The runway for distressed senior living properties is getting shorter.
Some operators have seen a slow march toward pre-pandemic occupancy gains and as well as to greater margins in 2022. Others have faced stalling or declining occupancy and revenue, coupled with strong headwinds from increased labor and operating expenses.
Banks and lenders gave operators a longer runway than usual to distressed assets during the pandemic. In essence, they have been willing to “extend and pretend’ and push costs or risk into the future. But that patience appears to be running out.
Instead of pushing out the runway much farther, they are now expecting senior living operators to meet the terms of their contracts, whether that means making regular loan payments, producing returns for investors, or meeting covenants such as for how much working capital they have.
And they could be more likely to sell underperforming assets, bring in new operators or take other dramatic steps to stop the bleeding on the balance sheet.
“I think a lot of lenders are saying it’s not getting better and that a change needs to happen,” said Senior Living Investment Brokerage (SLIB) Managing Director Jason Punzel. “They’re not extending and pretending.”
‘Haircuts’ are coming, reset looms
Ziegler Managing Director Dan Revie said he’s received “as many or more” in-bound calls from owners pondering just what to do with distressed assets this year than ever before. He noted that each situation is different and needs to be handled on a “case-by-case” basis. Ziegler is a Chicago-based specialty investment bank, capital markets and proprietary investments firm.
“There’s a lot of pressure that we’re seeing now that we didn’t see a year ago, or two years ago,” Revie said.
If an owner does decide to sell, Revie noted the time-intensive process that follows. A sales process can take “at least” six months start-to-finish, and projects going to market now would likely result in closing “sometime in 2023.”
“If the trend lines are up, you’ll have buyers that can see their way through from where we are at today and where they will be at closing,” Revie said. “On the flip side, if the trend lines are flat, I’m not sure there’s a big benefit to waiting to go to market.”
With new construction starts down as the industry stands on the precipice of 2023, investors could turn their focus to refining their portfolios in search of higher returns. Acquisition pricing in the sector has remained favorable, with some of the largest U.S. operators predicting a “transactional” year of M&A activity in 2023.
Evans Senior Investments (ESI) CEO Jeremy Stroiman said his firm has looked at “literally hundreds” of new senior living buildings that were built at $250,000 per unit but end up selling at $120,000 per unit. That creates a clear gap.
Stroiman said that what often happens is, an operator during planning may have thought it was going to be able to push through monthly rates of $6,500. But faced with the realities of leasing up during a pandemic, the operator was only able to put through $4,000 per month. At the same time, occupancy is in the 70th percentile — and that creates a squeeze.
“There’s going to be a reset of basis, meaning that an asset built at $250,000 a door is most likely going to trade and reset the basis to some number significantly lower than that,” Stroiman said. “Haircuts are coming and someone’s going to have to take one.”
Since 2020, ESI has closed on 108 communities, representing $1.43 billion in M&A volume.
In these tough situations, something’s got to give. And Stroiman said he’s hearing that lenders are “running out of options” with operators when it comes to distressed assets. He anticipates that will ultimately lead to a “huge falling out” from the lenders that is “months, not quarters away.”
“The impact of rising interest rates creates a perfect storm for a re-basis,” Stroiman said. “For the first time, the industry has been freaking out and for all the right reasons. I think it’s going to come crashing down here pretty quickly.”
Punzel said he felt the industry’s practice of extending and pretending was “coming to an end.” There are multiple reasons why, but a big one is that the urgency of the Covid-19 pandemic somewhat faded into the background as operators got more skilled in dealing with it.
“If you haven’t made any improvements in the last two-and-a-half years, you probably aren’t [going to,]” Punzel said. “Maybe it’s time for us to just be real and figure out a work-out plan.”
If there’s a struggling property on the books for an owner that hasn’t improved in recent years, Punzel said it could be a sign that the property is “functionally obsolete” and that property might need major capital improvements, or a new operator altogether.
