August 25, 2017, Steve Monroe, Senior Care Investor - Out of all the care and service models available to the elderly population, the CCRC market has been marked for death far too many times. Is the CCRC model doomed? It depends on whom you ask. Will the baby boomers want it? Some, but not all, but no one really knows what this cohort will really want. One thing not helping the marketing is that the not-for-profits decided on a name change to Life Plan Communities (LPC), while the for-profits have largely kept with the original moniker of Continuing Care Retirement Communities. Apparently, the customer does not want to hear about “care” and “retirement,” but wants a “life plan.” There are two sides to this argument.
One complaint we hear is that consumers do not relish the idea of moving into a new community knowing that it will be the place in which they will die, even though they are relatively healthy when they move in. The other complaint is that there is the weekly (sometimes daily) reminder of that, when the latest death of a resident is posted in the lobby or outside the dining room with information about the memorial service. In addition, most CCRC campuses (we are old school and continue to use this name) are somewhat isolated from the community at large because of the space requirements. This requires transportation to do anything. Uber and driverless cars may take care of the problem before the boomers arrive en masse.
Not-for-profit organizations dominate the CCRC sector, with about 75% to 80% of the ownership. There are a few reasons for this. First, it really started as a not-for-profit sponsored model, usually church-sponsored, and people were comfortable thinking their church (or any church) would be providing care for the rest of their lives. Second, as time went on and tax-exempt bonds were used to finance most of the new construction, not-for-profits found that they could finance almost the entire project (sometimes even more) in the bond market over a very long term. Other sources of capital were scarce for CCRC development, let alone the entire senior care sector. And the time it took, from idea to opening the doors, was just too long for most for-profit investors and providers.
According to our data, over the past three years, 78% of the CCRCs sold were for-profit-owned communities, with the remaining 22% not-for-profit. There are several reasons for this. First, for-profits are much quicker to sell than a not-for profit, where selling is usually the last resort. In general, the holding period for a for-profit investor, and even a provider, is much shorter than a not-for-profit, even without financial distress. But when distress hits, as Dan Herman of Ziegler likes to say, not-for-profits are more likely to “raise their hand” when in financial trouble, and another not-for-profit will “absorb” the community if the existing debt is not too troublesome. So there is no formal sale of the property. In addition, the nature of the creditors is different between for-profits and not-for-profits.
Debt is one of the major reasons why not-for-profits lose their financial footing, because the typical structure involves more long-term debt than a for-profit owner would be willing to borrow, not to mention lenders in the for-profit market. Poor management at some of the standalone communities can also play its part in creating distress, but it is the debt that is supposed to carry relatively low interest rates that forces the hand of management. Just to be fair, for-profits have had their share of mismanagement issues and over-borrowing in the past as well. But the ability of for-profits to perhaps borrow too much is also the sector’s Achilles’ heel, because so much capital is required. Since there is not much equity usually invested, if the units are not sold in the first generation of sales after opening, sufficient cash is not there to pay down the excessive debt (even with the debt service reserves), and the snowball effect begins. This risk is true with all CCRCs, but the not-for profits seem to carry more debt that has to be paid down with initial entrance-fee sales.
One current example of this problem is Greenfields of Geneva, a 247-unit CCRC in Illinois that five years ago and was financed with $117.6 million of tax-exempt debt. That comes to more than $475,000 per unit. The sponsor, Friendship Senior Options, apparently claims that delayed approvals and occupancy negatively impacted their ability to pay down some of the “temporary” debt that should be paid off with first generation entrance fees. But in the bankruptcy filing, they listed $113 million in liabilities and $57 million in assets. We have to wonder, with the community’s 147 independent living units reportedly more than 90% occupied at the time of the bankruptcy filing, what happened to all those entrance fee payments received?
The cash operating losses have been high, and we assume that means they have finally eaten through all their reserves. Now, the court has approved an auction of the community, and the bondholders have agreed to allow Friendship Senior Options to be the stalking horse bidder with a price of just under $53 million. That’s one easy way to reduce your debt by 50%, and tax-exempt bond investors will be rushing in to buy the new bonds to finance the “acquisition” even though it appears the debt was only part of the problem. The community needs to make money from operations, which is something often forgotten by management and their board overseers. One criticism we have is that the community’s website has a picture of two men walking on a golf course with their golf bags slung over their shoulders. Sorry, residents of a CCRC don’t carry their bags. They pull, ride or have caddies. Come on, let’s get back to marketing reality.
Another example of what seems to be a mismatch between operations and debt levels is the CCRC known as The Admiral at the Lake in Chicago, sponsored by The Kendal Corporation. The community is fully stabilized, with this year’s census budgeted to maintain 95% occupancy in the 200 IL units, 95% in the 39 AL units, 94% in the MC units and 92% in the 36-bed skilled nursing center. The community sold $202 million in tax-exempt bonds in seven years ago, which came to $692,000 per unit/bed. Last year, The Admiral had an operating profit of $3.2 million on $17.6 million of operating revenues, for an operating margin of 18.2%. Not too bad. But then there was $10.3 million of interest expense, resulting in a deficit of $7.1 million before about $900,000 of miscellaneous income. But net entrance fees were just $2.6 million, not nearly enough to cover the shortfall. The year before, net entrance fees were $11.5 million.
