Do just once what others say you can’t do, and you will never pay attention to their limitations again. ~James R. Cook
National Real Estate Investor Sep 16, 2015 Beth Burnham Mace
Investor interest in the seniors housing sector is strong and growing. Transaction volumes are at record high levels, pricing is close to a cyclical peak, and auctions are active and often fully priced. Developers from other property types are actively building seniors housing pipelines, and the cadre of capital providers continues to expand. Balance sheet lenders, such as life companies, and debt providers such as CMBS lenders and growing numbers of pension funds, are actively investing in the sector today.
In part, this can be explained by the growing transparency and understanding of the sector. Indeed, information about market fundamentals and capital market conditions is now available from sources such as NIC MAP, Real Capital Analytics (RCA), REIT earnings calls and Wall Street analyst sector coverage. In addition, the sector’s relatively high investment returns and generally improving market fundamentals have driven investor interest. Demographic trends and post-acute care coordination opportunities are also considerations. And lastly, today’s low interest rate environment has fueled activity as the cost of capital for both acquisition and development is historically low.
Questions about the sustainability of these burgeoning trends are frequently asked. This is particularly the case for pricing, and is a question for other commercial real estate assets (office, industrial, retail and multifamily) as well. In general, pricing trends for commercial real estate are strong. According to the September 2015 Moody’s/RCA Commercial Property Price Index (CPPI), the national all-property index was 13 percent above its pre-recession peak, while apartment prices were 50 percent above their pre-crisis peak. While a parallel type of index does not yet exist for seniors housing, seniors housing prices are currently close to peak levels.
Raising questions about bubbles
Arguments in favor of sustainable prices for seniors housing include the following:
- Seniors housing is becoming a property type that fits into a “core” investment strategy for a multi-asset portfolio. Some of its core-like characteristics include its steady and predictable income and cash flow, high income yield and relatively strong “tenant” credit quality. Properties located in major urban areas and with limited leverage would further fit into the “core” bucket. Because of these characteristics, investor interest is likely to further expand, bringing more capital into the sector, and putting upward pressure on prices. In addition to domestic capital, foreign capital flows into the U.S. will continue to rise, as sovereign funds work to hit their commercial real estate targets, with a share of those dollars going into seniors housing as an alternative asset type.
- Typically, riskier investments are associated with higher returns. One way to measure a risk premium for an investment is to compare the return for the investment to the return for the risk-free 10-year Treasury bond. With an average cap rate of 7.7 percent for seniors housing and a 2 percent yield on the 10-year Treasury bond, the risk premium can be measured as the difference, or 570 basis points. This is 200 to 300 basis points more than the risk premium for multifamily assets. Yet the sector’s investment returns are often stronger and less volatile than those of multifamily properties. Moreover, rent growth is the least volatile of any commercial real estate sector and is less tied to the business cycle due to its need-based characteristics. As the sector becomes better understood, its present seemingly inflated risk premium may no longer be justified.
- The sector’s greater and increasing transparency will allow lenders and borrowers to better understand evolving market conditions and provide a more disciplined capital market and prevent excessive development activity.
- Long-term demographics alone are sufficient to justify investor interest and provide a floor for solid market fundamentals in the coming decade.
Arguments against sustainable prices for seniors housing include the following:
- We have re-entered perfection pricing, where underwriting assumptions are stretched to their limit in terms of rent growth, lease-up and exit cap rates, as well as assumptions regarding the direction of interest rates and the cost of debt. As the economy gains further steam and the Federal Reserve increases interest rates later this year and/or next, cap rates will rise in lock step and values will fall. (However, in this scenario, the stronger economy could justify aggressive rent and leasing assumptions that would result in higher NOI growth, which could offset the risk to values to some degree).
- Asset pricing in general, beyond seniors housing and including all commercial real estate, is in a bubble due to years of aggressive accommodative monetary policies, which have driven money into risky assets, making a correction inevitable.
- Rents are rising to the point that development makes sense in many instances. However, developers often think that they have the best product offering in the best market and that their property can avoid the challenge of competition. Such thinking can create excess supply, and result in falling occupancy rates, rents and property values.
- Not all markets behave the same. The U.S. is an array of micro real estate markets, and select metropolitan areas may already be flashing signs of the early stages of excess supply, while other markets, typically those in secondary locations, hold less risk.
- There’s no bubble yet, but it’s inevitable. The U.S. economy is well into this cycle’s recovery. The average length of the past 11 business cycles was 58 months. As of September 2015, the economy had entered 75 months into the upswing phase of this business cycle. If and when a contraction occurs, commercial real estate valuations, including seniors housing and care, will likely fall. That said, the 1990 expansion lasted 92 months, and the 2001 expansion lasted 120 months, or 10 years.
Hindsight is always easier than foresight. With compelling arguments on both sides of the sustainable pricing question, it may be important now to determine your viewpoint—a viewpoint that may offer the wise investor outsized opportunities or challenges.
Beth Burnham Mace serves as chief economist and director of capital markets outreach with the National Investment Center for Seniors Housing and Care (NIC).
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