Senior Living Development Feasibility

By Scott McCorvie | CEO, Enhance Senior Living

Learn about Senior Living Investment Brokerage and Senior Living Investment Advisory Strategies at Enhanced Senior Living.

Senior Living Development Feasibility

With the increasing number of seniors housing transactions trading at a large premium to the replacement cost (sometimes double), along with the increased availability of construction debt, there seems to be a renewed energy in the seniors housing development space. However, what makes a seniors housing development project feasible?

Simply put, a development project is feasible with the expected returns are greater than (or equal to) the weighted average cost of capital (WACC). But, what is the WACC of each project, and how is it calculated? As an equation, the WACC is a percentage-based average of the cost of debt added to the cost of equity (WACC = (% debt x cost of debt) + (% equity x cost of equity)). Since the equity is in a riskier position then the debt (remember, the debt holder will always be paid first), the cost of equity is always higher than the cost of debt.

Let’s say you receive a 75% loan-to-cost construction loan with an effective (inclusive of loan fees, etc.) interest rate of 6%. Also, let’s say you were able to secure the remaining 25% equity from an investor expecting to make a total return of 20%. Multiplying these together will give you the implied WACC of 9.5% ((75% x 6%) + (25% x 20%)). In other words, you would need an unleveraged internal rate of return (IRR, or annualized total return) higher than or equal to 9.5% for the project to be feasible.

Since the internal rate of return includes a holding period assumption and uncertain exit cap rate (to be discussed in a later article), another simpler way to analyze the feasibility of the project is to measure the WACC to the stabilized yield-to-cost. The stabilized yield-to-cost is similar to a cap rate, but divides the expected stabilized net operating income by the total development budget (YTC = stab. income / dev. budget). The development budget should include all fees and costs needed to fully stabilize the project (including pre-marketing costs, development fees, and lease-up/interest reserves). So, for a senior housing development project to be feasible, the stabilized YTC must be higher than the WACC. Also, the selected market rates, care charges, and operating margin should be carefully analyzed to determine the suitability of the proforma assumptions. Since the annual income drives both feasibility metrics, an unrealistic proforma model can artificially inflate or deflate the returns.

Last, one of the most important metrics to determine the feasibility of the seniors housing development project is to analyze the total development budget on a per unit basis. If the development per unit cost is too high, there is risk that another developer will construct a less expensive seniors housing project down the street, be able to charge lower rates/fees, and most likely drive down your operating performance. But, what is an appropriate development cost per unit? Unfortunately, this varies from market-to-market (varying land costs, entitlement, licensure, CON, construction costs), and operator-to-operator (varying pre-marketing costs, management fees, lease-up reserves), but generally can be compared on a segmented basis by allocating the land costs, hard costs, soft costs, FF&E, contingencies, developer fees, pre-marketing costs, and reserves.

To learn more ways to enhance our senior living industry, be sure to subscribe to the podcast, The Inner Circle of Senior Living.

By Scott McCorvie | CEO, Enhance Senior Living

Learn about Senior Living Investment Brokerage and Senior Living Investment Advisory Strategies at Enhanced Senior Living.

enhanceseniorlivnig.com | seniorlivinginvestments.com | srgrowth.com | generationalmovement.com

Senior Living Cap Rates

By Scott McCorvie | CEO, Enhance Senior Living

Learn about Senior Living Investment Brokerage and Senior Living Investment Advisory Strategies at Enhanced Senior Living.

Senior Living Cap Rates

If you're involved in the senior housing real estate industry, you’ve likely heard the term ‘cap rate’ more than once. But, what is a cap rate? And, how does it affect the value of a senior housing property? And last, what are some senior housing characteristics that can impact the cap rates?

Capitalization Rates (or Cap Rates) are one of the primary metrics used by investors in evaluating commercial real estate investments. In short, cap rates measure the relationship between the price (or value) to the expected annual income (cap rate = income / price). Therefore, given even income at a property, a lower cap rate indicates an investor is willing to pay more for a property with a higher cap rate indicating a lower price.  

How does this affect value? As in algebra, as long as we know two variables, we can solve for the third. So, if we know (or can reasonably estimate) the expected annual income at the property and can derive an appropriate cap rate from similar market transactions, we can solve for the expected price, or value (value = income / cap rate). So, the expected price of a senior housing property can ultimately be derived from both the income and market expectations of the capital (cap rate).

However, what property characteristics contribute to the variance in cap rates? Like all investments, an investor requires a higher rate of return for taking on additional risk. Simply put, with all other things being equal, cap rates measure the perceived risk in an investment. So, what makes a senior housing real estate investment more or less risky? One of the major factors in senior housing risk relates to the acuity level. A lower-acuity independent living community is not licensed, and does not provide nursing services, so the risk of improper care (or losing an AL license) is much lower than a higher-acuity memory care or skilled nursing facility. Although the income might be higher at a memory care facility, resulting in a higher value per unit, the overall cap rate will be lower with level income. Accordingly, a property located in a larger market is deemed to have a larger demand and employee pool, and is perceived to be a lower risk to a similar property in a smaller, tertiary market.

There are many characteristics that can impact the perceived risk and cap rate at a property. In general, qualities that are perceived to have lower risk include larger markets, stabilized operations, larger property size (number of units), private pay reimbursement, newer construction, continuum of care, reputation of operator, and superior building quality. Alternatively, the risk is perceived to be higher (with higher cap rates) in smaller, tertiary markets, non-stable operations (lease-up or turnaround), smaller property size (less units), management transitions, government reimbursement (Medicare and Medicaid), older construction, and inferior building quality. In short, properties with the lower risk profile tend to trade for lower cap rates than similar property types with the higher risk profile.

Although there are many other macro-level influences on the cap rate environment (capital markets, interest rates, supply of equity/debt, etc.), the above attributes are a few of the micro-level attributes. Also, when a property's income stream is inconsistent, an investor may also use a discounted cash flow analysis to calculate the present value of the future income stream (with an appropriate risk-adjusted discount rate).

Learn more about ways to enhance our senior living industry by subscribing to the podcast, The Inner Circle of Senior Living.

By Scott McCorvie | CEO, Enhance Senior Living

Learn more about Senior Living Investment Brokerage and Senior Living Investment Advisory Strategies at Enhanced Senior Living.

enhanceseniorlivnig.com | seniorlivinginvestments.com | srgrowth.com | generationalmovement.com