Delve into the senior housing transaction market with Beth Mace, Senior Advisor at NIC, in this captivating conversation with Al Della Porta, Managing Director and head of the Capital Markets Group at AEW Capital Management. Learn about the challenges and opportunities arising from the swiftly changing interest rate environment, and gain insights into how seasoned professionals like Della Porta are adapting to market shifts. Explore how senior housing fares in today’s shifting landscape.
Beth Mace (00:03):
Hello, and welcome to the NIC Chats Market Conditions podcast series. My name is Beth Mace and I’m currently a senior advisor at NIC focusing on the economy and capital market trends and implications. Thank you for joining us today. The focus of this series of NIC Chats podcasts is talking to experts and industry leaders impacted by today’s property and capital market conditions and trends as they pertain to the senior housing transaction market, property, pricing, deal flow, and market sentiment. As you listen today, I hope that you will find some insights and ideas that are relevant to you in your business, be it as an operator, developer, banker, private equity provider, public entity, or other capital provider. Today’s podcast will be a free flowing conversation with my guest Al Della Porta. Al is a managing director at AEW Capital Management and head of the Capital Markets Group. Al and I have known each other for many years as we worked with one another for nearly two decades at AEW Capital Management when I was a director in the research team at the firm. Hey Al, and thank you for joining me today on our NIC Chats podcast series focused on capital markets.
Al Della Porta (01:10):
Hi, Beth. Thanks for having me. Pleasure to be here.
Beth Mace (01:13):
Great, thanks. So Al, tell us a little bit about AEW Capital Management and your position.
Al Della Porta (01:19):
Sure. I’ve been with the firm for 25 years and head of capital markets. And our primary responsibility is to manage our financing strategies across the firm, across all accounts and property types. And that includes senior housing, additionally, that also includes some of the alternative investment strategies such as cold storage, medical office, and life sciences. The firm currently has roughly $40 billion of assets under management here in the United States. We manage roughly $16 billion loan portfolio with longstanding relationships across all lender types, including the life insurance companies, the agencies, the banks, debt funds, etc., etc. And our senior housing exposure is roughly three and a half billion over 70 properties and over 9,000 units. Historically speaking. We’ve averaged roughly two to three billion a year in financings across all of those product types. But obviously this year those volumes will be significantly less than that. But given our longstanding history and track record and our relationships we have pretty good insight into the broader credit markets and capital markets which can be proven to be sort of advantageous specifically for senior housing.
Beth Mace (02:43):
That’s terrific. So this is exciting ’cause I think you’re gonna give us a sort of unique view on the capital markets from your perspective. Being in charge of the financing at AEW. So a lot has happened in the capital markets since the Federal Reserve began raising interest rates in March of 2022. Today, the Fed funds rate is in a range of five and a quarter to 5.5% up from virtually zero 18 months ago. As the Fed has hiked interest rates 11 times, the Fed acted quickly to raise interest rates to slow overall economic growth to take the steam out of inflation. Now, there’s been a lot of debate as to the causes of inflation that was as high as 9% as measured by the CPI in June of 2022. Since then, the rate has slid down to 3.2% in July before advancing to 3.7% in August on a year-over-year basis.
Beth Mace (03:32):
According to the most recent measure of consumer prices just last week, the FOMC met again and kept interest rates flat for now, but it did indicate that the Fed would remain data dependent in making its decisions until inflation actually comes down and until inflation comes down, the Fed has said that it will do whatever it takes. Fed projections released last Wednesday suggested that to bring inflation down to the target of 2%, the Fed might need to move the Fed funds rate up to 5.6% by the end of the year, and hold rates above 5% in 2024, higher for longer is a Wall Street summation of the Fed’s current interest rate policy. Now, I know you tracked this pretty closely because of the interest rates and the impact that it has on the financing. So what’s your view on Fed policy and the broader economy and what the fed’s recent actions last week suggest?