But that perspective isn’t shared ubiquitously across the industry, with some in the space noting that “extend and pretend” might be a far better alternative than for an owner to default on a loan and be forced into foreclosure or Chapter 11 bankruptcy proceedings.
Walker & Dunlop Managing Director Mark Myers urged capital partners to work with lenders and owners to “work together” to overcome the “black-swan” impact of the pandemic. Between January and July of this year, Walker & Dunlop sold $1.3 billion of seniors housing and long-term care facilities.
“It would seem much better for a lender to extend credit or to not foreclose on the borrower, but rather work with them to extend beyond that crisis period,” Myers said.
Even still, Myers thinks that “many properties” are below the technical standards of their specific loan, whether it’s debt service coverage or days of cash on-hand.
“Just about every lender in the country could cause problems for their borrower,” Myers added. “They can’t force a sale, but encourage heavily. They can certainly put pressure on a borrower to either sell or foreclose on it.”
Avoiding the pain
Stroiman said that regardless of changing cap rates and fluctuating valuations, lenders will continue to chase cash flow as that is “king,” he added.
“Cash-flowing assets will always trade, because people are always chasing cash flow,” Stroiman said.
As recently as last week, Stroiman said he advised nearly a dozen owners not to sell a distressed community that was seeing occupancy in the 60th percentile. Instead, he urged them to initiate a turnaround, including by switching operators or finding new revenue streams.
“And I think this is a time to really be honest with one another and say, ‘We have got to hunker down and try to get through this,’” Stroiman said. “And there’s probably going to be some pain along the way.”
Myers said Walker & Dunlop is advising clients to establish or deepen ties to real estate investment trusts (REIT) and lenders.
“These companies are going to need these credit companies and the credit companies are going to need experienced operators and buyers,” Myers said.
Punzel added that valuations are often dependent upon whether or not the value falls into a price range “that works” for sellers.
And he cautioned companies that can’t get the price they want to “figure out how to improve the operations of your property.”
With industry headwinds around rising interest rates, and generally a tougher lending environment in general, Revie said owners must weigh their community’s data against industry trend lines and decide quickly on whether or not to transact.
“If you have trend lines that are flat, then I’m not sure there’s a big benefit to waiting,” Revie said.
Future opportunity
In the third quarter of 2022, 133 publicly-disclosed deals were made, marking the fourth-highest quarterly total ever, recent Levin Associates transaction data shows. Publicly closed transactions fell from 35 in August to 23 in September across IL, AL, active adult and CCRC publicly-disclosed transactions, according to the data.
Even so, anticipated M&A activity could lead to major opportunities for buyers, sellers, the brokerage community and everyone in between. In the short term, interest rates pose the biggest obstacle to deals.
Operationally, Punzel said he anticipates further gains being made in “all categories.” He argued that a “mild recession” would, while no doubt bad for workers, help operators shore up their workforces amid a historic labor crunch, which has already been on the way out this year.
On the M&A side, Punzel added that he felt the second half of 2023 could see a “pretty big boom” in activity, followed by a “huge year” for M&A in 2024.
Revie said 2023 may provide relief for some operators, with the hope that costs in certain areas go down while occupancy growth continues. But he acknowledged that inflation of certain budgetary line items, like labor costs, are here to stay.
In terms of future activity in the M&A markets, Revie said the runway for struggling properties might have truncated.
“The pandemic was a unique time for everyone,” Revie said. “That uniqueness really created these longer timeframes but I think as we’ve emerged from Covid we will get back to those shorter time periods.”
Last year and 2022 were “record” years for ESI, Stroiman noted, adding that M&A volume might not differ drastically from then. But instead of seeing a swath of transactions sell at $300,000 per unit, they could come in the form of smaller deals priced closer to $100,000 per unit.
“You can only extend that for so long,” Stroiman said. “At some point, you need to transact and we’re already seeing it.”
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