Interest Rates, Cap Rates, and Property Values
Investor interest in the seniors housing and care sector is strong. Transactions are near peak levels in terms of both dollar volumes and the number of deals closing. Over the past four quarters, 554 deals closed, a near-record pace and equal to $23.4 billion of transactions. Strong demand is pressuring prices higher, with per-unit pricing averaging $173,000 for seniors housing and $73,000 for skilled nursing on a four-quarter moving average basis in the second quarter of 2015. Prices for seniors housing have never been so high.
A host of factors are drawing investors into the sector, including:
- Deepening demographic trends.
- Compelling investment returns.
- Greater transaction volumes and liquidity of the sector.
- Rising transparency and understanding of the sector.
- Emerging post-acute care coordination opportunities.
- Governmental and social policy changes towards healthcare and its costs.
- Mounting understanding of the positive social and psychological benefits for residents.
In addition to these factors are today’s capital market conditions, where capital is relatively inexpensive and readily available. Looking ahead, the question becomes what will happen if and when the capital markets change, which is a likely outcome in the coming months. Indeed, recent comments from Fed Chair Janet Yellen as well as the minutes of the recent FOMC meetings suggest that the Federal Reserve is moving closer to raising short-term interest rates later this year, perhaps as soon as this week. Recent volatility in the global stock markets amid concerns about China’s economic stamina have added uncertainty to the timing of a rate increase, however. When the Fed does shift its policy, it will be the first time since 2008 that the Fed’s benchmark interest rate has not been zero, a sea change for both lenders and borrowers.
For seniors housing, higher interest rates will change the economics of a transaction and will cause some investors and lenders to reconsider deals and opportunities. Expansion and renovation projects may be less feasible in a higher-interest-rate environment, while recapitalization opportunities may be less viable as well. Higher interest rates also will increase the cost of developing new seniors housing properties.
For existing property operators, a pause in development may be perceived as a good thing if they are located in a metropolitan market that has high levels of new development (for example, San Antonio). For potential residents, a slowdown in development may be less positive if it means that fewer housing options are available to them.
Most importantly, higher interest rates indicate that the Federal Reserve believes the economy has enough heft, strength, and stamina to absorb the effects of a higher cost of capital. A stronger economy, in turn, will sustain the demand side of the seniors housing equation and help lead-generation, conversion rates, and, ultimately, move-in rates, absorption levels, and rent growth.
Cap rates and values also may be affected by a higher-interest-rate environment. Conventional wisdom says that an increase in interest rates will lead to an increase in cap rates. If this occurs, and if cap rates go up in lock step with interest rates, and if property level net operating income (NOI) does not adjust, property valuations have to decline for the integrity of Cap Rate = NOI/Value to remain in place. That being said, values could remain stable if NOI grows either through increased revenues or reduced expenses (note that the latter may be challenging in light of upward pressures on wages). And values could remain stable if cap rates do not rise in lock step with interest rates, thereby allowing the risk premium, or the gap between the risk-free 10-year Treasury yield and the cap rates for seniors housing, to narrow. Today the risk premium averages 550 basis points. The risk premium could narrow if the perceived risk of investing in seniors housing declines. And this outcome is entirely possible since institutional investor interest in the sector is quite strong, keeping downward pressure on cap rates.