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NIC on Financing

March 1, 2005
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SNFs Need to "Tough It Out" for the First Part of 2005 by Raymond J. Lewis

NIC ON financing

SNFs need to 'tough it out' for the first part of 2005 Skilled nursing providers have been experiencing a relatively stable operating environment during the past few years. However, because of continued concern over the ability to sustain recent performance, capital providers have not yet loosened their purse strings for skilled nursing. And until the resolution of the RUGs refinement in July, financiers will continue to be circumspect about investing in the sector.

SNF Loan Volume Lagging
Each quarter, the National Investment Center for the Seniors Housing & Care Industries (NIC) compiles key performance and financial data from the nation's leading seniors living lenders, owners/operators, and appraisal professionals. Part of that data is the quarterly lending activity of the top lenders (non-REITs) that make permanent debt or short-term debt investments in seniors housing and care, including Fannie Mae, Freddie Mac, and several of the larger credit companies and banks.

For the third quarter of 2004, the NIC Key Financial IndicatorsÖ showed that loan volume placed in the industry was up significantly from a low in the second quarter-$783 million compared with $336 million-but skilled nursing facilities continued to lag behind independent living and assisted living facilities in terms of the total number of investments.

The funding discrepancy was particularly true with permanent debt. Whereas skilled nursing had a slight rise in financing from the second to the third quarters of 2004, the amount of assisted living funding increased almost threefold and independent living rose approximately 35%. The likely reason is that there really are not, other than HUD, any significant sources of long-term, fixed-rate financing for skilled nursing facilities. Most of the current financing sources are short-term credit companies and bank sources.

We can expect this trend to continue through 2005, although some new development does appear to be on the horizon. For example, Credit Suisse First Boston apparently has completed recently a large commercial mortgage-backed securities (CMBS) financing for the acquisition of Mariner Health Care. This is a significant development in the industry because it represents the first major nursing home/CMBS financing in a number of years. In addition, several other companies are developing capital market capabilities that use CMBS financing, which they plan on offering to skilled nursing customers. Thus, although no real permanent debt was placed in the third quarter of 2004, we should see the beginnings of more CMBS-like permanent debt products for skilled nursing facilities later in 2005.

Occupancy Rates Flat
According to the NIC Key Financial Indicators, third quarter occupancy rates for skilled nursing facilities stabilized in the 86 to 87% range on average. In fact, the average occupancy rate for these properties has been stuck in a fairly narrow range between 85 and 88% for the past four years.

While overall occupancy has remained relatively flat, these statistics don't show how astute operators are shifting the composition and quality mix of their census to drive more profitability into the facilities. Strategically, they are shifting their census away from the custodial care, long-term, Medicaid residents toward the more short-term, subacute care, Medicare-paid patients to generate incremental profits. As average length of stay decreases, the properties experience higher vacancy, but profits improve because of significantly higher margins on Medicare reimbursement.

Anthony J. Mullen, NIC research director, believes that occupancy rates are not going to go much higher over the next couple of years. "The only way that operators can really help grow their net operating income is to increase revenues by increasing their services or what they charge for their services," he said. "And since most operators are already charging the most that they can, it probably comes down to increasing their services. Either that or they can concentrate on decreasing expenses. So they need to ask themselves questions such as, 'How do I become a better manager?' and 'How can I become much more creative on how I add services?'"

Wide Range in Capitalization Rates
Toward the end of 2004, capitalization rates started to come down for independent living and assisted living, in particular. But capitalization rates for skilled nursing remained relatively flat.

Moreover, we didn't see compression in capitalization rates for skilled nursing as in the other sectors. The NIC indicators showed that the range between the highest and lowest reported assisted living capitalization rates increased 160 basis points in the third quarter, with the lowest at 8.4% and the highest at 14%. For skilled nursing, the spread increased 440 basis points, with 9.2% reported for the lowest capitalization rate and 16.8% for the highest. That means a wide range of rates is still being used by purchasers of skilled nursing properties, with capitalization rates on the lower end reserved for top operators with stabilized properties in premier locations.

Operators should know that capitalization rates used for properties actually trading in the marketplace tend to be lower than those reported by lenders for their internal valuation approach, which generally means more equity will be necessary to complete transactions. Also, selling off a number of properties in a portfolio will generally yield a much better capitalization rate than one-off transactions.

Reimbursement Issues