Investors have for several years enjoyed historic low interest rates. But with recent statements from the Fed being interpreted to mean a rise in rates may finally be coming, it could be the end of an era.
While it’s no question that interest rates have no where to go but up, an essential question remains: What impact will rising interest rates have on cap rates and acquisitions in the senior housing market?
“Interest rates have a lot bearing on our sector in terms of cost of capital as well as in terms of pricing for real estate as it affects cap rates,” said Beth Mace, chief economist of the National Investment Center for Seniors Housing and Care (NIC), during a Senior Housing News webinar Wednesday.
“If cap rates go up, [senior housing] operators will want to maintain value,” she said. “They’ll have to see some type of increase in NOI growth to compensate for a cap rate increase. This is a serious implication.”
For instance, NOI growth of 9.1% is needed to compensate for a cap rate at 5.5% that increases by .5% to maintain constant value, Mace cited as an example.
As of March 25, the 10-year U.S. Treasury rate was at 1.88%, but that number could climb to as high as 3% or 3.5% by the start of 2017, according to Wall Street economists.
“This has generally been the forecast for many years and hasn’t come true in part because capital keeps coming into the U.S. economy as foreign capital finds investment opportunities more attractive here than overseas,” Mace said. “My feeling is that interest rates will move up some time later this year.”
However, cap rates are unlikely to increase in tandem with interest rates because of new capital coming into the sector, leading investors said.
“Cap rates are as low as they’ve ever been,” said Scott M. Brinker, executive vice president and chief investment officer of Health Care REIT (NYSE: HCN). “There’s more new capital entering the sector that we see than exiting, so cap rates may go down. Interest rates may increase, but I’m not sure we’ll see a point-to-point increase in cap rates at the same time because of the demand for product in the space.”
And a rising interest rate environment is unlikely to deter merger and acquisition (M&A) activity, said Chad Lavender, director of HFF, a Dallas-based provider of commercial real estate and capital markets services.
“We’re seeing new entrants in the space trying to enter with scale and [executing] larger transactions,” Lavender said, noting that the sector boasts a healthy competitive landscape.
In fact, transaction volume, not including non-traded health care real estate investment trust (REIT) transaction activity, will likely keep pace with last year’s record breaking M&A activity.
“At the property level, I think the volume will increase based on what we’re seeing and hearing from others in the marketplace,” Brinker said. “It’s a good time to buy and sell. It’s a good time to be a buyer because there’s plenty of access to equity and debt.”
Despite concerns over rising interest rates, industry analysts agree that activity among the “Big Three” health care REITs, specifically, won’t be significantly impacted as long as rates rise gradually.
“We never saw a big change in acquisition volumes as interest rates fluctuated [steadily],” Daniel Bernstein, Stifel analyst, tells SHN. “Now, if we have a really rapid rise, say 3%, then they will curtail their investment platforms.”
Bernstein notes that a small increase in rates, such as a 25 basis-point bump, won’t deter the top health care REITs from conducting business as usual.
“As long as there’s a rational and modest pace in interest rates, it won’t change their investment philosophy much,” he says. “It’s the rapid change in rates that will change investment philosophy to be either more or less aggressive.”
However, as noted in a recent industry update, Stifel suggests a continued focus on smaller cap health care REITs, such as Omega Healthcare Investors (NYSE: OHI), National Health Investors (NYSE: NHI) and Sabra Health Care REIT (NASDAQ: SBRA).
Growth among these industry players can “mitigate some risk from rising rates,” the report states. Such M&A activity could be a source of outperformance for the smaller REITs if interest rates do rise.
“There’s been continuing pressure on [consolidation],” Bernstein says. “We’ve seen recent public-to-public transactions — HealthLease was acquired by Health Care REIT, American Realty Capital Healthcare Trust was bought by Ventas, and the merger between Omega and Aviv. As other competitors have moved into the health care industry, there’s been a little bit of pressure to consolidate within the REIT space.”
Many companies invested in senior housing, not just health care REITs, are looking to scale to gain the advantages that come with a bigger pool of assets.
“Bigger companies tend to have better performance over time,” Health Care REIT’s Brinker said. “With scale comes better access to debt and equity. You see smaller companies trying to scale and mid-size companies getting bigger through mergers.”