Bears or bulls? Financiers reveal attitudes on reductions in capitalization rates.

What do some of the most active financiers in seniors housing and care think about the lending and investing activity playing out in the industry? Are they bullish toward capitalization rates remaining low for some sectors? Or do they believe rates are becoming too low to justify risk? How about spreads, and what are their beliefs on how they compare with other real estate asset classes?

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Panelists taking part in a recent National Investment Center for the Seniors Housing & Care Industries (NIC) Executive Circle conference call shared their insights on these and other pressing questions relating to financing for the senior living industry. Some of those observations are shared here. Moderating the call for NIC were Robert Kramer, president, and Anthony Mullen, research director. The panelists were: Kevin McMeen, director and segment head at Merrill Lynch Capital; Raymond Braun, president and CFO at Health Care REIT, Inc.; James Pieczynski, managing director of the Healthcare Real Estate Group at Capital-Source Finance LLC; Sarah Sumner Duggan, senior vice-president at GMAC Commercial Mortgage; and Kathryn Sweeney, principal at AEW Capital Management, LP.

Kramer: Reflecting the great deal of energy that's going on in the marketplace for seniors housing and long-term care, there's been a general debate whether the reduction in capitalization rates for the top quartile properties--those most coveted by top lenders and investors--is appropriate. The "bulls" argue that the risk premium above equivalent apartment properties has been unwarranted. That is, that risk has been mispriced and the spread over equivalent apartment properties should be 50 basis points for independent living and 100 to 150 basis points for assisted living properties, irrespective of interest rates and alternative equity yields. The "bears" claim that the reduction is solely cyclical and that the historic 200 basis points for independent living properties is warranted because of the increased risk of these property types over the equivalent multifamily class, and that the reduction in cap rates simply is tracking the downward reduction in apartment cap rates. But the historic spreads of approximately 200 basis points for independent living and 300 basis points for assisted living still hold. Are you a full bear, meaning you don't believe that the cap rate spread has changed? Or are you a full bull, meaning that you believe the cap rate spread has changed significantly? Or are you somewhere in between?

McMeen: I'm probably more in the bull category when referring to the top quartile properties. We're talking about whether the drop in capitalizations rates is cyclical and if a lot of the chasing down of the cap rates in those top-quality properties is driven by equity investors chasing after yield, because it's so low in other asset classes, such as bonds and stocks. I think that it should be lower. The question is whether it's sustainable and, as opportunities change in those other asset classes, will equity return to those, and then will cap rates start to creep back up? That, I think, is the real question. But the view of our organization is that the cap rates for those top-quality properties are--or should be--closer to apartment levels than further away.

Braun: Our view is that there's a global repricing of real estate going on, and generally lower yields and cap rates are the expectation of investors. The spreads in the multifamily sectors relative to U.S. treasuries have been increasingly narrowing, and that's a bit distorted by what's going on with the condo-conversion marketplace. So one of the issues is whether apartments are at appropriate spreads, and then, relative to those spreads, whether the risk in the seniors housing industry is being appropriately priced in. We're in between on it. We think that the historic spreads have been too wide--particularly for independent living and assisted living--and that they needed to come in some. Have they come in too much? I think in some of the assisted living transactions, they probably have.

Pieczynski: I would put myself in the full bear camp with respect to the spread. I think the historic spread of 200 to 300 basis points is more appropriate, particularly as it relates to the assisted living industry. I think there can be an argument for independent living. But as it relates to assisted living, although real estate is a large component of the business, there is the provision of care, so there is always the possibility of regulation and other unknowns. So from my perspective, I believe that the risk premium that has historically been there will return once the real-estate boom starts to dissipate.

Sweeney: From a private-equities stand-point, AEW is viewing the market and how independent living and assisted living are being priced from a full bull perspective. And the rationale is that we believe that there is a true paradigm shift in the business for what was formerly all lumped together in the category of "healthcare." I think investors have really begun to understand independent living and what it takes to create a solid margin, as well as assisted living operations and what goes into producing a margin there. So they have gotten a lot more comfortable with that risk, which was, frankly, formerly way overpriced--so much so, that the spread was much too high.

In addition--and I should qualify that this relates to the spreads that we're at today--the 50 basis points for independent living and the 100 or so basis points for assisted living really speak to top-quality operators in top markets. For secondary and tertiary markets, there probably is still some lag. And I think that the cap rates in the major metropolitan areas--albeit they may be driven by the fact that multifamily cap rates have been historically low because of condo conversions--are more like 4%, and you're still looking at assisted living cap rates that are 7%. So you still have a very healthy spread compared with the condo conversion.

Sumner Duggan: At GMAC, we would look at it more in between both the variables, sort of divided by the product type. Obviously, independent living has been more embraced by the multifamily market. The pricing there has definitely compressed, and there's much more interest in investing in that product type. I agree that the assisted living operating issues and regulatory challenges would add to the risk factor of that sector.

Mullen: Now, let's talk about how the pricing of risk relates to the interest-rate spread of lenders. During the first half of 2005 or during late 2004, have you reduced the historic spread that your company charges for interest over the equivalent interest rate benchmark for that loan term, either due to competition or a change in your risk assessment of either independent living properties, assisted living properties, or skilled nursing?

McMeen: Absolutely. We have seen reductions in spreads over the course of the last 12 months or so, and I would say it's primarily because of competition. I think that there are still certain risk factors that we would price into the spreads that we lend at, but the primary driver of the reduction is competition in the marketplace and having to respond to that to continue to do business.

