Despite Strong Industry Fundamentals, The Top Is Here
The seniors housing and care industry has had a tremendous run-up in the past three years, with almost everything going its way. Yes, qualified labor remains a constraint on operational performance, but ask anyone in the industry and they will most likely tell you they have never seen it this good—and then they whisper they are keeping their fingers crossed. Most of them are “knockin’ the leather off the ball,” from a financial point of view, and they really see nothing on the horizon to change that. For the most part, they are right.
Occupancy levels have been strong, although a little flat of late, and demographics will keep demand strong for the next 30 years. The increase in demand will actually be fairly steady for the next 15 to 20 years, and then it will ramp up faster than the industry will be able to cope with (the housing and service product we will want in 20 years, however, is a discussion for another time). There was some speculation last year that we would see a mini-splurge in new development soon, primarily because new construction practically disappeared five years ago. With construction costs so high, however, and land never easy to find, it hasn’t happened. In fact, perhaps more dollars are going into the large $100 million to $300 million campuses than ever before, as opposed to smaller assisted living facilities, but this will not result in “over-building” as we think of it, and these do not get built until they are heavily pre-leased. Perhaps most importantly, these campuses were never the problem in the 1990s.
So what exactly do we mean by the phrase, “The Paradox of a Market Peak”? The paradox, simply stated, is that despite strong industry fundamentals, now and for the future, industry valuations and merger and acquisition activity are at a market top when, in theory, they should just keep on marching upward. Just as much of the three-year run-up had more to do with “external” reasons than industry fundamentals and performance, the change in atmosphere will also have more to do with these external factors. Before you shoot the messenger, grab a cup of coffee (or glass of wine, if it is early evening) and listen to the theory.
Our entire industry emerged from a period of extreme trauma in the 2000 to 2002 period, an era brought on by overbuilding, excessive leverage, inexperienced management, herd mentality capital and, quite frankly, ego (assisted living sector). In addition, there was a problem with changes in reimbursement, plenty of acquisitions done for the sake of covering up previous bad acquisitions and to make earnings comparisons irrelevant, too much capital and a liability insurance crisis (skilled nursing sector). Everyone knew it would improve at some point, but no one really knew to what extent.
Then there was the schizophrenia in terms of defining the industry. Is it real estate or a health care services business, or both? There has been a big push over the last 10 years to get seniors housing classified as a distinct real estate class in the minds of investors, much like office buildings, retail, multifamily and hotels. While this makes sense from an investment perspective, and for the goal of trying to attract institutional money, there are some perils as well. Because there are such large differences between skilled nursing, assisted living and independent living, especially with regard to the health care service aspect, investors have developed their own appetites for the various sectors within the asset class. This push for “legitimacy” has largely worked, given the dramatic rise of institutional equity now in the seniors housing and care market, but it also may result in an increase in the volatility of our market.
Let’s take a look at some of the signals for a market peak, both within our industry and outside of it. For the most part, publicly traded assisted/independent living stocks peaked this past spring. Their rise since the bottom of the market was the result of a combination of low values (three years ago), improving industry fundamentals, a rising stock market in general and a certain amount of takeover premium embedded in some of the stocks. Take the case of Capital Senior Living (NYSE: CSU), a company that has been reporting improved operating fundamentals and growth, but with a major shareholder that gave up, after more than a year, on its quest to have the company auctioned off to the highest bidder. The stock has dropped by 25% in three months, when there has been no negative news. Emeritus Assisted Living (AMEX: ESC), which most likely got way ahead of itself, has plunged by more than 35% since it peaked six weeks ago. The overall market was rising during most of this time period, and both companies seemed to have nothing but positive news.
The publicly traded skilled nursing companies, or what’s left of them, have experienced a similar fate. With the obvious exceptions of Genesis HealthCare, which is now a private company with the recent going-private transaction completed in early July, and the recently announced purchase of Manor Care (NYSE: HCR), the remainder have all peaked as well. HCR even dropped a few points in late July with the growing fears of private equity firms either being unable to close their deals or having to put in more equity and pay more for the debt (but more on that later).
