Senior living facilities took the brunt of the early COVID-19 pandemic. A fragile elderly population was no match for an aggressive novel virus. As a large percentage of residents succumbed to the virus, you had to wonder if the industry itself would succumb. After all, it’s hard to bounce back from headlines painting group homes and senior communities as death traps. It might be hard, but apparently it isn’t impossible, and new figures released by the National Investment Center for Seniors Housing and Care (NIC) indicate the senior housing market is doing just that.
According to third quarter 2023 NIC data, the average occupancy for senior housing overall stands at 84.4 percent, which is 6.6 percentage points above its pandemic-related low of 77.8 percent recorded in mid-2021 and only 2.7 percentage points below its pre-pandemic level of 87.1 percent in the first quarter of 2020. This marks the ninth consecutive quarter of occupancy growth.
In August, NIC introduced a new measure to help analyze the senior housing supply/demand dynamic. This new measure, the absorption-to-inventory velocity ratio, stood at 28:10 for primary markets in the third quarter, which implies that for every newly added unit, nearly three (2.8) were absorbed.
All of this is encouraging for senior housing investors. Occupancy is inching toward normal levels. Demand is growing while supply remains constrained. That’s what every asset class looks for. But can the upswing continue? What is driving the demand? What is depressing the supply?
The answers aren’t easy. Senior housing has become the perfect example of an industry where every positive feature seems to be balanced by a concerning feature. The “one hand” and the “other hand” are sharing a lot of space.
“The senior living sector is at a critical inflection point,” notes Zach Bowyer, head of living sectors for valuation and advisory at Cushman & Wakefield. “Property market fundamentals are stronger than ever, driven primarily by the secular tailwinds of our aging population and magnified by a near halt in new construction. The number of occupied units has reached an all-time high with net absorption and rent growth remaining at very favorable levels.
“On the other hand, we are enduring one of the more challenging capital market environments, which is exacerbated by a costly labor market coupled with inflated insurance and property tax costs,” Bowyer continues. “Net-net, operating margins are down, and valuations are impaired. It does, however, appear that the bottom is near with green shoots ahead — with some caveats, of course.”
Demand vs. supply
Since the acceptance of senior housing as an institutional-grade investment opportunity, investors have been looking forward to the baby boomer cohort reaching elderly status. Now, it seems the flood has arrived. With the historical average age of those moving into senior housing being between 80 years old and 83 years old, baby boomers are literally knocking at the door. Yet, despite favorable demographics and steadily returning demand, construction has remained below pre-pandemic levels. According to NIC, the 11,133 units under construction in the year ended third quarter 2023 amounted to less than half the starts reported during all of 2019.
New development is obviously falling far short of the need. Extrapolating from the percentage of the 80-years-and-older population that entered senior living facilities in 2016 (7.9 percent), we can estimate the housing stock is going to need to increase by 35,000 units per year, starting today, to meet the coming demand.
“To put this in perspective,” explains Bowyer, “the sector has averaged approximately 25,000 units per year in the five-year period leading up to the pandemic, with construction levels now suppressed to the lowest levels since the great financial crisis. Affordability by the middle market will be an even greater shortfall if not solved quickly.”
There is no indication this shortfall will be solved quickly.
“Development is not going to pick up for a number of reasons,” predicts Shlomi Ronen, managing principal and founder of Dekel Capital. “First off, the capital markets for senior housing development are pretty much frozen. In the past, you had a small group of specialized lenders, primarily banks, that were willing to provide construction financing to senior housing developers. Those banks are not lending to anybody, let alone senior housing projects, right now. Even if financing was available, the targeted yields on cost from the equity side are so high that land would probably have to be contributed at a zero basis to even remotely make a project pencil. So, development simply is not feasible.”
Ronen also notes there is no incentive to take on development risk because managers and investors can buy newly built senior housing communities in nearly any market at below replacement cost. The certainty of going-in costs makes underwriting the investment much easier.
Another factor depressing construction is the lack of exponential demand growth. Although baby boomers are adding to the aging population, the growth is slow and steady as opposed to energetic.
“Senior housing is not like multifamily, where you have a lot of movement and growth that can happen in a particular market,” explains Ronen. “Senior housing is relatively slow and steady. We do have an aging baby boomer population that’s starting to increase that demand, but the increase has so far been relatively incremental from what we’ve seen.”
Although investors are finding it hard to find properties that meet their investment needs — often because they are trying to underwrite what should be a core or core-plus investment in the value-add and above range — the sector has historically been one of the industry’s return leaders.
