In 2024, improving senior living industry fundamentals and evolving market dynamics are building momentum in the senior housing real estate market, and well-capitalized REITs have found themselves in a unique position to take advantage of the current buying environment.
Many healthcare REITs have primarily been net sellers throughout the pandemic recovery period, shedding underperforming assets and portfolio outliers to focus on stabilizing their own portfolios, but are now touting robust investment pipelines of actionable deals. In contrast, bank debt continues to be in relatively short supply, with fewer lenders allocating funds in the sector, and higher interest rates limiting the rate of return investors can achieve when they can line up debt. So how have REITs been able to invest while much other capital has remained sidelined? To answer that, we will examine the series of events that led to the current, favorable position well-capitalized REITs find themselves in today.
Pandemic: As we all know, the devastating impact of the pandemic disrupted senior living operations, as well as many other industries including commercial real estate, with the office and retail segments hit particularly hard.
Rising rates: Inflation accelerated rapidly, marked by the sharp jump in the CPI-U in April 2021 and peaking at 9.1% in June 2022. The Federal Reserve (the Fed) was in hindsight, perhaps slow to respond, attributing the early spike in inflation to supply chain disruptions that would eventually normalize, waiting nearly a year after the first spike in the CPI-U to raise the Federal Funds rate in March 2022, steadily increasing it to 5.33% in July 2023.
Market dislocation: Perhaps taking a cue from the Fed that the inflationary environment was temporary, coupled with the promise of recovering operations, the senior housing real estate market rebounded quickly in 2021 and 2022, pushing cap rates to pre-pandemic levels and at times even lower. Given interest rates were still relatively low at this time, financial institutions were still active in supplying capital. With fewer favorable buying opportunities given the low cap rate environment and lack of stabilized senior living deals, many healthcare REITs instead focused on selling underperforming assets at low cap rates, using sale proceeds to improve their balance sheets by reducing debt and/or improving equity through stock buybacks, shrinking their companies in the near-term but positioning themselves to take advantage of future opportunities as markets normalized.
Regional banking crisis: The failure of Silicon Valley Bank (SVB) in March 2023, while fairly contained, sent ripple effects across the regional banking industry, which is a major real estate capital source, accounting for 80% of commercial real estate loans. With $2.2 trillion in commercial loans coming due over the next 3 years, smaller and regional banks may continue to be limited in their ability to lend to our industry at levels prior to this crisis. As the regional banks had to more aggressively manage their own loan portfolios and financials sponsors, which rely heavily on leverage, and began pulling back on capital allocation, the result was a significant slowdown in commercial real estate transactions, including the senior housing industry.
Higher for Longer: Following the onset of the regional banking crisis, capital dried up, forcing sellers and borrowers to reassess. With the Fed not being quick to reduce rates, in early 2024, market expectations began to shift to acceptance that rates would be higher for longer, and the market became much more favorable for well-capitalized financial intermediaries, including REITS.
Rates are now starting to adjust to slowing inflation and employment data, and the Federal Reserve cut the federal funds rate at its September meeting. Even with this movement, the cost of debt remains elevated by recent historical standards, and we are seeing transaction spreads that adequately compensate for this reality. More recently, the publicly traded healthcare REITs with a focus on senior housing and skilled nursing have experienced a significant improvement in their cost of equity, and investors are showing optimism that they are in a unique position to deploy accretive capital while their competition has remained sidelined.
Many REITs are now actively engaged as buyers, and some are expecting to meet or exceed pre-pandemic investment volume in 2024. In addition to acquisitions, with fewer lending options in the market from traditional banks, some REITs are increasingly stepping into the lender position, capitalizing on high-yielding debt and ideally striving to create a pipeline for future growth through purchase options on properties at stabilization.
In closing, given current market conditions and what is anticipated in the short-term, we envision an active role for REITs in senior housing throughout the end of 2024 and into 2025.