Al Della Porta (04:23):
Certainly, I mean, there’s no question We’ve seen the fastest rate hikes probably in our career, right, since the early eighties. And so we’re going through a transitional period of time right now. Effectively all risk-based assets are migrating from a low interest rate environment into a high interest rate environment. And effectively we’re going through a de-leveraging process. We were the beneficiary of zero interest rates for a good portion of the last decade or so. But now it’s time to sort of deliver those assets. But unfortunately it’s not a smooth transition and that’s gonna take time and certain assets will deliver faster than others and, and others may take a longer period of time. And to some degree, we’re actually returning back to some normalcy. I think with a zero interest rate environment no matter what asset class, it seemed like everybody was a winner effectively.
Al Della Porta (05:27):
But in today’s higher interest rates, you’re going to, you’re going to have differentiated asset classes and differentiated business plans there. There’ll be more winners and losers in today’s higher rate environment. And to some degree, we’ll, we’re gonna, we’ll be migrating back to, I know it seems like a long time ago, but we’ll be back to between 1995 and 2000 when the Fed funds rate averaged five and a quarter interest rate. Investors at that period of time had to buy assets at a good basis, had to execute a business plan and had to opportunistically exit assets in order to gain a return. And so today’s investors will really have to sort of earn their return and the free ride that I think a lot of people had over the last decade is a thing of the past.
Beth Mace (06:32):
Yeah, that’s, I guess that’s a little scary thinking about that in terms of being able to really manage your properties better to gain NOI, you can’t just benefit from any kind of cap rate compression anymore. You’re gonna have to really do your homework to grow NOI to maintain your values. So how do you think this period of capital market turmoil will play out? And how do you think this compares to past cycles.
Al Della Porta (06:57):
In terms of how it turns out? I mean, it depends on a number of factors, right? It depends on inflation. And whether or not the Fed has inflation under control, depends on how high interest rates will rise, depends on the recession, whether we will have a soft landing or prolonged recession. And depends on whether or not today’s credit environment spreads into other sectors and spills over into a broader credit crunch, right? So those are all variables that I can’t predict but they all impact how this correction will play itself out. How it’s different this time around. From my perspective compared to the a great financial recession for example is at this time last time it was certainly a balance sheet issue, right?
Al Della Porta (07:50):
This time around the banks have plenty of reserves. They’re solvent and any of the recent banking issues that we’ve had have been idiosyncratic. But overall, particularly the money center banks are pretty well healed with their balance sheets whereas they weren’t during the great recession. And the other difference as well, this time around is, capital formation continues to basically take advantage of opportunities that this correction may present itself. Whereas during the great financial crisis that capital formation happened afterwards, not like, not beforehand. So there’s a lot of proactive capital formation that’s happening, happening today that will be used to address any issues during this correction. And then the other differences that I see from, the Great Recession and today, obviously the interest rates are far higher than they were during the Great recession, and therefore the ability to sort of kick the can approach on loan modifications will be tested certainly during this during this correction compared to last time.
Al Della Porta (09:13):
And so it’ll be a question of how patient is that capital, whether it’s the equity capital or the deposition. That’ll be interesting to see how that plays out during this correction and depending on how severe and how long this correction will last.
Beth Mace (09:28):
Interesting. Okay, so let’s stay on banks for a second. We know there was certainly a lot of discussion a few months ago about what would happen to banks with some of the regional banks like SSVB and others had challenges. And I think, I agree with you, they’re idiosyncratic, but I think that the overall scrutiny by banks towards borrowers is much deeper than it had been. So who steps in to take that position that some of the banks had had? Certainly regional banks are really important for commercial real estate borrowers in general, more so since than some of the other groups. So any sense of who’s stepping in are some of the challenges. I know that the GSEs, Fannie Mae and Freddie Mac are having any view on that in terms of, will that just be a dearth of lending capital or debt funds might step in, but will that be sufficient?
Al Della Porta (10:19):
Sure. I mean, the banks went through a tremendous growth period over the last couple years. I think the tally that I saw between 2020 and, and 2022, they grew their balance sheets or exposure to CRE by $200 billion, um, in a pretty short period of time. That was due to the fact that the public markets were virtually shut down because of the fed rate hikes. And all those borrowers pivoted towards balance sheet lenders, including the banks, specifically the banks, which at the, at that point in time was the cheapest cost of capital. Today those banks are not seeing the payoffs, right? So transactional activities are minuscule compared to years past. And so I don’t see the banks returning in a meaningful way anytime soon.
