A gap between asking prices and bids is emerging in senior housing valuations, as the mergers and acquisition landscape begins to stabilize. Capital markets, meanwhile, continue to struggle with imbalance due to tighter loan underwriting and a lack of bridge debt.
Signs of growing distress among smaller and struggling operators are contributing to the pricing disconnect, especially among sellers that have not adjusted their expectations as a result of Covid-19 pressures, according to deal advisors who spoke to Senior Housing News. But senior housing cap rates among sales of core assets have mostly held steady throughout the coronavirus pandemic – a sign of the sector’s relative stability compared to other real estate product types.
Investors, meanwhile, are seeing lower returns due to leverage constriction stemming from higher pandemic-related expenses, CBRE National Senior Housing Capital Markets (NYSE: CBRE) Executive Vice President Lisa Widmier said during a recent podcast. Bridge debt for acquisitions remains tough to secure, and lenders continue to insist on higher reserves for interest and operations.
Despite signs that the balance is returning to the debt and equity markets, sales advisors still report struggles obtaining debt – notably bridge debt – and lenders are still requiring significant reserves for interest and operations when underwriting loans. It is unknown when true balance will return, Berkadia Seniors Housing & Healthcare Investment Sales Lead Tim Cobb told SHN.
Minimal cap rate movement
Commercial real estate cap rates have widened since the pandemic swept the country in the spring, according to a new Q3 2020 U.S. cap rate survey released by CBRE.
Investment volume is down significantly across all real estate sectors, relative to pre-pandemic levels, although investor sentiment and liquidity remain strong in some segments. Most of the cap rate compression is a result of assets being underwritten with lower first-year income assumptions resulting in lower cap rates, because cap rates are calculated as net operating income (NOI) divided by the acquisition price.
The report also suggests that a pricing disconnect has emerged, with more than 60% of buyers looking for discounts from pre-pandemic prices versus 9% of sellers willing to offer them.
Despite operational struggles, senior housing is still considered a stable investment and has not experienced cap rate compression or significant pricing disconnects, Widmier said.
The Los Angeles-based firm has not experienced significant discounting on stabilized assets it has brought to market so far, although it placed non-stabilized properties on hold in March. These deals have returned as the general market stabilizes.
“The assets we’ve been selling have compelling reasons as to why an investor is interested in them,” she said.
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A historic low interest rate environment is another factor for the lack of senior housing cap rate movement, Healthcare Transactions Group (HTC) Founder/Principal Mark Davis told SHN. Based in Reisterstown, Maryland, HTC offers brokerage and advisory services in health care real estate mergers and acquisitions.
Even as lenders raise the equity-to-loan percentage in their underwriting, the cost of capital remains very low, and that is spurring activity.
“We still see robust interest in the industry, despite all the [pressures],” he said
Outsized seller expectations
There are signs of pricing disconnect emerging in senior housing, primarily from sellers who see the pandemic as a temporary setback. These sellers have not adjusted exit expectations as the outbreak continues to pressure operations and occupancy rates, and lenders now require buyers to place up to a year of cash reserves for interest and operating expenses.
Pre-pandemic, pricing was more aggressive because it was based on where operations stood at the time and buyers could project where improvements could be made. Now, buyers are content if operators can hold their own with the ongoing outbreak, and are willing to price bids based on 2019 levels but not much more, Davis told SHN.
“We explain to [sellers], ‘You need to understand that if you could get 2019 prices, that’s a success,’” he said.
The quality of the operator is another contributing factor to any pricing disconnect, Knapp Group Seniors Housing Advisors Investment Associate Joseph Knapp told SHN. Based in Southfield, Michigan, Knapp Group is an affiliate of real estate services firm Marcus & Millichap.
The pandemic clearly differentiated operators that responded well to Covid-19 outbreaks from operators that struggled, and continue to struggle, to keep residents safe from the virus. Buyers are willing to meet a bid, or offer only slight discounts, on opportunities where there is a strong operator in place that has managed to keep residents safe and capably manage NOI over the past seven months.
“If they’re operating on all cylinders, their NOI was very strong, and entered the pandemic still showing a slight dip, they’re in a very good position [to find] a good buyer,” Knapp said.
Constrained bridge debt
The imbalance in the debt and equity markets is primarily in a lack of bridge debt. Few lenders in the space are willing to consider underwriting bridge lending, unless it is tied to debt from Fannie Mae, Freddie Mac or the Department of Housing and Urban Development (HUD).
Bridge debt is riskier and comes with higher interest rates and terms, and is placed if a lender has confidence that a borrower can use the proceeds to stabilize an asset to where it can obtain more permanent financing, thereby justifying servicing the higher debt.
There is no appetite at this time to underwrite a significant pro forma upside, unless it is a situation where there are clear economies of scale. Lenders still on the sidelines understand that there will not be dramatic increases in occupancy or significant decreases in expenses, as long as operators continue to restrict communities in order to prevent outbreaks and keep residents safe, Davis told SHN.
“No one is willing to go to the upside scenarios,” Davis said.
The bridge debt environment has a disparity between recourse and non-recourse debt, as well. Recourse debt, which is typically backed by collateral from the borrower, has very tough underwriting and lower leverage, but it can be obtained. Conversely, non-recourse debt is virtually nonexistent, Cobb said.
“As long as the agencies are still putting on reserve requirements and less leverage, bridge lenders don’t have a clear sight line to [return],” he said.
Borrowers should not expect a loosening of bridge lending anytime soon. Lenders and operators are still getting a sense of what expense increases stemming from the pandemic will be permanent, and which ones will fade away.
“I don’t see reserves loosening up – certainly not until the first quarter [of 2021],” CBRE’s Widmier said. “Hopefully by then, operators will get a handle on what’s their new normal.”