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Exclusive Research: Building to a Crescendo?

High construction levels are tempering some of the enthusiasm in the seniors housing sector.

Seniors housing has carved out a larger place in investors’ commercial real estate portfolios due to the compelling demographics and a track record as a steady performer in both up and down market cycles. Yet even as capital continues to flow into the sector, the fifth annual NREI / NIC seniors housing survey indicates a note of caution creeping in because of how much new supply is coming into the market.

Broadly speaking, respondents in this year’s survey remain confident in seniors housing’s stable fundamentals. A majority are optimistic that both occupancies and rents will continue to increase over the next 12 months. In all, 65 percent expect an increase in occupancy rates, while 76 percent anticipate an increase in rents. Both levels are consistent with sentiment from the 2017 survey, when 78 percent predicted that rents would rise and 65 percent said occupancies would rise.

Most respondents (roughly 45 percent) believe occupancy rates will improve between 1 and 50 basis points over the next year, while 20 percent expect an increase of greater than 50 basis points. Respondents were more split on views of how much rents are likely to rise, with 40 percent predicting an increase of less than 100 basis points and 37 percent who said rents could rise more than 100 basis points over the next year.

At the same time, survey results show growing unease about pressures from the development pipeline.

“There are more concerns this year about construction and new supply and new competing properties than in prior survey years,” says Beth Burnham Mace, chief economist for NIC. “This makes good sense in light of the market fundamentals that we highlight with the NIC MAP data.”

For example, construction as a share of inventory in the second quarter was at 6.3 percent, which is the equivalent to about 38,000 new units being built in the largest 31 metros. Construction is at a near record-high level for seniors housing overall and construction is even greater in majority assisted living projects at 7.9 percent of inventory.

Competition weighs on occupancies

When respondents were asked about factors affecting occupancy levels over the past six months, respondents pointed to new competing facilities as a big concern, a finding consistent with previous surveys. The number in this year’s survey, however, is greater than in past years.

On a scale of one to five, with five being the most significant impact, 69 percent of respondents in the 2018 survey rated new facilities as a concern as compared to 59 percent in 2017 and significantly higher than the 47 percent who held that same view in the 2014 survey. Respondents also rated the state of the U.S. economy as a “very” or “somewhat” significant factor at 50 percent; and the state of the U.S. housing market at 41 percent. Rental discounts and concessions were viewed as having the lowest impact on occupancies.

“I am a little surprised that rent discounts were not a bigger concern among survey respondents,” says Mace. During the second quarter, annual asking rent growth was 2.7 percent, which was up 0.3 percentage points from the prior quarter and down from a recent high of 3.7 percent in the fourth quarter of 2016.

NIC data also shows that occupancy rates are being affected by the new supply. The occupancy rate for seniors housing properties averaged 87.9 percent overall in the second quarter, dropping 0.8 percentage points from year-earlier levels. Occupancy rates have been eroded over the past four years and are now 2.3 percentage points below their most recent high of 90.2 percent in the fourth quarter of 2014. Occupancies for independent living and assisted living properties averaged 90.2 percent and 85.2 percent in the second quarter, respectively, according to NIC.

“I am cautious about the sector right now, because there are pockets of the country where there is more supply currently in the market than there is existing demand today, which is resulting in downward pressures on occupancy rates,” says Mace. Flat or declining occupancies will translate to greater pressure or challenges on owner/operators’ ability to raise rents and grow revenues and NOI. Compounding the pressure on NOI are rising labor costs in a competitive labor market where workers are more difficult to find in many metros across the country. “So, there is a cascading sequence of events,” she adds. 

Owners brace for more supply ahead

On top of the new supply that has already been added in the past few years, nearly half of respondents (48 percent) expect to see an increase in seniors housing construction starts over the next 12 months. In all, 28 percent believe construction starts will maintain its current pace and 24 percent predict a decline. However, among those respondents anticipating an increase, only 27 percent expect the new construction to result in overbuilding.

“There is definitely concern in the market about overbuilding. Seniors housing, once something of a stepchild in the real estate industry, has now become an accepted—even desirable—asset class. This has resulted in new entrants into the development space, capital inflows and a lot of new product being built,” says Zeke Turner, founder and CEO of Mainstreet, a Carmel, Ind.-based developer and operator of seniors housing and healthcare facilities. Yet healthcare is inherently local, he adds. So, even though there are markets that are significantly overbuilt, there also are those that still have room for new product.

Developers, investors and lenders across the board recognize the elevated levels of construction, but that is not deterring them from pursuing investments in the sector. Many continue to find demand within markets, submarkets and micro-markets. “New supply is impacting all aspects of the business, and we factor that into every decision we make at this point,” says Steve Blazejewski, senior portfolio manager for seniors housing at Newark, N.J.-based PGIM Real Estate. PGIM typically acquires seniors housing communities that are newer and have a continuity of care, and the firm also invests as a joint venture partner on new development deals.

