Shocks Waves Of The Subprime Meltdown Continue
The great big sucking noise you hear is the liquidity evaporating from the capital markets, but please don’t shoot the messenger. Although lenders are still “open for business,” we are hearing of more and more cases where they are technically open but slow to return phone calls. Don’t blame them, as they are still trying to figure out where to price debt and who will buy it, much the same way that buyers and sellers are still trying to figure out what a market cap rate is and the “right” price to buy or sell. It is difficult, however, to come up with a “market” anything when there is no market. We have heard that while some of the big lenders (no names mentioned here) are still “open,” they have basically told their customers to wait until January.
With the CMBS and CDO markets in turmoil, and many lenders having grown out of the habit of keeping their loans on the books, in many cases they are now forced to price for the long term, which means debt is more expensive, when it is even available. It is one thing to be aggressive when you don’t have to worry about being repaid, but quite another when instead of being an intermediary, you become a partner. And with a healthy amount of skepticism (called real underwriting), the amount of equity required in deals has gone up, but we haven’t quite figured out who is going to provide that equity, and on what terms.
We all know that once The Carlyle Group (unlike the SEIU, we spell it correctly) closes on its purchase of Manor Care (NYSE: HCR), we may not be seeing much private equity in the senior care market, at least for any large deals that may be left. Does every private equity or investment firm about to enter this sector now have to worry about Congressional oversight, investigations, hearings and documentation of its ownership structures? If a certain amount of capital is scared away from the seniors housing and care industry because some of our elected officials in Washington, D.C. want to be in the limelight “protecting” the elderly, it will be the elderly who will suffer in the long run, because the industry needs capital to grow and meet the demand that will only begin to skyrocket in another 10 to 15 years. If they really wanted to protect the elderly, they would fix the Medicaid and Medicare programs, not to mention Social Security, but then that would expose the misinformation they have been peddling for too many years about a supposed “lock-box” and a “we will fix it when we have to” attitude. But I digress.
In the facility acquisition market, we have had an unprecedented number of “small” transaction closings postponed by a few months because of the financing “issues.” By far the most common reason provided has been delays by HUD in approving the existing loan assumption. In some HUD offices, we hear, one missing piece of information can compel the underwriter to send the entire file back, only to start all over again when the file is resubmitted. In addition, some lenders have been changing their terms or just getting cold feet, and when the lender’s feet turn cold, the deal can turn to ice. At the eleventh hour, no buyer wants to be forced to look for a new lending source, especially in this market.
It is particularly dramatic to look at what has happened to debt spreads, which will provide a better understanding as to why some people think cap rates have risen above the 50 basis point increase so commonly tossed around in casual conversation. From what we have gathered, the spread between AAA-rated CMBS credits and BBB-rated CMBS credits had narrowed to well under 100 basis points, and probably to around 60 basis points, during the height of the market. Now, we understand that the spread has widened to well over 200 basis points. We have also heard rumblings that some borrowers in the seniors housing market may be in technical default on their debt, with lenders putting them on a short leash to improve their financial performance. This is leading to some speculation that we may see an increase in defaults later in 2008, and we have already heard of some investors, with plenty of liquidity, gearing up to take advantage of either buying debt at a discount or properties at a discount. Perhaps both.
Getting back to cap rates, when the liquidity was sucked out of the market this past summer, everyone knew that cap rates would be impacted, and it was easy to justify a broad stroke 50 basis point increase. The reality, however, is that no one really knows where cap rates are because any deals that are getting done now, and they are far and few between, were negotiated at least a few months ago, back in what some call “the la-la times.” Well, those times are over, and some people believe they are gone for good. We will opt to take a pass on that judgment for now, because cycles do come and go, and seniors housing will see some more “hot” times in the future.
There are some people who think that cap rates, at least for your ordinary, 75-unit, “B” quality assisted living facility in a secondary market, have increased by 100 to 200 basis points, because buyers and their lenders will no longer do these deals at sub-8% cap rates. Our response is that for these properties, the spread in cap rates has always been the widest in this recent bull market, from as low as 7% to as high as 10% (and even higher), depending on a number of factors. So, our guess is that those lower-cap rate, plain-vanilla deals will be the ones that get knocked out of the market (or done at higher cap rates), and that will be a good thing for the industry (but don’t try telling that to a seller).
The other reason for cap rates going up is that a risk premium is back to being priced into acquisitions, which is also a good thing for all sectors of seniors housing and care. While we agree that seniors housing should be looked at as a separate asset class for institutional real estate investors, we also strongly believe it is very different than the other categories, such as multi-family, office, retail and hospitality. These others ones, rarely, if ever, have Congressional committee hearings about them, well-publicized SEIU union drives, state regulatory scrutiny, reimbursement problems and health care liability concerns. And let’s not forget front page articles in The New York Times whipping up a frenzy of allegations and calls for change and increased oversight.
Where does the market go from here, and where will the buyers and investment dollars come from? Speaking of dollars, the value of the dollar may well be a significant factor in the seniors housing acquisition market next year if it stays at the current lows for much longer. Foreign institutional money, primarily from the Middle East, Australia and some parts of Europe, have already invested in our industry, and while their returns to date have been depressed by the weakening dollar, new acquisitions have to be looking very cheap right now. They will be benefiting from both higher cap rates and a higher value for their own currency, and that combination can make almost any deal look like a winner. In addition, the returns are just plain attractive, unless the dollar continues its dive. When was the last time the Canadian dollar was at parity with the U.S. dollar? Answer, 30 years ago. Canadian pension funds have already been active and we expect to see some additional acquisition activity from them in the next few years.
As for the rest of the market, everyone seems to be sitting on their hands, unwilling to make a move, other than backing out of deals. It’s not for lack of interest, but for a desire not to make a mistake. We have heard from some of the seniors housing brokers that the number of inquiries regarding selling and actual proposals made has been very high in the last several weeks. While this may mean that marketing activity will pick up, we are not convinced that all those sellers are on the same wave length as the buyers in today’s market. We hope so, or else life is going to get pretty boring.