Amid fierce competition for stabilized properties, private equity investors pursue partnerships to develop new facilities.
By Bendix Anderson
In May, The Franklin Cos. broke ground on Franklin Park at Alamo Heights, a 221-unit seniors housing property in San Antonio. Cash from private equity investors helped the locally-based developer finance the deal.
“We are seeing tremendous interest from equity investors in seniors housing,” says Matthew Whitlock, senior vice president and co-head of production for CBRE National Senior Housing Group, which helped arrange a joint venture between Franklin and private equity firm Harrison Street Real Estate Capital LLC, along with a construction loan for the project from a regional bank.
Private equity investors are eager to buy into the seniors housing business — both by purchasing stabilized properties and by partnering to develop new facilities. In their eagerness to invest, private equity is driving up property prices and pushing development into a growing number of markets.
“There is a tremendous amount of capital chasing too few opportunities … even development sites,” says Scott Stewart, founder and managing partner of Capitol Seniors Housing (CSH), based in Washington, D.C., a boutique private equity firm focused on seniors housing. Since 2003, CSH has invested in more than 50 properties at a value of more than $1 billion.
Private equity buyers accounted for 10 percent of the $6.8 billion in U.S. seniors housing transactions completed during the third quarter of 2014, according to the National Investment Center for the Seniors Housing & Care Industry (NIC). Private equity firms are raising money from institutions and individuals around the world who are hungry for relatively high-yielding investments.
Strategic shift
Private equity investors are increasingly helping finance new seniors housing development. That’s largely because opportunities to buy fully occupied seniors housing are difficult to find, especially at a price that would provide the attractive yield that investors require.
Equity funds like CSH now focus on investments that include a component of development. “We are leaving stabilized properties for the REITs,” says Stewart.
His private equity firm is now working on the development of six new seniors housing properties in the Northeast, including New York, Boston and Northern New Jersey.
CSH has already matched equity investors with developers to build three seniors properties now under construction. CSH has also hired its own in-house development team so that it will be able to create exclusive opportunities for investors to put equity into new development in the future.
Construction loans are also available from many commercial banks to help finance the development of new seniors housing properties. These loans often cover up to 60 percent of the development cost of a property, according to Stewart. “The debt is available… that used to be the gating factor,” says Stewart. “In 2013, you couldn’t get non-recourse construction financing.”
To satisfy both the need to provide yield and avoid risk for its investors, CSH seeks sites with strong demographics and barriers to entry. “We haven’t relaxed our criteria on sites that we can develop,” says Stewart. “We demand great markets and high barriers to entry.” For example, CSH now owns seniors housing properties in wealthy suburbs of major metro areas like Peachtree City, Ga., outside of Atlanta, and Annapolis, Md., outside of Washington, D.C.
However, increased competition is driving equity investors and seniors housing developers to consider a longer list of locations. “As things have heated up, people are going to more secondary markets because that’s where you can find cheap land and come out of the ground quickly,” explains Stewart.
Investors lower expectations on returns
As the competition heats up to put money into seniors housing, equity investors are also willing to accept a smaller share of the profits from the properties in which they invest.
“Yields are now at historic lows,” says Stewart. Typical preferred returns now demanded by equity investors have fallen to 8 percent annually, he says. In extreme cases, equity investors may accept yields as low as 6 percent. That’s down from 12 percent early in the economic recovery, when equity tentatively became available again for new development. It’s also a big change from a year or two ago, when private equity investors often demanded preferred returns of 10 percent, according to Stewart.
The preferred return is the annual return on investment that equity investors require before they will agree to put their money in a development deal.
After the equity investor is paid its preferred return, any remaining profits are split between the developer and the equity investor using a complicated “waterfall” calculation. If the property is successful and earns a very high yield, the developer will receive a larger share of that yield.
Preferred yields demanded by equity investors are now historically low. That’s because equity investors now have few options that offer a yield equal to or higher than seniors housing. During the last real estate boom, when interest rates and investor yields were much higher overall, the typical preferred yield for equity investment in seniors housing was around 10 percent, says Stewart.
Buyers pay top dollar
Bidding wars for seniors housing properties aren’t going away, and experts now expect prices to keep rising. “I don’t think we have hit a ceiling,” says CBRE’s Whitlock.
The average capitalization rate (initial annual return to the investor based on the purchase price and net operating income of an asset) has been below 8 percent for the last year for stabilized seniors housing properties, including assisted living and independent living. That’s down from a high of 9.2 percent in the fourth quarter of 2009, according to New York-based Real Capital Analytics.
There is a limit to how low cap rates can go compared to other real estate investments. Cap rates for seniors housing properties are still 150 to 200 basis points higher than the cap rates for conventional multifamily properties, according to CBRE’s Whitlock. That’s unlikely to change much.
“Seniors housing still represents a higher level of risk than apartments because of the intense management nature of the operation,” he says. “With the wrong person at the head of a seniors housing property, you can empty the building out.”