“With respect to development opportunities specifically, what we really see in the market right now is a flight to quality,” says Blazejewski. Buildings that were constructed 18 to 20 years ago have become somewhat functionally obsolete. So, PGIM is focusing on newer products with modern amenities that are more appealing to the current resident base, he adds.

PGIM likes acquiring assets in the more densely populated, infill markets on the East and West Coasts, but also is looking at opportunities in smaller markets. “As we look at the overall supply and demand growth in the country, we do think there are opportunities in smaller markets that have been ignored by other institutional investors,” says Blazejewski. “We’re finding opportunities to develop in markets as small as 300,000 to 400,000 people where the existing inventory is fairly dated and the occupancies for the market are very attractive.”

Although concerns about potential overbuilding did climb slightly higher from 20 percent a year ago to 27 percent in the current survey, fears remain relatively subdued. One reason for that may be due to the concentration of development in select markets. About one-half of growth is concentrated in six of the top 31 markets.

These six markets each had more than 1,000 units of new inventory brought on line in the past year, with Chicago leading the pack with nearly 1,900 units. For Chicago, its occupancy rate slipped to 84.8 percent in the second quarter from a recent peak of 87.7 percent in late 2016. On the opposite end of the spectrum San Jose, Calif., which is seeing limited development and has an occupancy rate of 95 percent at the end of the second quarter of 2018, according to NIC data.

Investor demand holds steady

Concerns about construction levels does not appear to be diminishing investor appetite for acquisitions. Nearly half of respondents (48 percent) expect investment sales volume to remain the same over the next year, while 39 percent believe sales will increase and 14 percent predict a decline. Of applicable respondents with holdings in the sector, more plan to hold seniors housing properties (48.2 percent), while 30.6 percent plan to buy more in the next year and 21.2 percent are likely to sell assets.

Following a big year of sales in 2015 with $22.1 billion in properties trading, sales volume dipped to $14.7 billion in 2016 and moved slightly higher to $16.4 billion in 2017, according to Real Capital Analytics. Sales also have been more modest this year with first quarter transaction volume coming in at $2.9 billion.

“We started out first quarter with sales transaction volume that was relatively light compared to what we have been seeing,” says Tim Cobb, managing director and investment sales lead for Senior Housing & Healthcare at Bethesda, Md.-based Berkadia. Sales have picked up in second quarter with a few large transactions and several smaller portfolio deals. For example, in June Apollo Capital Management LLC was reported by Bloomberg as the proposed buyer of a 22-property portfolio from HCP Inc. for $428 million.

Discussion about the volume of capital flowing into seniors housing has been repeated so frequently in recent years that it has become to be a bit of a cliché, notes Cobb. “Over the past three years there has been a huge influx of capital. The difference in what is happening now is that a lot of that capital is buying,” he says. New capital that has come into the market is not just looking, but buyers are getting deals under contract and closing on sales, he adds.

When asked to rate the strength of market fundamentals by region, the South rated the highest. On a scale of 1 to 10 with 10 being the highest, the South ranked at 7.15; followed by the West at 6.98, the East at 6.65 and the Midwest at 6.37. (The scores were similar to how the regions had fared on past surveys.) “The South and West seem to be favored regions, and that may be the case because those are the Sunbelt regions where seniors often prefer the climate,” says Mace.

American Healthcare Investors (AHI) looks at buying assets in all 50 states and across the different product types of independent, assisted living and memory care. “It’s a risk-adjusted return analysis for us. We try to get the best risk-adjusted returns we can within each of those asset classes,” says Danny Prosky, founding principal of Irvine, Calif.-based AHI.

AHI is the sponsor and manager of Griffin-American Healthcare REIT IV Inc., which continues to have a strong appetite for seniors housing assets. The non-traded REIT acquired about $200 million in assets in 2017 and as of early July the REIT had closed on $42 million in assets with additional acquisitions under contract. For example, the firm announced in July that it had acquired an assisted living facility in Beaumont, Texas for $19.5 million.

These days, the local development pipeline is one of the first things that AHI looks at when evaluating acquisition opportunities. “That has a huge impact on where we buy,” says Prosky. Development information is pretty readily available. “We go to the database to see what new product is coming online in that area, and we have had deals that we have passed on because there is too much new construction coming out of the ground,” he says.

Supply, interest rates impact pricing

Cap rates have been creeping up along with rising interest rates and higher levels of new supply, notes Cobb. In some cases, high levels of new supply have directly affected sale prices. The pool of buyers drops significantly in markets that are seeing high levels of construction, he says. But there has still been demand for properties in those overbuilt markets, because everybody understands the demand drivers that will drive fundamentals in the long-term, he adds.

