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NIC on Financing

September 1, 2005
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Bears or Bulls? Financiers Reveal Attitudes on Reductions in Capitalization Rates by Robert G. Kramer and Anthony J. Mullen
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NIC ON financing
BY ROBERT G. KRAMER AND ANTHONY J. MULLEN

Bears or bulls? Financiers reveal attitudes on reductions in capitalization rates What do some of the most active financiers in seniors housing and care think about the lending and investing activity playing out in the industry? Are they bullish toward capitalization rates remaining low for some sectors? Or do they believe rates are becoming too low to justify risk? How about spreads, and what are their beliefs on how they compare with other real estate asset classes?

Panelists taking part in a recent National Investment Center for the Seniors Housing & Care Industries (NIC) Executive Circle conference call shared their insights on these and other pressing questions relating to financing for the senior living industry. Some of those observations are shared here. Moderating the call for NIC were Robert Kramer, president, and Anthony Mullen, research director. The panelists were: Kevin McMeen, director and segment head at Merrill Lynch Capital; Raymond Braun, president and CFO at Health Care REIT, Inc.; James Pieczynski, managing director of the Healthcare Real Estate Group at CapitalSource Finance LLC; Sarah Sumner Duggan, senior vice-president at GMAC Commercial Mortgage; and Kathryn Sweeney, principal at AEW Capital Management, LP.

Kramer: Reflecting the great deal of energy that's going on in the marketplace for seniors housing and long-term care, there's been a general debate whether the reduction in capitalization rates for the top quartile properties-those most coveted by top lenders and investors-is appropriate. The "bulls" argue that the risk premium above equivalent apartment properties has been unwarranted. That is, that risk has been mispriced and the spread over equivalent apartment properties should be 50 basis points for independent living and 100 to 150 basis points for assisted living properties, irrespective of interest rates and alternative equity yields. The "bears" claim that the reduction is solely cyclical and that the historic 200 basis points for independent living properties is warranted because of the increased risk of these property types over the equivalent multifamily class, and that the reduction in cap rates simply is tracking the downward reduction in apartment cap rates. But the historic spreads of approximately 200 basis points for independent living and 300 basis points for assisted living still hold. Are you a full bear, meaning you don't believe that the cap rate spread has changed? Or are you a full bull, meaning that you believe the cap rate spread has changed significantly? Or are you somewhere in between?

McMeen: I'm probably more in the bull category when referring to the top quartile properties. We're talking about whether the drop in capitalizations rates is cyclical and if a lot of the chasing down of the cap rates in those top-quality properties is driven by equity investors chasing after yield, because it's so low in other asset classes, such as bonds and stocks. I think that it should be lower. The question is whether it's sustainable and, as opportunities change in those other asset classes, will equity return to those, and then will cap rates start to creep back up? That, I think, is the real question. But the view of our organization is that the cap rates for those top-quality properties are-or should be-closer to apartment levels than further away.

Braun: Our view is that there's a global repricing of real estate going on, and generally lower yields and cap rates are the expectation of investors. The spreads in the multifamily sectors relative to U.S. treasuries have been increasingly narrowing, and that's a bit distorted by what's going on with the condo-conversion marketplace. So one of the issues is whether apartments are at appropriate spreads, and then, relative to those spreads, whether the risk in the seniors housing industry is being appropriately priced in. We're in between on it. We think that the historic spreads have been too wide-particularly for independent living and assisted living-and that they needed to come in some. Have they come in too much? I think in some of the assisted living transactions, they probably have.

Pieczynski: I would put myself in the full bear camp with respect to the spread. I think the historic spread of 200 to 300 basis points is more appropriate, particularly as it relates to the assisted living industry. I think there can be an argument for independent living. But as it relates to assisted living, although real estate is a large component of the business, there is the provision of care, so there is always the possibility of regulation and other unknowns. So from my perspective, I believe that the risk premium that has historically been there will return once the real-estate boom starts to dissipate.

Sweeney: From a private-equities standpoint, AEW is viewing the market and how independent living and assisted living are being priced from a full bull perspective. And the rationale is that we believe that there is a true paradigm shift in the business for what was formerly all lumped together in the category of "healthcare." I think investors have really begun to understand independent living and what it takes to create a solid margin, as well as assisted living operations and what goes into producing a margin there. So they have gotten a lot more comfortable with that risk, which was, frankly, formerly way overpriced-so much so, that the spread was much too high.

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