Senior Housing on the U.S. Side of the World

For those of you who have read my previous postings here and elsewhere, you know that a primary focus of mine over the past three or so years has been the birth and evolution of the senior housing industry in China. My view has been from the perspectives of how the industry has been developing in China, and how the experience and expertise of foreign operators, particularly those in the U.S., might be of benefit to developers, investors, operators and government ministries and bureaus in China as the sector develops. The theory goes that the U.S. has thirty years of experience in developing senior housing of all types, and that China can take advantage of that experience and avoid the mistakes made in the U.S., where the market is quite mature.

I was recently invited to attend a panel discussion entitled “Senior Housing Investment Trends,” sponsored by a New England (U.S.)-based group, the Real Estate Finance Association. The panelists were the CEO of a senior housing (mostly assisted living and dementia care, with some independent living) company with 46 high-end communities in the Mid-Atlantic region of the U.S.; investment professionals from two institutional investment fund managers, each with substantial – over ten years’ worth – experience in senior housing; and a capital markets specialist based in the Boston office of a global real estate services company. The panel was moderated by a partner in an international law firm, with many years of experience in senior housing across the U.S. Full disclosure – I know each of the panelists, except for the capital markets specialist, quite well, and the moderator and I were partners in his current law firm before I relocated to Hong Kong in 2008. I have since returned to the U.S., and am an Asia Fellow at the Harvard Kennedy School, researching and writing on the senior housing industry in China.

My involvement in senior housing in the U.S. started a dozen years ago, when I began representing one of the panelists’ companies in its first senior housing investments. His company was among the early institutional investors in the industry, and its investments in the sector have been very successful. A large part of that success was due to the evolution of the industry, as it became a more accepted property type, which served to drive capitalization rates considerably lower over the relatively short – in the neighborhood of five years or so – holding period of the investment.

It is true that the industry has evolved in many ways over its thirty-year history, but what I found particularly interesting at the discussion, having been away from it for several years while I was living and working in Hong Kong, is the degree to which it continues to evolve. The industry in the U.S. may be many years ahead of China in its development, but it continues to change and adjust.

Snapshot of The U.S. Market

According to research conducted by the National Investment Center for the Seniors Housing and Care Industry (NIC), as of the fourth quarter of 2011, the U.S. had approximately 22,086 senior housing properties: 3,977 of which were majority independent living, 6,921 majority assisted living, and 11,188 majority nursing care. These properties contained 2,892,124 units: 860,422 independent living, 519,586 assisted living and 1,512,116 nursing care. The aggregate market value of the senior housing and care market is $260 billion and growing. To put this value in perspective, the market value of the senior housing industry is approximately 20 – 25% less than hotels, and is only 30% of the value of apartments.

The average monthly rent ranges from $3,000 for independent living to $8,000 for nursing care, reflecting in part, the level of services required as the facilities move up the acuity scale. It should be noted, however, that these are average monthly rents. Assisted living units in affluent areas in the U.S., for example, can carry monthly rents of $10,000 or more – and typically, assistance with the activities of daily living (ADLs) is an additional cost. Done correctly, the business can be quite profitable.

Performance of the U.S. Senior Housing Industry

Senior housing in the U.S. has performed quite well compared to other property types. The National Council of Real Estate Investment Fiduciaries (NCREIF) monitors and reports on the performance, in 100 metropolitan areas, of the major property types: multi-family rental, office, retail, industrial, hotels and, more recently, senior housing. Measuring returns over the previous 1, 3, 5 and 7 year periods, NCREIF found that senior housing out-performed all other property types in income returns in each of these periods, and in all but the previous 1-year period, in annualized total return. (Total return equals income plus appreciation.)

The failure of senior housing to out-perform the other property types in 1-year total return was most likely owing to the rebound in the other property types, a rebound not shared by senior housing because senior housing had remained relatively stable during the downturn in the property markets. Occupancy fell somewhat during the financial crisis, but unlike all other property types, rent growth in senior housing never declined. Rents tend to be less volatile than in other property types, primarily owing to the need-based characteristic of senior housing.

Demand Growth Drivers

Factors driving the growth in senior housing in the U.S. have been: demographics, rising product acceptance, greater affluence, longer life expectancy, higher education levels and a declining availability of informal family care givers. The prediction is that these factors will continue to increase demand for the product in the U.S. for the next 40 years and close the market size gap between senior housing and apartments, as the growth of the senior population will exceed the growth of the “renter” population over this period.

