Buy, Sell or Hold?

In July 2018, Welltower and ProMedica Health System acquired Quality Care Properties and its main tenant, HCR ManorCare. Pictured is the cafe at Arden Courts of Northbrook, an HCR-operated memory care community near Chicago. In July 2018, Welltower and ProMedica Health System acquired Quality Care Properties and its main tenant, HCR ManorCare. Pictured is the cafe at Arden Courts of Northbrook, an HCR-operated memory care community near Chicago.

The preferred investment strategy in today’s tumultuous seniors housing industry can vary greatly by investor type.

By Jeff Shaw

It would be a gross oversimplification to say that trading is trending down in the seniors housing industry. While the dollar volume of property and portfolio sales may have dipped, the sector is still bustling as new investors try to work their way in, and capital providers look for smart ways to spend their money in senior living. 

Heading into the final quarter of 2018, the industry was on pace for approximately $12 billion in annual transactions compared with $16 billion in 2017, according to the National Investment Center for Seniors Housing & Care (NIC). Deal volume for all of 2018 was not yet available at press time.

However, the hard numbers belie the view from the ground, according to Beth Burnham Mace, chief economist for NIC. 

“There’s still a lot of new capital, new private equity — people looking at the longer-term fundamentals,” says Mace. “So, there’s a lot of capital on the sidelines waiting to come in.”

The main factor in the slow volume is that the major publicly traded REITs have been net sellers and largely stayed on the sidelines for the past three years or so. In the preceding years, REITs were the main engine of acquisitions by far.

This complacency is more a result of the fever pitch of 2014 and 2015, though, suggests Mace. REITs represented 52 percent of all deal volume in 2015, but only 25 percent in 2017 and 38 percent in 2018. The REITs needed time to digest their purchases, and are also looking to diversify their portfolios after a seniors housing buying spree in those years, concludes Mace.

“The REITs are expanding into other property types, such as medical office and life science,” says Mace. “As a result of some weakening market fundamentals in seniors housing, they are trying to diversify their portfolios.”

Part of the reason the REITs are net sellers is that portfolio acquisitions made during the buying phase are now being sold off if they don’t fit into the companies’ larger strategies, says Isaac Dole, CEO of Birchwood Healthcare Partners, a Chicago-based private equity investor.

“If you are one of the buyers who built up or recapitalized large portfolios rapidly post-recession, you are more likely a seller or holder as you prune your portfolio,” says Dole.

“If you are one of the organizations that was conservative through the post-recession boom, but already had a decent-sized portfolio, you are likely a buyer right now, trying to fill in markets that you think are favorable,” explains Dole.

“If you are a newcomer to the industry you are likely a ‘holder,’ still waiting to fully understand the industry and where you want to play in it, or a buyer if you figured out the strategy you want to pursue,” adds Dole.

Market fundamentals are noticeably soft right now, most clearly shown in occupancy rates. The overall seniors housing occupancy rate was 87.9 percent in third-quarter 2018, according to NIC, the lowest point since 2011 and 80 basis points below the prior year (though the fourth-quarter numbers did show a 10 basis point increase). But all the interested investors looking to enter seniors housing or expand their portfolios has enabled the property sector to remain a seller’s market.

Investors see the demographic wave of aging baby boomers, and capitalization rates that are higher than most other commercial real estate sectors, and continue to be interested in seniors housing. This is despite the fact that the largest wave of residents turning seniors housing age is still several years away.

“The mindset, the reason people are still building new communities, is the demographics. That’s where the justification is coming from,” says Adam Lewis, a vice president and national director of Marcus & Millichap’s National Seniors Housing Group. “To this point, we haven’t seen much loss in interest that would lead us to believe investors are feeling differently.”

Even though the narrative is accurate that REITs are sellers, with private equity and other investors as the buyers, there was a major exception to this rule.

One massive purchase

In July, a joint venture between REIT giant Welltower (NYSE: WELL) and nonprofit healthcare operator ProMedica Health System completed the acquisition of Quality Care Properties (NYSE: QCP). For the price of $4.4 billion, the venture acquired both QCP and its main tenant, HCR ManorCare. 

HCR ManorCare filed for Chapter 11 bankruptcy in March after struggling to pay rent to QCP, which owns nearly all of the facilities that HCR ManorCare operates. QCP itself is a spin-off of healthcare REIT HCP (NYSE: HCP), which created the company in 2016 specifically to remove HCR ManorCare’s 320 properties from its portfolio.

ProMedica will operate the massive HCR portfolio — approximately 450 assisted living facilities, skilled nursing and rehabilitation centers, memory care communities, outpatient rehabilitation clinics, and hospice and home health agencies — with plans to invest up to $400 million in property upgrades over the next five years.

(In a separate series of transactions announced in December, Welltower also acquired $725 million in seniors housing properties. Though details were very sparse, the announcement could be an indication that Welltower plans to be a net buyer for 2019.) 

On its face, the QCP deal bucked many of the trends in the industry: A REIT was the buyer, and many of the assets were much-maligned skilled nursing facilities. However, Shankh Mitra, Welltower’s chief investment officer, is quick to point out that it was actually a conservative, opportunistic play.

“We bought the skilled nursing assets at $57,000 per bed. That’s a massive discount over replacement cost,” says Mitra. “We paid a premium over the company’s stock price, but we still got a very, very deep discount. People only saw the risk. They did not see the value.”

One reason Welltower stayed largely on the sidelines until now is that the company represents “patient capital.” Under CEO Tom DeRosa, who accepted the position in April 2014, Welltower is focused more on quality of deals rather than quantity, according to Mitra.

“We are not focused on transaction volume, but on making actual money on each transaction. Nobody in our shop gets paid on how many deals you do anymore. It’s based on performance,” emphasizes Mitra.

