For much of the past 20 years, capital expenditure allocations in senior living have been largely trapped in amber.
That has changed in recent years. Faced with aging buildings and competition from new communities and operators, CapEx spends have grown gradually since 2015, and even buildings delivered within the past decade are undergoing renovations, Green Street Advisors Senior Analyst Lukas Hartwich said Wednesday at the 2020 National Investment Center for Seniors Housing & Care (NIC) fall conference.
Many operators expected CapEx spending to decrease slightly in 2020. But that was before Covid-19 disrupted the industry, and any pre-pandemic issues with buildings have only been exacerbated by the coronavirus. Therefore, new CapEx investment is now necessary even as such spending becomes more difficult in the face of increased expenses, reduced revenues, and project complications related to Covid-19 restrictions.
But, as the stock of senior living communities across the country continues to age, simply committing to more CapEx spending may not be the best strategy. Some of the older stock may be beyond renovation and could be better suited for adaptive reuse into a new class of real estate, or demolished and the land used for new developments, Blumenthal said.
On the whole, assisted living communities appear to be positioned to benefit the most from CapEx projects, and — as some industry leaders already have been urging — owners and operators would be well advised to reevaluate their CapEx spending allocations and think carefully about projects as they consider their post-pandemic strategies.
An inflection point
It is common for owners and operators in any commercial real estate segment to increase their CapEx allocations over the lifespan of a building, with consideration given to the prime earning years of a community.
The average age of senior housing stock in the 31 primary markets tracked by NIC was 21 years as of the third quarter of 2019. Buildings between 10 and 17 years old are in peak ranges for occupancy and performance.
It is also during this time frame when CapEx spends begin to increase, Hartwich said.
Green Street views CapEx spending from the vantage point of a long hold, or “perpetual,” owner, and believes between 20% and 25% of net operating income (NOI) is an adequate CapEx reserve.
But the allocation increases begin as communities reach the 20-year mark of existence – just past the point of a community’s peak earning years.
Senior housing and care is a relatively young asset real estate class, and much of the stock in the 31 primary markets NIC tracks is reaching that inflection point. CapEx spends have been at or above 20% of NOI every year since 2014, and peaked at 26% in 2018.
Failing to allocate higher levels of CapEx as buildings pass the 20-year mark can have negative implications on the value of communities, if owners plan to execute exit strategies. Spending less on CapEx during the hold period can impact pricing, if a buyer accounts for deferred maintenance in an offer. And buyers almost always do.
“We want to underwrite the economic useful life of an asset,” Hartwich said. “How long can you rent the asset, given its current state? And to the extent does a property look outdated and it’s going to need to be redone, even if the physical quality is there?”
Assisted living stands to benefit
CapEx spends have grown at similar paces among health care real estate investment trusts (REITs), communities tracked by the National Council of Real Estate Fiduciaries (NCREIF) and in theoretical modeling conducted by Green Street.
Continuing care retirement communities (CCRCs) see the most CapEx allocations, due to a combination of the age of the product and consumer expectations, Blumenthal said. CCRCs have a high complement of amenities and common areas for residents. The entrance fee model of most campuses corresponds to higher expectations among consumers. And the expectation of regular maintenance is more expected than at a more modestly priced community.
“Between the higher expectation on the consumer side, and the [age of] properties, [CCRCs] year-over-year have been much higher than what we typically see for any other community type,” she said.
The care type that stands to benefit the most from higher CapEx spends is assisted living. The majority of stock was built in the 1990s, is located in tertiary markets with little new competition, and the size of these communities are generally between 40 and 60 units. Additionally, some assisted living communities receive the majority of their revenues from Medicaid waivers. These factors have allowed operators to keep CapEx allocations lower than normal.
But as new operators seek footholds in tertiary markets and new product comes online, the need for capital improvements becomes more urgent. Operators and owners tend to be the perpetual owners that Green Street models for, and they already have good reputations and a performance advantage over new competition.
“They have the most opportunity to benefit from CapEx, but we just don’t see a lot of it being spent,” Blumenthal said.
Older buildings may be cycled out
The long-term lag in CapEx spending compounds what Blumenthal calls “structural obsolescence” issues, which fall into two camps. The “curable” kind can be replacing HVAC systems, reducing touchable surfaces, and repurposing visitation rooms into staff quarters where employees can change in and out of their work clothes.
“Incurable “ issues involve the original design and layout of a building, which likely were informed by the era in which it was built. For example, if a community was built with an excess of studio apartments, combining any into larger units would actually hurt the financial operations of a community. Likewise, high ceilings and narrow hallways are set and cannot be changed.
“There’s no curing eight- and nine-foot ceilings,” she said.
For communities built in the 1980s and early 1990s, the amount of CapEx necessary to keep a building competitive in the face of new competition may not be worth it – especially in secondary markets. If the numbers do not work, repurposing a building for another use is an option, Hartwich said.
“Maybe that becomes an opportunity to be converted into a non-senior housing use,” he said.
The CapEx proposition in older product in primary markets changes a bit, because of land values which does not depreciate, nor does it require reserves.
“A lot of those are infill locations, where the land is so valuable that you can afford to spend more to maintain the improvements,” Blumenthal said.
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