The Fitch Ratings Public Finance outlook dropped earlier this week and not surprising, their outlook for Life Plan Communities and Non-Profit Hospitals/Health Systems remains negative or in their terms, “deteriorating”. Their forecast is for deteriorating credit conditions in these two sectors due primarily to labor and cost pressures (insufficient supply of labor at higher comp levels plus commodity cost increases at rates higher than reimbursement/revenue increases). The report is available here: RPT_2024-01_10256018
For non-profit hospitals and systems, Fitch’s view is that the labor pressures driving higher compensation levels, particularly for clinical staff, will continue throughout 2024. They note that providers that have been able to attract and retain staff, even at higher compensation levels than pre-pandemic, outperform (margin) their peers that continue to rely on contract labor. Fitch also correctly notes that providers that primarily have built their own staffing models via employees are likely to perform better in terms of care quality and safety. This point, while not directly transferrable to margin, is accretive to overall performance over time via lower rehospitalization rates, improved liability insurance premium and coverage levels, reduced litigation risks and costs, etc. Fitch’s core observations/indicators are below.
- A sector outlook reassessment would likely require significant improvement in labor
productivity given the current scarcity of available labor industrywide and for clinical
positions in particular, which historically have been in high demand but short supply. Gains
in labor productivity will likely be achieved only through redesigned labor processes,
possibly through technology and artificial intelligence (AI) advancements. Recent years
have seen enhanced recruitment and retention efforts, emerging as one of if not the single
most meaningful differentiator between operational success and failure. - A sector outlook revision to neutral would necessitate more widespread sector wide
improvement to operating income, particularly in the wake of a very challenging 2022 (with
an essentially break-even median operating margin) and an equally challenging 2023. - Equity market stability and a return to materially positive returns YoY could restore and
increase rating headroom, in turn signaling a higher likelihood of a sector outlook revision as
greater credit stability is amassed. - Though not expected to be a widespread event, a second year of debt service covenant
(DSC) violations are of particular concern this year. Second year violations, which would
occur in calendar 2024 as late fiscal 2023 and early 2024 audits are finalized, may intensify
the potential for bondholders to declare an event of default and accelerate bond payments.
In terms of rating actions, in 2023 YTD downgrades outpaced upgrades by almost 3-to-1, compared to just 1.1-to-1 in 2022. Affirmations (no rating change) still represent 88% of all ratings in 2023.
For Life Plan/CCRC communities, Fitch’s outlook is more negative than its hospital outlook. They note that the fundamental drivers of the negative 2023 outlook remain, labor costs pressures, real estate liquidity (or illiquidity), and commodity price increases (food, energy, supplies, etc.). While the demand for the Life Plan product remains strong and the demographics, favorable, converting the demand to unit sales has been difficult due to illiquidity in the residential real estate market. Similarly, sales continue to come via incentives, often rent abatement of one form or another (rent reductions, no rent periods, etc.), suggesting that increases in occupancy don’t yet translate to larger increases in revenue. Rate increase trends have been at or above inflation levels and Fitch questions (as do I), how long ‘sizable’ rate increases can continue without hurting occupancy and sales.
For years, across many articles (most on this site) and in many presentations (again, can be found on this site), I have pointed out that Life Plan occupancies and unit sales are very tightly tied to the sales/resale health of the residential real estate market (the liquidity). Life Plan demand is highly elastic and entry fees for most new residents, are sourced from net realized sales values from their primary residence.
The current market has produced strong housing prices/values but the same, are not materializing via sales (thus, illiquidity). Interest rate increases, translated to mortgage rates, plus bank lending tightening and the Fed no longer supporting mortgage rates directly via mortgage back security purchases (quantitative tightening via balance sheet contraction), has reduced the universe of buyers, substantially. Fitch notes this condition, albeit a bit more couched, in their report: “Decelerating growth in real estate pricing may also slow the current strong pace of independent living unit (ILU) sales and limit an LPC’s ability to raise entrance fees to absorb cost inflation and pay refunds.“
Fitch’s points to watch are below.
- A heightening of regulatory requirements, particularly minimum staffing ratios, would
add to already increased operating costs and exacerbate the headwinds in the LPC
sector. - Mergers & Acquisitions, provider affiliations and industry consolidation are going to
remain key themes as providers seek the benefits of economies of scale.
A final note to this post is that the December CPI report was released today. I’ll comment more in an upcoming (soon) post. In relationship to the Fitch outlooks above, the report sufficiently confirms that headwinds continue for Life Plan/CCRCs and frankly, all providers. Some data points from the report worth noting.
- Headline inflation (CPI all components) came in at annualized rate of 3.4%. Monthly growth was .3%.
- Inflation minus energy and food was 3.9%. This is the “core” measure that the Federal Reserve most closely follows for rate policy changes.
- Shelter or housing remains hot – plus .5%. This is the largest component by weight of the CPI.
- Energy has helped to suppress the CPI rate as fuel and fuel oil prices have fallen. This is why the core metric at 3.9% is higher than the headline metric (CPI) of 3.4%.
