For years the investment returns on senior housing have been a bright spot in the real estate market. Understandably, that’s attracted more capital, particularly from private equity and institutional investors. In turn, capital has become plentiful and relatively easy to acquire, attracting owner/operators who see this as an opportunity to build new, state-of-the-art specialized facilities. But there is a growing danger. Construction rates are seemingly surpassing occupancy and absorption rates, creating a risky environment for owner/operators.
According to the National Investment Center for Senior Housing & Care (NIC), the occupancy rate for senior housing, which includes properties still in lease up, fell to 87.9% in the second quarter. Also through end of June 2018 quarterly absorption was only 55.7% for all new senior’s inventory growth. That was the lowest occupancy rate in seven years, concurrent with the largest inventory increase since NIC began reporting the data in 2006. Among the hardest hit sector was assisted living, which saw occupancy rates, fall to 85.2%. NIC forecasts that inventory growth in assisted living will outpace the ability for these new units to be absorbed over the next four quarters, pushing the occupancy rate down further.
Is senior housing construction in a bubble? Not yet. Although this is market dependent, there are danger signs that owner/operators should heed, before it’s too late. To rein in today’s rampant enthusiasm, avoid a potentially disastrous overbuilding scenario, and the potential for rising loan defaults, industry players should consider the following four points.
Boomers are getting old, but not that old
Much of today’s construction is justified by the aging Baby Boomers. There’s no question this 76 million strong generation will put plenty of demand on the senior care market…eventually. But the average age of today’s Boomer is 72; that’s 10 years younger than the average person in the previous generation, the Silent Generation, opted to move into senior housing.
Moreover, Boomers are generally healthier than the Silent Generation, so they may make use of these facilities at a later age. In other words, today’s building boom could be 10 years too soon. Adding to the uncertainty is that Boomers might make use of facilities differently than their predecessors.
Easy capital isn’t always the best option
Capitalization rates are coming down, so clearly investors are willing to take a lower return than in the past. But what’s more worrisome is that loan terms are getting so loose. Non-recourse construction loans with fewer covenants are becoming more common. While this may seem attractive on the surface, those who take a loan from lenders based on these looser terms could face future troubles. Instead of simply searching for easy capital, owner/operators should look for a bank that maintains consistent credit standards. A healthy loan portfolio over the long-term will ensure the lender will continue to support the senior housing and care industry, even during an economic downturn or market disruption. Borrowers should look for a lending partner experienced in the sector with a team of professionals who have worked through multiple economic cycles and “lived to lend another day.”
While new capital options are good and healthy for the industry by maintaining competition and spurring on new growth and capital options; their commitment to the sector has not been tested during the tough times. Will the Bank stick with your company through its challenges, or will it fold up its tents, sell your loan, or become aggressive in exercising its “legal remedies” to force a loan payoff?
For example, even though absorption rates are falling, some lenders are not requiring borrowers to guarantee beyond just completing the construction of the building. Now there is a new, but empty facility with no secondary source of capital. If the facility isn’t filling enough beds to enable the borrower to begin paying back the loan, what happens to that loan? With some form of guarantee during lease-up, the Bank can work with an owner to provide additional equity to extend the lease-up period without having a “classified” or bad loan in the bank portfolio. Without this capital support from the owner, the Bank has limited options. The last thing a bank wants to do is take ownership of a senior care facility, but that’s what could happen in this scenario given the Bank’s limited options. Once the lender starts having classified loans in the portfolio we see them pull back on providing new credit, if any at all.
That’s not all. Once-common covenants in Seniors Housing deals, such as requiring a certain cash flow-to-debt service or occupancy, are getting weaker or disappearing because many of the institutional and private equity investors view this as just another real estate class, and this was never a requirement in multi-family or other real estate segments. In reality it’s not about the real estate; this is about the quality of care, resident safety and customer satisfaction provided inside those walls.
Riskier than it seems
The population is getting older on average so the demand for senior housing certainly won’t cease. There are new facility types that owner/operators need to build to meet demand—such as memory care and a more moderately priced solution for skilled, assisted, memory care and independent
living. The older stock of seniors care and housing solutions just won’t cut it for Boomers who demand solid surface counter tops, the latest appliances, active lifestyle amenities, and “country club” like campuses. While we still see long corridors in many of the older skilled nursing facilities, the public views these as “the last stop” as opposed to a place of healing so they can return to their active lives. This must change. Plus, the facility must include a more moderately priced solution that also meets all the demands of the next seniors’ generation. Boomers have one of the lowest savings rates on record, with almost 50% of them having saved nothing for retirement. Pensions have become a thing of the past with few being able to rely upon that stream of cash flow in their retirement years. Where does that leave us? With the largest population of people moving into their senior years with only social security, and maybe the value of their homes to carry them through to the end. Owner/ operators should build now, to stay ahead of the curve all the while being careful to avoid falling into the trap of having empty beds. Being thoughtful about the type of facility built and doing deep research to determine site selection are good ways to avoid falling victim to the trend.
The next downturn
The current economic expansion is the second longest on record and in another year it will become the longest. It’s unlikely to end before hitting that milestone but it will end someday—a fact that some lenders as well as owner/operator seem at risk of forgetting. Global populism, anti-trade policies, and aggressive interest rate hikes by the Federal Reserve could all conspire to tip the country into a slower economic cycle. But whatever the precipitating event, the effects on an overbuilt senior housing market could be severe. Many new facilities are already struggling to achieve stabilized occupancy levels; an economic slowdown could create a shockwave that puts some owner/operators out of business.
We don’t think senior housing is in a bubble. But the industry must be diligent not to allow the sector to become overbuilt, and be realistic about the risks inherent in the senior housing market.
Owner/operators should seek out lenders with a deep expertise that can serve as true advisors in the development and success of new senior care facilities.
Owner/operators must also avoid making too many long-term assumptions—and too many long-term financial bets—about when and how the Baby Boomer generation will use these facilities. Much can change in the next 10 years before they are predicted to begin using senior housing en masse. We know the demand will eventually outstrip the current supply, but when? Will there be enough people with the means to support a continued construction of high end campuses being built today?