By Mark Rothschild
While government reimbursement issues remain, the health care REIT sector appears to be in stable condition. However, the diagnosis varies depending on which segment of the industry you examine. In particular, health care REITs have been enjoying improved performance this year with their assisted-living facilities (ALFs), which are housing facilities for the elderly who need help with some aspects of daily living. There are more than 7,000 ALFs in the U.S., containing more than 500,000 beds.
The current performance improvements are a welcome turnaround from past troubles (operator problems, overbuilding, low occupancy) that many ALFs have been laboring under in recent years. Several trends have helped fuel the resurgence in this subsector. Assisted-living facilities attract private-pay seniors in better health than nursing home clients, and their private-pay status avoids the payment limits and program fluctuations of government-paid healthcare. In addition, construction of new facilities is way down from nearly 33,000 units in 1998 to less than 4,000 in 2002, improving the supply/demand equation and enhancing property stabilization.
While escalating vacancy rates have plagued several commercial real estate sectors, ALFs have seen occupancies improve, albeit slowly, and some of the more troubled operators have successfully worked through their problems. In addition, the U.S. population is both aging and living longer, both positive signs of the future demand for ALFs.
To the extent ALFs increase occupancy while holding rents constant, margins improve substantially. In fact, some REITs recently have reported rising margins, an indicator that pricing power has increased in some ALF markets.
One of the ways ALFs attract residents is by building alliances with hospitals. The main reason people enter an assisted-living facility is a change in health status that requires more care than independent living. Many ALF operators have built strong relationships with local doctors and hospitals. To the extent a hospital has had good experiences with an ALF, they can be a consistent source of new residents.
In addition, once an ALF has become established in a community, attracting residents becomes easier. Furthermore, current residents tend to be the best referrals, getting their friends to move in.
| Health Care |
| # of REITs |
13 |
| Market Cap. |
$8,416,873 |
| Industry Market Cap. |
$161,661,777 |
| % of Industry |
5.2% |
| Average Dividend Yield |
8.2% |
| YTD Total Return |
14.5% |
| 1-year Total Return |
15.6% |
| 3-year Total Return |
26.1% |
| 5-year Total Return |
2.6% |
| Weighted Daily Volume (shares) |
97,767,000 |
| Weighted FFO Growth (2001–2002) |
4.4% |
| *These figures represented in thousands.
Data as of November 30, 2002 Source: NAREIT |
Despite Positives, Risks Remain
Despite these positive factors, investing in assisted-living facilities carries its own set of risks. There are minimal barriers to entry with ALFs, and the sector has had problems with overbuilding in the past. Whereas most states require Certificates of Need before you can build a skilled-nursing facility, this is not the case with ALFs. The mid- to late-1990s saw a boom in construction of ALFs that led to intense over-capacity and competitive pressure among facilities to attract residents. However, these stresses are now easing.
In addition, stabilization is a slow process. It typically takes a new facility around two years to fill its available rooms, and some struggle to reach 90 percent occupancy. This process is not dissimilar from the stabilization challenges that new manufactured housing communities face.
Investors in this segment of the health care REIT industry should not only consider those risks of the REIT itself, but also those associated with the operators that the REIT management teams must monitor. Trouble often arises when these risks are not monitored closely enough.
Weak operators in this sector remain a red flag for many investors. With few exceptions, ALFs are managed by either low-rated or small, private operators. Thus, the stability of the operator is often at risk. Typically, the rent from higher-rated and larger operators is viewed as more stable.
| Assisted Living Construction by Units |
 |
| Source: American Seniors Housing Association (2002 Construction Survey) |
Another challenge lies in the very nature of the facilities: most of the residents have several housing choices. ALFs are private pay, and many of the residents could be living with other family members, or even in independent-living facilities. Also, those residents with the financial means may prefer home care.
So, much like multifamily properties, assisted-living facilities need to be competitive in the amenities they offer to attract residents. Triple-net leases should be structured in a way to ensure adequate investments are made in the facilities by the operator. The capital expense challenges can be high for properties that are returned to the owner by a weak operator.
In an attempt to attract more residents, some operators can go too far in the care they offer. ALF operators need to monitor the level of acuity care being provided to ensure that they are not providing too much care, and thus becoming more like skilled-nursing facilities, which have different business models. While offering more patient care may help maintain occupancy, there is greater cost involved—which may not be easily passed on to residents. There are also liability issues if a resident has a problem.
Prognosis for 2003?
Although the performance of assisted-living facilities continues to improve and signs point to a stronger 2003, Moody's Investors Service is not optimistic that the problems with operators are over, or that all properties will outperform. We at Moody's are waiting for positive demographics to fuel an increase in demand, and for potential residents' knowledge of assisted-living facilities as a housing option to deepen. The overbuilding mountain was big and could leave a lingering shadow in some markets.
While occupancies have improved, we have not yet seen that translate into significant improvement in EBITDAR coverages (Earnings Before Interest, Taxes, Depreciation, Amortization and Rent/Rent Payment) for many ALFs. However, over time Moody's expects lower supply and improving demographics to increase pricing power going forward, ultimately resulting in improved coverages. Moody's views EBITDAR as an important credit indicator of how successfully a facility is being operated. To the extent a facility is operating close to or below a one-time coverage, the owner/ REIT may have to try to replace the operator. If the operator enters bankruptcy, there is a likelihood they will turn the keys back.
To ease this situation, several REITs structure leases in the form of a master lease, where all the properties with an individual operator are tied together under one lease. The idea is that an operator will not be able to “cherry pick” which facilities to keep, while abandoning the others in bankruptcy. Moody's views these structures favorably because they can support troubled assets as they are mixed in with the more profitable ones. However, investors should note that master leases do not make weak properties strong.
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Mark Rothschild is associate analyst in Moody's Investors Service's Real Estate Finance team. |
Are Assisted-Living Facilities on the Mend?