Higher capital costs, new supply and competition from private equity groups force industry giants to rebalance their portfolios.
By Jane Adler
Remember 2011? That year marked the heyday of the real estate investment trusts (REITs), when they ruled the acquisition market by snapping up seniors housing and skilled nursing portfolios at a rapid clip. In fact, publicly traded REITs and operators hit a high point back then, with U.S. deals totaling $24.5 billion, or about 89 percent of the total transaction volume.
Times change. Fast-forward to 2017, and the REITs are taking a pause and recalculating their seniors housing and care investment strategies as quickly shifting economic and market conditions come into play.
Several large public REITs have spun off large skilled care portfolios as questions about government reimbursement and falling occupancies due to length-of-stay pressures continue to stress the sector.
A wave of new construction, mostly of assisted living and memory care projects, has increased competition and heightened concerns that overbuilding has already and will continue to hurt occupancies.
Although REIT stock prices have rebounded somewhat lately, the companies still face a climate of rising interest rates. There is an inverse relationship between interest rates and REIT prices. Interest rate increases are likely to cause REIT price declines as the cost of capital climbs and earnings decline. That makes it harder to finance new acquisitions.
Non-traded REITs have faced their own investment capital shortages for a number of reasons, including new regulations that require the upfront disclosure of fees, which has stymied their ability to raise funds from retail sources.
Meanwhile, competition for properties from private equity groups has helped to keep asset prices high and slowed REIT investment activity.
Other factors weighing on the seniors housing industry include uncertainty of a new administration in Washington, D.C., growing labor expenses, and the overall direction of the economy, the latter of which has a big impact on family decision-making and the willingness to commit to an expensive living arrangement.
“It’s challenging to invest widely in the [seniors housing] space,” says Dave Hegarty, president and chief operating officer at Senior Housing Properties Trust based in Newton, Mass. “We are not being aggressive.” The REIT has an $8.5 billion portfolio. Senior living communities comprise 53.6 percent of the total portfolio.
In 2016, transaction dollar volume for seniors housing and skilled care properties totaled $14.4 billion, a 34 percent drop from $21.8 billion in 2015, according to the National Investment Center for Seniors Housing & Care (NIC) based in Annapolis, Md.
Acquisitions by public buyers, dominated by the REITs, declined in 2016. Public buyer volume was down 72 percent compared with 2015, a decline from $12.7 billion to $3.6 billion, according to NIC. Transaction dollar volume by private investors (including non-traded REITs) remained stable in 2016, while volume by institutional investors grew to $4.4 billion.
“The REITs are in a disposition mode,” says Chad Vanacore, analyst at Stifel, an investment banking firm based in Saratoga Springs, N.Y. “It’s a good time to sell.” Cap rates remain tight on a historical basis and valuations are elevated, he explains. Yields remain attractive to investors and capital continues to flow into the space.
The REITs are selling underperforming assets, those in need of large capital expenditures, and property segments such as skilled nursing that no longer fit current investment strategies, according to industry sources.
REITs are also looking to sell assets not managed by their core operators, and those in oversupplied markets with new competition. According to NIC, more than 5,900 new seniors housing units were delivered nationally in the last quarter of 2016, the most in a single quarter since NIC’s data collection began in 2006. Nearly 4,100 of the units were assisted living.
“The REITs are cleaning house,” says Ross Sanders, first vice president at brokerage firm CBRE. Sanders works from an office in St. Louis and previously ran the acquisitions group at American Realty Capital, a non-traded REIT that has since changed its name to Healthcare Trust. “The REITs are spinning off what doesn’t make sense,” adds Sanders.
The big three healthcare REITs are retooling their portfolios. Chicago-based Ventas (NYSE:VTR) expects to be out of the skilled nursing business by the end of 2017. The company has been diversifying with its purchase of Ardent Health Services, an operator of health systems and hospitals, and plans to acquire life science centers operated by Wexford Science Technology for $300 million.
HCP (NYSE: HCP) spun off its skilled nursing ManorCare portfolio, and is developing a life science campus in the San Francisco area. The REIT also announced in November that it would sell a portfolio of 64 Brookdale-leased properties for approximately $1.1 billion to affiliates of Blackstone Real Estate Partners VIII LP, and to Columbia Pacific Advisors.
Last November, Welltower (NYSE: HCN) announced that it had increased its 2016 disposition target from $1.3 billion to $4.1 billion, though the company only reached $2.8 billion by the end of the year. Of that amount, about $1.2 billion consisted of seniors housing triple-net leased properties. Welltower’s target for 2017 is $2 billion in dispositions, according to its February earnings call.
At Senior Housing Properties Trust (NASDAQ: SNH), holdings are split about 50/50 between seniors housing and medical office buildings. For 2017, Hegarty expects to invest more in medical office properties than in seniors housing projects. He specifically cites the higher cost of capital and a flood of new seniors housing projects for the pullback.
Over the last year, interest rates have increased 25 to 50 basis points for debt financing — both acquisitions and refinancings — sources say.
Another factor is the large amount of capital pouring into the sector from private equity groups, which helps to keep property prices at high levels and drive down returns. “We are not going to compete against that kind of money,” says Hegarty. “It seems like every month another fund is announced and they have to find deals.”
Last October, the large private equity investor ROC Seniors Housing Fund Manager launched its second fund with plans to acquire more than $2 billion in medical office properties and seniors housing.
