By Roger E. Randall, II, Senior Vice President of BB&T Capital Markets
For-profit providers will continue developing rental communities – market fundamentals support it.
Senior Vice President
BB&T Capital Markets
Non-profit organizations have long been the dominant provider of senior care in Life Plan Communities. Because of the Lifecare pricing model (large one-time entrance fee plus an ongoing monthly service fee), they are only affordable to (roughly) the top 25% of local residents who have both the assets and income to afford entry. The other 75% of the senior population has to look elsewhere for the care they need.
Rental communities offer an alternative, particularly for people with few net assets (life-long renters, as we will see). For-profit organizations (whether family-owned or publicly held) tend to avoid the full continuum, providing care in stand-alone communities offering one level of care or possibly Independent and Assisted Living on one campus, through a rental-pricing model.
According to a report by The Joint Center for Housing Studies of Harvard University, entitled “Projections & Implications for Housing a Growing Population: Older Households 2015-2035,” as the population of this country continues to age, we will see the highest growth occur in the low income and middle market income levels. People tend to vote with their checkbooks so we will continue to see for-profit rental communities enter markets traditionally served by non-profit senior living providers.
Consider the Demand-side of the business:
- 9 million homeowners age 65 and older have less than $50,000 in net assets beyond the value of their home, amounting to average net assets of $267,000.
- Savings by senior households that rent is a whopping 98% lower (totaling just $6,100 average net assets).
The Supply-side is also compelling:
- Rental communities with one or two levels of care tend to be far simpler to develop than the Life Plan Communities. Fewer levels of care mean:
- Simpler building design
- Faster development timelines
- Lower debt burden
Moreover, since we are talking about for-profit organizations, driven by return on investment and delivering that return to shareholders, these projects are easier to sell for a quick investment return.
Rental communities serve a needed purpose in the senior care market. For-profit owners and operators will continue to identify new and existing markets to disrupt. The opportunity is simply too great to ignore.
Non-profit providers will respond to the increased competition from For-Profits – Focusing on the Middle Market and Urban Developments.
Executives of non-profit providers look at their current senior care offerings, and because of history, mission and/or economics, they mostly see entrance fee-based Life Plan Communities and possibly some low-income housing, but too often, the middle market is left unserved or underserved. Those feeling pressure from for-profit start-ups or those who want to stay ahead of them will increasingly look for ways to enter new markets and defend existing ones. Here are a couple interesting ways they may choose to do so.
Serve the middle market
To serve the middle market senior, non-profit providers will likely need to embrace the rental model, as the typical mid-market senior does not have the assets to afford living in a Life Plan Community. Fortunately, the benefits for-profit companies enjoy from the rental model are the same benefits non-profit organizations can enjoy, and they offer business diversification (achieved by offering different pricing models and different levels of products, services, etc.); and another way to further the organization’s mission and serve more people.
However, for providers used to operating Life Plan Communities, the rental business has less room for error. Here are just a few examples:
- Resident turnover is approximately twice as fast;
- The lack of entrance fees means rental communities typically do not have as much liquidity (cash); and
- There is no buffer if occupancy declines in the level of care you offer, whereas in a Life Plan Community, while one level of care is having occupancy challenges the other levels of care can support the community.
Develop in an urban environment
Today’s senior increasingly eschews the country club-style retirement of prior generations. Instead, retirement is seen as an opportunity to reinvent one’s self, not the time to rest after a lifetime of hard labor and toil. This is not a new observation, but its implications are important for senior living providers. Empty nesters and younger seniors are moving to vibrant cities where anything and everything is within a short distance.
As people age, they do not want to leave the city behind. Senior living organizations (for-profit and non-profit alike) will need to develop communities in urban areas. Urban communities allow providers to:
- Serve a new group of seniors who likely would not relocate to suburban or rural campuses;
- Help urban seniors fight the increasing loneliness and isolation brought on by cities unable to meet their specific needs;
- Take advantage of existing city resources to reduce the need to develop them inside the walls of the senior community itself – dining venues, activities, movie theaters, swimming pools, etc.; and
- Raise awareness of the organization and enhance its profile.
Urban development offers a high barrier of entry. Depending on what stage you are in likely determines if you view this as a pro or con. If you have not entered the market, these high barriers are onerous, time-consuming and costly. However, if you have a successfully operating urban community, you enjoy this barrier for the exact same reasons.