… Can’t Get No Respect …

It is interesting to note that, in some key respects, senior housing seems not to enjoy what you might expect it to enjoy from the combined forces of the strength and stability of the product type and the demand drivers noted above. Here are a couple of examples of this:

• Cap Rates. The performance and risk profile of senior housing would suggest that cap rates for the product type are higher than they should be. Yet, even though as I noted in the introduction, cap rates have fallen considerably over the past decade or so, they have leveled out at approximately 300 – 400 basis points higher than cap rates for apartments. The panelists agreed that these rates do not accurately reflect the risk of senior housing, but disagreed on what spread over apartments would be appropriate. Not surprisingly, the owner/operator on the panel argued that there should be no spread, but the consensus view was that a spread of about 150 +/- basis points would be appropriate, taking into account the relative lack of liquidity of the senior housing market. It is, after all, a smaller market than the market for apartments.
• Availability of Capital. In the early years of this business, due to unfamiliarity of the product type, capital was relatively scarce. Construction debt was hard to obtain, and only a small handful of lenders provided permanent debt for projects, and then only on stabilized properties and on relatively onerous economic terms. Debt is more easily obtained now, as the number of lenders committed to the sector has increased. Still, the number of lenders active in the senior housing industry is far less than in other property sectors.A number of major institutional players provide equity capital, as the product type has become more acceptable as an institutional property type. That being said, the number of institutional players is much smaller than for other property types; and, on the pension fund side of the ledger, only the large funds have the capacity to invest in the sector, as the smaller funds tend to need to fill up their allocations to the “traditional” property types before venturing into senior housing. REITs have been very active in the market, acquiring properties and in many cases, operating them.

So, What about China?

Here are some observations that I took away from the discussion that might have some relevance to the China senior housing market:

• To state the obvious, the China market is just beginning to develop. It has taken the U.S. industry over thirty years to get where it is today, and it still appears to be experiencing growing pains of one sort or another. The same will be true of China, although it might be able to truncate the maturation period by drawing upon U.S. experience in the industry.
• Thirty years ago, the industry in the U.S. consisted primarily of nursing homes, and evolved to include assisted living, independent living, dementia care and continuing care retirement communities (CCRCs). Each property type continues to be tinkered with and refined, adjusting to changes in the needs and desires of the target population – baby boomers are aging very differently from their parents, and adjusting to advances in best practices.In China, different property types will be experimented with, depending somewhat on what type of entity is developing and financing the project. For example, in the near term, many developers appear to be set on doing business as usual – building and selling large residential projects with a senior housing component, which will most likely be of the independent living type, providing little if any health care. Insurance companies seem to favor CCRCs, for their entrance fees and long-term rental and service income potential. Foreign investors – and there are very few of them at present – are hedging their risk by developing smaller, “laboratory experiment” projects at the higher end of the acuity scale. Each of these property types is quite mature in the U.S., so the experience here can be of help to the China market in planning and operating the projects.
• Each of the demand growth drivers noted above holds true in China as well, perhaps to a more exaggerated degree in some cases. For example, the one-child policy lessened the number of family care givers far more than did the natural decline in the fertility rate that occurred in the U.S. I would expect explosive growth in the market, particularly once a few projects have come on-line and proven successful, leading to acceptance of the product in the marketplace.
• A discussion about capital markets in China for senior housing is premature, to put it mildly. I expect that domestic capital, provided by developers and insurance companies, will dominate the market until the product type gains acceptability. However, the time will come when other domestic and foreign sources of capital enter the market as proven business models emerge. If and when REITs are approved by the Chinese government, they should gain popularity among individual and institutional investors, as they would offer stable cash flow and the likelihood of substantial appreciation as cap rates adjust to reflect the relatively low risk that the property type presents.

Conclusion

Although the U.S. and China senior housing industries are in far different places in terms of their development, it is worth noting that, while the U.S. is far ahead in the process, changes and adjustments continue to be made, and the same will be true of China as it moves forward. At this early stage of China’s senior housing business, however, much can be learned from the U.S. experience. Cultural differences will, of course, need to be taken into account, but many of the complexities of planning and operating these purpose-built, specialized projects have been pretty well thought out by the U.S. market, and much can be learned from that experience.