Private equity funds bid high
Private equity buyers are chipping away at the dominance of REITs in the bidding wars to buy equity stakes in seniors housing properties. “Obviously, the REITs are still a sizable player but they are not the only player,” said Steven Blazejewski, principal at Prudential Real Estate Investors, during the NIC National Conference that took place in Chicago in October.
REITs continue to be the biggest purchasers of large portfolios. Public companies, including REITs, accounted for 70 percent of the $6.8 billion in seniors housing property and portfolio transactions completed in the third quarter of 2014, according to NIC. That’s up from an average of 56 percent since the beginning of 2012.
But private equity buyers also account for an increasing share of seniors housing transactions, particularly for single assets, squeezing out some other buyers such as direct purchases by institutions.
Private equity funds are finding ways to partner a variety of new equity investors with experienced operators, allowing new money to enter the seniors housing business. Some of these equity investments are structured as simple purchases in which the private equity fund buys the property outright and hires a third-party manager or leases the facility to an operator, perhaps the seller.
Many private equity development deals are structured as joint-venture partnerships in which the buyer purchases a controlling interest in the property, though the buyer’s share of the ownership can range from 51 percent to 95 percent. “Equity wants control,” says Whitlock. That gives the equity investor the ability to sell its stake in the property.
The property’s operator keeps a smaller share in the ownership of the property. “That ensures the operator has some skin in the game,” says Beth Burnham Mace, chief economist for Annapolis, Md.-based NIC.
Private equity fund managers are often more willing to partner with smaller operators than REITs, which typically prefer to form long-term, lasting relationships with experienced operators. REITs also often buy whole portfolios of properties, while private equity buyers are more likely to invest in single assets.
Private equity fund managers are increasingly among the top buyers of seniors housing properties. The players include TPG Capital, headquartered in Fort Worth, Texas, and Kayne Anderson, based in Los Angeles.
“You’ve begun to see private equity creep onto that list over the last 12 months, and you’ll see more of that as investors have a greater appetite,” according to Prudential Real Estate Investors’ Blazejewski.
Private equity funds are flush with cash because many equity investors now treat seniors housing as core real estate, a term that refers to stabilized properties in favorable locations. “Seniors housing is becoming more accepted as an institutional investment,” says Mace.
For example, Chicago-based Harrison Street Real Estate Capital LLC, a large private equity fund manager, recently included seniors housing assets in one of its core commercial real estate private equity funds.
Other private equity firms are simply increasing their focus on seniors housing. Prudential Real Estate Investors just launched its fourth seniors housing fund, called “Prudential Housing Investor,” with plans to raise $600 million. Based in Madison, N.J., Prudential Real Estate Investors has been investing in seniors housing for 15 years.
Another private equity fund manager, AEW Capital Management, headquartered in Boston, just closed its second seniors housing fund with a total of $371 million in equity commitments, exceeding its target of $250 million.
“Both of those funds are larger than private funds have been,” says Mace. “Many of the same investors have stayed in those funds, plus capital is coming in.”
Seniors housing is attractive to private equity investors in part because of the fundamental strength of seniors housing real estate. “Seniors housing has never had any negative rent growth,” emphasizes Mace. Even in late 2010, one of the worst years of the downturn, rents still grew at an annual rate of roughly 1 percent for both independent and assisted living, according to data from NIC MAP.
Overall, consumer demand for seniors housing seems to be strong enough to absorb the newly constructed seniors housing. “Construction has probably doubled or tripled, but it has doubled or tripled from a very low level,” says Blazejewski. “Supply growth is just not outpacing absorption.”
The inventory of assisted living properties in primary markets is anticipated to grow by roughly 3.3 percent through the third quarter of 2015 — slightly less than anticipated absorption of 3.7 percent, according to NIC.
This trend should result in assisted living occupancy increasing and reaching 89.8 percent during the third quarter of 2015, up 40 basis points from its current rate,” says Mace.
Seniors housing has provided strong returns to investors in good times and bad. Total returns for seniors housing, including both income and price appreciation, outperformed the returns of the NCREIF Property Index in nine of the last 10 years. Over the last decade, seniors housing provided an annual total return of 13.35 percent, compared to 8.64 percent for the NPI, according to NCREIF and PREI Research.
Deals harder to find
Because of the intense competition for quality seniors housing assets, private equity fund managers may have a difficult time spending all that new private equity money amassing on the sidelines.
“It might take these funds a longer time to put their capital to work,” says Mace. “The return expectations may be less today than in the past.”
In addition to the publicly traded REITs, the non-traded REITs also have money to spend from eager investors and are actively bidding for seniors housing properties. Non-traded REITs set a record in 2013 by raising $19.6 billion, up from $10.3 billion the previous year, according to NIC.
“There are always a lot of buyers when looking at anything that is a public offering. There’s very few opportunities to find off-market transactions,” says Carl Mittendorff, chief investment officer for The Freshwater Group, a seniors housing operator and developer based in Tucson, Ariz.