In all, 58 percent of respondents expect cap rates to increase over the next 12 months, which is not surprising given the rising interest rate environment. Overall, respondents anticipate that cap rates will increase only slightly at an average of 16.7 basis points. Meanwhile 22 percent of respondents said cap rates will stay the same, while 19 percent believe cap rates could decline further.

Due to the flight to quality, higher quality properties in strong markets with top operators are commanding a premium. Communities that are more dated or located in markets that are supply challenged are seeing a little discount in pricing, notes Blazejewski. “Transaction activity has been down a little bit over the last six to 12 months, but we still think it is very healthy and we’re seeing class-A communities sell pretty aggressively,” he says.

A majority of respondents (84 percent) expect interest rates to rise over the next 12 months. However, sentiment was mixed on how the risk premium (the spread between the risk-free 10-Year Treasury and seniors housing cap rates) would change. Pressure from rising interest rates could be offset by the fact that there is still strong demand from investors and plenty of capital waiting on the sidelines looking to move into seniors housing. Overall, 44 percent think the risk premium also will increase, while a nearly equal amount at 43 percent think the risk premium will remain the same.

Capital remains available

Respondents remain optimistic on their ability to access equity over the next year. Nearly half of respondents (52 percent) said access to equity will remain the same, while 29 percent think they will have greater access to equity in the coming year and 19 percent think access to equity will tighten. Respondents were less confident on their ability to access debt with 43 percent who think access to debt will remain the same and 36 percent who said it would tighten, while 21 percent believe they will have greater access to debt financing. In addition, nearly half of respondents (49 percent) expect underwriting standards to remain the same, while 39 percent anticipate that they will tighten and 12 percent think they will loosen.

“Equity is available and has been flowing towards this space for several years now. However, debt availability, particularly construction financing, is becoming a problem,” notes Turner. “Lenders are pulling back and managing their exposure to the space. Deals can still get done, but it is not like is was even 12 to 18 months ago when debt was pretty easy to line up.”

Part of what’s fueling construction activity is that there are a number of institutional equity sources and funds that have a huge appetite to invest in new construction deals, says Stuart Oswald, senior vice president and managing director of NorthMarq Capital’s Seattle-based regional office. “So, that’s helping to keep the development pipeline robust,” he says. On the debt side, all of the traditional construction lending sources are open for business, including money center banks and regional banks, he adds. That being said, lenders are increasing their equity requirements with loan-to-cost levels dropping due to concerns about new supply coming online.

More than half (58 percent) expect loan-to-value (LTV) ratios to remain the same, while 18 percent anticipate an increase and 23 percent predict a drop in LTVs. Two-thirds of respondents said debt service coverage ratios would remain the same, while 26 percent think they will increase and 8 percent believe they will decrease.

Fannie Mae and Freddie Mac continue to play a big role in financing seniors housing properties. Underwriting has remained fairly consistent on the independent and assisted living side, while the agencies have become slightly more conservative on free-standing memory care facilities due to the volume of development that has occurred in that sector, notes Oswald. FHA also is a huge source of capital along with banks and some of the life company lenders, he adds.

Seniors housing is preferred product

Survey respondents continue to believe the seniors housing sector is the most attractive property type with an average score of 7.2 out of 10, followed by industrial at 6.9, and apartments at 6.5. One of the reasons that investors continue to favor seniors housing is that it looks attractive on a risk-adjusted basis compared to some of the other property types and returns remain relatively strong, notes Mace. “Seniors housing is being looked at by some investors as more of a core investment opportunity. They look at the fundamentals and demographics and think that they can’t go wrong because of the aging of the population,” says Mace.

There also is growing interest in the sector from foreign capital and pension funds, she adds. “Its performance during the last recession suggests that it is less prone to the ups and downs of the business cycle, largely because of the needs-based characteristics of the property type, especially assisted living,” she says.

The preference for seniors housing is not surprising given the base of respondents is already active in some aspect of the seniors housing market. Respondents’ firms represent various facets of the commercial real estate industry, from owners and managers to developers and lenders. However, results are consistent with other broader surveys conducted recently that rated seniors housing as one of the top asset choices for a broader audience of investors, including the PwC’s 2018 Emerging Trends in Real Estate report, which rated seniors housing only behind fulfillment and warehouse facilities in both investment and development prospects.

“Certainly, long-term we’re bullish on the sector. We might have to batten down the hatches for the next couple years, because there is still a decent amount of new development that will be coming to the market over the next year or two,” says Prosky. There will be more pressure on managing assets effectively; putting cap ex dollars in when necessary to compete with new facilities; and riding out the wave of new supply, he adds.

Survey methodology: In May 2018, Informa Engage emailed invitations to participate in an online survey to subscribers of NREI. By June 20, 2018, Informa Engage had received 140 completed, qualified surveys. Only respondents involved in seniors housing were qualified to complete the survey.

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