For years, the investment returns on senior housing have been a bright spot in the real estate market. Understandably, that has attracted more capital, particularly from private equity and institutional investors. In turn, capital has become plentiful and relatively easy-to-acquire, attracting owner/operators who see this as an opportunity to build new, state-of-the-art specialized facilities.
A growing danger exists, however. Construction rates seemingly are surpassing occupancy and absorption rates, creating a risky environment for owner/operators.
According to the National Investment Center for Seniors Housing & Care, the occupancy rate for senior housing, which includes properties still in lease up, fell to an average of 87.9% in the third quarter, the lowest occupancy rate since the second quarter of 2011, when it was 87.5%. Also, through end of September 2018, annual absorption was 2.4%, down 0.1 percentage point from the second quarter and 0.1 percentage point from one year earlier.
Among the hardest hit sectors was assisted living, which saw average occupancy rates of 85.3%, up 0.1 percentage point from the previous quarter but down 1.2 percentage point from a year ago. NIC forecasts that inventory growth in assisted living will outpace the ability of these new units to be absorbed in the near future, pushing the occupancy rate down further.
Is senior housing construction in a bubble? Not yet. Although this is market-dependent, there are danger signs that owner/operators should heed before it is too late. To rein in today’s rampant enthusiasm, avoid a potentially disastrous overbuilding scenario and the potential for rising loan defaults, industry players should consider the following four points.
1. Boomers are getting old, but not that old
Much of today’s construction seemingly is justified by the aging baby boomers. There’s no question this 76 million strong generation will put plenty of demand on the senior care market … eventually. But even the very oldest boomers are 72 years old (the youngest are turning 54 this year); that’s 10 years younger than the average person in the previous generation, the Silent Generation, opted to move into senior housing.
Moreover, boomers generally are healthier than members of the Silent Generation, so they may make use of these communities at a later age. In other words, today’s building boom could be 10 years too soon. Adding to the uncertainty is that boomers might make use of communities differently than did their predecessors.
2. Easy capital isn’t always the best option
Capitalization rates are coming down so, clearly, investors are willing to take a lower return than in the past. But what’s more worrisome is that loan terms are getting so loose. Non-recourse construction loans with fewer covenants are becoming more common. Although this may seem attractive on the surface, I believe that those who take a loan from lenders based on those looser terms could face future troubles.
Instead of simply searching for easy capital, owner / operators should consider looking for a bank that maintains consistent credit standards. A healthy loan portfolio, over the long term, could ensure that the lender will continue to support the senior housing and care industry, even during an economic downturn or market disruption. Borrowers should look for a lending partner experienced in the sector, with a team of professionals who have worked through multiple economic cycles and “lived to lend another day.”
Although new capital options are good and healthy for the industry by maintaining competition and spurring on new growth and capital options, their commitment to the sector may not have been tested during the tough times. Will the bank stick with your company through its challenges, or will it fold up its tents, sell your loan or become aggressive in exercising its “legal remedies” to force a loan payoff?
For example, even though absorption rates are falling, some lenders are not requiring borrowers to guarantee beyond just completing the construction of the building. Now there is a new, but empty, facility with no secondary source of capital. If the facility isn’t filling enough beds to enable the borrower to begin paying back the loan, what happens to that loan?
With some form of guarantee during lease-up, the bank can work with an owner to provide additional equity to extend the lease-up period without having a “classified” or bad loan in the bank portfolio. Without this capital support from the owner, the bank may have limited options.
The last thing a bank wants to do is take ownership of a senior living community, but that’s what could happen in this scenario, given the bank’s limited options. Once the lender starts having classified loans in the portfolio, we see them pull back on providing new credit, if any at all.
That’s not all. Once-common covenants in seniors housing deals, such as requiring a certain cash flow-to-debt service or occupancy, are getting weaker or disappearing because many of the institutional and private equity investors view this setting as just another real estate class, and this covenant never was a requirement in multi-family or other real estate segments. In reality, it’s not about the real estate; this is about the quality of care, resident safety and customer satisfaction provided inside those walls.
3. Riskier than it seems
The population is getting older, on average, so the demand for senior housing certainly won’t cease. There are new facility types that owner / operators need to build to meet demand — such as memory care and more moderately priced solutions for skilled nursing, assisted living, memory care and independent living.
The older stock of seniors housing and care communities just won’t cut it for boomers who demand solid-surface counter tops, the latest appliances, active lifestyle amenities and “country club”-like campuses. Although we still see long corridors in many of the older skilled nursing facilities, the public views these as “the last stop” as opposed to a place of healing so they can return to their active lives. This must change.
Plus, the community must include a more moderately priced solution that also meets all the demands of the next seniors generation. Boomers have one of the lowest savings rates on record, with almost 50% of them having saved nothing for retirement. Pensions have become a thing of the past, with few being able to rely on that stream of cash flow in their retirement years.
Where does that leave us? With the largest population of people moving into their senior years with only Social Security, and maybe the value of their homes, to carry them through to the end.
Owner/ operators should consider building now, to stay ahead of the curve, all the while being careful to avoid falling into the trap of having empty beds. Being careful about the type of facility built and doing deep research to determine site selection are good ways to avoid falling victim to the trend.
4. The next downturn
The current economic expansion is the second longest on record, and in another year, it will become the longest. It’s unlikely to end before hitting that milestone, but it will end someday— a fact that some lenders as well as owner/operator seem at risk of forgetting.
Global populism, anti-trade policies and aggressive interest rate hikes by the Federal Reserve all could conspire to tip the country into a slower economic cycle. But whatever the precipitating event, the effects on an overbuilt senior housing market could be severe. Many new communities already are struggling to achieve stabilized occupancy levels. An economic slowdown could create a shockwave that puts some owner/operators out of business.
We don’t think senior housing is in a bubble. But the industry must be diligent not to allow the sector to become overbuilt, and it must be realistic about the risks inherent in the senior housing market. Owner / operators should seek out lenders with a deep expertise that can serve as true advisers in the development and success of new senior living communities.
Owner / operators also must avoid making too many long-term assumptions — and too many long-term financial bets — about when and how the baby boomer generation will move into and use these communities. Much can change in the next 10 years before they are predicted to begin using seniors housing en masse.
We know the demand eventually will outstrip the current supply, but when? Will there be enough people with the means to support a continued construction of high end campuses being built today?