Al Della Porta (11:13):
Unfortunately, I think they’ll still have to wrestle with their existing book and focus internally and externally, but there is private capital forming around these opportunities to completely replace that void is not realistic. So I think that capital is going to be very selective in terms of its strategies and opportunistic as well. And frankly, I think the reality is is that even though maybe the kick the can approach is not as prevalent this time around, I am seeing it make a little bit of a return to the marketplace and I’ll just use office as an example whereas 18 months ago a lot of lenders were taking a little bit of a harder line on the on office transactions, whereas today, I think all of the, the market participants are realizing that forcing issues a sale or note sale or some sort of liquidity event today will realize losses to whether it’s the equity or the debt position.
Al Della Porta (12:25):
And so I’ve seen sort of the kick a can approach return a lot of lenders in today’s environment. And I think that will probably continue. But in the meantime that capital formation will pick off some really interesting deals in this marketplace. And so will it completely fill the void, probably not, but it’ll certainly, make up some market share over time in the next couple years.
Beth Mace (12:57):
Okay. So let’s talk a little bit about pricing and, and what you’re seeing in pricing and sort of bid-ask spreads and how pricing compares to return on costs. In your observations right now are there a bit where starting to come a little bit closer together in terms of values or where do you see things playing out right now? I know that we certainly have seen, according to Green Street, we’ve seen like a 12% average drop in pricing in July. From your earlier levels, earlier, MSCI, CPPI is showing a 10.2% drop. So what are you seeing in terms of price drops in terms of the transaction market more broadly?
Al Della Porta (13:36):
Sure. I mean, in today’s world where you have such uncertainty, and volatility pricing is not the risk of, pricing is not efficient, right? So, and I’ll just use the example on a simple 50% stabilized multifamily, scenario where you would look to finance pre covid, we would see 10 to 15 bids, and that pricing would range within a pretty from high to low within a 25 basis point range. In today’s world, even though it’s a stabilized 50% levered deal, you would only see five bids and you could see as much as a hundred basis points difference in spread between the high and the low. And so that tells you that the markets are not efficient. And because of that bid ask spreads between buyers and sellers and what we’re carrying or someone’s carrying on, I think on your books carrying values versus appraised values, there’s a pretty, pretty big differential. And so I think that gap will likely continue unless participants are forced to transact whether it’s debt related or not. I think that bid ask gap will, will just continue for the foreseeable future until there’s greater visibility in the capital markets.
Beth Mace (15:14):
So is that related to if you have such different pricing between a bid and an ask related to on how people underwriting it related to how they’re looking at exit cap rates, when you guys look at deals in your win or that you lose, what are you seeing in terms of some of the different assumptions that people are making?
Al Della Porta (15:34):
Yeah, I mean, we’re, we’re bidding, but we’re obviously being fairly conservative. I think the reality is that folks are building in conservative assumptions In today’s world, if you just look at, at interest rates for example, and relative to cap rates, it doesn’t take much for someone to fall into negative leverage territory, right? The 10 year treasury blew up 40 basis points just within the last three to four weeks. The five year did the same, right? So it’s really difficult to hone in on assumptions unless you build in a lot of cushion and those assumptions. And hence the reason why there’s a huge difference between what buyers are willing to buy and sellers are willing to sell. We AEW and then a lot of investors are we’re not underwriting. We’re looking sort of what’s in place and what we can get done today whereas in better markets, people are underwriting growth, right? And so you can only, you can only underwrite what you’re seeing in today’s today’s world. And you taking that risk on future growth assumptions is probably not something that you would see in today’s world.
Beth Mace (16:55):
So are you guys looking at a lot of new construction or is that sort of, when you look at their replacement costs versus building? I think at least in the senior housing sector, for example, there’s very limited new construction going on. And is that the case with, are you guys looking at new construction.
Al Della Porta (17:11):
Generally speaking across the firm seniors, multi-family, etcetera? We’re not looking at new construction. I think there are, there are potential potentially better deals to buy. It’s basic reprice core. I think we’re watching core values, adjust based on higher cap rates. And so we think there could be some opportunities just to simply buy, reprice core. And in some cases these might be generational type assets that only come to market. And during these types of cycles to go out and put a shovel on the ground in a construction development project today is a pretty relatively risky proposition. I think finding a construction financing would be very difficult, particularly with the, the banking CRI crisis that’s still prevalent.
