For the past several quarters, there has been a distinct hurry up and wait mentality among many seniors housing investors. We saw this partially reflected in 2018’s total transaction volume of $13.6 billion, which was a five-year low for the sector. The dip in transaction volume was partially due to a dearth of large-scale portfolio deals but can also be attributed to a growing number of investors waiting to “buy the dip.”
These investors are waiting for deeply distressed situations – typically recently built assets that are not leasing up at the expected pace and are not hitting budgeted revenue projections. Opportunistic investors theorize that there will be a wave of these assets hitting the market and that they will be able to pick up properties at deep discounts relative to replacement cost.
It is true that 2017 and 2018 saw cyclical highs in seniors housing construction starts, leading to market saturation in many areas. This is especially prevalent in low-barrier-to-entry markets such as Atlanta, Dallas and Houston. As a result, 2018 ended with 88 percent occupancy nationally, down 70 basis points from a year ago and 220 basis points lower than the most recent peak of 90.2 percent in the fourth quarter of 2014. And as occupancy levels declined, operations were negatively impacted by labor cost increases due to the tight national job market and minimum wage increases mandated by some cities and states.
Those challenges have led to large amounts of capital being raised with relatively high “value-add” or “opportunistic” return thresholds. While such opportunities do surface even in the healthiest of markets due to the intensive operating nature of seniors housing, we have yet to see a wholesale decline in valuations and the dumping of assets at deeply distressed prices.
It may be that the deep distress many have been expecting is simply not going to occur in this cycle, and that opportunistic investors seeking to buy in a market trough could soon find it in the rear view mirror. Several factors support this view.
Supply and Demand Rebalances
First construction is tapering off. Activity in the fourth quarter of 2018 was down 5 percent quarter-over-quarter with 37,355 units under construction. In total, construction represented 6 percent of existing inventory, down 40 basis points from the prior quarter.
Second, even with the inventory growth, the fourth quarter still registered the highest increase in the number of occupied units during a single quarter since 2006. The number of occupied units increased by 5,149, which represented a quarterly absorption of 1 percent. Annual absorption was 2.6 percent, up 10 basis points from the prior quarter’s pace. And with every quarter, we grow closer to 2021 when the first wave of boomers hit 75 and the growth in demand for seniors housing begins to spike.
Another factor is that equity and lenders also seem to be taking a patient wait-and-see attitude, and are not forcing assets with subpar performance to be dumped. The Federal Reserve Bank’s data indicates that commercial real estate loan delinquencies nationally are at a low 0.6 percent, and this low overall rate gives lenders more room to be patient and flexible with the problem loans they do have.
Lastly, cap rates and investor expectations for cap rates are holding steady. According to JLL’s 2019 Seniors Housing Investor Sentiment Spring Survey, seniors housing sector cap rates have held steady and rates were generally consistent from the summer 2018 survey.
Looking forward, there is no certainty that there will be a significant wave of distressed seniors housing assets. Instead, the current market fundamentals will present buyers with opportunities to buy assets at prices that are attractive, but not deeply distressed.
Our advice to investors is to look hard at the opportunities in the market now, and not remain sidelined waiting for deeply distressed opportunities that may never materialize.
Charles Bissell is a Managing Director with JLL Capital Markets.