Financing senior living projects getting complex.

ABOUT 18 MONTHS AGO OUR FRIENDLY LENDERS INTRODUCED a new industry sound bite. They told the senior housing and health care industries that they were "embarking on a flight to quality." Properly decoded, this means that lenders are focusing more on the safe, high-quality loan transactions and less on just any deal presented to them. There are, of course, exceptions, but lenders now focus almost exclusively on experienced sponsors and owner-operators who have assembled an impressive team--and have a sound market feasibillty study and a comprehensive financial plan. You must also address several important issues:

* How much can I borrow? Lenders are tightening loan criteria on the borrower's terms sheets and requiring equity to be in the form of hard cash for new projects and stronger collateral for projects being refinanced. The important ratios, "loan to value" and "loan to cost" have taken on a new pragmatic definition. In today's world, you can probably borrow approximately 75 percent of your project's total cost or indicated value. The other 25 percent must be provided by you in cash for a new project, or very strong collateral for the refinancing of an existing senior living community. If you are a not-for-profit organization, it is possible to obtain 100 percent financing using tax-exempt bonds.

* You must prepare a comprehensive and realistic capital budget. Lenders particularly look for several items frequently overlooked by the borrower, among them a comprehensive working capital reserve fund. For example, there will be significant negative cash flow in the early months of fill-up for your new project, as most of your costs are fixed; only about 25 percent of your operating expenses are variable. A typical assisted or independent living community takes 12 to 18 months after opening to reach break-even cash flow (after debt service). During that critical fill-up period, the project may experience cumulative negative cash flows of perhaps $500,000. This shortfall must be funded by the capital budget.

Another area frequently overlooked by borrowers is the cost of early sales and marketing activities needed initially to bring your community to stabilized occupancy. These costs will probably add up to about $3,500 to $4,500 per unit for assisted living, and frequently in excess of $5,000 per unit for independent living. This budget allocation includes all collateral/brochures, program development, media costs and sales office overhead expenses; plus base compensation and performance incentives for sales and marketing staff.

* Lenders want a sound income statement and an exit strategy Lenders must always consider the distasteful prospect of foreclosure, so they must envision a graceful borrower exit strategy. Along with a carefully conceived and comprehensive capital budget you must develop an income statement with at least two important financial safeguards. Lenders want to see a management fee of approximately 5 percent of revenues along with a reserve for repair and replacement of approximately $225 to $250 per unit annually. The concept is called Cap "X" (for future Capital Expenditures). The management fee allows the lender to hire another asset manager (if necessary) and the Cap "X" allowance is intended to keep the property in like-new condition. Lenders will probably want a 5 percent operating expense contingency factor.

This presents a good news/bad news situation. The good news is that these safeguards help insure the success of your project. The bad news is that these factors are considered normal operating expense line items that will lower your project's indicated value, therefore reducing how much money you can borrow.

* Debt service coverage ratio is the lender's acid test. The required ratio is typically 1.25X to 1.35X. This critical lender ratio is defined as available annual Net Operating Income (Revenue minus Operating Expenses) divided by the peak annual debt service (principal and interest). In addition, tax-exempt bond financing for a not-for-profit organization usually requires that an amount of cash equal to approximately one year's total debt service payments. This is called a debt service reserve fund and usually must be placed in a restricted reserve account.

* How much will my loan cost? Not-for-profit organizations enjoy the lowest interest rates being charged. These involve variable-rate tax-exempt bonds, which, as of August 2000, are in the range of 5 to 6 percent. Other forms of more conventional long term financing are likely to be 1.5 to 2.5 percent over the yield on similar term treasury bonds; or currently in the 8 to 9 percent range. Creditworthy borrowers closing on construction loans typically can get interest rates from 0.5 to 1.5 percent over the prime rate. [Beware: These rates may even have changed from the time we went to press with this issue to when you're reading it.]

Regardless of the type of financing you are after, remember that things always get more complex as you approach the close. But knowing ahead of time what you need and what the lender is likely to ask can make the process much easier.

Jim Moore is president of Moore Diversified Services, a Fort Worth, Texas-based senior housing and health care consulting firm, and author of Assisted Living 2000.