Seniors Housing Stacks Up
Last year’s investment performance signals a strong 2015.
Seniors housing generated solid returns for investors in
2014. By many measures, the returns were well above those of other investment
opportunities. The sector has attracted growing attention from seasoned
veterans in the sector as well as new entrants who find the fundamentals
compelling and the investment thesis reasonable. A look at the sector’s 2014
performance helps explain the factors that will shape this year’s
Investors are attracted to seniors housing’s
favorable investment return and portfolio diversification attributes. While the
data is quantifiable for only a limited number of institutional-quality properties,
NCREIF has been collecting income and appreciation returns for seniors housing
from its tax-exempt plan sponsors since 2004. The data show that seniors
housing returns have been quite strong. In fact, one-year returns for third
quarter 2014 were more than 900 basis points higher than for the broad property
market tracked by the NCREIF Property Index, or NPI. This equated to a one-year
total return for seniors housing of 20.37 percent versus the NPI of 11.26
The one-year return also compares favorably to stock and
bond investments that tallied returns of 19.74 percent for the S&P 500
Index and 2.28 percent for the Barclays Capital Government Bond Index. Longer
term, on a 10-year basis, seniors housing has consistently generated strong returns
as well, at 15.09 percent.
Seniors housing’s strong performance stems from
outperformance for both appreciation and income. On a 10-year basis, the NCREIF
index of income return has outperformed the NPI by 131 bps, while the
appreciation return for seniors housing has outperformed by 495 bps.
The seniors housing property transactions market is very
active, with 3Q14 acquisition activity the strongest on record. Nearly $7
billion worth of deals were closed during the 3Q14, up more than 30 percent
from the previous high-water mark of $5.3 billion during third quarter 2011.
For comparative purposes, $8.5 billion of hotel deals and
$27 billion of apartment deals closed in 3Q14, according to Real Capital
Analytics. For the 12 months ending in September 2014, seniors housing
investment totaled more than $15 billion, surpassing any four-quarter total on
record. Investment activity should close out the year on a high note, as the
fourth quarter itself is traditionally strong and two large real estate
investment trust transactions, representing nearly $6 billion, are expected to
Acquisition activity has been spread across investor types,
with institutional, equity, and private investors accelerating investment
activity. These investor groups closed roughly 30 percent of the 3Q14
transaction volume by dollar amount. Investors include pension funds, insurance
companies, universities, endowments, and high net worth individuals who provide
funding to an ever-increasing roster of private equity firms. These firms are
specifically targeting seniors housing acquisitions and development
However, publicly traded companies still account for the
lion’s share of activity, with more than $9 billion in
completed acquisitions during the past four quarters, including nearly $5
billion of investment during 3Q14. While $9 billion represents significant
investment in the sector, that sum is about 25 percent below the peak rolling
four-quarter activity established during late 2012.
The acquisition wave for public companies, particularly
REITs, should continue into 4Q14. The two blockbuster deals that are scheduled
to close during 4Q14, Ventas’ acquisition of American Realty Capital and NorthStar
Realty Finance’s acquisition of Griffen-American Healthcare REIT II,
collectively represent $5.7 billion of investment and should propel the rolling
four-quarter total for public investors to new heights.
A survey conducted by National Real Estate Investor and the
National Investment Center for Seniors Housing and Care among 223 industry
participants during mid-summer 2014 further corroborated the appeal of seniors
housing to investors. A full 95 percent indicated that 2015 transaction volumes
would exceed those of 2014. The majority of survey respondents also believed
that both debt and equity capital would be readily available for acquisitions
A separate survey conducted by GE Capital in September 2014
of 150 seniors housing and care executives showed similar results and interest
levels. More than three of four persons surveyed expected better business
performance in the next 12 months and 56 percent of the survey respondents
believed that property valuations are sustainable.
Certainly seniors housing is not yet considered one of the
traditional real estate property types, alongside office, retail, multifamily,
and industrial. Nevertheless, it is becoming more mainstream and is now showing
up in core real estate funds.