The operating budget for this year is similar to actual results from the prior year, with projected net operating income of $4.0 million, representing a 22% margin, and with a cash deficit of $5.8 million, which they expect to fund with $5.7 million of net entrance fees ($8.1 million before refunds). The problem we have is that this is a successful community, with high occupancy, rental increases of 4% this year and entrance fee increases budgeted at 6.8%, yet operating profit covers just 50% of interest expense, and in order to cover interest expense, they need more than $8.0 million of new entrance fees. Imagine if they had to pay real estate taxes. Some will say this is how CCRCs are meant to work, with normal turnover providing the necessary cash flow to cover the cost of what is often excessive debt. Well, it works until it doesn’t, or until principal repayments are required and debt service reserves are depleted.
The Admiral at the Lake became a successful CCRC after Kendall took over sponsorship, and we are not predicting a downfall. But there is still $125.8 million of bond debt on the books, or more than 60% of the original issuance, so it does not appear that those first generation entrance fees paid down as much debt as we believe is prudent for the long-term success of an entrance-fee CCRC. In the next economic hiccup or two, when the debt has to start to be paid off, there could be some cash shortfalls. And the obvious solution? Refinance the debt, as there always seem to be willing investors.
In perhaps the largest bankruptcy on record, Erickson Retirement Communitiescould not support the excessive debt levels it put on the books, some of which ended up being tax-exempt bonds as the company, misguidedly in our opinion, created not-for profit entities to refinance its newer communities as financial fuel for its growth. In our mind, it committed one of the financial sins of CCRC development and finance. The Great Recession put an end to it, which was a shame because it had been the most successful, and unique, for-profit growth story we had seen among CCRC owners. Fortunately, the buyer, Redwood Capital, was so strong financially, with a very long-term commitment to the success of what is now called Erickson Living, that the company is a long way back on its growth path with new developments and mostly sticking with the original strategic plan laid out by John Erickson. Today, company-wide occupancy hovers between 95% and 97%, well above national averages for any property type. There are no debt worries, just finding appropriate new development site worries.
There is not too much public information about the financial performance of the for-profits, but Brookdale Senior Living (NYSE: BKD) still operates 32 rental CCRCs with 9,214 units, down from 44 a year ago. In the first quarter this year, average occupancy was 83.5%, which is low, and the operating margin was 24.9%. With these 32 properties, the RevPOR (revenue per occupied unit) was $6,091 in the first quarter, the highest we have seen it recently. So if they can get the customers in, it appears to be getting more profitable. What we don’t know is what is keeping the occupancy so low, and whether it is some of the corporate turmoil, poor local management or something else. But it seems there would be some opportunity, especially since BKD’s retirement centers perform better. They are 88% occupied with an operating margin of 42.9%, but both are down from last year’s first quarter.
There are some people who believe we will be seeing more financially troubled CCRCs hitting the market for sale in the coming years, especially as principal repayments come due. We mentioned that 78% of the recent CCRC sales were sold by for-profits. In the three-year period from 2012 to 2014, the average price was $158,800 per unit. But in the two-year period from 2015 to 2016, the average price dropped to $136,600 per unit. What was peculiar was that in both periods, the average cap rate was 8.7%, an unusual level of consistency. When people ask what the average CCRC cap rate is, we usually explain that it is a blend of the IL, AL and SNF cap rates, which usually comes to approximately 9%. It depends, however, on the mix of units and whether the skilled nursing portion is a profit center (sometimes it is) or a loss center.
The other problem with CCRC valuations and cap rates is trying to decide what cash flow to apply the cap rate to, and how different it is for operating income compared with net entrance fee income which is much more unpredictable despite the best efforts of the actuaries. In our recent webinar on the CCRC and independent living market, Cushman & Wakefield presented several case studies of CCRC sales. In one, the trailing NOI cap rate was 6.4%, but was 13.9% based on first-year projections. In another, it was 3.3% on trailing NOI, but 14.3% on first year. Two others, with we assume more stable current operations, had a 12.4% and 13.6% cap rate based on trailing and first year, and 6.0% and 7.3% based on trailing and first year, respectively. The key is always the turnover rate of the IL units, and the ability to re-sell them. In an ideal world, there would be a hefty turnover rate with strong demand to refill the units, since in some cases the operating profit is not enough to cover all expenses, let alone debt repayment.
Yes, the baby boomers may not want it, but when you think of the size of the boomer market, you don’t need a whole lot of demand to fill the current inventory, let alone any new developments that will appear. One comment we recently heard about why a couple was moving into a CCRC on the other side of the country (a not-for-profit) was that they did it for their children. Not only to be close to them on the other coast, but so their adult children didn’t have to worry about them and their care needs. That says it all. They are planners, moving into a Life Plan Community.