Today’s Tough Credit Market Increases The Likelihood Of Defaults
November 1, 2008
Everyone would agree that this is a tough environment for every sector of the economy. We’ve seen the collapse of venerable financial institutions. Fear and uncertainty have riddled the financial markets. And throughout the world, companies in industries across the board are experiencing cutbacks, mergers, restructurings, bankruptcies, or complete shutdowns.
Can we expect some not-for-profit senior living providers to face default or default conditions in the near term? “Absolutely,” say some industry watchers. Providers whose operations are doing poorly—particularly some who have been aggressive with their pricing—are slowly sinking into default situations. Others have proceeded with projects without anticipating that their ultimate cost of capital could be substantially higher, or that the previously burgeoning senior living market might experience a decline in demand.
Banks are reluctant to lend as a result of credit market conditions and the aftereffects of the subprime mortgage crisis. Many LOC banks are taking write-offs and are saying, “Let’s talk after the first of the year.”
For borrowers whose loans have come due and need to be extended, the availability of credit is tighter and the spreads are wider, which puts added pressure on the organization’s operating cash flow. And many banks are simply unwilling to renew LOCs for weaker clients.
If a borrower with variable-rate bonds can’t renew an LOC, the trustee typically will call back the bonds—which then become bank bonds (usually for 90 or 120 days) at a rate that may be somewhat higher. But that’s not the punishing blow. If an LOC is still unavailable after 90 or 120 days, the bank bonds become an amortizing loan, typically written for a five-year period, and the borrower must start repaying principal—$20 million per year on a $100 million loan, for example. In the meantime, the borrower tries to renegotiate the deal.
That said, all situations are unique. “Most high-level credits are finding a lender but at very high rates,” observed William Pomeranz, Managing Director of Cain Brothers in San Francisco, “so that presents a very difficult situation for the mid-level not-for-profit provider. And with many LOC banks consolidating, banking relationships are also likely to change. The acquiring institution may not even want the deal or, if it does, may demand three or four times the previous rate. So this credit crunch is definitely leading to market stress.”
Banks that are still working with senior living providers are focusing mainly on their existing clients; but where deals were highly leveraged in the past, that’s no longer the case. Banks are requiring more equity, higher fees and stricter bond covenants.
Preserving cash has never been more important in terms of preparing for unforeseen situations or events and particularly for anyone looking to access the credit markets. Liquidity and equity will play an important role, but any organization planning a project should certainly expect a lot more negotiation and a longer time to process the deal.
Not-for-profit providers are particularly vulnerable in this scenario, according to Pomeranz. “Many of them had private bond insurance that tanked,” he said. “Then they rescued themselves with one- or two-year LOCs that will come due very soon.” At his firm alone, Pomeranz is looking at a list of hundreds of client LOCs that will come due in 2009. And at least one large system is about to sell off some of its weaker properties to save its stronger ones. “This is the kind of activity that you’ll be seeing over the next two years,” he said.
CCRCs that are the most vulnerable are those that have just opened or are just filling up. For established communities, the level of vulnerability depends on their number of vacant units and annual turnover rate. Having to resell or rent one unit a month is not the end of the world. Filling five a month, though, will be tough.
Not-for-profit organizations are more inclined than for-profits to accept and retain residents/patients who are either enrolled in Medicaid or have limited resources or no resources whatsoever, whereas for-profit organizations may be more assertive in trying to garner a better mix of reimbursement—a mix of clientele. And with states having revenue problems because of weak economic conditions, few will be increasing their Medicaid reimbursements.
“The not-for-profit, thereby, will be more dependent on philanthropy,” suggested John Stoner, CFO of United Church Homes, Inc. (UCH) of Marion, Ohio, “and now is a horrible time to be dependent on philanthropy. So that actually exacerbates the condition for any not-for-profit organization that has been—or will be in the immediate future—dependent upon philanthropy or use of philanthropic proceeds.”
