Shifting M&A Climate Puts Senior Housing Cap Rates in Question

This coverage of the 2016 National Investment Center for Seniors Housing & Care Spring Investment Forum is brought to you by Mainstreet. As the nation’s largest developer of transitional care properties, Mainstreet specializes in real estate development, value investments and health care. With Mainstreet’s support, SHN brings this on-the-spot reporting from the NIC conference, which draws developers, providers and operators within the post-acute and preventative health care services space.

Conditions in the senior housing mergers and acquisitions market have shifted from where they have been in the last few years, and stakeholders are sending mixed signals about what to expect in the next 12 months.

There’s no question that real estate investment trusts (REITs) have become much less acquisitive, creating an opportunity for private equity and other types of buyers. But when it comes to predicting the future, industry leaders are not certain how the market will shake out, and conflicting expectations on cap rates may already be causing consternation among parties trying to get deals done, according to experts at last week’s National Investment Center for Seniors Housing & Care (NIC) Spring Investment Forum in Dallas.

Spotlight on private equity

The retreat of REITs is among the starkest differences between today’s dealmaking environment and that of the last several years. A rising interest rate environment that compromises the REITs’ cost of capital advantage, in tandem with acquisition prices that recently hit record highs, have sidelined the players that previously were snatching up large portfolios for a premium.

Many of the public REITs acknowledged in their recent earnings calls that they have slowed deal activity, and this was widely confirmed at the recent NIC Forum.

“It’s definitely true,” Chad Elliott, managing director of Lancaster Pollard’s mergers and acquisitions group, told Senior Housing News. “We’ve got a pipeline of about $350 million in transactions, and we’ve seen that in our deals. There are only about 15 senior care REITs, and I’ve met with eight already and they’re certainly on the sidelines [more so on assisted living deals].”

Toledo-based Welltower (NYSE: HCN), one of the “Big Three” health care REITs, is among those that have been public about being priced out of deals, with CEO Tom DeRosa saying so on the company’s two most recent quarterly earnings calls. The point was driven home at the NIC event by John J. Getchey, the company’s senior vice president of business development.

“Our cost of capital is up, our stock price is down,” he said during a NIC panel. “We’ve had a fun five-year run.”

Transaction volume has been down over the first quarter in particular, Getchey noted, saying that even the REIT’s recently announced investment in a $555 million joint venture came together over the summer.

The REITs are still bidding to keep their finger on the dealmaking pulse, but whereas before they were outbidding private equity buyers by 10% to 15%, now PE is often outbidding them by similar margins, said Elliott.

Private equity is the main buyer stepping up to fill the vacuum left by REITs, but so are smaller to medium sized regional operators looking to add scale, said Elliott and his colleague Steve Kennedy, senior managing director at Lancaster Pollard.

These owner-operators now have an opportunity to expand into underserved markets, such as certain pockets in the Midwest where the product tends to be aged, Kennedy said. But given that these buyers typically do not have the same breadth of capital as REITs, efficient and effective execution of these transactions is critically important.

The sweet spot

With REITs on the sidelines with their massive amounts of capital, it raises questions as to what deal flow currently looks like and whether there’s a “right size” deal for the bulk of likely buyers.

There still is a “tremendous” buyer group for deals ranging from $25 million to $100 million, said Aron Will, executive vice president with CBRE. For portfolio deals in the $300 million to $500 million range, the universe of buyers is smaller and there no longer necessarily is premium pricing on these transactions, Will said.

“There’s sometimes a portfolio premium if it’s precious real estate, but there’s not a premium just because it’s easy to acquire a large portfolio,” Will said.

Welltower still would be willing to pay a premium for a portfolio, but concentration of the assets is crucial, Getchey said.

“People come to us and say, we’ve got a portfolio of 20 buildings and it’s in 15 states,” he said. “That’s not a portfolio in my mind.”

If a deal involved, say, 10 buildings in the Los Angeles market, Getchey said he would entertain paying a premium.

Cap rates in question

With the M&A market at a seeming inflection point after the years of REIT-driven activity, there is some uncertainty about whether cap rates will increase or stay stable in the near-term.

“If you asked that quesiton a year ago, what a Class A senior housing property would trade at, 9 out of 10 people would give you the same answer, a 5.5 to 6.5 cap rate,” said Getchey. “Today, you talk to 10 people and you get three people who say it will stay the same, three people say it might stay the same, four say it’s going up, it’s really a tough answer.”

Indeed, when asked whether cap rates would stay the same or go up 50 basis points over the next year, give or take 5 points, the audience at Getchey’s NIC panel was split.

Getchey himself is in the camp that cap rates will likely go up by about that much. But at least for Class A properties, that might not be the case, said Will. Those types of properties might see a more modest 25 basis point increase, he proposed.

“We’re starting to see a larger delta in the B, B-minus [assets],” he added. “A lot of them were yield plays where they were trading like A-minus deals, and now they’re trading like B’s. That spread has gapped out more so than the A’s.”

Cap rates most likely will creep up gradually, although Class-A assets will see less change, agreed Colleen Blumenthal, managing director of HealthTrust, a senior housing and health care real estate advisory service.

But with so much uncertainty in the current environment, buyers and sellers may have different perceptions of what is reasonable. A deal she was working on fell through last year because there was about a 50 basis point gap between what the two parties expected, Blumenthal shared. Sellers may have to accept that pricing has passed its peak and the recent market cycle has ended.

“Right now, we’re kind of at a pause where there’s a little bit of a disconnect between buyers and sellers,” she said. “Sellers can’t believe it’s over and buyers are just not going there.”

Written by Tim Mullaney