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January 2008 issue
Mitigate Risk In Repositioning Projects--
Strategies And Best Practices To Better Navigate The Financing
By their very nature, repositioning projects involve considerable risk.
Brian Pollard, president of Lancaster Pollard, shares some effective
strategies for mitigating those risks and actionable best practices for
negotiating repositioning projects.
...
Mixed
Funding For Affordable Housing--
Cabrini Eldercare’s Senior Housing Project In Seattle Is A Model
Cabrini First Hill Apartments in
Seattle broke new ground when it combined HUD 202 and LIHTC financing —
along with eight additional funding sources. It’s not an easy task to
accomplish, but mixed funding is being replicated for affordable senior
housing projects nationwide based on the Seattle model.
...
Q&A With Dan Rexroth
Rexroth is president and CEO of
John Knox Village, one of the largest CCRCs in the nation, and talks about
challenges the industry is facing and some solutions.
...
Recent Not-For-Profit Transactions
We detail some deals that closed in
the last few weeks.
....
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Companies Mentioned in this issue:
January 2008
A
AAHSA p2
C
Cabrini Eldercare p6
Cabrini First Hill Apartments p1
Caring Communities Insurance Company p2
Cascade Senior Apartments p7
Continuing Care Accreditation Commission p2
Council House Apartments p3
E
Enterprise Community Investment Partners p6
F
Fannie Mae p6
Federal Home Loan Bank p6
FHA p5
H
HUD p5, p6
I
Institute to Transform Senior Life p2
J
John Knox Village p2
Judson Services, Inc. p3
K
Kendal Communities p3
Kendal on Hudson p3
KeyBank p3
L
Lancaster Pollard p1, p3
Low Income Housing Institute (LIHI) p1
M
Missionary Sisters of the Sacred Heart of Jesus (C p6
Missouri Association of Homes for the Aging p2
P
PremierLife p2
R
Red Capital Markets, Inc. p3
S
Sarah Moore Home p3
South Franklin Circle p3
Sovereign Bank p3
T
The Industrial Development Authority of the County p3
U
Urban Innovations p3
USDA p5
W
Washington Community Reinvestment Association p6
Washington State Housing Finance Commission p6
Z
Ziegler Capital Markets p3 |
Mitigate Risk In Repositioning
Projects--
Strategies And Best Practices To
Better Navigate The Financing
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While we’re consistently seeing the development of new and innovative
approaches to senior living, the overall industry is fairly mature— and so
are many of the facilities. CCRCs are increasingly recognizing the need to
update and revitalize their campuses in order to remain viable and
competitive over the next decade or two, a period which undoubtedly will
prove to be the heyday of the industry.
By their very nature, repositioning projects involve considerable capital
improvements and/or additions to existing physical plants that are largely
funded at a high level of risk — risk that translates to a higher debt
burden and increased organizational liability, according to Brian Pollard,
president of Lancaster Pollard. “Increased debt service and higher
leverage,” he says, “negatively impact the organization’s cash flow at
least initially or until the organization can offset the higher costs with
some sort of incremental revenue growth — perhaps rental increases,
improved occupancy, or filling up a new unit if that’s part of the
project. “
In the intermediate term, the dilution of cash flow can be inconsequential
if the organization is a well-performing entity when the repositioning is
pursued. On the other hand, a reduction in cash flow could be long lasting
and debilitating to an organization if the repositioning is undertaken as
a defensive measure to stem many years of operating decline.
Differing financial challenges
More care must be provided as a CCRC’s services move up the continuum, and
each increment increases the operational risk. A skilled nursing facility,
for example, involves government reimbursement risk, additional liability
risk, and a more diverse staff than, say, assisted living. To some degree,
however, senior care providers looking to reposition any type of facility
face similar financial challenges. “Any time you add debt,” Pollard says,
“you increase leverage. That inherently entails added risk regardless of
your operating profile.”
In some ways, though, the financial challenges differ. “The facility’s
ability to offset the additional debt service taken on as part of the
repositioning by generating incremental revenues is the key to minimizing
risk,” he explains. “For example, a skilled nursing home that derives a
large percentage of its revenues from government reimbursement programs
may have less opportunity to generate the incremental revenues or the cash
flow needed to cover the additional debt service. In that case, the
provider may have to either improve occupancy or improve the quality mix.”
An independent living facility may find it equally difficult to pass onto
existing residents rental increases in the magnitude that may be necessary
to generate enough revenues or increased cash flow to cover the additional
debt service. The facility may have to wait until the existing residents
turn over their units to new residents who can afford to pay a higher
rental rate. “That can be several years down the road,” Pollard says, “so
a provider in that situation could experience an extended delay in the
ability to generate those important incremental revenues.”
