The New Fitch Ratings Report Provides A Macro View Of The Sector
The Fitch Ratings 2010 Senior Living Outlook, released in mid-March, maintains the firm’s “negative” outlook for the senior living sector, based on various external pressures: the fragility of the global economic recovery, sector-specific negative credit factors, and the turmoil in the real estate, capital, and financial markets over the past 18 months. At the same time, the report notes that senior living organizations have shown a “surprising resiliency” in dealing with unprecedented pressures. So the outlook also includes positive elements.
“A negative outlook is really a technical description,” explains Jim LeBuhn, Senior Director at Fitch Ratings. “It implies that we expect to see over the coming year more downgrades than upgrades within our rated portfolio. As we state in the report, however, we don’t expect to see a vast array of downgrades for the borrowers that we currently rate; rather, we expect that most of our rating actions will be affirmations.” In fact, the bulk of the ratings in 2009 were also affirmations—which was surprising to the authors. “We expected to see a greater number of downgrades,” LeBuhn added.
On the other hand, it’s important to keep in mind that the Fitch report is based only on the senior living credits currently in the firm’s rated portfolio— about 70 not-for-profit organizations—which is a very small segment of the overall senior living market. And because of the relative strength of rated organizations, market challenges may affect nonrated organizations quite differently.
“Within the nonrated universe, there may or may not be greater stress than what we’re seeing with the rated credits,” LeBuhn cautions. “Clearly, organizations that are able to garner investment-grade ratings usually are well-established facilities that, for a fair number of years, have demonstrated solid management practices, a good demand for services, and a good reputation and trust within the communities from which they’re attracting residents.”
Facing the challenges
Among the sector-specific credit risks facing senior living organizations this year are renewal risk on letters of credit (LOCs), weaker liquidity, higher capital costs, and real estate market stress.
LOC renewal risk: A lot of LOCs will be up for renewal in the next 12-24 months. Fitch is concerned about the pullback among LOC banks that have traditionally extended credit into the senior living market, although the stronger, larger, and more creditworthy organizations will have access to LOCs—albeit at a higher cost.
“For LOC-backed floating-rate debt, banks are currently working with organizations rated BBB or better, but fees are up by 50-200%,” added Dan Hermann, Managing Director & Group Head at Ziegler Capital Markets. “But with floating rates still so low, borrowers can generally absorb those fees and still end up with a very favorable interest rate.”
As LOC costs start to climb and the gap between fixed- and variable-rate debt narrows, fixed-rate debt becomes more attractive, according to Gary Sokolow, Associate Director at Fitch Ratings. The borrower’s desire to have permanently committed capital becomes an important consideration. Capital is locked in for 30 years when a borrower issues fixed-rate debt and isn’t conditional on a credit rating two years hence. So while it may cost more to issue fixed-rate debt, providers are comfortable with the added expense in return for a much lower risk when compared to bank LOC and LOC renewal risk. Fixed-rate debt has become an attractive alternative for unrated or below investment-grade borrowers that had been locked out of the market.
“As the economy improves and the banking industry takes care of its real-estate-related problems, we won’t be surprised if banks have a much greater appetite for the senior living market,” said LeBuhn. “The fundamental strengths of the senior living market haven’t changed.”
The demographics clearly favor the industry, for example, and a fairly affluent elderly population continues to support it. In addition, strong managements have reacted effectively to the worst market the senior living industry has ever seen. Organizations have been able to maintain solid debt-service coverage and have been creative in their marketing efforts, so Fitch expects continued support for borrowers in the sector once the banking industry stabilizes. “The issue seems to be more on the bank side than the senior living industry side,” said Sokolow. “The banks have pulled back for their own reasons and not because anything has changed fundamentally within the senior living sector.”
Amy Castleberry, Vice President and Senior Living Credit Specialist at Ziegler, expects LOC renewals to loosen up as well, as banks emerge from their own credit crises. “They’re starting to look at borrowers a bit differently,” she said. “The amount of LOC-backed floating rate debt for unrated new construction is still limited, however, and we expect it will take an extended period of time before it is available in a meaningful way.”
Bank-qualified debt has become a popular short-term alternative to LOC-backed variable-rate debt and has filled a gap, in particular, for single-site organizations with a debt load of $30 million or less. It has also opened up the market for banks without the A rating or better that is required by the money market funds that buy floaters. The bank-qualified program allows those banks to compete on an equal playing field with the rated banks. The program is set to expire at the end of 2010, however, although a one-year extension is included in the Obama budget.
