Why capital markets are bullish: middle-market operators now have even more attractive financing options.

About a year ago in this publication, I began my article "Need Capital? Know How Lenders Assess Your Operations" (June 2004, p. 60) with the observation that "the outlook for the senior housing sector appears to be the brightest since the mid-1990s.... [C]apital markets are showing increased confidence in the entire senior housing and care industry." Judging by the sector's fourth quarter 2004 performance and recent developments, this optimism was well founded.

According to the National Investment Center for the Seniors Housing & Care Industries (NIC), loan volume placed in the seniors housing industry rose to an impressive $1.143 billion during the fourth quarter, compared with $763 million in the fourth quarter of 2003. "This was the highest quarterly amount placed that we've seen since tracking our Key Financial Indicators," said Robert G. Kramer, NIC president.

In addition, the seniors housing market's fundamentals remain strong, and an influx of new lenders, including large banks and investment banking firms, have moved capitalization rates for all properties to relatively low levels. For SNFs, the best news came in mid-May 2005 with the proposed notice from the Centers for Medicare & Medicaid Services (CMS) on its long-anticipated RUGs refinements. Although CMS did eliminate certain add-on temporary payments, it added nine higher-acuity groups to the current RUGs categories with the anticipated impact being revenue neutral. In addition to the RUGs refinement being neutral, CMS also increased 2006 rates by a full market-basket factor of 3%.

What does this all mean from a financing perspective? Currently, an increasing number of lenders are ready and eager to provide capital to top-performing SNFs and assisted living facilities, especially those in the middle market. Although the sector has begun to show the first hints of overheating (e.g., the mean assisted living capitalization rates are approaching 8%), we at CapitalSource remain confident that its solid fundamentals will continue to attract both debt and equity investors over the next 12 to 18 months. Following is a brief scan of the factors that give cause for this optimism and a review of the options available to companies to take advantage of today's more favorable financing climate.

Occupancy Rates, Bed Prices on the Rise

Several marketplace and demographic trends underscore the seniors housing sector's promising potential for steady, long-term growth. Following the aftershocks from the 1990s, with over-building of assisted living facilities and drastic Medicare reimbursement cuts affecting SNFs, the surviving properties had no choice but to tighten their belts and streamline operations. With these efficiencies in place, operators have been well positioned to capitalize on a continuing rise in occupancy rates, as well as recent increases in bed prices. NIC reported that 2004 was the best ever in terms of year-over-year occupancy increases, with both median assisted living and nursing home occupancy rates up 200 basis points to 88%.

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Demographic factors also portend a positive outlook. With each passing year, more and more of the 76 million baby boomers (born between 1946 and 1964) will become part of the prospect pool for seniors housing residents. From 2003 to the end of this year, the number of people requiring long-term care will have jumped from 7 million to 9 million--nearly a 25% increase. According to the U.S. Census Bureau, the number of Americans aged 65 or older is expected to climb to approximately 40 million by 2010 and to approximately 54 million by 2020. A study by the U.S. Department of Health and Human Services says that people who reach age 65 will likely have a 40% chance of entering a nursing home, and 10% of those who do will stay there five years or more.

No Reimbursement Cuts

As I've already noted, the CMS announcement on its proposed RUGs refinements was perhaps the most positive--and unexpected--development thus far in 2005. Many experts believed the changes to the RUGs would cut Medicare rates by a minimum of $10 a day, and few would have been shocked if the cuts were as high as $30 a day. Instead, according to CMS, "The increase in payments associated with the RUG-III refinements, together with an annual inflation increase of three percent, will result in virtually no change in overall SNF Medicare payments in FY 2006."

This good news brightens a reimbursement climate that has consistently improved on both the federal and state levels. For Medicare, annual inflationary adjustments have increased payments each of the last five years. Medicaid provider payments (which account for roughly two-thirds of a nursing home's revenues) have apparently stabilized in most states, as the cutbacks threatened by some have not yet materialized. In fact, a dozen or so states have initiated provider bed taxes which, despite their onerous connotation, increase Medicaid payments by qualifying the states to provide nursing homes with matching federal funds.

Although Congress earlier this year approved a budget that calls for trimming Medicaid spending by $10 billion over the next five years, even if this is enacted, these measures would likely have no substantive impact on the nursing home industry. The proposed cutbacks are in the areas of copays, eligibility, and drug discounts, and consequently would not affect reimbursement. It has also been suggested that some Medicaid changes may provide tax incentives for long-term care insurance, which could expand beneficiaries' coverage. Meanwhile, most states' progress toward funding the much-talked-about home- and community-based alternatives has been negligible so far.

More Lenders and Financing Options

With its financial health more robust than at any time during the past decade, it's no surprise that the seniors housing sector has attracted an unprecedented level of investor interest. Large banks are coming back into the market, and even nontraditional healthcare lenders such as private equity funds are joining the fray to take advantage of a burst of activity in mergers and acquisitions. Many of these new entrants are primarily interested in securitizing these large loans, which will serve to keep capitalization rates relatively low.

Lenders have also brought new products into the market, including fixed-rate loans. For the most part, however, operators planning an expansion or acquisition pursue a familiar strategy: Finance the initial deal through a bridge loan, get their business running smoothly, and then obtain HUD financing.

Today, short-term (3 to 5 years) variable-rate bridge loans have become a popular financing choice, particularly for strategic property acquisitions. This type of funding often can be secured in a matter of weeks (in contrast to 3 to 6 months for HUD loans) and can provide owner/operators with leverage multiples up to seven times EBITDA for SNFs and even higher for assisted living facilities. When the loan matures, they can either cash in their profits from selling the business or obtain permanent debt financing (e.g., 10-year loans with Fannie Mae and Freddie Mac or 30- to 35-year loans from HUD) at relatively low interest rates. Once they can finance their debt at 6% for 35 years, all their energies can be focused on the profitable operations of their facilities.

For owner/operators who want to maximize the amount of the loan and are unconcerned about building equity, real estate investment trusts (REITs) are another possibility. The typical REIT transaction is structured as a sales-leaseback (with lease terms usually 10-15 years), which gives the REIT full ownership of the property. This financing vehicle enables the operator to monetize equity while maintaining a steady cash flow from operations.

A Time to Grow?

Although intensifying competition has fueled more aggressive funding practices, lenders for the most part have maintained a discipline that was glaringly absent in the 1990s, when runaway investors exacerbated the sector's underlying problems. This cautiousness bodes well for the entire seniors housing sector which, because of its dependence on government funding, will always be vulnerable to the vagaries of politics and the broad economy.

Nursing home and assisted living operators likewise must be prepared to overcome anticipated and unforeseen challenges in regard to staffing pressures, insurance costs, liability concerns, and competition from larger chains, along with any new home- and community-based programs encouraged by states. Still, valuations are up, market demand is strong, and the reimbursement environment is generally positive with respect to recent state and federal revenue growth. And in terms of financing options, it's definitely a borrower's market. If it's true that to everything there is a season, now may be the ideal time for middle-market operators to recapitalize in order to aggressively pursue long-delayed strategic growth opportunities.

James J. Pieczynski is Managing Director of Real Estate for the Healthcare Finance Group of CapitalSource, Inc., a specialized commercial finance company offering asset-based, senior, cash flow, and mezzanine financing to small and midsize borrowers. CapitalSource professionals have been involved in securing financing for more than 1,200 healthcare companies, and the firm has more than $2 billion in loans committed to this sector. For further information, phone [phone] or visit www.capitalsource.com. To send your comments to the author and editors, please e-mail [e-mail]. To order reprints in quantities of 100 or more, call [phone].