Citing a not-for-profit facility in Akron that recently defaulted and is now in receivership, and based on the fact that UCH is receiving a number of inquiries from organizations that appear to be troubled, Stoner believes that it’s very likely that many organizations are facing near-term default. “I think it’s coming,” he said. “I believe that the way the market is developing right now is a prelude to defaults or bankruptcies or closures if the organizations can’t merge or be acquired.”
Still, there are a lot of buyers out there—mostly strong organizations or those with a lot of cash. “And if they have cash, they’re going to need it,” Stoner quipped.
“It’s very clear that there’s stress in the business,” affirmed William Sims, CEO of Herbert J. Sims & Co. “Certain places were having troubles before this financial crisis, and I don’t know of many new ones that have come on since September/October. But we’ll find out in perhaps six to nine months whether defaults are a widespread problem.”
The housing market is the root cause of current financial pressures on senior living providers, but that’s primarily a local phenomenon, according to Sims. Senior living organizations in areas where the housing market has remained relatively stable—Seattle on the West Coast, for example—are having few problems. The picture may be quite different, however, for organizations located in Las Vegas or Southern California. “The first consideration in terms of whether an organization is likely to have difficulty is its location and the direction that its real estate market is headed,” he explained. “The second consideration is whether fees are too high relative to the local economy.”
Wise CCRCs, for example, are adjusting their entry fees on a unit-by-unit basis—making deals, cutting extras, offering house-selling programs, doing whatever they need to do to get people into the units. House values in certain markets, though, are little different than they were five years ago. Homeowners interested in moving to a senior community might have missed out on the 2005 real estate peak, and 20 years ago the attitude might have been to wait for another peak before selling. Sims doesn’t believe that attitude is still prevalent among people who can afford to move. “The benefits of living in a senior living community have become better known over the last two decades,” he said, “so people ask themselves: Can I afford it? Why wait four or five years for the market to come back—if it ever comes back? Why live by myself, when my friends living in these communities are enjoying a better lifestyle. And if my house is worth the same as in 2003, why not sell?”
A calculation that’s harder to gauge in terms of its effect on the industry is the number of people who were planning to move to a senior community but have their money tied up in the stock market and may no longer be able to afford to make the move. That, in turn, diminishes the pool of future residents.
Maintaining quality in a distress situation
With the dynamics of reimbursement changing from cost-plus to prospective, prearranged payment amounts, organizations must make major adjustments in both attitude and operations. The challenges of making such a transition are exacerbated, of course, by the current external financial woes in the marketplace.
Adapting to the new fiscal environment is certainly not something an organization should do blindly. “It definitely must be done carefully and selectively,” said Stoner, “and it requires study. The challenge now for management is to acquire knowledge, make itself aware of the organization’s condition, and then act accordingly in terms of modifying operating standards or performance. They need to have a plan.”
Everything needs to be reviewed and evaluated, but staff salaries—including benefits—typically amount to roughly two-thirds of the cost structure of most organizations. Clearly, then, staff cuts must be a focal point. When considering staff reductions, jobs (including middle management) that proliferated with regard to the previous cost-plus type of reimbursement mechanisms are the primary levels that must be reviewed. Those staff members who should be maintained are, principally, those who provide direct care to the residents and/or patients.
Perhaps the most important consideration during this transition, though, is to maintain quality in terms of the care of residents and/or patients. “If the organization doesn’t adapt at all or changes inappropriately,” said Stoner, “that will affect the quality of care which, in turn, will affect the organization’s future operating capability. It will then have developed a reputation of simply cost-cutting, and any whispering about possible default will prove to be prophetic.”
Once the economy sorts itself out, the senior living sector will be facing a different environment, much like what is going on in the banking and finance industries, according to Stoner. “It’s not that I think national or regional senior living chains or organizations will become dominant, as they are for banks,” he said, “but I will say that I expect there will be a reconfiguration of the market. Those who are adept at making operational changes that retain quality will be in the best position to benefit. Whether they are individual homes or a collective group, they will be best suited and best positioned to meet the challenge when market conditions change.”
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Today’s Tough Credit Market Increases The Likelihood Of Defaults