Weaker liquidity: Across the rating spectrum, Fitch’s 2009 medians (based on 2008 audits) showed weaker balance sheets, which have yet to return to pre-recession levels. The “thinner financial cushions” of providers in 2009 vs. 2008 is a concern should there be another market downturn or other draws on liquidity. Median days cash on hand dropped to 390 days from 462 in 2008; the cushion ratio of 9.1x and cash to debt of 65% were down from 10.2x and 75.5%, respectively, in the prior year.
A short-term analysis can be somewhat deceiving, though, given the bloated markets just prior to their collapse in fall 2008 and the fairly material drop in 2009 liquidity indicators relative to 2007 and 2008. Actually, the 2009 median liquidity ratios are in line with 10-year historical averages for Fitch’s investment-grade facilities, according to the report, which reflects the ongoing strength of the industry (at least the Fitch-rated credits) in terms of good cash flow and good balance sheets. “A longer term perspective gives you a better comparison,” said LeBuhn, “and also leads to why we saw a preponderance of affirmations as opposed to downgrades.”
Higher capital costs: Capital costs remain higher than in recent history, but the fixed-rate market across the board is at about the average of the last 10 years—and has been for the last six months, according to Hermann. “The availability of floating-rate debt is more limited and more expensive,” he said, “which reflects in higher costs for the sector over the last three years. But again, we’re still at about the average for the decade. And that’s not bad.”
Keep in mind, though, that the cost of capital depends on the borrower’s credit standing. Two years ago, the cost difference between an A-rated and a nonrated senior living borrower was very narrow. “The debt gap has widened pretty dramatically,” observed LeBuhn. “The market has begun to open up to nonrated borrowers, but their costs will be much higher due to the credit spreads and investor requirements. Rated credits should experience a less detrimental impact on capital cost.”
Also, since many senior living providers delayed debt issuance for capital projects over the past year or so, they may face rating pressure as they enter the bond market to meet capital needs and/or to fund expansion projects, according to the Fitch report.
Real estate stress: While the real estate markets are showing signs of a “nascent recovery,” occupancy continues to be a primary credit concern. The organizations most affected by the downdraft in real estate over the last 12-24 months were startups or recent expansions that had a lot of new units to fill. “The interest was there, but getting people to sell their own house and make the move has been a challenge,” noted Sokolow. “And presales don’t often have a lot of teeth. There’s very little penalty for potential residents who cancel.”
Although occupancy levels remain below the average levels of three years ago (down 3-5% for the sector), occupancy has stabilized or is improving in most markets around the country. “As a sector, we clearly bottomed out on average occupancy about a year ago,” Hermann noted. According to NIC data for independent senior living communities (including rental communities), 54% were at 95% occupancy or higher in 1Q 2007; the comparable figure for 4Q 2009 is 34%. The average occupancy level in 1Q 2007 was 92.8%; in 4Q 2009, 88.9%.
“New communities and those filling up expansions are having a harder time than established communities that normally have 10% or less of their units to fill in any given year,” added Castleberry. “As a result, managements have come up with creative ways—such as promissory note programs, deferred entrance fees, and a variety of other incentive programs—to get people into the units. We’re keeping an eye out for a spring pickup in presales and in occupancy compared to this time last year.”
Even organizations that were dealing with just turnover experienced a decline in aggregate occupancy, but not to such a great extent that, through fairly tight cost control, they weren’t able to maintain profitability (albeit somewhat lower than in prior years) and debt service coverage that’s consistent with an investment-grade rating. Startup projects that were depending on entrance fees to pay down their debt load just didn’t work financially when the fees didn’t materialize.
Some positives going forward
Fitch analysts expect the vast number of senior living rating actions in 2010 to be affirmations; however, they continue to believe that the number of downgrades will outpace the number of upgrades—which is why, from a technical standpoint, they came out with the “negative” outlook for the industry.
Providers are taking a more thoughtful look at their investment portfolio relative to their debt structure and their expense needs. “We’ve definitely seen providers tamper down their appetite for investment risk,” noted Sokolow. “The most acute situations [in the last year or two] were organizations with exposure to alternative investments. Their portfolios were weighted more heavily toward equities, which were more volatile, and to a lot of variable-rate debt that significantly increased the risk profile of those organizations. Coming out of the economic crisis, they’ve been more thoughtful about restructuring their investment portfolio with, perhaps, only 20% variable-rate debt.”
And now, as borrowers are having better access to capital, a significant number of projects that have been on hold are moving forward—which surely is a good sign. “Investors are coming out from behind their bunkers, so to speak, and expressing confidence in the future of the industry,” said LeBuhn. “The more risky transactions—startup facilities and large-scale expansions—are finding willing investors for those projects, which we view as a positive for the industry as a whole.”
The New Fitch Ratings Report Provides A Macro View Of The Sector