Developing in an urban environment comes with a unique set of challenges:
- Limited site opportunities, with prime locations commanding premium pricing
- Extended entitlement and permitting processes
- Construction costs alone are substantially higher in the tight confines of city streets
- Cities are increasingly requiring new projects to have “green” elements and may require attainment of a particular level of LEED certification
- Urban development will often have longer timelines:
- Pre-finance period (the time from start of development to close on permanent financing) is often longer as entitlements, architectural work and engineering are more complex
- Urban communities tend to have more units (to cover the higher development costs) which leads to longer pre-sale and fill-up periods
To help manage these risks, consider (a) developing your senior community as part of a mixed-use project; and/or (b) forming a joint venture with a likeminded organization. In each of these, you will give up degrees of control in return for spreading these risks across organizations.
Potential Changes to Capital Formation for Non-Profit Life Plan Communities – Tax Reform and LIBOR Replacement
Perhaps the easiest prediction of all is that tax reform will affect each of us – how, and to what degree, remain to be determined. Non-profit senior living organizations dodged a bullet as the private activity bonds used to finance these projects remain tax-exempt (the House bill proposed removing this provision). Here are two changes that will affect non-profit senior living financings:
Elimination of Tax-exempt Advanced Refunding Bonds
Non-profit organizations can no longer advanced refund(i) their debt with tax-exempt bonds. Many other industries lost this ability when Ronald Reagan enacted tax reform in 1986. Advanced refundings are a financing tool allowing borrowers to take advantage of lower prevailing interest rates. It can also be used to remove or amend covenants, which may be necessary to achieve certain strategic goals.
For new offerings, there are ways to mitigate the effects, including:
- Shortening the no-call period(ii)
- Most non-profit senior living fixed-rate bond transactions have a 10-year no-call period.
- Shortening this to 5 years would allow borrowers to refinance their debt with tax-exempt debt within 5 years of closing on the financing, instead waiting 10 years.
- Doing this, at least in the short-term, will likely result in borrowers paying a premium as a shorter no-call period increases the reinvestment risk of fixed-rate bondholders, for which they will expect to be compensated.
- Utilizing taxable debt
- Borrowers can still advance refund debt using taxable debt, but this would prove to be costly.
- Options and other derivative instruments can be used to mimic a fixed-rate bond, but maintain the call-ability of variable-rate bank debt.
There are other strategies that can be used, but each of these options carry a cost that likely would not exists if tax-exempt advanced refundings were still allowed. Borrowers will need to weigh this cost against their strategic goals, recognizing these goals could change in the interim.
Planned elimination of LIBOR
The regulator that oversees the London Inter-bank Offered Rate (“LIBOR”) has indicated the world needs to find a replacement. LIBOR is the base rate that serves as a foundation for credit cards, mortgages and other securities totaling $350 trillion (with a ‘t’) worldwide, including $3.8 trillion (“t”) of tax-exempt municipal debt (which includes variable rate senior living debt). In 2017, BB&T Capital Markets published a Capital Markets Update entitled “Possible Elimination of LIBOR could Impact Senior Living Communities” exploring this topic in detail.
The body responsible for selecting the new benchmark rate has voted to use an index determined by the interest rates that large financial institutions charge each other to borrow money overnight, secured by US Treasuries (also known as “repo” transactions). This new index must go through a public comment period before it is formally accepted as the index to replace LIBOR. Voluntary use of a new rate is planned to begin in 2018, with full replacement targeted for 2021.
Financings are still occurring while lenders and borrowers are waiting for the change to become official. In the meantime:
- Bankers and attorneys involved in new financings have developed a number of provisions for how to handle this situation.
- Borrowers with outstanding variable rate debt should review their existing documents and talk with counsel to determine exposure to the replacement of LIBOR.
It would be great to know with confidence which of these predictions will prove correct. The one thing we can reliably expect is the senior living industry will have to adapt to new challenges in 2018. Those that will thrive in 2018 and beyond will need to be proactive and not let the market determine their future.
i An Advanced Refunding is a refinancing of existing debt performed more than 90 days before the date at which the bonds are “callable.” Bonds are “callable” at the end of the no-call period (see note ii). Tax reform does not affect the use of tax-exempt debt for “Current Refundings”, which are refinancings that occur within 90 days of the end of the no-call period. [back to article]
ii The “no-call” period is the length of time the bonds must be outstanding before they can be called for refinancing. [back to article]