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An insider's guide to understanding LTC lending.

As an owner or operator of nursing homes, it's to your advantage to know how lenders identify and calculate risk when evaluating a skilled nursing facility (SNF). Understanding their general credit principles and key underwriting risks can help you in your quest for financing.

Seniors housing and care facilities attracted record levels of capital last year - more than $12 billion, according to the National Investment Center for the Seniors Housing & Care Industries (NIC) in its 1998 Lender and Investor Survey. What's more, SNFs were also the one type of project that investor survey respondents still preferred most.

Preliminary results from NIC's 1999 Survey, however, indicate that many lenders and investors intend to be less active in financing nursing homes this year. NIC suspects that some lenders might be reticent about funding an industry where average occupancy rates are in decline and a new Prospective Payment System (PPS) could mean lower Medicare reimbursement. But other lenders, however, sensing opportunity and competitive advantage in the current market turbulence, say they will increase their financing of SNFs in 1999. (Final results of the NIC 1999 Survey will be available in October. For further information, visit the NIC Web site at

As a lender to the long-term care industry, we at GMAC Commercial Mortgage are optimistic, given the needs of the ever-increasing age 85+ population. We also like the industry's barriers to entry (e.g., Certificate of Need and Medicaid contracts), and the fact that nursing homes are the lowest-cost provider of many healthcare services and have historically managed cost under a reimbursement environment that has required cost containment. On the other hand, nursing homes as a very specialized industry sector have inherent risks that lenders must also consider.

General Credit Principles

Lenders use several principles and accepted industry concepts to help determine the creditworthiness of nursing homes. Guidelines, such as those that follow, are derived from years of on-site inspections of skilled nursing facilities and interviews with "Licensure and Quality Care" officers in many states.

* First and foremost, each nursing facility is considered as a stand-alone operating business. The facility's property is viewed as primarily offering "stop loss" protection for the loan. In other words, it is the operating business of that property, not the general corporate value or its other tangible or intangible assets, which serves as the primary asset upon which loan coverage and payback depend.

* As a self-contained business, a key operating test is the facility's ability to sustain a stable level of occupancy at or above the state's average occupancy. If a facility's census is stable, virtually all other operating issues, such as labor costs and responses to reimbursement changes, can be addressed within a reasonable time. Since 1995, average occupancy levels in nursing homes have been declining. In 1998, according to the 1998 HCIA/Arthur Andersen Guide to the Nursing Home Industry, the average nursing home occupancy in 24 states was below 90% and in seven states below 80%. Shorter-than-average lengths of stays by residents and competition from other care alternatives (primarily assisted living facilities) have contributed to the decline in average census. Still, most facilities can operate profitably if they sustain a stable occupancy at or above what is considered average in the state where it is located (for one reason, because Medicaid reimbursement caps in many states are based on statewide average occupancy).

* A key determinant of occupancy, and ultimately profitability, is the operator's ability to deliver"quality of care" to its residents. This ability can be validated by a review of the state's Operating Survey and Punitive Action Report for a specific facility. The review process includes: (1) a comparison of the current survey with prior year surveys focusing on trends in operating deficiencies: (2) inquiry as to the number and frequency of complaint investigations and if they are substantiated; (3) review of the monetary fines paid to the state; and (4) a discussion of the patient care issues from the last two surveys with the facility's administrator and director of nursing and with a representative from the state's Department of Licensure and Survey.

* Due to the nation's healthcare reimbursement policies and the demand-driven need for its service, the long-term care industry can sustain a high degree of leverage. How does a lender determine the appropriate level of leverage for a facility? One approach is to first determine a facility's nominal valuation by capitalizing a facility's historical net operating income, often using a 13.5 to 14% capitalization rate. The loan value (capacity) is then determined by taking the same historical net operating income, the projected interest rate, amortization terms and the target debt service coverage to calculate the present value of expected earnings. In addition, a lender must assess the future impact of a facility's Medicare rate as it phases into the full federal rate under PPS.

These two values, nominal valuation and loan capacity value, are then further refined by running them through a series of questions, such as:

1. What is the actual replacement cost to build a comparable new facility?

2. What property or capital cost reimbursement component is allowed by the state's Medicaid system for that facility and is it sufficient to cover the proposed debt service? (The most conservative review would be to assume a 100% Medicaid census.)

3. What is the condition and layout of the physical plant, such as the number of nurses' stations required, evidence of maintenance, number of rooms that are private, semi-private and wards?

4. What is the sustained private-pay census and how does this facility compare competitively in an inspection and analysis of competing facilities.@

5. What are comparable sales, excluding sales to nonoperating companies (e.g., REITs, public partnerships and all-equity purchasers)?

6. How stable or fair is the state's reimbursement system and its issuance (or lack of issuance) of new Certificates of Need (i.e., factors that are key to the facility's franchise or monopoly value)?

7. What is the impact of Medicare PPS on the facility?

These determinations of the nominal and loan values are not the end of the evaluation process, however. The numbers need to be further adjusted by considering the key risks inherent to nursing care properties.

Analyses of Key Risks

Because the risks associated with lending to this industry are ongoing, financiers require frequent monitoring of the quality of care being administered, periodic inspections of the physical facility, and quarterly financial and occupancy reviews. Four key risks, in particular, are considered critical to the success of a facility and, if minimized, can help ensure that other problems are quickly remedied should they occur:

Overlending: A facility must be able to service debt from its internal cash flow. Projections showing revenue increases from changes in occupancy, patient mix and increasing patient rates (especially private rates) are viewed with caution. The prudent lender will confirm proposed Medicaid rate increases with the appropriate state Medicaid office and determine the average Medicare rates under the full phased-in PPS.

Reimbursement: Since each state's Medicaid system is different, a lender must have knowledge of how the reimbursement system (especially the property component) works for the state in question. The lender will also query whether the state has historically paid on time and if the state nursing home association's relationship with the state agency is adversarial or supportive.

Quality and Regulatory Environment: The state regulatory inspection and survey process is extremely important and determines whether or not an operator can continue to provide nursing home services on an ongoing basis. In this regard, a lender needs to meet with the facility's chief operating officer, as well as its administrator and director of nursing. The lender will also want to know about a facility's employee turnover history, since low employee turnover in key positions is usually a sign that the operations are stable and consistent. The lender might also question hospital social workers, since they are important sources of referral and usually know if an operator or specific facility has a reputation for quality care.

Character: The character of operating management is always important. Lenders will ask the state licensure agency to ascertain a facility's licensure standing, as well as the reputation of the provider. Other operators that have existing relationships with the lender can also be used as sources of information about a provider.


Overall, despite the highly publicized problems of several publicly traded companies, we at GMAC Commercial Mortgage believe that the nursing home industry has excellent growth potential for the next several decades. Understanding how lenders evaluate a skilled nursing facility for underwriting purposes should help give owners and operators a "leg up" in securing financing to support their facilities' future growth.

Sarah Sumner Duggan has been actively involved in lending to the seniors housing industry since 1984. She is currently senior vice-president in GMAC Commercial Mortgage's Healthcare Division, which exceeded $1.5 billion in loans in 1998. Sarah also serves on the Board of Directors for NIC.
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Title Annotation:long-term care
Author:Duggan, Sarah Sumner
Publication:Nursing Homes
Date:Sep 1, 1999
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