According to NCREIF’s first quarter 2023 report, the 10-year return for senior housing (9.33 percent) was the second strongest of the core property types, trailing only industrial (15.64 percent). In addition, it outperformed the NCREIF Property Index (NPI) 10-year annualized total return of 8.34 percent. Income returns for senior housing (5.17 percent) surpassed the NPI (4.64 percent), as did the appreciation return (4.02 percent versus 3.58 percent). While we all know past performance is no guarantee of future returns, historically strong low-volatility core sectors typically continue to be consistent performers. For many investors, today’s lower valuations provide a very attractive lower-cost entry into one of the sectors that is expected to perform well in the coming decade.
However, rising labor costs and other increasing operational expenses are making this another “on the one hand, on the other hand” situation.
“Valuations are resetting, which investors view as an opportunity to go in at a lower basis,” says Bowyer. “However, the current 30 percent operating margin yields a different risk threshold than the 40 percent to 50 percent operating margins of the past, which may be a deterrent to some investors, yet an opportunity to others who are willing to roll up their sleeves a bit.”
Because of the tight labor market and rising operational costs, some relatively new and attractive properties are stressed. In addition, some properties are facing a financing squeeze as their loans come up for renewal at much higher interest rates than they started with. Nearly $18 billion in sector-specific debt is scheduled to expire over the next two years. This can provide an opportunity for investors with turnaround skills to purchase good properties at significant discounts.
Purchasing stabilized properties is not as attractive — or as possible.
“Right now, there’s still a fairly significant bid-ask spread on stabilized properties that can be financed with Fannie and Freddie financing,” says Ronen. “We are seeing investor interest in the low 8 percent cap-rate range, but the sellers seem to be needing cap rates that are significantly lower to have a desire to sell or exit.”
Not all the same
In a recent Cushman & Wakefield investor survey, 33 percent of participants identified assisted living as the preferred property type for investing. This is a property type that people enter because they have to, rather than because they want to (e.g., independent living or active adult). The need-driven component allows for more stable occupancy in recessionary periods and has a higher barrier to entry than active adult or independent living. With our aging population and respective activity of daily living needs, this need-driven demand component should allow continued improvement in occupancy and rent growth.
Active adult is gaining momentum with investors, however, coming in second place at 23 percent of respondents, surpassing independent living.
“From a capital markets standpoint, capitalization rates will mirror conventional multifamily,” says Bowyer. “On the lending side, active adult will typically fall within conventional multifamily loan terms, making it easier to finance in today’s environment. What makes active adult interesting is that most of the services are contracted directly by the resident. This not only gives the resident more optionality, but significantly reduces the operational cost and risk, making it more attractive to the institutional investor.”
But here comes the other hand. Active adult has a lot of investment advantages, but it is more of a lifestyle option, so a declining housing market or recessionary environment may affect occupancy levels as potential residents are more likely to delay a move in this type of environment.
Looking ahead
The industry is currently climbing out of the basement, and investors are investing. But what future trends are they looking at? Trends seem to focus on efficiency — the industry needs to bring costs down to continue to grow.
“I believe we will see an increase in healthcare partnerships, focus on creating scale in operations, more incentive-based management contracts, continued evolution of active adult, and other building design components that enable greater operating efficiencies,” predicts Bowyer. “One item we are watching is the wave of loan maturities. How the banks react will influence pricing. We originally believed that banks would respond by forcing tough decisions on their borrower, essentially resulting in increased transactions at significantly discounted valuations. While we are seeing a little of this, it is still on a more selective level. Based on discussions we are having with lenders at year end, most are planning on continued extensions in 2024, with small balance pay-downs and two-year loan extensions. While this may result in reduced transaction activity, I believe that it will help maintain valuations.”
Other trends that bear watching involve how the product is delivered to the end user. Just as employees are demanding better work/life balance options from employers, residents and their families are demanding better communication and care from the senior-living facilities. Operators are meeting this demand via technological advances that allow better real time communication, as well as activity and care options that focus on the individual rather than the group. Residents know they are in a group setting, but they want to feel like it is a private home.
“What we’re ultimately providing to our residents is a combination of care and community,” explains Ronen. “Every now and then we will do an analysis, and the cost of living in a community versus the cost of in-home care ends up being about the same. The difference is that, oftentimes, when a resident has care provided at home, you still need a large time and energy investment from the family to help. In addition, the elderly spouse or parent isn’t getting any meaningful social interaction. Study after study has found that a rich social life is the key to longevity and happiness.”
For investors, the key to finding the right investment is due diligence and a little luck. On the one hand, a stable economy and a growing need for elderly care bodes well for the industry. On the other, the economy is currently looking good, but will it remain that way? And the baby boomers are at the door, but will they walk through? As with any investment, it all comes down to balancing the one hand and the other. Opportunities exist for those with the fortitude to choose a side and jump in.
Sheila Hopkins is a freelance writer in Auburn, Ala.