Al Della Porta (18:08):
So, and that cost, and if you do find a construction loan in today’s world, that cost of capital can be pretty expensive and, and pretty conservative on a LTC basis and probably pretty full recourse. And then you add in the factor of your underwriting assumptions, what the forward curve looks like on interest rates and what insurance costs could be a year, two years from now. We would rather pivot towards core, strategies on the equity side. And reprice core would be very much along that, along those lines.
Beth Mace (18:48):
Let’s look a little forward. What do you think will be the catalyst that will get the transaction market moving again? Is it will be until the Fed has declared, we’re done inflation’s under control, we’re not raising interest rates anymore, or what are the other sort of indicators that we need to be watching? Or do you see any green shoots?
Al Della Porta (19:07):
Yeah, I mean, we need some stability, right? Stability in the treasury markets. I think the market has underestimated how high rates will have, have gone and what the fed, will do in terms of rate hikes. And so once we have conclusion to the fed tightening, I think that will certainly bring in some stability in the, in the marketplace. And then finally seeing where treasury rates will end up 10 year treasuries given the last month’s runup in treasuries I think participants are back on the sidelines. When, just by example, we’ve been bidding on a number of multifamily assets and when the treasury rates were hovering around 4%, even though we weren’t the winning bid, it did seem like those deals were actually transacting, but as soon as the treasury rates ran up to close to 4.5%, then all of a sudden a lot of folks who were selling assets had failed sales, sales assignments.
Al Della Porta (20:13):
So we need a little bit of stability in the marketplace so that people can feel comfortable that they’re making the right assumptions and they don’t fall into negative leverage. And then they need a little bit more visibility in terms of the overall economic and capital market environment. And so as soon as we have that comfort, I think people will be able to transact.
Beth Mace (20:35):
So, not to put you on the spot, but I will, so probably sometime in 24, so 23, sort of the rest of 23, when you have three months left, continue to be where we are right now, which is pretty weak transaction markets. And in 24, maybe some stabilization we might see an improved market.
Al Della Porta (20:53):
Yeah, potentially, yes. I mean, I think the reality is that we have been opportunistically deploying capital in 2023, and I think, we’ll continue to do that in 2024. So we on average will deploy roughly 4 billion of acquisitions or deploy capital roughly in that range. And this year we’ve only deployed about a billion across all product types. And that includes a couple of construction loans, industrial construction loans so, and so we’re finding unique opportunities whether it’s equity investments subordinate debt some mezzanine or preferred equity investments or just stretch seniors or construction loans. So I think the reality is that 23 and 24, I don’t think we’ll see, even though assuming we have some stability in the marketplace, I don’t think everyone will be pivoting to rush back in. But I think the reality is that we’ll be opportunistically investing during that time period.
Beth Mace (22:03):
Well, the fed’s goals were really to sort of slow inflation and by doing so, slowing the economy. So since commercial real estate is one of the most interest rate sensitive sectors, I mean that we’re seeing the results of really what the intentions of the Fed were. So I guess until we see a change in their viewpoint that it makes sense that things would slow down. So let’s switch for a minute to senior housing and what’s AW’S view on senior housing? Have you been doing any deals? What looks good, what doesn’t pass muster so forth.
Al Della Porta (22:36):
I mean, we’re, we’re positive and on senior housing, We’ve been in the sector for 20 years and, and I personally was in the senior space earlier in my career and really enjoyed watching the whole sector mature over the past 20 years. So I think it’s a sector that we’re committed to. We have clients now that are actually picking up the phone calling cause they’re interested in the sector and the reasons why they’re interested in the sector is that fundamentally I think the sector is in a really good spot. From a demand perspective, you we’re really at the beginnings of an aging baby boomer population, and that population is gonna grow four times faster than the overall US population.
