Despite an extended government shutdown and some negative press, the federal lending program for nursing facilities and other health care properties saw a slight boost in overall dollar volume for the year — even as the absolute number of deals experienced a dip.
The Department of Housing and Urban Development’s Section 232 program for skilled nursing facilities and other institutional care sites logged $3.7 billion in total initial endorsements during fiscal 2019, which ended September 30. That overall number is an increase of more than 4% from fiscal 2018, even as the total transaction count slid from 317 to 288 over the same span.
Due to favorable interest rates and persistent investor interest in long-term non-recourse loans, multiple HUD lending leaders said the outlook for mergers-and-acquisitions activity remains positive — particularly as smaller facilities adapt to new payment models and increased attention on star ratings.
Adam Offman, managing director in Dwight Capital’s health care finance operation, cited savvy operators investing in health care and good investment opportunities in this sector when discussing the year’s results.
“There’s more interest in HUD loans in the skilled nursing sector, and a lot of capital for it,” Offman said. “And the return you get from skilled nursing is the highest cash flow return. With more capital out there, people are chasing deals.”
More consolidation is a good sign for smaller operators focusing on a particular region, which results in better quality care for patients, according to Offman.
“If there’s more of a local focus, it’s better for patient care. And would you prefer the operator that has one small building in Kentucky or five buildings for patient care?” he asked.
The trend toward regional consolidation has contributed to increased loan volume, as smaller facilities bow out of the business.
“Larger operators have an advantage with today’s requirements. This divestment creates opportunities for others. The regional consolidation that’s taking place in the industry is leading the volume of loans,” Scott Thurman, chief credit officer for Federal Housing Administration (FHA) lending at the New York City-based lender Greystone & Co., told SNN.
The preparations for the new Patient-Driven Payment Model (PDPM) remained a complication and expense that smaller operators are struggling to keep up with, Thurman added — echoing a common sentiment among M&A advisors.
“It’s the changing of hands, and the fact that many are also getting out of operations of real estate side. There’s a noticeable shift of owner/operator structures, where you have related parties deciding to do one or the other, but not both,” Thurman said. “Lots of people are divesting, and the sale/ leasebacks to new operators — and taking those applications into a new generation of owners and operations, and then repositioning — is adding volume as well.”
Real estate investment trusts (REITs) are cash-heavy and generally avoid HUD debt. However, smaller family offices and operating groups that aren’t necessarily sitting on cash continue to find the program attractive.
“REITs are still relevant, but the more privately owned buildings, the more activity HUD we’ll see — and the more the REITs are selling, the more opportunities there are for owners to be interested and invest,” Offman said.
Michael Gehl, chief investment officer of Housing & Healthcare Finance in Maryland, observed that the SNF space has been out of favor in public markets — and especially REITs due to tenant challenges through shortened length of stay and staffing issues.
Kass Matt, president and head of production of the health care practice at Lancaster Pollard, pointed to a slightly different reason for increased loan loan amounts over the past year.
“We are seeing newer projects cost more to construct and over time, higher loan amounts for these projects. We are also seeing larger projects,” said Matt — adding that ORIX Real Estate Capital, a combined company of Lancaster Pollard and RED Mortgage Capital, closed 78 loans totaling $903 million in par amount, or the amount of money that bond issuers promise to repay.
HUD financing isn’t often used for construction because it takes longer and is more difficult to underwrite than other lending options. The agency isn’t actually set up to do a lot of construction lending, Matt said, but Lancaster Pollard/OREC completed seven transactions totaling $112 million — just under 50% of HUD’s total construction volume at $214 million.
The group’s construction loans consisted of new projects and 241(a) loans, which provide funding for improvements that prevent fire damage to structures, for both skilled nursing and assisted living facilities.
“This was a record year for individual production and over $900 million in new production,” Matt said.
Thurman, of Greystone, agreed that the uptick in HUD loans since 2016 is a sign of the industry’s overall health.
“From 2016 to 2019, the volume in HUD loans has grown extensively, and 85% percent of volume are in skilled nursing facilities, rehabs, and additions,” Thurman said.
Bridge loans, temporary solutions to bridge the gap for one to two years before obtaining longer-term loans, have also become popular for investors looking to eventually capitalize on HUD’s more permanent features.
“This mid-step is part of the reason for the overall growth,” Thurman said.
These sunny stats come in the face of some public headwinds in the HUD lending space over the course of fiscal 2019.
Early on in the fiscal year, an extended government shutdown temporarily froze loan processing, stoking fears of a backlog that would take months to unravel. A few months later, the New York Times highlighted a record-setting HUD skilled nursing loan default, raising public questions about the health of the program — despite HUD officials pointing to an overall default rate below 1%.
In turn, proponents of the program pointed to its positive credit subsidy and dearth of other options on the market; speaking to SNN back in June, Offman described the program as “essential for nursing homes to function.”
In terms of overall interest in the SNF sector, Gehl, Matt, and Thurman agreed current buyers consist more of regional players, who will typically fund their acquisitions with a bridge loan and the long-term goal of HUD financing. This two-prong step has been the dominant trend in securing long-term mortgages.
“We know that nursing homes are changing hands, and M&A activity leads to increased financing needs,” Matt said.
That said, HUD lenders — and the government itself — have increased their focus on quality measures, especially as the Centers for Medicare & Medicaid Services (CMS) tightens the reins on facility requirements for inspections and quality outcomes.
Some lenders reported their borrowers’ ratings as slightly lower than HUD’s 3.5-star average in fiscal 2019, though that isn’t necessarily a dealbreaker: One and two star ratings call for “a greater amount of reserves and can make underwriting more difficult,” Offman said.
At Lancaster Pollard, buildings with lower star ratings require a bit more research before a deal can close.
“The vast majority of the star ratings in our portfolio compare to HUD or are a bit lower,” Matt said. “We have also underwritten those with ratings of only one and two stars, focusing on the industry and the buyer’s ability to articulate the merits of a credit, and we have a clinical group to research all of those factors.”
Greystone’s additional quality focus has also included an investigation into whether a given property has prepared sufficiently for PDPM, among other factors.
“It comes down to quality of sponsorship or the operator,” Thurman said. “Even HUD is more focused on ratings and quality than it was in the past.”
Gehl suggested that inspection scores drive the surveys and that at times, one bad inspection could quickly decrease ratings. While his group and others still pay attention to ratings, it’s not a perfect system, according to Gehl.
“You can have a one-star facility taken over by another operator a year ago and have that facility still blemished by the previous performance – even though there’s a change in leadership,” he said. “If there’s been a problem for a while, you need to look into it.”