Finally, we recently wrote that every health care REIT dropped in value in June and, with the exception of two that were in takeover discussions, they are all off their peaks from late last winter, and many of them are significantly down from those peaks. Why the dismal performance? The simple answer is rising interest rates. But the reality is that they have not risen so much to have this large an impact, and they have not had the same impact on the other REIT sectors. The other answer is the current, and prolonged, softness in the housing market and its potential impact on seniors housing occupancy, but providers are not really feeling that…yet. Health care REIT fundamentals are still strong, and the seniors housing and care industry obviously is still in good shape. In addition, in a little fact that health care REITs don’t talk about much, the theoretical value of any seniors housing and care properties they have purchased from 1995 to 2004 has increased dramatically because of a combination of the increased cash flow (in most cases) and the significant drop in cap rates (in all cases) over the past three years. And with an average dividend yield that is 200 basis points higher than the average of all the other REIT sectors combined, investors should be pouncing on them for yield alone, but they aren’t. The peaks in assisted living, skilled nursing and health care REIT publicly traded stocks all occurred before the subprime mortgage meltdown.
As everyone knows, real estate can be very cyclical, and while seniors housing does not have the same cyclical elements, once it is established as one of the classes of “real estate,” it will join in the real estate investment cycles whether it likes it or not. And during the past several years, as seniors housing was gaining acceptance in the investment community, the spread between seniors housing cap rates and every other real estate asset class was criticized as being too wide, representing a tremendous investment opportunity. Yes, there were some business risk aspects that many other types of real estate did not have, but they did not merit the wide spread, or so the argument went. While this was convincing, and in many regards true, what was not asked was whether the low cap rates on other real estate classes were justified, and sustainable, over the long term. If you can buy multifamily at a 4% cap rate, what a great deal seniors housing is at a 6% cap rate. But is 4% for multifamily such a great deal over the long term?
The point is that cap rates for seniors housing have dropped to record lows when cap rates for other real estate are also at historic lows because of a strong economy for five straight years, continued low interest rates and an extremely liquid capital market with too much money to invest. What we don’t know is what will happen to seniors housing cap rates, and their spread relative to other real estate classes, when interest rates rise, the economy softens and money is no longer so loose. Quite frankly, our guess is that most of us do not want to know.
Speaking of cap rates, it is obvious that cap rate compression in seniors housing and care, which many believe was long overdue, has been driving value for a few years. As properties bought three or four years ago are now being flipped, we are able to see how much of that increased value has come from rising cash flow compared with a decline in cap rates. While it will be different for every case, our best estimate at this point in time is that, all other things equal, approximately 40% of the increased value is derived from the increased cash flow, while the remainder comes from the lower cap rate. In the skilled nursing sector, a smaller percentage of the increased value would come from the cap rate decline because, on average, cap rates have dropped less. We have all known that declining cap rates drive value, but when the current valuations are so dependent on this low cap rate environment, someone is going to be stuck holding the bag when (and if) cap rates across all real estate sectors rise. Unfortunately, it may take a downturn in the traditional real estate market to find out where the real spread should be between those sectors and seniors housing and care, with the understanding that it could always be a moving target.
Now is as good a time as any to talk about the current disruption in the bond and leveraged bank loan markets as it relates generally to the merger and acquisition market and the private equity that is spurring much of the deal-making, and specifically to seniors housing. Just the fact that several of the largest and best-known private equity firms are having trouble selling some of the debt for their deals at terms originally contemplated is a shock to many. Up until recently, the private equity firms could almost dictate the terms of the substantial debt component in their deals, usually with low interest rates and liberal terms (with toggle notes and covenant-lite debt becoming common cocktail conversation pieces). Perhaps the most amusing description of what was done to sell the debt came from Bill Gross, manager of the world’s largest bond fund, Pacific Investment Management, who referred to “the make-up, those six-inch heels and a ‘tramp stamp’” for the debt on some of the deals. While a bit severe, and we assume tongue-in-cheek, the point was clearly made.
