Facing New Realities: Higher Rates and Greater Borrower Scrutiny
By: Beth Mace | April 26, 2023
It’s now been a little over a year since the Federal Reserve began to increase interest rates to slow the pace of inflation and the rate of economic growth. The increase in rates has been large, and it has been fast. Short-term interest rates have gone from virtually 0% in March 2022 to 4.75% today, the most significant tightening in monetary policy since the 1980s, when then-Fed Chair Paul Volcker also increased rates to combat inflation and slow economic growth. Meanwhile, longer-term interest rates have also risen, with the yield on the 10-year Treasury bonds increasing from 1.7% in early March 2022 to 3.5% today as the bond markets respond to the changing economic and policy landscape.
Higher rates have made it significantly more costly and more difficult for borrowers to do what they do: borrow—i.e., borrow for acquisitions of stabilized properties, borrow for new investment, borrow for business-as-usual and on-going business activity, borrow for construction and development projects, and borrow to refinance existing debt when it comes due.
Further, the movement of short-term interest rates away from historically low rates to above 4% has triggered a rapid shift of deposits away from regional bank savings accounts to higher interest-bearing instruments including U.S. Treasury bills, money market funds, and time-bearing deposits such as certificates of deposits (CDs). This poses an additional risk to borrowers because lending by regional banks is highly dependent upon deposit levels and flows. And even if the danger of more deposit outflows lessens, regional banks are likely to exert greater caution with their lending as they experience more regulatory scrutiny.
This is particularly concerning for senior housing borrowers since an estimated one-third of real estate lending stems from regional banks. Even before recent weeks, there were both credit and capacity issues in lending. Most loans today require recourse, face lower loan-to-value ratios (50 to 60%), stricter loan covenants, and higher all-in rates.
In addition, many permanent loan lenders prefer to extend credit to borrowers with stabilized assets. And for those with non-stabilized properties, bridge financing is significantly scarcer because the recycling of bank capital has diminished as deals are no longer quickly coming off lenders’ books. Construction financing is very difficult to source for all but the best sponsors with a history of relationships with their lenders. For those in the transactions markets, deals are increasingly all cash with the expectation that borrowing costs will be less formidable in the future.
The lending environment is just one of many challenging realities facing senior housing operators and their capital providers as we move into the summer months. Other considerations include the valuation adjustments going on across all commercial real estate asset classes including senior housing. Operators also face rising, albeit slower growing, expenses, which continue to take a toll on margins.
Other realities are more positive in nature, however, and include continued improvement in senior housing market fundamentals. First quarter 2023 NIC MAP data, released by NIC MAP Vision, shows rising occupancy rates, steady demand, and limited inventory growth. In addition, labor shortages are shrinking and staffing challenges are improving for many operators. Relatively strong demand in an inflationary environment is also supporting rate growth, which rose at its fastest annual pace in the history of the time series going back to 2006.
Taken as a whole, there are near-term uncertainties and risks ahead, but the medium- and longer-term prospects for senior housing are steadfast, promising, and robust. Health care coordination stands out as one compelling opportunity with revenue enhancing possibilities and promises of cost-efficiencies and savings. Partnerships with other service providers, the use of technology, and the overall agility and creativity of operators seen during the worst days of the pandemic are also reasons to be bullish on the future of senior housing. And of course, there are the demographics, with larger and growing numbers of older adults finding the value proposition of senior housing increasingly compelling and desirable.