A Fascinating Perspective From Recent Cain Brothers Research
Does the higher cost of capital increase the likelihood of a default? The initial reaction might be, “Yes, of course.” Yet it’s really not so simple. In fact, Joseph P. Mulligan, Managing Director of Cain Brothers in St. Louis, Missouri, has spearheaded a research project aimed at digging into the historical correlation between high capital costs and default rates for not-for-profit senior living financing. In March, he shared the initial results of that research. And it’s not all bad news.
First, it’s important to clarify that the primary market for non-rated, fixed-rate, tax-exempt bonds is still experiencing scarce issuance as we enter Q2 2009. “The non-rated market is still pretty frozen,” said Mulligan. “We have seen only one publicly offered, non-rated senior living bond issue close since last September.” That was the $30 million deal for Christian Living Communities in Colorado, which was issued with a 9.00% yield on the long end and structured by Ziegler Capital Markets. It closed in February (see Senior Living Business, March 09, p. 4, and February 09, p. 1).
“And just to give some added perspective,” he noted, “60 non-rated, fixed-rate senior living transactions with a par amount greater than $10 million and a total value of $2.7 billion were completed in 2007, according to Thomson Financial Securities Data. In 2008, only seven non-rated, fixed-rate senior living transactions were completed with a total value of $170 million. That’s an astounding difference.”
Therefore, with virtually no non-rated volume occurring in the primary market, the secondary market for non-rated senior living bonds assumes increased importance when trying to gauge current institutional market activity.
Primary market: A new bond issuance that trades within the 90-day syndicate period.
Secondary market: Bonds that trade in the after market — after the 90-day syndicate period has closed.
Looking at secondary market trading activity in the first few days of April, it appears that trades of $250,000 or more in value are occurring at yields of 9-10%. “That becomes your best proxy,” said Mulligan. “If investors are trading at that level in the secondary market, that’s probably the spot rate for anyone bringing a new issue to market. An investor is unlikely to buy bonds with, say, an 8% yield if bonds in the secondary market—perhaps for projects where the construction risk is already finished— are being sold at 10%.”
The Cain Brothers research project includes an analysis of all publicly offered, fixed-rate, tax-exempt senior living bond issues for new projects that were issued between 1991 and 2002 with a par amount of more than $10 million and a yield of at least 8.5%. There were no transactions with a coupon of 8.5% or more between years 2003 and 2007, when credit spreads tightened and muni yields went down.
The researchers identified 47 separate transactions with coupons ranging from 8.5% to 12%. The vast majority of bond issues were offered by CCRCs, and most were issued in the early to mid-1990s. Among the 47 deals, 37 (79%) were for start-up communities, five (9%) were for acquisitions, three (6%) were for expansions, and two (4%) were for replacement communities. Further, 36 (77%) of the 47 bond issues were refunded subsequent to the date of original issuance, and four (8%) remained outstanding with no default. Only seven (15%) experienced a payment default—five start-up communities, one acquisition, and one replacement campus.
Perspective is always important, however, so Mulligan compared his findings to a default study—“Municipal Default Risk Revisited”—that Fitch Ratings completed in 2003. In that study, which analyzed municipal defaults from 1979 through 1997 across all sectors, structures, and coupon rates, Fitch found a 5.5% default rate for retirement/congregate living community financings.
“While our research and the Fitch study vary in timeframe and parameters, it is noteworthy that we found the default rate for senior living bond issues with a coupon above 8.5% to be more than three times higher than the broader senior living default rate reported in the Fitch study,” Mulligan acknowledged. “But we’re not suggesting that capital cost is the only reason for default. An infinite number of factors—including the capital markets—influence the ultimate success or failure of a project. So the point of our study is really to drill down and try to determine the elements or characteristics that have historically resulted in strong projects.”
Mulligan was also curious about how long expensive capital stayed on the organization’s balance sheet before it was refinanced. “For all organizations with a coupon of more than 8.5%, the average duration on the books was just under five years,” he said. “Intuitively, that makes sense. Whether it’s a start-up or an existing community doing a major expansion, there’s generally a 12- to 24-month construction period and then a 12- to 24-month fill-up period. According to most feasibility studies, it’s really not until the fifth year that the project becomes fully stabilized from a credit perspective and the organization is able to refinance the debt.”