Expect smaller deals
Despite the headwinds, the REITs are still buying properties and financing the development of new ones. While investment returns in seniors housing are slowing, the sector still outperforms other real estate asset classes, according to the National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index. The annual return through the third quarter of 2016 was 13.11 percent.
The REITs are primarily focused on niche locations and partnering with operators with a proven track record of success.
Welltower and its development partner Hines plan to build a 15-story assisted living building in Midtown Manhattan. Executives from the companies have said in press reports that they aim to fill a supply gap in the densely populated urban area amid strong demand. The project is expected to open in late 2019 and will be operated by Sunrise Senior Living.
“Equity is chasing the good operators,” says Brian Robinson, senior vice president in the healthcare division at Chicago-based MB Financial Bank. The REITs can still expect decent returns as long as they choose the right operators in the right locations, he explains.
Small portfolios and one-off transactions are likely to dominate acquisition activity at Seniors Housing Properties Trust in 2017. Several months ago, for example, the REIT acquired two properties in Illinois. The stand-alone, 10-year-old assisted living projects are located in the greater St. Louis area on the Illinois side of the Mississippi River.
The properties, Morningside of Shiloh and Morningside of Troy, are nearly 100 percent occupied, says Hegarty. Five Star Senior Living has been brought in as the operator.
A fair amount of new seniors housing development is underway in the greater St. Louis area, according to Hegarty. But the Morningside projects are located on the east side of the river, and Illinois residents tend not to cross the Mississippi for services. “It made me feel better about the investment,” he says.
National Health Investors (NYSE: NHI), based in Murfreesboro, Tenn., seeks small seniors housing portfolios as well as single properties to complement its existing portfolio. The company completed about $450 million in acquisitions in 2016, about two-thirds of which was seniors housing. “We see better returns from single assets rather than chasing large portfolios,” says Kevin Pascoe, executive vice president of investments at NHI.
Selective new development
Despite worries about oversupply, new development continues to be part of the REIT investment strategy.
NHI has five projects either underway or which recently opened. Bickford Senior Living will operate all five communities. “Our partners understand the local markets,” says Pascoe. NHI recently renegotiated its agreement with Bickford, adopting triple-net lease structures in place of a partnership structure under the REIT Investment Diversification and Empowerment Act (RIDEA).
Industry observers expect more REITs to shift their strategy away from RIDEA structures in favor of triple-net leases (see sidebar).
New development still plays a role at Sentio Healthcare Properties, a non-traded REIT based in Orlando, Fla. The company, backed by a $158 million investment by private equity firm KKR, seeks acquisitions and redevelopment opportunities, according to John Mark Ramsey, president and CEO at Sentio.
Ramsey expects the REITs will face ever-increasing challenges around the appropriate level of capital expenditures to improve older buildings as new properties open nearby.
“We will hear more and more about owners making larger reinvestments in portfolios to keep them competitive,” he says. “It’s something we are focusing on, as are other large owners.”
A sample of new Sentio development projects includes the Delaney at Georgetown Village, a 207-unit project just north of Austin, Texas, and Accel at Golden Ridge, a 120-unit rehab care facility located in Golden, Colo.
Ramsey prefers primary markets with high barriers to entry in order to limit competition. He also sees an opportunity to offer senior apartments with access to services in order to reach seniors who cannot afford an expensive product. “The industry owes a response to a need that is already here and increasing,” says Ramsey.
MB Financial’s Robinson agrees that the industry hasn’t figured out how to create an affordable housing product that generates decent returns for middle-class seniors. “The upper end of the market is well covered,” says Robinson.
LTC Properties, Inc. (NYSE: LTC), the Westlake Village, Calif.-based REIT, has committed $54 million toward three new development projects, and $20 million for major expansions of two Michigan properties, all currently under construction.
Two of new projects are stand-alone, private-pay memory care communities located in Glenview and Oak Lawn, Ill., suburbs of Chicago. Anthem Memory Care will operate these communities. LTC has two other recently opened memory care projects in suburban Chicago in Tinley Park and Burr Ridge, also operated by Anthem.
The third new project is a $24 million skilled nursing center that will be built in the Cincinnati metro area. It will be located in Union, Ky., and feature 143 beds. The facility is scheduled to open in 2018 and will be operated by Cincinnati-based Carespring, which operates other facilities in the metro area, according to Clint Malin, chief investment officer at LTC.
“We look for operators with a strong presence in the marketplace,” he says. That strategy builds relationships for LTC with operators that have leverage to better assist in negotiations with local hospital systems and managed care providers, he adds.
The REITs are exploring creative, new opportunities. For example, LTC is providing mezzanine financing and preferred equity to operators. The REIT deployed $3 million of mezzanine financing to a regional operator for construction of a private-pay community in Ocala, Fla. The goal is to grow these relationships to expand the REIT’s network of regional operating companies.
Like all real estate investors, the REITs face a lot of uncertainty. Will interest rates continue to rise? If so, capital could become more expensive for them. On the other hand, higher interest rates might also push cap rates higher, making it easier and less expensive for the REITs to invest.
How will the broader economy fare? And questions about the Affordable Care Act and healthcare regulations under the new administration will continue to play out.
Vanacore, the analyst with Stifel, sums up the situation succinctly. “The uncertainty makes it challenging to build a long-term investment outlook.”