Capital markets seek strength
The perception of risk by the capital markets varies with regard to
repositioning projects undertaken by not-for-profit providers. “If the
repositioning is a proactive strategy undertaken by a well-performing
organization that is looking to maintain a competitive position well into
the future, then the project will generally be viewed favorably by the
capital markets,” says Pollard. “On the other hand, if the organization
has allowed a substantial decline in its physical assets and/or its
operating performance over a period of many years, then the repositioning
will be viewed as a defensive measure in hopes of saving the organization.
The capital markets will have much less interest in that type of project.”
Therefore, much of the perceived risk hinges on whether the organization
is operating from strength when it is looking to reposition or whether it
has weakened to a point where it must reposition in order to survive.
“On occasion, we have seen organizations that have delayed and delayed and
delayed their repositioning projects,” Pollard says. “As the competition
around them becomes more formidable, their operations begin to decline.
And by the time they realize that they need to take some action, it is
often too late. They get into the so-called ‘debt spiral’ and just can’t
recover.”
Effective strategies to mitigate risk
Along with acting from strength, Pollard recommends two effective
strategies for mitigating risk:
1. Phased approach: Break the repositioning project into several phases in
order to seek smaller amounts of capital for each phase. The increments of
new debt added for each phase will be more manageable and, therefore, less
disruptive to existing operations. Each phase will be able to get up and
running before the next phase begins.
2. Silo approach: Create a new subsidiary entity for the repositioning
project, then fund the project with debt that is non-recourse to the
larger entity. If, for any reason, the project doesn’t work out as
expected, it won’t bring down the credit characteristics of the entire
organization.
“A CCRC with a large health care component in its continuum may find that
component dragging down the credit characteristics of the whole
operation,” he suggests. “A CCRC that wants to undertake a repositioning
project that involves substantial rehabilitation to its skilled nursing
facility, for example, may want to create a new subsidiary entity (silo),
transfer the nursing facility into the new entity, then fund the project
(or the nursing home part of the project) with one of the non-risk-based
funding programs. The remaining components of the project will have a much
stronger credit profile and can use traditional funding techniques at a
much lower cost of capital.”
Fitting HUD into the scheme
HUD has many mortgage guarantee programs, but the HUD 232 program is
specifically available to licensed long-term care projects such as a
nursing home or assisted living facility. “The HUD 232 program can be used
for either new construction or substantial rehabilitation,” explains
Pollard. “In HUD’s world, substantial rehabilitation means that the
improvements to the property, when complete, will drive 15 percent of the
value of the property. Another program — HUD 232/223(f) — allows licensed
long-term care providers to do improvements to the property up to that
substantial rehabilitation threshold.”
Applying for the HUD 232 program is typically a two-step process. The
first step is to submit a pre-application to HUD. If that is viewed
favorably, HUD will invite the organization to submit a firm application
that is significantly more comprehensive, in that it includes the full
architectural plan, the specs, the project costs, and the operating budget
for the property. “From beginning to end, you’re typically looking at
anywhere from six to nine months for the whole application process,” says
Pollard.
In terms of mitigating risks, the HUD programs are some of the few
available funding options where CCRCs can separate projects that entail
more risk and push them into a lower cost funding strategy. “By doing so,
what’s left of the project may have improved credit characteristics,” says
Pollard, “and that component can borrow at a lower cost of capital.”
Risk-based vs. non-risk-based pricing
Risk-based pricing is a fundamental concept of the credit markets and is
certainly the norm, according to Pollard. Simply put, projects that are
perceived to have a high degree of risk must pay a higher cost of capital.
“And typically,” he says, “those projects also are structured with much
less flexibility for the borrower.”
Non-risk-based pricing is an anomaly in the market, one that occurs only
in a few government loan guarantee programs such as those available
through HUD, FHA, or the USDA. In those programs, the
federal government receives a flat fee for providing the repayment
guarantee regardless of the project’s underlying credit characteristics.
“Once an applicant gets a government guarantee, the debt can be sold as
HUD-rate debt regardless of the project fundamentals,” Pollard explains.
“You could take a strong deal to HUD where, based upon historical cash
flows, it would cover debt service three to one. Or you could take a more
risky project to HUD that covers debt service one to one. Both projects
will pay the same amount to HUD.”
Short- and long-term impacts
Any negative impact on a repositioning project is more apparent in the
short term. Existing operations will almost always experience some
disruption, as it will take some time to increase revenues to the point
where they offset the new debt service associated with the repositioning.
“The operating metrics will be diluted, at least over the short term,”
says Pollard. “And there’s clearly an additional burden on management. In
the short term, there are probably more challenges than benefits.”
The long term, of course, is really why an organization pursues a
repositioning project. “At the end of the day, you’re looking for a
facility that can be highly competitive over the long haul and meet the
needs of a more diverse and growing senior population,” says Pollard.
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