Pieczynski: I would echo exactly that. There's no doubt that we have lowered the spread on our loans and definitely our spreads on the skilled nursing side. We have lowered our spreads slightly on the assisted living and the independent living sides, but what we're finding is that there is just a ton of competition out there and the only way we're going to be getting business is by lowering our rates somewhat over the historic levels. I still think we have very good risk-adjusted yields; however, they are most definitely lower than they were before. I think that's a positive sign for providers, in that it does reflect that there are a lot of lenders coming back into the industry, particularly on the banking side.

Mullen: So you are seeing more new competition come in for loans in our space?

Pieczynski: Absolutely. I think a few years ago, a lot of the larger banks had really abandoned this industry or certainly curtailed their activities. In addition to the banks stepping up, you see some of the investment banks now getting into the industry and starting to explore the securitization in the conduit market. The advent of them coming into the space has certainly had the effect of lowering our spreads.

Mullen: Have you actually seen any of the hedge funds entering the industry?

Pieczynski: What I've seen in the hedgefund world is that they are looking to make loans on the mezzanine side. When that mezzanine piece is combined with a lower yielding bank piece, it provides a very attractive alternative for operators.

McMeen: If I can add one thing regarding the hedge funds and the mezzanine type of investors, there's an interesting dynamic in that they are looking at transactions and have an interest in the industry because of the yields. But they also have size hurdles. We've talked to a number of different organizations that say they would love to get involved, but their minimum is about $20 million, or they could possibly come down to $15 million. So you're talking about them really only being interested in large transactions.

Pieczynski: I would agree with that exactly.

Kramer: Let's go on then to another topic for REITs and equity investors. The going-in cap rate for the very best--and I want to emphasize very best--current portfolios of assisted living properties now actually appears to be pushing down to 7% or even slightly under. This appears to be below the overall weighted cost of capital for many of the publicly traded REITs and some other types of institutional investors. This pricing would seem to require 2 to 3% compound rent growth in the leases and a going-out cap rate equal to the going-in cap rate, just to cover the cost of capital. What is the thinking here, and the pros and cons of the different assumptions that investors have to make?

Braun: The best way to understand how we think about it is to talk about our pricing model and how we derive cap rates. There are really three components. First, there's our cost of capital. Second, there is our policy that a transaction must be accretive to our earnings from day one. And third, we need to have some level of operating income over our rental payment, in order to have payment coverage that provides a margin of safety for us. When you look at our cost of capital, it's really driven by our debt cost and the percent of leverage we have, what costs we attribute to our equity, and then adding in a general and administrative expense factor. Even under our most aggressive pricing models, where we look at the equity cost as our dividend yield, we still come up with cap rates to cover our cost and provide payment coverage in the 9% range. So looking at deals below that, I'm not sure how they're working.

Sweeney: Because I represent private equity, I don't have the same constraints with regard to investments being accretive from day one. In fact, I don't really necessarily rely on a cash yield. Certainly, I do look at the cap rate, but that's not in a vacuum. I'm much more driven by internal rate of return and certainly, since AEW began investing in seniors housing in 1997, our internal rate of returns is much lower today. We started out more in a development mind-set, and today we're buying more stabilized operating portfolios, but we'll do development, as well.

The criteria or the underwriting that we're looking at is 2 1/2 to 3% rent growth, but we haven't seen that across any of our portfolios. They're all much higher. Our revenues are getting underwritten at 4% or higher depending on the particular market, product type, demographics, and the amount of new supply. Additionally, there's the occupancy that will drive your revenue growth, and in certain markets for certain product types, we can justify underwriting above 95%. Fortunately, the NIC Market Area Profiles data are proving us right with regard to our assumptions, which were based on some fact but a lot of instinct.

To hear a recorded version of this panel discussion, which also featured discussions on what financiers are doing to stay competitive in an active market, the performance of their portfolios, big transactions under development, and the expected activity of institutional and traditional real estate in senior living, visit "Executive Circle" at www.NIC.org or call [phone]. Founded in 1991, the National Investment Center for the Seniors Housing & Care Industries (NIC), a nonprofit organization, uses proceeds from its annual conference--scheduled for September 28-30, 2005, in Washington, D.C.--to fund original research, particularly that dealing with business strategy and capital formation for the industry. To send your comments to the authors and editors, e-mail [e-mail].

Glossary

Basis Points

A basis point is 1/100 of 1%. For example, 20 basis points would be 0.2%.

Capitalization Rate

The expected annual yield of a property if it were purchased for all cash. For example, if the net cash flow of a property were $1,000,000 in the first 12 months after purchase on a purchase price of $10,000,000, the capitalization ("cap") rate would be 10%. A "going-in" cap rate is the expected cap rate upon purchase. A "going-out" cap rate is the expected cap rate upon sale of the property.

Conduit Market

Generally describes the investment banks and other intermediaries that provide mortgages on real estate properties that are subsequently securitized. The conduit market competes against life insurance companies and other real estate lenders for permanent mortgage loans on real estate properties.

Hedge Funds

Unregulated investment partnerships that typically take riskier positions in different types of debt and equity securities and seek higher returns. Usually more flexible than banks, and will compete on riskier loans that are large in size.

Internal Rate of Return

The internal rate of return or "IRR" is the percentage yield that equates the future cash flows of an investment (including a sale) to the present value of the investment. It is similar to the compound annual growth rate of an investment.

Mezzanine

A type of financing that is either preferred equity or subordinated debt (i.e., subordinate to the first mortgage) that allows the borrower to use less equity for an acquisition or new development.

Securization

The process of turning a mortgage into a security that can be sold and traded in secondary markets. Buyers of these securities tend to be institutional investors such as mutual funds and pension funds.