M&A Volume Falls Back to Earth

Welltower purchased Vintage Golden Gate, an independent living, assisted living and memory care community in San Francisco, as part of a $1.15 billion portfolio in August 2016. Welltower purchased Vintage Golden Gate, an independent living, assisted living and memory care community in San Francisco, as part of a $1.15 billion portfolio in August 2016.

While acquisition activity drops dramatically in 2016 as REITs retool their strategies, institutional investors make a splash.

By Jeff Shaw

Investors started putting the brakes on acquisition activity in late 2015, and that trend continued throughout 2016. The end result: a 35 percent drop in year-over-year activity from $21.8 billion in 2015 to $14.1 billion in 2016, according to preliminary totals of publicly closed deals in the United States tracked by the National Investment Center for Seniors Housing & Care (NIC).

However, that drop may simply signify a return to normalcy, as the 2016 total is nearly identical to the $14.2 billion tallied in 2013. The industry experienced three consecutive years of major increases leading up to 2016. The 2012 total was only $11.7 billion, barely half the 2015 total.

The number of deals per year also fell from 2015 to 2016, but by only 15 percent from 563 to 477. In 2014 there were 556 deals and in 2013 there were 414. This shows that the deals themselves were mostly smaller, one- or two-property acquisitions instead of massive, nine-figure purchases. The average acquisition in 2016 was $29.6 million, compared with $38.7 million in 2015 and $34.2 million in 2014.

“The sale of large portfolios was down, and entity-level transactions — where one company buys another — has really gone away entirely,” says Jim Costello, senior vice president with data firm Real Capital Analytics. “But certain types of transactions were still around. Single-asset activity was actually up for the year, $5.9 billion in 2016 up from $5.3 billion a year earlier.”

Despite the overall decline in deal volume, the average price per unit has stayed consistent, notes Beth Burnham Mace, NIC’s chief economist. In 2016, the price per unit for independent living, assisted living and memory care was approximately $176,000, comparable to the previous two years, thus remaining “in the $175,000 to $180,000 range.”

“The price per unit is hovering around the same level, and close to peak,” says Mace. “Despite the slowdown we saw in volume, pricing still held up pretty well.”

On the skilled nursing front, the price per unit even increased 34 percent — from $76,000 in 2015 to $101,800 in 2016. Out of all skilled nursing deals in 2016, 28 properties sold for more than $200,000 per unit, adds Mace.

REITs pump the brakes

The main reason for the overall transaction slowdown was that publicly traded REITs significantly pulled back, continuing the trend they started in late 2015. Public buyer transaction volume dropped a dramatic 71 percent from $12.7 billion in 2015 to $3.7 billion in 2016, according to NIC.

Private REITs and other private buyers, such as owner-operators, held steady year over year, with transaction volume of $5.7 billion in both 2015 and 2016. Institutional buyers, such as private equity groups and pension funds, covered some of the void left by the big REITs, increasing their volume 37 percent from $3.1 billion in 2015 to $4.3 billion in 2016, according to NIC.

The cause for the REIT slowdown, Mace says, is a combination of low stock prices early in the year, increasing interest rates and their need to digest all the new properties and portfolios they purchased in 2014 and 2015.

“The REITs’ cost of capital shifted last year, and that slowed some of their acquisition activity down,” explains Mace. “There was also some portfolio repositioning going on in some of the larger REITs. They were absorbing all the activity from prior years.”

Much of the REIT transaction volume was in dispositions. The industry’s three biggest REITs ¬— Welltower, Ventas and HCP — all sold massive portfolios during the fourth quarter of 2016.

In November, Welltower announced it was more than tripling its 2016 disposition goal from $1.3 billion to $4.1 billion. Shortly thereafter, the company closed two major dispositions. In the first transaction, Welltower sold 64 properties to Second Spring Healthcare Investments for $1.1 billion. The second major disposition was the sale of 75 percent interest in a 28-property skilled nursing portfolio to Chinese investors as part of a $930 million transaction.

Ventas, meanwhile, continued its exit from the skilled nursing business by selling 36 skilled nursing facilities to Kindred Healthcare Inc., the operator of the properties, for $700 million. Kindred is looking to exit the skilled nursing business as well, but needed to purchase the facilities to get out of the lease contract, creating an opportunity for Kindred to sell off the properties.

HCP’s own disposition was similar to Welltower’s — 64 properties for $1.1 billion. In this case, Blackstone Real Estate Partners VIII LP was the buyer of the portfolio, which includes 5,967 units leased to Brookdale Senior Living.