A cautionary note: An organization’s board of directors should be careful not to fall into the same trap that too many homebuyers fell into in recent years; that is, taking out a short-term ARM and worrying about the rate reset in five years. We’re all seeing the results of that strategy.
Likelihood of default
The Cain Brothers study does not indicate a break-even point where capital costs may cause a higher incidence of default. “We’re trying to compute a weighted average cost of capital to figure out the answer,” he said. “It’s quite challenging, though, because there are so many moving pieces.” While it’s only speculation and certainly not scientific, a break-even point somewhere around 7-7.25% weighted average cost of capital is the figure that is generally “floating through the halls.”
Default, of course, has two different interpretations: technical default, when a covenant is violated, and payment default, which involves missing a scheduled payment requirement. In cases where a letter of credit is the security for the bond issue, an organization may not be required to publicly report a technical default; even then, banks have the ability to waive technical violations.
“We have not yet seen significant payment defaults,” said Mulligan, “but we are absolutely seeing organizations that are under significant stress because they are unable to meet their projections. We’re seeing fill-up, presales, and occupancy levels underperform. We’re seeing declining liquidity levels due to equity market losses. Organizations are generating less investment income; consequently, many start-ups or communities that did significant expansions are really struggling. And if these trends continue, I don’t think we’d be surprised to see more payment defaults.”
Strategies for tough times
Despite the current environment, an organization may have good reason to move forward on, say, an expansion project at this time. And since financing is not only scarce but also expensive, Mulligan wants to be able to give his clients guidance with regard to how long they should plan to keep that debt outstanding. “We’re looking at the past to help our clients plan for the future,” he said.
“Again, it’s always a matter of perspective,” he added. “Yes, the default rate that we found was three times higher than that determined by the broader, more comprehensive, longer duration study that Fitch did in 2003. The flip side, though, is that the 15% default rate that we found wasn’t particularly high based on default rates for non-rated corporations or other types of debt.” In fact, 85% of the communities in the study successfully refinanced their high interest-rate debt or continued to operate without a default.
The other piece of good news from the Cain Brothers study—and there absolutely is good news, according to Mulligan—is that none of the defaults involved expansions. “The implication there is that a not-for-profit retirement community can probably sustain some expensive capital as long as it doesn’t represent all of its capital,” he explained. “It’s not uncommon for some of the larger single-site organizations and multi-site organizations to have two or three bond issues outstanding at any given time. If one financing has a true interest cost of 5.5%, another of 6%, and new debt is then issued at 8.5%, for example, the weighted average cost of capital becomes something less than 8.5%. So with a base of more manageable debt—and depending on how significant the expansion project is—the organization may be able to withstand the more expensive debt.” Based on some of the lessons learned from the default analyses, as well as on feedback from investors and lenders, Mulligan suggested five new planning strategies to take into account:
1. The days of 100% financing are pretty much gone. Letter-of-credit banks are now looking at 65-70% LTV (loan-to-value) financing, so organizations must expect to put some skin in the game.
2. There’s a lot more focus on the relationship between average entry fees and median home values, as weighted average entry fees exceeded 110% of the median home value in the PMA for many larger projects that were recently completed. Organizations should consider looking closely at the number of new units they are offering at a higher price point in conjunction with the market depth of homes in the upper 50% of median area home sales.
3. With liquidity levels down, organizations that have budgeted capital expenditures of at least one times depreciation and are keeping their plants fresh and marketable are generally not running into the spiraling problems faced by those who can’t afford to reinvest and have to wait to make improvements via “catch-up” financings that are not revenue accretive.
4. Many organizations used presales strategies for new projects that functioned more as a gauge of market demand than as a prospective resident’s firm commitment to move into a unit. To minimize high levels of cancellations, qualified presales should require financial penalties for early withdrawal by the depositor.
5. With regard to project financing “take-out” strategies, plan for the worst and hope for the best. Consider, for example, what would happen if the time between origination and refunding became 10 years instead of five.
In the meantime, Mulligan and his team are continuing to analyze the historical data and expand the research to help provide insights to clients that are grappling with the economic stresses caused by today’s high capital costs, wide credit spreads, and scarce issuance of non-rated, fixed-rate, tax-exempt senior living bonds. More results are expected in the next few weeks.
April 1, 2009