Senior Living/Housing M&A and Fitch

The title of this post likely appears a tad bifurcated but as you read through it, the title should make a bit more sense.  In the past two weeks, I’ve had numerous conversations with potential buyer’s looking at or for (to acquire), senior housing projects  (AL, IL, some CCRC and a few SNFs).   Invariably, the conversations center around the current prevailing notion that “now” is a good time to buy.  The most salient reasons I hear to support this belief are “values” are plentiful and capital is coming back to the industry.  Alas, I guess it is my job to be the bearer of “bad news” or, not really bad news but “truth”.  This is where the Fitch part of the title comes into play.

Fitch, the ratings agency, released its industry outlook for Senior Housing in mid-March and as suspected by most, the outlook remains negative.  This said, it should be noted that Fitch does somewhat confirm the belief that capital is returning, albeit slowly to the sector, and that the industry as a whole has “shown suprising resiliency”. Still, as detailed within the report, 2010 contains (likely) more negative or static news for the industry than positive or encouraging news.  Principal to Fitch’s outlook is its prognostication on ratings of debt issues (new and existing) and in this case, Fitch is predicting that the majority of rating decisions will be affirmations of existing ratings and when changes to ratings occur, Fitch is predicting more downgrades than upgrades.  For Fitch, the ratings outlook plus the overall sector economic outlook and trend is the basis for their sector outlook.

Overall, the report presents a great deal of carry-over of issues from 2009, namely the taint in the industry left over from the Erickson collapse.  Per Fitch, little has changed across the industry dynamic that caused Erickson to melt-down.  In specifics, their conclusions are;

• Current economic recovery laxity and a slow and very limited recovery in the real estate sector will continue to hurt the industry.
• Letter of Credit repricing risk in the next 12-24 months is high as current Letter’s of Credit renewal, banks that previously extended credit either may pull away entirely or provide renewals at significantly higher prices.  Today, the going rate trend for renewals is running at 50 to 200% higher for investment grade debt (BBB or better).  
• Weaker liquidity levels for the industry will continue throughout 2010.  Since 2008, liquidity levels have dropped in the key measures of days cash on hand (down by nearly 75 days), the cushion ratio (down by nearly a full point) and cash to debt (down by 10%).  The concern as expressed by Fitch is for continued slow economic recovery or the potential of an additional market downturn, shocking liquidity again.
• Cost of capital continues to run higher than periods prior to the economic downturn.  This is particularly true for non-rated debt and floating-rate debt and less so across a broader horizon for fixed rate debt.  In reality, fixed-rate debt today is priced attractively, considering the cost of variable-rate debt and LOC (Letter of Credit) fees.
• The real estate recovery is barely, if at all visible, and for Fitch, this trend foretells occupancy fortunes for the sector.  The biggest impact on occupancy remains for new projects or projects with recent sizeable expansions.  Occupancy in general is down by 3 to 5% and for established providers, the trend has remained stable to marginally improving.

So the Fitch tie-in in the title?  What is known by Fitch is known by lenders and the capital markets and thus is known by investors.  In reality, a willing buyer and a willing seller today is only 50% of the deal; the other half is capital – unless the buyer is in an all-cash position.  I’ll elaborate a tad more at the end.

As I indicated earlier, my job is to be the bearer of the truth when I talk with buyers or interested acquirers.  The truth regarding the M&A scene today for senior housing is that the real value plays are projects that are small or distressed and those are virtually impossible to finance (notice I said “virtually”).  When and where financing can be obtained, if needed, for these distressed or smaller projects, the terms are stiff (rates, covenants, term, overall costs).  Where buyers are assuming more discounts should be available, sellers are not cooperating.  In short, there is a pretty solid gap between a seller’s valuation and a buyer’s valuation of the same project or group of projects.  Sometimes, this gap can be overcome but most often, for solid projects with decent cash flow, it cannot.  Sellers today have precious little incentive to reach down to buyers, especially if their project (single or portfolio) is stabilized, cash-flowing, and has a solid balance sheet (average or better than industry average capital and liquidity ratios).

Another complication for buyers is the lack of decent comparable transaction data over the past two years, especially in certain areas or regions.  Comparables drive valuations/appraisals and of course, valuations/appraisals drive lending terms and limits.  I have seen a pretty decent disconnect between deal terms and valuation results over the past two years and in a large part, due to a lack of decent, reasonable and recent comps.  Lenders, skittish as they are about the sector, are highly wary of comps from deals completed three or four years ago when the market was frankly, a tad over-heated and the economy, over-bloated.  Summary: Throw out the comps that may have made sense on a representative basis three to four years ago and try to find representative comps that are from a period of market stagnation and recession – the alchemy for a valuation disconnect.

For buyers, the reality is that the market is still seller-driven and I don’t see a dramatic change occurring throughout 2010.  Perhaps the most investment-ripe play is in the SNF sector as volumes are slightly up, bed prices are slightly up (albeit fractionally compared to a double-digit decline from 2008). In 2009, AL prices per unit continued to decline (30% aggregate since 2008).  Note: The price suppression is a reflection again on the weakness of the housing market plus the deals completed comprised primarily of weaker projects.  What the SNF sector offers today is “known” external variables and a disconnect from the real estate market.  With health care reform complete, the SNF sector is essentially “stable” for investment.  What this means is that revenues are easier to forecast and operating ratios quicker to analyze.  The prospects in other words, of a transaction are more tangible and easier to quantify.  This said, I still don’t see a ramp-up of activity, more perhaps a gradual increase with modestly rising or stable per bed prices and effectively, stable cap rates.

The AL and IL sectors will still remain a bit problematic for buyers unwilling to put a fair amount of cash into a deal or unwilling to use enough cash to create a financeable transaction for a distressed project.  Value buyers are going to continue to find that sound projects are few and far between on a true value play and the stickiest issues regarding valuations and financing will remain.

The conclusions I draw and the counsel I provide today is rooted in basic economics (my history).

1. Buyers and sellers exist across the entire price/value continuum.  At times, the proportion of one versus the other (sellers vs. buyers) creates different strength/weakness propositions hence when a market becomes a buyer’s or a seller’s market.  Most often, historically, the market is neutral.  There is not enough volume today to characterize the market as predominantly strong for either side (buy or sell) but the dynamics are such that sellers with good projects have an upper-hand for the time being.
2. The near term trend also favors sellers, especially as buyers begin to gain access to reasonable cost capital.  Initial cycles where capital becomes cheaper or easier to access favor sellers as buyers typically will use the new-found access to buy at price points recently considered by them as too high. 
3. The intermediate term will favor buyers as the market seeks to return to “neutral”.  Sellers, seeing deals done at increasing prices and with increasing volumes, will shift their positions from hold to sell, trying to reap a piece of the action.  Too many sellers will enter the market and buyer’s will be favored.
4. The credit markets will continue to gradually loosen but again, cautions regarding valuations need heed.  Buyers with solid credit, cash to add equity and sound balance sheets will find fixed rate deals more and more attractive.  New bond deals will also find fixed rate deals almost as attractive if not as attractive as floating rates with LOC enhancement, given the rising prices of LOCs. 
5. As a rule, properties that are stabilized are likely at or just beyond their low census point.  I think occupancies will or have stabilized and start to trend back-up, although the slow to non-recovering real estate market will keep progress gradual.  Some markets will fare better than others.  I also see these same properties in a better overall position financially in 2010 than last year or the year before.  Providers have done a decent job getting “lean”, save perhaps their debt load.  The good news is that rates are not under pressure to rise so even potential increased LOC costs (as applicable) won’t alter too many balance sheets among the stabilized provider group.