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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   February 2005

Financing Trends & Options in the Senior-Housing Market

After muddling through a prolonged slump caused by overbuilding and a sputtering economy, the senior-housing sector came to life during 2004. For skilled-nursing facilities (SNFs) and assisted-living facilities, deals are starting to get done at a faster clip. In the assisted-living market, for example, several aggressively priced acquisitions closed in the third quarter, most notably the $148 million purchase of a major portion of the Benchmark Assisted Living portfolio. Also, the stock prices for public long-term care companies have skyrocketed, with a half-dozen increasing 30 percent or more (as of Oct. 29, 2004) from their January 2004 levels.

The infusion of capital into the senior-housing sector is indicative of several positive developments that have considerably improved the financial outlook for middle-market companies. While challenges still abound, many nursing-home and assisted-living owner/operators are better positioned than they have been in years to recapitalize their businesses and/or pursue growth opportunities. Following is a brief scan of the marketplace trends that give cause for this optimism with a review of the options available to companies to take advantage of today’s more favorable debt- financing climate.

Demographic Factors

Even in the most trying conditions, senior-housing operators know that if they can just stay solvent, they always have an ace in the hole—the 76 million Baby Boomers born between 1946 and 1964. Finally, the first wave of the industry’s key demographic segment is approaching retirement age. The aging of these Boomers, coupled with their increased life expectancies, will progressively expand the prospect pool for senior-housing residents during the next 5 to 10 years. In 2003, the nursing and assisted-living facilities market was estimated at approximately $280 billion. By 2005, the number of men and women requiring long-term care will have jumped from 7 million to 9 million—nearly a 30 percent increase.

Other demographic trends highlight the sector’s potential for steady, long-term growth. According to the U.S. Census Bureau, the number of Americans ages 65 or older is expected to climb to approximately 40 million by 2010 and to approximately 54 million by 2020. Moreover, studies show that two of every three individuals ages 65 or older are likely to become either cognitively impaired or disabled in at least two activities of daily living. A study by the U.S. Department of Health and Human Services says that people who reach age 65 have a 40 percent chance of entering a nursing home; 10 percent of those who do will stay there five years or more.

Improving Fundamentals

Already, the senior housing market shows signs of being in the early stages of a sustainable recovery. The reimbursement climate continues to improve on both federal and state levels. In July 2004, the Centers for Medicare and Medicaid Services (CMS) announced a 2.8 percent increase in Medicare payment rates to SNFs, which will result in an estimated $440 million increase in Medicare payments in the fiscal year 2005. While several states have made noises about cutting Medicaid provider payments (which account for roughly two-thirds of a nursing home’s revenues), few have followed through on this implicit threat, no doubt fearful of the public’s reaction to cutting off funding for the indigent. In fact, more than a dozen states have initiated provider-bed taxes, which despite their onerous connotation increase Medicaid payments by qualifying the states to provide nursing homes with matching federal funds.

In addition, nursing-home occu­pancy rates and other key operating performance metrics have begun to stabilize, albeit at relatively modest levels. Median occupancy rates for assisted-living held steady during the second quarter of 2004 at 86 percent, with freestanding skilled-nursing facilities rising slightly to 88.5 percent.

Capital markets have begun to take notice of these positive developments. According to recent surveys from the National Investment Center for the Seniors Housing & Care Industries (NIC), the average assisted-living capi­talization rate dropped slightly in the second quarter of 2004 to 10.8 percent, with the lowest reported rate at 8 per­cent compared to 8.75 percent during the first quarter. The mean rates for SNFs still hover around 13 percent, but even this figure is a significant improvement over comparable capitalization rates of a few years ago. The relatively low cap rates, combined with the recent flurry of acquisitions, provide clear evi­dence that operators and debt providers envision sustainable profit potential for high-performing properties.

More Financing Options

The speed, strength and duration of the sector’s anticipated recovery will depend on multiple factors, particularly unforeseen developments in the broad economy and regulatory actions. For the short-term, however, it appears highly probable that senior-housing operators will need more capital. Not only are more properties expected to change hands, but many facilities will require refinancing because the 10-year mort­gages so prevalent in the mid-1990s are about to mature.

The availability of alternative sources for financing is a relatively recent devel­opment. Until a few years ago, entre­preneurial middle-market SNFs and assisted-living facilities essentially had two options. If their facilities had long histories of impressive financial perfor­mance, or if they had solid relationships in their local communities, they could probably get 10-year loans from their local banks. Or, if they were willing to make a long-term commitment to the business and didn’t mind doing the paperwork to comply with strict under­writing requirements, they could qualify for a 30- to 35-year HUD loan.

Today, a popular financing choice, particularly for strategic property acqui­sitions, is the short-term (three to five years) variable-rate bridge loan. This type of funding often can be secured in a matter of weeks (in contrast to three to six months for HUD loans) and can provide owner/operators with leverage multiples up to seven times EBITDA. When the loan matures, they can either cash in their profits from sell­ing the business or obtain permanent debt financing (e.g., 10-year loans with Fannie Mae and Freddie Mac or 30- to 35-year loans from HUD) at relatively low interest rates.

For owner/operators who want to maximize the amount of the loan and are unconcerned about building equity, Real Estate Investment Trusts (REITs) are another possibility. The typical REIT transaction is structured as a sales-lease­back (with lease terms usually 10-15 years), which gives the REIT full own­ership of the property. This financing vehicle enables the operator to monetize equity while maintaining a steady cash flow from operations.

Even the “vanilla” HUD loans now come in slightly different flavors. For example, some lenders are now offering a locked-in rate program for HUD loans to give borrowers a hedge against rising interest rates.

Lastly, middle-market owners more interested in exit strategies than debt financing should consider partnering with private equity firms, which are estimated to have at least $30 billion available to invest in companies with $10 million to $200 million enterprise values. As the prospects for SNFs and assisted-living facilities continue to improve, these private equity buyers will consider the senior-housing sector an attractive target.

Final Word

According to a December 2004 NIC report, the senior-living industry has seen an approximate 15 percent increase in market capitalization (i.e., net profit returns converted to a capitalized investment value) despite its decreasing operating margins in the past six years. The report attributes this surprisingly vigorous growth rate to increases in rev­enues per unit occupied—an indication of strong market demand and improve­ments in operational efficiency.

As we’ve seen, the senior-housing sector is heating up and poised to capitalize on favorable demographic and marketplace trends. With capital markets showing increased confidence in the senior-housing sector and more financing alternatives available, the top-performing SNFs and assisted-living facilities are well positioned for strategic growth.


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