Al Della Porta (23:31):
And so, that will certainly, that’s a great story for seniors and then when you think about it relative to other sectors, you’re starting to see some headwinds in multifamily, for instance, that rent growth is no longer there. That renter profile is starting to see some, some cracks and even in the industrial space you’re starting to see things slowing down. So from a senior’s perspective we believe the worst is over and we’re at a trough, and from a demand perspective that will continue. And we’ve seen rent growth in our portfolio between five to 10% over the last 12 months. And we expect that rent growth to continue and to 24. Then on the supply side because of the banking crisis, we’re not expecting supply to be as robust as it has been in the years past. So for example, in 2018, we were adding roughly 43,000 units or 8% of the total senior housing supply. And now that number’s down below 20,000 by half and that trend is likely to continue in 2024, given what we’re seeing in the banking crisis. So fundamentally I think we view it very positively and eager to see what the sector, how the sector performs over the next couple years.
Beth Mace (25:09):
So when you go out to try to finance a senior housing deal using it more or less challenging or the same as, let’s say multifamily or another product type.
Al Della Porta (25:17):
It’s a little bit more challenging ’cause there’s fewer players in the space, right? So there’s still a fair amount of liquidity in the multifamily and industrial space and right now there’s limited liquidity in the senior housing space and the major players are obviously the agencies and a handful of life insurance companies. And we really need to have a healthy debt market for the senior housing sector to thrive, right? And I know that the agencies just like many other lenders are dealing with some loan issues but they’ll certainly return. And when that happens, I think that’ll bode well for the senior housing credit markets. And the advent of debt funds too into the space has been welcomed liquidity in that space that wasn’t available when I started my career. So anytime when you see new types of lenders enter the space and add liquidity to space, I think that’s a good thing. And it does appear the debt funds who tend to be a little bit more I would say nimble across different asset classes. I think overall they’re viewing seniors positively as well.
Beth Mace (27:32):
So Al I know that when you and I worked together closely, we used to look at the risk profile, for example, of senior housing versus multifamily, and you could measure that by looking at the premium to the US treasury or the premium against multifamily. So in the time that you and I worked together, we certainly saw that risk premium decline or senior housing. Do you think that that’s, where are we today with that? Do you think that the risk premium has changed more institutional investors, as you point out, are coming to you actually looking for possible opportunities in senior housing? So from my perspective, it seems like that risk premium has continued to decline. It’s becoming senior housing becoming more of a core like product at least. And do you think that the capital market conditions to now have changed that or given the demographics and the positive market fundamentals that will maintain a pretty tight premium?
Al Della Porta (28:24):
Yeah, given where we are today, having gone through covid and, and now dealing with a higher rate environment, we did see those premiums increase, right? Probably more than multifamily. I agree with you. Like over the years that premium did decline for a number of reasons. But given today’s most recent today’s world, I think that premium did increase. So historically, senior housing cap rates would trade at a premium to multifamily and just, just generally just say it was a hundred basis points or so depending on the asset and market, etcetera. In the today’s world, I think that differential is probably closer to 200 basis points, but I think that trend probably has moderated and likely to tighten going forward, given the growth prospects and the real estate fundamentals for senior housing. That said overall cap rates are still highly correlated and contingent upon how high treasury rates go, right? Right. So we’re, and so if treasuries continue to run up, then obviously those cap rates will make an equivalent move as well.
Beth Mace (29:37):
Alright, well this has been great. Is there any thing you wanna sort of wrap up as a summary statement for where you think we’re in capital markets trends and what would be the catalyst to change things, especially as it relates to senior housing?
Al Della Porta (29:50):
Yeah, I think for me it seems like the sector has gone through some pretty tough times and finally it feels like the light is sort of at the end of the tunnel. And seniors is personal to me, meaning I’ve been in seniors for 20 plus years and I’ve worked with you and a number of other folks and developed a lot of relationships. So I’m eager to see seniors recover in today’s world. And I think the pieces are there for growth. And so like I said, AEW’s optimistic on the sector fundamentally and we’re forming capital around it. And so we’re looking forward to the next phase of our this in this new world basically of deploying that capital.
Beth Mace (30:42):
So Al thanks so much for taking time to talk to me on this NIC Chats capital markets focused podcast series. I really appreciate your time.
Al Della Porta (30:50):