The REITs have also been diversifying their portfolios. In some cases, this means increasing the percentage of private-pay properties, or sometimes entering separate healthcare industries, such as life sciences. The most notable example was Ventas’ $1.5 billion purchase of Wexford Science & Technology’s national portfolio.

“This diversification has now pretty much been accomplished,” says Chris Kazantis, director with global asset manager AEW. “So you are seeing the public REITs focusing on consolidating and improving operations and being more highly selective in their acquisition appetite. They’re also looking to step up the overall quality of acquisitions and prune their portfolios of older, less state-of-the-art communities.”

Another reason for the REIT drawback could be low capitalization rates, making deals more difficult, and a “swoon in the credit market,” according to Costello.

“It just created a bit of caution on the part of investors,” says Costello. “Maybe the ongoing decline in cap rates has reached an end. They’re at record lows.”

According to NIC’s data, cap rates in private-pay seniors housing have hovered between 7 percent and 8 percent for several years, down from a peak above 9 percent in 2009. In skilled nursing, cap rates have steadily declined from a peak above 12 percent in 2009 to just over 9 percent. By comparison, cap rates in other commercial real estate industries are often below 6 percent for Class A properties, according to CBRE data.

Investors step up to the plate

At the end of 2015, Mace predicted that more foreign capital would flow into the seniors housing space as the industry became better understood. It was her belief that the higher capitalization rates in the seniors housing sector compared with other property sectors would draw yield-hungry investors.

This prediction proved to be true, most notably with the aforementioned $930 million Welltower deal. Investors from Bahrain, Canada and others from China also made investments each totaling hundreds of millions of dollars seniors housing during 2016.

The institutional investor class, which includes foreign investors, accounted for 30 percent of the total transaction volume in 2016, up from 14 percent in 2015 due at least in part to the pullback by REITs.

PGIM Real Estate, an institutional fund manager and division of Prudential Financial, uses “a little bit of foreign capital” in its funds and generally seeks deals between $25 million and $125 million, according to Steve Blazejewski, managing director and portfolio manager of the company. The increase of institutional equity as a response to a REIT slowdown is a natural part of the cycle, he says.

“With the REITs drawing back, that’s opened up opportunities for us that we wouldn’t have had a couple months ago,” says Blazejewski. “There’s an ebb and flow of capital into the space. It’s always been that way. Some are dominant players while others take a back seat, and then it switches.”

Blazejewski cites another potential reason for the slowdown — a dearth of major portfolios available for purchase.

“There are only so many large transactions that can be completed. There simply aren’t that many big portfolios available,” says Blazejewski. “It’s not that the REITs aren’t active. They still have the ability to strike. When deals reach a certain size and have certain characteristics, they are very active and very competitive.”

Private investors have endured a steep learning curve, according to AEW’s Kazantis. “Everyone is aware of the industry’s compelling demographics and investors are getting much more comfortable with the operating nature of the business and its inherent risks.”

The stability of the seniors housing sector and its strong cash flow characteristics have become increasingly compelling for private equity investors, according to Kazantis. “As the asset class has matured and its acceptance continues to increase, seniors housing is migrating from being categorized as an opportunistic/value-added asset class to more of a core or core-plus investment asset class.”

Looking ahead to 2017

Once the influx of new supply peters out, Blazejewski expects to see an uptick in M&A activity several quarters later. Construction starts have been down for two consecutive quarters, Blazejewski notes, although he’s quick to point out that “two quarters does not a trend make.”

“If you look back, very little was developed between 2008 and 2011. Then you saw a lot of aggressive M&A activity between 2010 and 2015,” he says. “As new development starts to come on, investors see yield eroding from all the transaction activity.”

The new communities that have opened have had a negative impact on occupancy. Assisted living took the hardest hit, with the average occupancy nationwide dropping to 87.6 percent at the end of 2016 in the markets NIC tracks, the lowest level since 2010, according to Mace.

The silver lining, she adds, is that absorption was still strong during 2016. In other words, while new completions outpaced demand, the fundamental assumption of the developers was correct: More and more seniors want to live in seniors housing. Absorption was a strong 2.6 percent annual rate during the fourth quarter of 2016 in the 31 markets NIC tracks.

“Unit absorption was as strong as it’s been since we started tracking that data in 2006,” says Mace. “Demand was strong, just not strong enough for the amount of inventory that came into the market.”

The future will be hard to predict, as the big REITs continue diversifying their portfolios into other industries and move away from skilled nursing. 

But the outlook is still bright, Mace notes, as the underlying fundamentals reflect a generally health industry, although some markets will feel pressure from new supply, especially in assisted living.

“When there’s a good opportunity, the capital will flow. There are many good opportunities in seniors housing.”