In general, institutional investors’ portfolios
encompass a mix of stocks, bonds, cash, and alternative assets. Commercial real
estate is typically lumped into the alternative asset bucket and can often
generate strong returns for an institutional portfolio. This has been most
evident for investors who have participated in seniors housing opportunities,
as discussed earlier. Moreover, seniors housing investments offer portfolio
diversification benefits, since seniors housing may not respond in the same way
as stocks and bonds during swings in business and interest rate cycles.
Seniors housing returns are also often less volatile than
that of other property types. Indeed, during the Great Recession, returns for
seniors housing, as measured by NCREIF, were less volatile and suffered an
outright decline of 6.7 percent over the course of only two quarters versus
returns on apartments, which declined 24 percent over the course of seven
quarters. Moreover, real estate can
provide a steady income stream from rental income. This economic resiliency is
especially true for assisted living properties, where residents often move in
out of necessity, regardless of the broader economic environment.
Market fundamentals for seniors housing continue to improve.
Occupancy rates in 3Q14 for the NIC MAP primary markets climbed to 90.3
percent, the best showing since late 2007. The 100-bps improvement from the
prior year reflected outsized gains in demand (as measured by absorption or the
change in occupied stock), which overshadowed inventory growth. On a
four-quarter moving average, absorption totaled 13,664 units, a record amount,
and well in excess of new supply, which totaled 9,031 units, for the same
four-quarter moving average. The differential between record strong demand and
new inventory has never been so great.
That said, nationwide there are a number of properties still
in lease-up, as well as a number that have broken ground but have not yet been
delivered in the primary markets. Combined, this amounts to 321 properties (128
non-stabilized properties and 193 properties under construction) or 29,531
units (11,368 non-stabilized units and 18,163 units under construction). In
aggregate, these properties represent an increase in the inventory of units of
5.6 percent. If demand keeps pace at its recent levels, this inventory should
be absorbed in a little over two years (new supply of 29,531 units/annual
absorption of 13,644 units = 2.2 years).
The delivery timeline will be staggered and will not be
evenly distributed across the country. Some properties will reach stabilization
quickly. Projects in the pipeline may be accelerated or delayed depending upon
the availability and timing of financing, permits, regulatory approvals, and
labor and materials costs and availability. With rising construction costs,
developers are incentivized to deliver as quickly as possible, although most
probably have some type of cost protection in place. Nonresidential
construction costs have increased 4.31 percent in the past year, according to
the 2Q14 Turner Building Cost Index. The increase was due to rising labor costs
and costs of manufactured and engineered construction components; raw material
prices remained flat.
The Threat of Oversupply?
There are some seniors housing markets that will be tested in the next 24 months if supply begins to outpace demand. In Houston, for example, there were 2,130 units of seniors housing under development as of 3Q14 (equivalent to 14.2 percent of its existing inventory, second to San Antonio with 16.1 percent and compared with the primary markets with 3.4 percent). In addition to these units, there were also 775 units in 11 properties that recently opened that have not yet stabilized. Combined with the units under construction, 2,885 units of new inventory will be introduced in the metropolitan area in the next two-plus years — equal to all the units developed in Houston since 2007. However, Houston has been able to absorb more than 1,000 units of new supply in the 18 months since early 2013, when its occupancy rate was at a cyclical low of 84.7 percent. Currently its occupancy rate is 88 percent, the highest since 2008 and near its long-term average rate of 87.7 percent. (Note that Houston tends to have a lower average occupancy rate than the average primary market occupancy rate of 89.1 percent.) At its current run-rate of absorption, it will take Houston roughly three years to fully absorb the new supply. With its strong economy, fast pace of job creation and significant in-migration of new residents, Houston will be a very interesting market to watch.
NIC projections for the next 12 months suggest that demand
will continue to outstrip completions, allowing further occupancy gains. For
seniors housing properties where the majority of units are independent living,
occupancy is projected to rise to 91.8 percent in third quarter 2015 from 90.9
percent in 3Q14. For properties where a majority of units are assisted living,
occupancy is projected to increase to 89.8 percent from 89.4 percent. This will
be the highest occupancy rate for majority assisted living since near the start
of the recession in early 2007. Note that, over the next year, the 90 bps
improvement projected for majority independent living far outpaces the 40 bps
improvement in occupancy for majority assisted living. This means the average
occupancy level for majority independent living properties will be a full 200
bps higher than majority assisted living.
