Senior Housing Deal Underwriting Adapts as Market Passes Peak Volatility

Senior housing capital markets are beginning to show signs of stability, more than two months after the coronavirus pandemic sent the markets into a time of peak volatility.

Investors — particularly private equity — are raising funds. Lending is slowly loosening. Temporary expenses such as hazard pay and personal protective equipment (PPE) are separated from permanent expenses in underwriting. And brokers are beginning to receive inquiries as the industry continues to settle from April’s massive disruption.

But barriers to completing transactions remain, and occupancy and rental rates are not likely to bounce back to Q1 2019 levels for at least a year, according to experts who spoke Thursday on a webinar hosted by the National Investment Center for Seniors Housing & Care (NIC).

Still, investors and brokers recognize that the pandemic is a temporary situation which will gradually improve, JLL Valuation & Advisory Services Managing Director Charlie Bissell said.

[Based on] the phone calls we have with investors and operators, it seems like every call I get is a little bit more optimistic,” he said.

Asset-focused underwriting

The retreat of lenders from the debt and equity markets as the pandemic spread resulted in brokers amending how they are underwriting deals, because there are very few sales comparables to reference. Brokers are now taking a property-by-property approach to underwriting, focusing on discounted cash flow.

“You take the pre Covid-19 financials, see what happens to the property during [the pandemic] and then make some reasonable forward assumptions over a five or seven year hold period,” Bissell said.

Brokers appear to be honing in on a common performance metric where Covid-19 is having adverse impacts across the industry: occupancy. This has a corresponding performance on rental rates moving forward — the steeper the occupancy drop in a community, the more conservative the underwriting.

“A lot of the investors are saying they don’t expect much rental rate growth for the next 18 months,” Bissell said.

Brokers are also advising providers to isolate Covid-19 labor and supply expenses from fixed costs, to give buyers a better sense of a community’s financial position, how it was impacted by the pandemic, and improvement over time.

“We are underwriting one-time expenses and trying to put those below the line where possible. We are battling with investors and buyers and trying to negotiate what is permanent here to stay in terms of escalated operating costs,” Blueprint Healthcare Real Estate Advisors Founding Partner and Executive Managing Director Ben Firestone said.

Structured deals gain favor

As a property type, the needs-based nature of senior housing continues to attract investors and capital to the space. Buyers are able to find lending sources with attractive interest rates, mainly from agency debt and non-bank lenders, as well as some banks.

But lease stabilization and occupancy pro formas are being extended, resulting in more leverage needed to secure financing, which is a sign of institutions viewing senior housing as a near-term risk, Firestone said.

Continued market frothiness has brokers turning to structured deals projecting a yield guarantee over a period of time, Cushman & Wakefield Senior Housing Capital Markets Executive Managing Director Richard Swartz said. These deals typically work best with recapitalizations where an operator stays in place.

“As long as that operator is staying with a new capital partner, that would allow a buyer to pay a more traditional value for the product knowing that they’ll get through the short-term expense issues and share the risk,” he said.

The panelists are receiving more calls in recent weeks from funds seeking to deploy capital toward distressed assets. Private equity, notably, believes there is a window of opportunity to acquire properties at a discounted rate.

Cushman & Wakefield recently completed a three-property, $100 million transaction. Two of the properties were struggling with occupancy and the bidding process received a high volume of activity.

Moving forward, Swartz sees growing competition for distressed properties and buyers will target opportunities on an asset basis, rather than by market.

“They could be anywhere in the country. We’ve seen that happen in the midst of very strong markets,” he said.

A slow bounceback

While many senior living professionals believe the industry will be able to tap into pent-up demand for senior housing once communities re-open, a quick return to form is not anticipated. The pace of reopenings, coupled with perceptions of long-term care’s response to Covid-19 from news reports, have brokers predicting a slow and steady increase in occupancy.

NIC data reported an occupancy rate of 87.1% in the first quarter of this year, prior to the pandemic. NIC Chief Economist Beth Burnham Mace predicts that the occupancy rate will be in the mid-80% range a year from now, but will eventually return to first quarter numbers.

Operators, however, are more optimistic in their discussions with brokers and believe the latent demand will result in a quicker recovery.

“We may see that recovery a little bit quicker,” Swartz said.