Currently, about 8,000 Americans will turn 65 each day according to the American Association of Retired Persons. Many of the individuals will eventually need some form of assistance in daily living and will entertain the idea of moving into a senior living community where many amenities are offered that make daily living easier than homeownership. As such, seniors housing has become quite the attractive industry for real estate investors and developers seeking new construction, turnaround projects or acquisitions of stabilized assets.
Although traditional funding sources such as agency financing and tax-exempt bonds still play a large role in seniors housing finance, the sector is seeing an increased interest in alternative capital sources. A recent influx of private capital and alternative financing structures into the seniors housing industry allows firms and individuals to consider multiple financing sources and capital pools to leverage their equity base and limit their own financial capital in projects.
According to The National Investment Center for Seniors Housing & Care (NIC) Map Data Service, senior housings sales transactions for 2014 totaled approximately $11 billion through August of 2014. This is an increase of 28% when compared to the same period last year. According to NIC, nearly $50 billion in closed transactions have occurred since 2010. Investment opportunities to capitalize on potential high return projects in the growing seniors population are available to investors and developers across the country. Figure 1 shows the projected population growth rates of individuals aged 85+ compared to those aged less than 85 years.
Findings from the CBRE’s 2014 Cap Rate Survey reveal that seniors housing construction is still a potentially lucrative investment for tenured operators looking to grow, as well as opportunistic developers seeking diversification from typical multifamily projects. While construction activity is currently in a high-growth expansion phase in certain markets, the total supply is still not enough to meet the projected demand for units. According to the survey’s findings, current supply will have to increase approximately 150% to meet demand in 2044, with a substantial shortage appearing in 2024. CBRE reports around 40,000 senior living dwellings must be added each year to meet demand. For comparison, the current construction rate of senior living units is about 16,000 units each year.
As has been seen in other commercial real estate sectors, a flood of equity capital has found its way to the seniors housing market. Ranging from individual investors to multi-billion dollar Real Estate Investment Trusts (REITs), equity partners may seek to own a property outright and lease the building to a qualified operator to provide daily oversight. While terms and conditions can vary widely between equity sources, this structure typically brings a well-capitalized partner to the table who can close on an expedited timeline which can help accelerate the development and construction of the facility.
Recent high profile transactions among publically traded REITs focusing on senior living include the Omega Healthcare Investors merger with Aviv REIT. In aggregate, the firms combined for 789 skilled nursing facilities at the time of the announcement. To apply scale to that figure, the nearest competitor in terms of pure size is Ventas, which currently owns 369 such facilities. From a market cap perspective, the size of the publicly traded senior living focused firms is consistently growing. Also, capital inflows to these organizations through the debt and equity capital markets continues to increase as retail and institutional investors alike recognize the industry’s strength. This may be driven in part by the general thirst for yield among investors, but the primary motive is certainly the projected growth in demand for the underlying services provided by the operating entity tenants.
With all the activity in the space, there is certainly capital available to those seeking new development projects or acquisitions of operational facilities. These can come in traditional forms of lending from banks or financing companies. The loan amount of a commercial mortgage is generally determined based on maximum loan to value (LTV) and minimum debt service coverage ratios. Personal and/or corporate guarantees are common in these financing structures.
Equity sponsors or mezzanine lenders provide capital in a number of ways. First, these capital sources can take the place of equity required from the developer during transactions utilizing traditional bank financing. For example, on a commercial mortgage loan providing 80% LTV, the developer’s equity requirement of 20% can be funded through a combination of mezzanine debt, preferred equity and/or true sponsor (developer) equity.
Alternatively, an equity provider in the form of a publically traded or privately held REIT can also fund close to 100% of total project costs. Predominantly, the individual transaction structures are landlord/lessee in which the operator pays a triple net lease to the REIT. The lease structures and terms of the agreements are variable, as is the amount of equity required, if any, of the development team. In some transactions, joint ventures are formed between operators and developers. This new tenant entity aligns the interests of both the development team and the operator by creating an organizational structure that offers a sharing of the upside from the project’s performance and eventual reversion back to the original ownership.
Some private equity providers may structure the lease agreement in a way that allows for the purchase of the asset by the tenant before the lease period ends. These purchase options are normally based on a capitalization rate applied to the then current net operating income generated by the facility, though they can be structured and negotiated in any number of ways to fit a particular need for the operator or asset owner. An equity fund such as ProperoTM Seniors Housing Equity Fund, LLC, for example, structures its lease agreements in a manner that incentivizes tenants to reach stabilization quickly by providing cost-based purchase options throughout the early years of the lease term. To the extent that a project leases up quickly and proforma margins are realized, the value creation can be significant in comparison to the cost-based purchase options. As such, operators can capture this upside, or value creation, by financing the acquisition of the facility with traditional first mortgage debt, often without contributing any further equity to the project.
Importantly, it should be noted that the lease structure, or lack thereof, is an important distinction between traditional REITs, private equity and an equity source such as ProperoTM. Traditional private equity structures typically are not lease transactions. They will provide the majority, if not all, of the equity and will receive priority returns. The other critical distinction is that the private equity investor controls the exit and determines when and at what price to exit, as opposed to the predetermined purchase options available with an equity fund such as ProperoTM.
The multitude of alternative financing structures and capital pools allows for operators and developers to accelerate growth without putting all the organization’s capital to work on a single project. Most organizations that are considering significant future growth to achieve scale welcome the prospect of stretching their equity with additional funding sources, especially new firms with limited resources. For many operators, it makes sense to seek these alternative funding sources as bank financing is not always the most efficient solution.
Partnering with a senior living financing specialist to seek advice on sourcing capital from these different pools should be the first step for most operators and developers. If the past is any indication, the growth of the seniors housing sector will draw more participants and investors to the space, increasing the number of opportunities upon which top operators can capitalize. The transaction volume, market participants, and financing sources will continue to grow along with the demand for this product in the medium- and long-term.
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