Welltower’s portfolio of U.S. seniors housing assets as of June 1, 2018, was 645 properties totaling 65,141 units, according to the American Seniors Housing Association (ASHA).

This is the reason Welltower has been a net seller the last three years amid “as much of a seller’s market as it gets,” adds Mitra. In a word, Welltower’s current strategy could be described as “opportunistic”— and opportunity is exactly what the company saw in QCP.

Skilled nursing rebounding?

For its part, National Health Investors (NYSE: NHI), a fellow REIT, considers itself “somewhere between hold and buy” strategically right now, according to president and CEO Eric Mendelsohn. 

NHI is also a big believer in the skilled nursing sector despite its recent travails. Mendelsohn hopes the Welltower-QCP deal will serve as “a bullish indicator for skilled nursing,” and emphasizes that the sector is not as troubled as many believe. NHI’s seniors housing portfolio comprised 139 U.S. properties totaling 11,675 units as of June 1, 2018, according to ASHA.

“Most of our providers are doing great. Two are public companies — the Ensign Group and NHC (National HealthCare Corp.) — and if you check their stocks they’re trading at three-year highs,” Mendelsohn said in an interview in late December 2018. “There’s a general consensus that skilled nursing is now a tale of two cities, with haves and have-nots. If you’re in partnership with the haves, skilled nursing is pretty good.”

However, one reason that REIT transactions are down is that many have tightened their underwriting standards to be “less forgiving with regard to negative trends and more cautious about new construction,” Mendelsohn is quick to add.

Using a gas gauge on a vehicle as an analogy, Mendelsohn says: “If you asked me two years ago, the gauge would’ve been much closer to the ‘buy’ indicator rather than the ‘hold’ indicator.”

While NHI’s total transaction volume for all of 2018 wasn’t known as of press time, Mendelsohn estimated the figure at $170 million, significantly lower than the annual average of approximately $300 million.

This caution extends to the lenders themselves, according to Mitra. “Construction loans are drying up.” 

In short, lower occupancy rates mean that many investors aren’t seeing new developments lease up as quickly as expected.

“We’ve seen occupancies drop to less than 80 percent in San Antonio,” says NIC’s Mace. “If you’d underwritten a deal two years ago to come out of the ground in 2018 and you had forecast occupancy in the low 90s, it’s going to be difficult to hit those [revenue projections] from your proforma. At some point that will cause stress and you won’t be able to comply with debt-service requirements.”

As a result, investors have become more cautious about their previously aggressive assumptions on statistics such as time to stabilization and long-term census rates.

“There are significant losses being taken,” says Mitra, noting HCP’s losses taken on recent sales of several Brookdale-operated communities. “Once you take the loss, it’s an expensive lesson but you’ve learned the lesson. You get more cautious the next time around.”

Meanwhile, many new entrants are excited by the relatively high capitalization rates and strong demographics in seniors housing, but ignorant of the details that separate a successful community from a failure. As Mitra puts it, many new investors in the sector “take risks they may not understand.”

“The new entrants that have had success are the groups that are partnering with successful operators in the industry and are providing capital in a structure such as a joint venture or third-party management agreement,” says Jason Punzel, managing director with Senior Living Investment Brokerage. 

“The ones that have not been successful are the ones that try to be owner-operators because they think this is just an apartment building for seniors.”

Birchwood’s Dole echoes the sentiment that new entrants can be successful if they play their cards right. 

“The new investors who are finding the most success are ones that have partners tied into the industry who can highlight pitfalls that inexperienced investors just haven’t experienced yet,” says Dole. 

“The question about these new entrants’ success needs to be answered over a long period of time. Are they creating great communities/investments that serve their residents, employees and markets well into the future, or are they just racing to get as many buildings to completion as possible?”

“There is no doubt many new entrants are doing great things for the industry, but we have unfortunately seen a lot of headlines in recent years of the opposite as well,” adds Dole.

Investors brace for challenge

The top issue raised by industry experts regarding the future of seniors housing is the mounting labor crisis, as demand continues to outstrip supply for frontline workers and caregivers.

“It’s a tight, tight labor market, which will affect NOI (net operating income) and therefore property prices. That’s going to be the biggest challenge in our industry in 2019,” says Punzel. “If you’re an investor, you have to serve your residents. How am I going to do that and how much will it cost me to provide the high-
quality care and service to my residents?”

Mitra agrees that labor is a top issue, and even suggests that many investors are underestimating its impact and “glossing over that issue too quickly.”

Most agreed that the seller’s market is slowly becoming a buyer’s market, and that the soft market fundamentals could lead to value-add opportunities as distressed assets are sold.

“Investors see the glass half full,” says NHI’s Mendelsohn. “If they are entering an investment that has below-average occupancy, they feel there is tremendous upside potential.”

“Lenders want to play, but they want more experienced operators with deeper pockets that can turn around a property,” adds Marcus & Millichap’s Lewis. “We’ve been hearing from our buyers that lenders are looking at the operators more than before and analyzing them better.”

In order for a true buyer’s market to emerge, notes Lewis, buyers and sellers are going to have to get on the same page. The disconnect between buyer and seller expectations is part of what led to depressed sales activity.

“Buyers say ‘interest rates are up so cap rates must go up,’ but it doesn’t happen as quickly as buyers want it to. That’s something to be mindful of in 2019. There might be a widening gap of expectations.”

Despite all these challenges, though, the experts anticipate real estate fundamentals will improve and the seniors housing sector will be strong for the long term.

“Cap rates are still higher than other asset classes,” says Punzel. “It’s going to be a pretty good year and probably very similar to 2018.”