Strong Investor Demand And Quality Boost The Market
Last August we stated that the entire seniors housing and care market had hit a peak by the summer of 2007. What we meant was that “new” prices would not go any higher, on average, than what was paid in 2007, and that buyers looking at the acquisition market subsequent to last summer’s credit market meltdown would have changed expectations and face new limits on accessing capital, both debt and equity. According to preliminary results from our 2008 edition of The Senior Care Acquisition Report, which will be released at the end of this month, the average price paid for skilled nursing facilities did hit a record in 2007 of approximately $55,200 per bed, or about 6% higher than in 2006, which was a record at that point in time. The likelihood of remaining at these price levels, however, seems somewhat remote at this point in time.
So, why did the skilled nursing market hit another record price in the market? Although there are many reasons, including the high quality of some of the facilities sold, which always has a significant impact on the average in any given year, it is safe to say that three main reasons include high investor demand for the asset class through most of the year, a continued rise in the cash flow per bed generated, largely as a result of Medicare reimbursement and, finally, because cap rates in the skilled nursing market hit a record low of about 12.0%, or just under the 12.5% average in 2006, which was the previous record low according to our statistics for the past 20 years.
Paradoxically, with the rising Medicare population and acuity levels in skilled nursing facilities, these properties are increasingly becoming more “health care” oriented, and not the real estate that some investors are looking for, but they are considered to be real estate nonetheless (we heard the same story in the 1990s market peak). In addition to the legal and liability issues, this is one reason why many institutional buyers split the real estate from the operations: different risk levels and different return expectations. In theory, as the health care component increases, the returns should be higher than plain vanilla, boring, un-management intensive traditional real estate assets that have no regulation and reimbursement problems, no liability issues and the absence of ambulance-chasing New York Times reporters who use outdated and erroneous statistics provided by ambulance-chasing malpractice lawyers and union organizers with a one-sided axe to grind. Are we making ourselves perfectly clear?
Despite the fact that skilled nursing cap rates hit a record low in 2007, as did practically all cap rates in other real estate asset classes, their decline was relatively slow and steady, and the spread between the highest average cap rate (2002) and the lowest (2007) over the past 15 years was just 280 basis points. This level of decline is relatively insignificant in the scheme of the overall markets, and especially when compared to the assisted/independent living market that has a 460 basis point spread between the highest average cap rate (1993) and the lowest (2007) in that same time period, and a 340 basis point decline since 2002.
The point is that extremely low cap rates have not been driving the skilled nursing valuation market, although the recent decline has certainly not hurt, and cap rates in this sector are still quite high relative to traditional real estate investments that had dropped to the 4% to 6% range until late last year. And, we might add, skilled nursing cap rates should be higher than most any other real estate asset class because of the much higher business risk, despite some of the stability provided by limits on new bed supply and “guaranteed” reimbursement. It’s called finance theory 101.
The skilled nursing market hit another record in 2007 despite the fact that we did not include in our statistics acquisitions such as the sale of Manor Care or Genesis HealthCare Corporation, both of which closed last year, because both sales involved a combination of leases, management agreements and ancillary businesses which preclude us from generating an unbiased price per bed for the skilled nursing component. Because the derived price of Manor Care’s nursing facilities was more than $125,000 per bed, and Genesis HealthCare’s more than $80,000 per bed, the national average would have been even higher than the record we reported. But we have never included the sale of publicly traded companies in our statistics because of the reason mentioned above as well as the fact that they are not reflective of the generic property acquisition market. They do, however, set the tone for the market and investor expectations, as well as seller expectations when they see some of the prices paid and the bidding wars.
So, what will keep skilled nursing facility prices strong in 2008 and beyond? First and foremost is a strong Medicare reimbursement environment combined with an increasing higher-acuity census. This is the driver for stability in cash flow per bed and the benefits of any ancillary service businesses. Private pay patients are fine, but they are a declining population, especially as assisted living facilities reach out to higher acuity residents for their programs. Foreign buyers looking for yield and a real estate asset class that will not succumb to overbuilding will also help to keep prices high, and the skilled nursing market looks particularly cheap relative to their own markets given the low value of the dollar. And they may hope for currency gains down the road whenever the dollar begins to stabilize.
In addition, there has been some attention diverted away from the assisted and independent living market, which is considered to be more real estate-oriented in a period when real estate is not too popular with investors and lenders. And don’t forget that as the economy worsens and if it dips into a recession, health care and health care assets have usually been considered a good recession hedge, and skilled nursing is more of a health care business now than at any time in the past. Finally, the demand for skilled nursing beds is going to outpace the supply for many years to come, even with the competition from higher acuity assisted living facilities. We would assume that more states may follow the lead of states such as Connecticut and Massachusetts that have closed some small and inefficient facilities and are hesitant to approve new CONs because of budgetary constraints. While the growth rate of the elderly population 85 and older is taking a temporary breather, it will resume later in the next decade and explode thereafter. The beds simply will not be there, which bodes well for the owners of existing beds in the future. Unless, or course, the whole nature of how we provide “long-term care” changes, and it might.
On the negative side of the ledger, what would cause prices to decline in 2008 and 2009 would obviously be a tightening in Medicare reimbursement, or worse, some rollbacks in the rates themselves. There are some powerful members of Congress who really do not like to see nursing home companies making a decent profit overall, especially if it is based largely on their Medicare census and reimbursement. We still don’t understand why they don’t understand the concept of low-cost producer, and if SNF operators decided to no longer take the higher acuity patients if reimbursement made it financially not worthwhile, the cost to the health care economy would certainly rise if they went to rehab hospitals or had longer stays in acute care hospitals. When you have a committee head whose basic desire is to rid the system of for-profit health care providers, well, more than Houston will have a problem if that attitude gets any traction (it won’t). Second, although Medicaid is not very popular with providers, as the economy weakens and state budgets come under pressure, this payment source will become even skimpier, with the only result being adverse pressure on quality of care when a lack of pay increases causes employee turnover to get worse.
Speaking of “out there” congressmen, if hearings resume this year on the so-called problems with private equity ownership of skilled nursing facilities, and if they get ugly, that is going to make more than a few large equity investors look elsewhere for their next investment. In the long run, the absence of private equity and leveraged buyout firms from the marketplace could provide some price stability and a more even playing field for strategic buyers, but in the short run it would put a negative damper on valuation attitudes, especially with what is going on in the credit markets. No one knows how much worse the credit market situation will get, but we haven’t talked with anyone who thinks it’s not going to get worse as the year unfolds. That being said, the skilled nursing industry should be relatively stable, and we believe the market will be dominated by small sales, usually single facilities selling in the $35,000 to $60,000 per bed range. Unless some high-end properties sell, the average for 2008 is not expected to set any records.