As investors started flocking to safety, the yield spread between treasuries and corporate bonds widened and is now the widest it has been since July 2002. This means that the cost of debt on all of the leveraged deals will be going up, reducing the economics of the acquisitions, at least in the short term. In addition, as debt investors began to reject the terms that had been imposed on them, they also demanded lower leverage on some of the transactions, which means that private equity firms will have to put up more equity. While they certainly have the equity to do so, it also contributes to a reduction in their returns, at least in the short term. We keep on referring to the “short term” because no one knows how long this panic in the debt markets will continue, and there is obviously the possibility that the market will return to “normal” in a few months, whatever normal really means. In the meantime, there is some $300 billion of bonds and loans that need to be priced for pending leveraged buyouts by private equity firms, and that is an unprecedented amount in normal times, let alone this time of turmoil where the buyers don’t know what they want to buy. And it goes without saying that when “private” equity firms decide it is time to go public, we have reached a top of some sort.
In the case of the pending acquisition of Manor Care by The Carlyle Group, our guess is that the term sheet for the debt, if it were re-priced today, would be at least 40 to 50 basis points higher than when the deal was first announced. That would “only” amount to an increased cost of $20 to $25 million annually, which really would not put a dent in Carlyle’s ability to close the deal or run Manor Care. It will, however, affect other deals in the coming months. Seniors housing does have an advantage in the credit markets because the debt is secured by real estate, and in many cases attractive real estate, but spreads are spreads, and if they widen for unsecured debt they will widen for secured debt as well. The problem now is that many of the buyers have disappeared, preferring to wait on the sidelines to see if this credit crisis will blow over soon or take on a life of its own and snowball into something far larger and more devastating. While it is unlikely that will happen, if another shoe drops (any shoe), whatever confidence that is left in the market could easily evaporate.
Finally, the surge in seniors housing merger and acquisition activity was spurred on in part by the significant increase in high-quality properties and portfolios that came onto the market in 2005 and 2006, a quality level that had really never before been seen. Was it the declining cap rates that did it, or did this new supply of quality product help push cap rates down? A little bit of both is the best guess. What has changed in the past two to three years is that the potential supply of these high-end properties and portfolios has decreased. Yes, there are still some very valuable portfolios out there, but only a certain percentage will come to market each year, and we believe that we have already seen a heavier than normal volume of these portfolios.
This has two consequences. First, if there is a decline in the overall quality of what comes to market, even low cap rates will not keep average values from falling (remember, we are speaking of the value of what is sold). Second, there are not many other large portfolios around like Manor Care and Holiday Retirement that keep the interest of private equity firms, and the same goes for those that are even one-tenth that size. The point is that unless there are some very quick re-trades, capital will flow to where it can best be deployed, and deployed in size. So, with the opportunities beginning to diminish by next year, it is quite possible that we will not see the same availability of capital, and when the supply goes down, the cost usually goes up.
So getting back to the paradox, there is actually nothing wrong with the seniors housing industry right now. In fact, a new independent/assisted living community or CCRC in a great market may be one of the best “real estate” investments you can make today. Demand will increase, cash flows should grow and it will be increasingly difficult for new competition to come into the market. But can it get any better from a valuation perspective when today (well, yesterday actually) everything is going the right way? Possible, but not likely. So while the industry itself should have smooth sailing for quite a while, it is just the acquisition market, and valuations, that should take a breather for reasons that have little to do with financial and operating performance. Just like the stock market in general, which is trading at its lowest multiple of earnings in 16 years and still getting pummeled in late July for reasons that have nothing to do with earnings forecasts, the seniors housing industry, from a valuation perspective, will have to deal with external factors in an otherwise very promising environment. And like corporate earnings in general, seniors housing earnings should be stable and growing, and it will be a great business to be in.
The skilled nursing sector, despite its continued stability, is another story altogether, because all you need is to have Congress take a swipe at Medicare reimbursement, and there goes the necessary cash flow to pay off, for example, Carlyle’s debt on the Manor Care purchase. But if there is one private equity firm that the industry would want to have a stake in the skilled nursing business, it is Carlyle, with its vast Washington, D.C. contacts. While their influence can not be underestimated, Medicare reimbursement, combined with a “tired” physical plant for the overall industry, presents sufficient concern. The future of the skilled nursing industry will most likely be in repositioning a large percentage of the assets, some into higher acuity services and others into lower acuity.
