Challenges For Providers And Ways To Avoid Or Address Them
March 1, 2008
It’s no secret that the financial markets are experiencing a particularly difficult time. In fact, they’re “deteriorating at an historic rate,” according to Michael D. Kelly, director at Ziegler Capital Markets. He sees three scenarios in which the current market may be a challenge for not-for-profit senior living providers.
1. “Many existing providers are contending with the dislocation of their existing debt structures,” Kelly explains. “And the insurance debacle has presented problems for those with outstanding variable-rate bonds insured by Radian — pretty much the sole bond insurer for the not-for-profit senior living sector — and, of course, standby liquidity facilities from a bank.” Essentially, those markets have frozen up, so providers with that type of outstanding debt are having to scramble to restructure, wrap the debt with a letter of credit, convert it to fixed-rate debt, or take any number of other steps to combat that dislocation.
2. Those with current debt needs are seeing long-term fixed rates rising dramatically as hedge funds and other non-traditional players dump municipal bond debt into the marketplace, causing interest rates to rise. At the same time, short-term rates are dropping dramatically as the Fed eases up, resulting in a much more steeply inclined yield curve. “That translates to borrowing at high interest rates but reinvesting at low interest rates,” says Kelly.
“And that dislocation has seriously affected a number of existing projects.”
3. A third situation is the collapse of the auction-rate market, where $350 billion worth of variable-rate demand bond debt is now competing in the marketplace for letters of credit to wrap or secure those auction-rate securities. “All of a sudden,” he says, “the demand on letter of credit banks – at precisely the time when their balance sheets are being eroded by the sub-prime mortgage collapse — has really resulted in something of a perfect storm.”
Kelly characterizes today’s financial environment as “night and day” compared to a year ago. “Last March, we had low interest rates on a nominal basis,” he says, “but we also had very narrow credit spreads. Based on the benchmarks of the Revenue Bond Index or the MMD (Municipal Market Data) Index, credit spreads were narrowed to 95-100 basis points for long-term, unrated, fixed-term senior living bonds.”
Today, in addition to rates rising on a nominal basis, credit spreads have widened dramatically. “The markets are looking for risk premium,” Kelly explains. “They won’t lend or invest without being compensated for the risk they’re taking. So that is a distinct difference between March 2007 and March 2008.”
And what about March 2009? “If you can tell me what the real estate market will be like and what world commodity prices will be, I might take a gander at that,” he says. “I’m certainly hoping that we can ride out the great majority of the housing dislocation during the course of 2008 and see some stability restored to the markets.”
Addressing credit defaults
While the current financial market is not a very good environment for senior living debt financing overall, Kelly stresses that the very rigorous planning and robust strategies undertaken by providers and sponsors with regard to their debt structures, both currently and in the recent past, has re-established a very high level of soundness to senior living debt transactions.
“In our experience with default rates, that stability tends to minimize any negative impact from credit stress and credit deterioration,” he says. “By and large, providers and sponsors are rigorously executing well-planned and well-thought-out financing structures that include higher standards, higher levels of covenant compliance and credit monitoring, and higher levels of secondary market disclosure and due diligence. As a whole, it has become a very interactive and proactive industry that is doing well by its investors.”
Nevertheless, Kelly points to some default scenarios that can turn up when, for example, developers and sponsors create an ill-suited debt structure or one that doesn’t have enough built-in flexibility to work through problems. “You can probably identify that as human error,” he says, “but there are other times when market shifts can absolutely change things — for example, when today’s marketplace is significantly different from that which existed when the financing was planned and secured. But with the right people involved, the right planning and process in place, and a rigorous devotion to proper execution, then, generally speaking, borrowers in the not-for-profit senior living sector ought to be able to ride out any anomalies in the broader market.”
Bank on credit shepherding
Indeed, some factors, actions, or inactions will send any senior living credit into financial deterioration. CCRCs have a greater capacity and propensity to ride out credit stress, it seems, due to their multiple levels of care, the structures implemented, and the cash infusion from entrance fees that can help bridge a difficult period. Freestanding skilled nursing, assisted living, and rental communities have much more risk and, in large measure, tend to seek financing more conventionally through direct lenders rather than in the capital markets.
Credit shepherding describes the proactive engagement of all resources and strategies at an organization’s disposal that are necessary to return it to financial and operating health.
“Credit shepherding is a very important part of what we do as investment bankers to address pending deterioration at its beginning to make sure it doesn’t spiral downward into financial default,” says Kelly. “We apply very aggressive and proactive strategies with borrowers and with their investors to see if we can get things restored to a level of normalcy.” The strategies may include debt refinancing, merger or acquisition, rewriting covenants, divesting certain assets, or affiliating with a third party.
To avoid the need for more serious strategies, here are some simple practices to put in place:
• Have a cadre of trusted advisors with links throughout the industry — such as your investment banker, counsel, audit and feasibility firm, developer, and development consultant — who can identify necessary support and use those relationships on your behalf.
• Establish direct contact with investors through letter of credit banks, rating agencies, or the investors themselves and disclose your financial information to them proactively and on a regular basis — quarterly, at a minimum.
• Monitor your covenants rigorously and pursue waivers if that becomes necessary.
• Benchmark your operations, manage your revenue and expenses, perform preventive maintenance, and budget for capital improvements.
Kelly cites organizations with a lot of cash on hand and that fail to increase rates regularly and appropriately as having a problem, one that is causing the most stress on existing providers. “That cash may not be needed today,” he warns, “but it is spoken for on a go-forward basis — weathering a problem, meeting increased health care expenses and usage, or dealing with an unexpected event.”
A CCRC is a very complex enterprise, and using the Consumer Price Index as a guide for setting rates doesn’t necessarily apply. The operating costs and rate of inflation applicable to the enterprise may be different from those for society as a whole. “Attention to margin is probably the biggest failing of boards of directors across the country,” Kelly suggests. “They must price the organization’s services to meet not only their current costs but also the need to build a reserve for the future.”
Failure to replace capital and failure to acknowledge depreciation as a true cost of business are recurring themes in challenged organizations. “Since these are non-cash items, it’s not considered a big deal,” he says, “but it is a big deal. They are real costs. And if the board isn’t budgeting for those items, the organization will find itself without the means to replace or improve or expand the facility down the road.”
…and some advice
Kelly offers this basic advice for avoiding credit stress in a deteriorating market — actually in any market:
1. Stay focused on your objectives at every level – the board, senior management, and the development team.
2. Be realistic about your assumptions and make sure they are appropriate to the market.
“The markets, even in this current environment, will probably receive well-structured and well-executed projects,” he adds. “We’ll get through this dislocation
just as we have in the past. Senior living providers and sponsors should continue to focus on the long term and where they want to be two, five, ten, and fifteen years
down the road rather than where the market will be in
six to nine months. It’s a long-term investment, so think long term.
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Challenges For Providers And Ways To Avoid Or Address Them