Lenders and investors provide mid-year review of seniors housing and care.

Editor's Note: The following conversation occurred prior to the mortgage lending crisis and subsequent interest rate changes and should be read in that context.

How has seniors housing and care performed during the first half of 2007, and how does the industry look going forward? Five of the country's most active lenders and investors gave their review on a recent call with Executive Circle members of the National Investment Center for the Seniors Housing & Care Industry (NIC). The following are highlights, as moderated by Bradley Razook, president of Cohen & Steers Capital Advisors LLC. Guest panelists were Kathryn A. Sweeney, managing director at The GPT Group; Kevin J. McMeen, managing director at Merrill Lynch Capital; Deborah Laycock, managing director for healthcare finance at Guaranty Bank; and Raymond W. Braun, president of Health Care REIT, Inc.

What do like about market conditions so far this year?

Deborah Laycock: The operating fundamentals still look good, and we're seeing that in our portfolio, as well. The amount of activity is strong. The projects that are going in are well thought out, with a lot of them in urban areas. The amenity packages are much more tailored to consumers, focusing on their personal preferences, wellness, preventive healthcare, personal enrichment, and so forth. We're seeing a lot of expansion opportunities that we like. We like the continuum of care on the same campus. Also, with the NIC Market Area Profiles (MAP) and other data available to us, information is much better, and I think our operators have become stronger over the years.

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Bradley Razook: In other good news, there remains a worldwide glut of investment capital looking for financial assets. There is unprecedented liquidity in the capital markets. One example is our experience at Cohen & Steers. Since 2006, we have served as financial adviser in connection with approximately $18 billion of merger and acquisition (M & A) transactions, or about $1 billion a month, which was as much as we would previously do in a typical year.

Also, more investors continue to show an interest in seniors housing and care, and this trend should continue absent any kind of major hiccup. The traditional private equity people who were burned by the reimbursement and overbuilding disaster in the late 1990s are back or starting to come back. Real estate-oriented investors have gone increasingly up the acuity scale, starting with independent living, moving on with assisted living, and then to skilled nursing. In some cases, we've seen them take their profits through real estate and maintain an ongoing investment in an operating company, which is something that you never would have seen four or five years ago.

What has caused these investors to look more at healthcare-related assets?

Razook: It's clear that capitalization rate compression and declining internal rate of return (IRR) expectations in other asset classes have forced investors who historically were fearful of the intensive operating component of healthcare to actually roll up their sleeves and jump in. As a consequence, private companies now have many more options than they did five years ago when mortgage or sale-leaseback financing was about all that was available. Today, private and public equity is available, along with joint venture financing, management buyout financing, leverage recaps, and M & A solutions, whether you are a seller, a buyer, or pursuing a strategic transaction.

What do you not like market? Any areas of concern?

Laycock: We dislike seeing the aggressive loan structures--for example, the nonrecourse loans. We're also bothered by the lack of price differential between national and local operators. In other words, local operators are getting a fairly attractive loan structure either from local banks or from larger finance companies that probably doesn't reflect the associated credit risk. Lastly, interest rates have continued to move up slightly, and we see that as a risk going forward, as well.

Razook: There are other worrisome developments. It seems clear that the Federal Reserve Board is not going to ease any time soon, and there is much worry about inflation. The subprime residential mortgage disaster seems to have affected rates, spreads over treasuries for commercial mortgage financing, and loan-to-values, with a further potential for affecting cap rates. This is a very fluid situation and bears close monitoring.

The REIT market is more competitive than ever. What are typical terms today for an average deal, such as a $15 million to $25 million transaction for a regional operator?

Raymond W. Braun: A number of REITs are actively doing transactions. As far as terms for a deal--and these would not be part of a portfolio or deemed strategic for the REIT involved--we're typically seeing leases of 10 to 15 years and going-in rates of 7.5% to 9.5%, depending on the type of asset and its condition, with annual increases of roughly 25 basis points. I would say that's reflective of the general market for those types of deals. Compared with three or four years ago, it's 100 to 300 basis points tighter on the rates. Otherwise, the terms are similar.

More REITs are selectively engaging in funding new construction. How might that type of partnership work for operators?

