Colorado Real Estate Journal - March 18, 2015

The new must-have asset class for senior care

Matt Lindsay Senior vice president, Lancaster Pollard, Columbus, Ohio

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The senior care industry recently has seen increased interest from outside investors, developers, and debt and equity providers.

The specific reasons may vary by participant but, broadly speaking, this increased interest is driven by an asset class risk profile that has gained acceptance by the capital markets, more so today than in previous years.

The senior care asset class is piquing interest, fueled by a lack of opportunities in other commercial real estate areas, such as office and retail, combined with the favorable demand demographics of senior care. The result is a real estate-based asset class that has outperformed other property types over the past decade. As diversified investors reach for the efficient frontier, senior care is an asset class that remains largely uncorrelated to the broader market and with relatively low volatility.

These attributes are appealing for investors and are driving demand for senior care assets.

Asset Class Risk Profile

It is important to first define how the capital markets view the senior care asset class. For the purposes of this discussion, we will focus on risks at the individual site level. Through this lens, two main categories of risk emerge – operational risk and financial risk. Given the range of business complexity and resident profiles, it would be imprudent to develop a onesize-fits-all risk profile for the asset class.

Spanning the financial risk spectrum, the various stages of a senior care asset’s business lifecycle include new construction, stabilization, turnaround and acquisition.

Further, subdividing the asset classes into continuing care retirement community, skilled nursing facility, assisted living or Alzheimer’s care, and independent living allows us to categorize operational risk across the revenue types, acuity levels and business complexity. In total, this gives us 16 characterizations across the asset class around which we can develop and subsequently assign quartile ratings and benchmark metrics.

Each site is assessed relative to its characterization benchmark metrics and assigned a risk profile. The site-specific risk profile dictates the capital mix and the cost of capital available to owners and operators to meet their own strategic objectives.

Lower Cost of Capital Driving Valuations

The appetite for portfolio holders and outside investors (diversified participants) to own senior care assets resulted in higher valuations and, in some markets, record-breaking valuations. This begs the question – are these valuations excessive and the result of a lack of investment discipline, or are these valuations justified? In order to make a proper assessment, we can compare cap rates to the cost of capital of the diversified participants.

For the most part, all participants have access to the same senior debt financing vehicles, such as agency financing via the U.S. Department of Urban Housing and Federal Housing Administration, or Fannie Mae.

The true advantage comes from access to a lower cost of equity.

As valuations stretch and cap rates decline, equity financing is needed to fill capital gaps required in transactions.

Outside participants and large portfolio holders have a distinct advantage on this front because they have a lower cost of equity. This lower cost of equity is achieved because they are more diversified, either by geography or asset class.

The cost of equity, using the capital asset pricing model, ranges from 3.1 to 4.8 percent for diversified participants. Comparatively speaking, owners and operators of smaller portfolios and single assets have a higher cost of equity from 10 to 15 percent. This is typical for entrepreneurs who may have a significant portion of their net worth invested in senior care assets and are not as diversified.

When the capital asset pricing model is applied to a transaction where loan to value is 80 percent and cost of debt is 4 percent, it translates to a weighted cost of capital of approximately 4 percent for the diversified participant and 5.2 percent for the less diversified participant. The lower cost of capital allows the diversified participant to lower its hurdle rate while maintaining a similar risk premium. The effect is higher asset values due to the lower cost of capital.

Does this mean risk premiums will remain stable indefinitely? The answer to this question remains to be seen. Historically, the data leads us to believe that as more diversified investors enter the market, the stability of the risk premium may come under pressure. The chart shows a tightening of spreads between the 10-year Treasury and cap rates of skilled nursing facilities and senior housing. As one can see in the table above, spreads are tightening while cap rates remain even. It is unclear as to whether shrinking risk premiums are causing spreads to tighten or if the asset class is becoming even less correlated to the overall market.

Generally, the acceptance of senior care as an asset class is a positive trend for an industry that relies on a variety of financing structures to achieve strategic objectives.

This is good news for the less diversified participants as they have the option of either continuing to realize the rewards of owning and operating a senior care asset or divesting their asset in a more robust and liquid market with growing valuations.