The steady stream of new senior housing inventory coming online through the mid-2020s has put pressure on operators to maintain occupancy. It is also focusing owners and operators to face the fact that historical trends in CapEx spending need to change.
Operators have been getting away with penciling in smaller allocations from their annual budgets toward capital expenditures because demand and supply dynamics were favorable, but they need to consider increasing those allocations or face a reckoning, LCB Senior Living CEO Michael Stoller told Senior Housing News. The Norwood, Massachusetts-based company has a portfolio of 27 communities in operation or under construction in New England and Pennsylvania.
Increasing CapEx allocations serves dual purposes of keeping properties in top shape in an increasingly competitive environment, and allows operators and their capital partners to recapture that investment if and when a property changes hands.
“It’s comparable to maintaining a car and trading it in for a newer model,” Stoller said.
Outdated allocation amounts
For the past 20 years, CapEx allocations have largely been trapped in amber.
Operators and their capital partners believed allocating between $300 and $400 per unit/per year was a good CapEx deposit baseline, one which was in place when Stoller founded Newton Senior Living in 1993. When he re-entered the space with LCB in 2011, banks were still suggesting the $300-$400 per unit annual range, which made little sense to him.
LCB allocates on average $1,200 per unit per year on capital expenses. For a 90-unit community, this equates to around $108,000 per year. The decision to increase CapEx was prescient, Stoller told SHN.
“From the standpoint of what is being built today, along with referrals and competition, senior housing is a different environment than a decade ago,” he said.
Not every operator or ownership group is being quite so aggressive. Bridgewood Property Company budgets between $300 and $500 per unit per year on CapEx, depending on the age of the building, founder and president Jim Gray told Senior Housing News. Based in Houston, Bridgewood owns and operates 22 properties in Texas, Oklahoma and Arkansas, totaling 2,600 independent living, assisted living and memory care units.
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There are exceptions to Bridgewood’s CapEx allocations, which are determined by extenuating circumstances such as resident turnover and needing to renovate or reposition common areas and amenities in response to new supply in some markets.
In these circumstances. Bridgewood’s CapEx spends can be as much as $3,000 per unit per year, Gray said.
According to CBRE’s Q2 2019 senior housing insight report, the average CapEx allocation for buyers remains between $300 and $500 per unit per year, depending on the age of the building and the strength of the market, CBRE National Senior Housing Executive Vice President Lisa Widmier told SHN.
“In [economic cycles] where the seller has an advantage, I’ve seen offering memorandums produced with no capital expenditure reserve above the NOI income line,” she said.
Buyers are budgeting and adjusting their CapEx depending on the age and condition of the property, and the hold period. They may be front loading their CapEx, if a community needs immediate improvements, or underwriting a more conservative allocation for properties in good condition.
Financial analysts agree that operators need to increase their CapEx funding, Green Street Advisors Analyst Lukas Hartwich told SHN.
“Green Street thinks 20%-25% of NOI is an appropriate long-term cap-ex reserve. Importantly, this is an average reserve. The real world is a lot lumpier with many years of little-to-no cap ex, and some years of really high cap ex spending,” he said.
REITs increasing allocations
In an environment with operating margins under pressure and labor expenses still ratcheting up, increasing CapEx spending is not necessarily an easy feat. LCB is drawing its CapEx allocations from cash flow, as part of its communities’ annual budgets. But in some domains — namely, RIDEA ventures undertaken with real estate investment truts — there are signs that CapEx allocations are increasing.
As health care real estate investment trusts have become more comfortable with RIDEA partnerships, they are increasing CapEx spends and often account for the entirety of capital expenditure allotments. REITs are spending between 20% and 25% of a property’s NOI on CapEx, to account for the age of the buildings and the improvements needed to compete with newer product, Hartwich told SHN.
CBRE is seeing buyers allocating between $1,000 and $1,500 per unit per year on CapEx. The higher allotments are more becoming more prevalent in markets where operators are combating occupancy loss, such as Dallas. These “defensive CapEx investments” are employed to stall further declines in occupancy, or to reposition a building in order to achieve maximum performance.
In other markets, investors are employing “offensive CapEx investments” to more effectively compete. Examples of offensive CapEx investments include a complete upgrade or renovation of common areas; adding additional amenities and activity areas; and combining smaller units into larger, more extravagant units to change target market of the community, Widmier told SHN.
REITs have even been proactive with triple-net leases and have funded some portion of CapEx allocations in these structures, and generally earn a return on this in the form of additional rent. They are doing so because operators in triple-net situations tend to invest only the minimum CapEx amount obligated under a lease agreement.
“There is little-to-no disclosure on how much CapEx is going into properties under triple-net leases. That being said, given poor rent coverage I would not be surprised to see that triple-net operators are not spending enough,” Hartwich said.