Braun: This year we're going to do roughly $300 million of development financing. We do it through what we call a "development lease," where we buy the land. We then sign a lease with our operators/tenants, which obligates them to build in accordance with the plans/specifications and guaranteed maximum price that we've approved. Each month, we buy whatever they've built and then the following month they pay rent on the land plus the improvements on the purchase. So it looks like a construction loan from the operators' perspective. When the building is completed, we make our final payment and set the lease rate for 10 to 15 years, typically based on a corresponding treasury plus a spread. So it's a very integrated type of investment.

The main issue occurring now is that people want to get in the ground quickly because construction prices continue to rise rapidly. Underwritings and rents are based on assumed construction costs, so many operators want to get going before the building is fully completed in terms of design. So usually, our biggest negotiating point is how to handle the risk of construction cost increases.

Can you point to anything that would cause healthcare REITs to cool off on a particular asset class?

Braun: We've seen considerable compression in capitalization rates, and that's made acquisition opportunities less attractive for us. We've been pursuing development on the seniors housing and care side of facilities with multiple levels of care. We like models that have independent living, assisted living, Alzheimer's. We like CCRCs. We think they are a product that will do well as the population ages. At the other end of the spectrum, we've been focused on medical office buildings and surgicenters and building new products to again serve the needs of the baby boomers. I think operating fundamentals still look very good and don't expect that to change dramatically over the next few years. If we saw a surge in new development, that would cause us to pause in certain markets. And if interest rates keep rising, then obviously capitalization rates are going to adjust.

Kathryn A. Sweeney: We are an Australian listed property trust (LPT), which is similar to a U.S. REIT. However, in Australia, the rules are more lenient in that we can invest directly in real estate as opposed to having to do a lease structure. In addition, The GPT Group is a stapled entity and, as such, can invest in operations, as well. As a matter of fact, GPT prefers to invest in an operator because that assures GPT the alignment of interest above and beyond a direct joint venture structure.

We've already aligned with Benchmark Assisted Living and recently acquired 15 additional properties in a joint venture with them. We also want to grow our presence with other seniors housing operators in regions with high barriers to entry for new supply, as well as strong senior and adult child demographics. The NIC MAP database helps us find these markets. But getting into skilled nursing is a "no" for us at this point. Even private pay. It's a medical model that a new investor in seniors housing just can't get comfortable with, especially one 10,000 miles away. And I agree that there is definitely a point at which the appetite for seniors housing here will dry up if cap rates continue to decline precipitously.

How small of a deal can you look at and have it be cost-effective?

Kevin J. McMeen: Most of what we do is shorter-term, floating-rate debt. By definition, we view that as two-to five-year base terms, and there may be extension options that go up to five to seven years in total. Generally speaking, the smallest deal we would look at is something in the $7 million to $10 million range. Below that, it's really not cost-effective. We have done smaller deals where we're trying to penetrate a relationship. Also worth noting, we have done some mezzanine transactions in the $900,000 to $2 million range, but those carry returns that justify the smaller size.

What do you look for when doing construction lending, and how does the market compare with two years ago?

Laycock: We look at several factors when underwriting. We want to be sure that the pro formas are realistic as far as lease-up is concerned. We look very carefully at each individual market. We typically look at more urban-type settings, but we will also look at tertiary and secondary markets if they are in a portfolio transaction or if that particular borrower has a strong operating history in those particular markets. We do look for the experienced developer/operator with strong sponsorship, and we would typically requre recourse as part of the loan transaction.

As far as volumes, we have definitely seen a trend toward the independent living/assisted living combination or the continuum of care, whether it is in a true CCRC or where people have expanded onto an existing facility. For example, operators are adding an assisted living or Alzheimer's component to existing independent living or perhaps adding cottages to a facility that they currently have in place.

Also discussed during the call were recent deals, comparisons of debt pricing now versus a year ago, terms for non-sponsored transactions, mezzanine lending and other creative structures, and cost per unit/hard cost per square foot. The panelists also provided pricing solutions to a couple of hypothetical scenarios. To listen to a taped replay of this call or learn how you can become an Executive Circle member and take part in future calls, visit www.nic.org/ec. Financial updates on the seniors housing and care industry will be presented at the 17th Annual NIC Conference on October 3-5, 2007, in Washington, D.C.

Founded in 1991, the National Investment Center for the Seniors Housing & Care Industry (NIC) is a nonprofit organization providing information about business strategy and capital formation for the senior living industry. Proceeds from its annual conference are used to fund research and data that lead to informed investment decision making to advance the seniors housing and care industry. For more information, phone [phone] or visit www.nic.org. To send your comments to the editors, e-mail [e-mail].