The 2016 and 2017 periods will also be affected by
properties just recently started or those started in 2015. In 3Q14, starts
totaled 2,795 units in the primary markets, a slowdown from 2013 when 3,600
units were started. Anecdotal observations and comments from the October 2014
NIC National Conference as well as ongoing discussions with operators and
capital providers suggest that many are contemplating development; however,
these projects don’t yet show up in the NIC starts data.
Developers favor the sector for several reasons, including
the strong market fundamentals just described, as well as the favorable
development return projections relative to other property types and acquisition
returns. Moreover, replacement costs or those associated with the construction
of a new state-of-the-art property are often lower than those associated with
acquiring an existing property.
With the talk of development picking up, there are concerns
that supply may outstrip demand and that market fundamentals may deteriorate.
While this is certainly possible, today’s pipeline indicates that the risk of
hyper-supply at the national level is not yet evident. Moreover, capital
providers may constrain development to some degree as better seniors housing data
improves their knowledge of market fundamentals and transactions activity. This
in turn has improved due diligence and underwriting, thereby potentially
limiting some development activity that may appear excessive. Such a trend
emerged in the multifamily sector to some degree, which is ahead of the seniors
housing sector in its development cycle.
What Could Go Wrong??
While the outlook for seniors housing investments looks
generally promising, there are factors that could alter this expectation. Among
these are rising interest rates, which will raise the cost of capital for
borrowers as debt providers are forced to respond accordingly. Higher interest
rates may also push up capitalization rates and potentially hurt investors’
returns. The economy is approaching its sixth year of expansion. At the same
time, the Federal Reserve is gradually moving away from its accommodative
monetary policies, as evidenced most recently by the end of its quantitative
easing programs. And it’s likely that the Fed’s stance toward a zero interest rate
policy will end sometime in 2015. As all of this occurs, there will be upward
pressure on cap rates for all property types. If net operating income growth
cannot offset this pressure, values may decrease.
Property location may also influence return performance. In
markets where there are limited barriers to entry and few regulatory
restrictions on growth through tough entitlement and zoning processes, or
restriction on growth due to physical barriers, occupancy rates may slip as new
units are fully integrated into the market.
Third, there may not be enough transaction opportunities for
the robust buyer interest that exists today. Indeed, by some measures, there is
a limited amount of product being offered to buyers today. And when properties
and/or portfolios are brought out to the market, buyer interest is very strong
and competition from interested investors may push prices out of reach for many
potential investors. Such a competitive landscape also raises the risk of
Lastly, there is a risk that property-level NOI growth could
slow if the macro economy slows for an extended period. External shocks to the
national economy could surface from a further slowdown in Europe, China, or
Japan, or further U.S. military involvement in wars. The long-term risk of a
spike in oil prices is presently less likely, given the recent drop in oil
prices to below $80 per barrel.
A Competitive Landscape
Cap rates continue to compress for seniors housing
properties. Strong investor interest and a compelling investment thesis have
led to a very competitive landscape with many potential buyers being bid out of
the market entirely. With the very strong likelihood of rising interest rates
in the next six to 12 months, there is considerable risk that today’s
record low cap rates may follow interest rates higher, at least to some degree.
With its compelling investment thesis, however, it’s
reasonable to argue that cap rates for seniors housing may be sticky and not
follow interest rates higher in lock-step.
To sustain values, operators will increasingly have to grow
NOI and maintain margins through higher occupancies and rents. This will be
particularly important and challenging for those operators who may be affected
by higher minimum wage levels or higher electricity prices, especially those
situated in the Northeast. Large operators who can create economies of scale
may be better positioned to face these threats. However, now more than ever,
quality settings, quality care resulting in quality outcomes for residents and
value will be the real differentiators that distinguish the top performing
properties in an increasingly competitive landscape.
Beth Burnham Mace is chief economist for the National
Investment Center for Seniors Housing and Care. Contact her at email@example.com.