “That tends
to be the trend in capital markets, as well,” says Pomeranz.
“The moderate income population is
difficult to serve without being a really good operator,” he adds. “These
folks are unable to afford the CCRCs, because CCRCs are not designed as
cost-efficient products. They offer too many amenities. As a result,
operators such as Sunrise Senior Living pick up that population for the
last couple of years of life, when those people spend down.”
A particular concern for purchasers of
not-for-profit CCRCs with a high percentage of entrance fees with care
obligations, is that appraisers don’t normally value the outstanding care
obligation. Sometimes those future obligations are underfunded, which will
have a huge impact on the balance sheet. Cash flows may say that a project
is worth $20 million with almost no money on the balance sheet — which is
typically true and the reason the property is on the block — but the
purchaser will have to meet the $6, $7, or $8 million underfunded
actuarial liability.
The best strategy for not-for-profit
organizations to improve their marketability is to get all zoning
approvals for expansion while it’s still a not-for-profit organization,
according to Pomeranz. “Land-use regulations are increasingly more
stringent in many communities, and a not-for-profit entity is more likely
to get zoning approval to build an expansion than a for-profit developer
buying the same property,” he says. “We advise our clients to get all the
necessary approvals before putting the property up for sale. The
incremental expansion represents incremental revenue, and that creates
desirable value. And the cash flow for an expansion is better for a
functioning operation than for a start-up.” The risk, of course, is that
the seller’s ideas aren’t the same as the buyer’s, so zoning approval for
a generic expansion makes the most sense.
Finally, while the not-for-profit sector
has tremendous value locked up in its products, owners don’t tend to sell
even when it’s strategic. Let’s say an operator has five or six facilities
and could sell one, raise a lot of money, and use it as seed capital to
build four new facilities. Some consider that a betrayal of mission.
Others aren’t willing to take the risk on new development. Instead, the
not-for-profit sector turns to third-party developers, which can be both
good and bad. The good part: The administrator transfers the risk to
someone else. The bad part: It jacks up the price dramatically and
suppresses the market.
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