Special Focus: Debt Markets (September 2007)

Credit crunch hits home

HEALTHCARE REAL ESTATE FEELING THE PINCH – FOR NOW

By John Mugford

The fundamentals of the U.S. healthcare industry remain solid. On top of that, the nation’s demographics point to continued demand for healthcare, which remains the largest and fastest-growing component of the Gross Domestic Product (GDP).

“That’s just not going to change, unless of course the population stops aging,” quips Danny Prosky, managing director of healthcare real estate for Santa Ana, Calif.-based Triple Net Properties LLC.

And what that means is that the long-term prospects and fundamentals for investing in medical real estate, including medical office buildings (MOBs), certainly are strong, according to quite a few people involved in the industry.

Even so, the country’s current liquidity crunch in commercial real estate, which in an indirect way stemmed from problems with residential subprime mortgages, is indeed having an effect on the financing of healthcare real estate transactions – both acquisitions and development deals. The credit crunch could also spur a rise in capitalization rates, according to some in the industry.

(The capitalization rate, or cap rate, is ratio between the annual cash flow of a real estate asset and its purchase price or market value. If the cash flow increases or the price declines, the cap rate increases. If a credit crunch results in fewer transactions and reduced market demand, prices could decline and cap rates could rise. )

Some experts in the healthcare real estate industry say lenders are currently “spooked” by difficulties in the residential mortgage industry, where problems with subprime loans are expected to wreak some havoc on the real estate market, and perhaps the economy, for at least several months.

As a result, commercial real estate mortgage underwriting standards have become more complicated and difficult, and leveraged buyers are paying quite a bit more for debt – including debt on medical real estate deals. No longer can buyers get financing for more than 90 percent of an acquisition, as they were able to just a few months ago. Also, lenders are typically unwilling to provide interest-only loans for medical real estate transactions, as they were also willing to do just a few months ago.

The result of all of this could be a decrease in deal volume and increased cap rates – at least for a period of time. Observers say some healthcare real estate transactions that were ready to close in recent weeks have stalled as lenders look to renegotiate agreed upon terms.

What happened?

The credit crunch might have planted its roots in the spring, when ratings agencies began telling lenders to reduce the risk in their commercial-mortgage backed securitized (CMBS) loan pools. Then, when losses started mounting from problematic subprime loans in the residential mortgage industry, investors stopped bidding and buying loan pools with any risk, such as the “B” tranches or lower in the conduit pools.

(Tranches are different classes of certain securities, such as collateralized mortgage obligations, or CMOs, that pay different interest rates, mature on different dates, carry different levels of risk or differ in some other respect.

(Conduit pools are groups of mortgages and other loans that are assembled by the government or private organizations, which then issue securities in their own names to investors. The first mortgage conduits were established by the Government National Mortgage Association and the Federal Home Loan Mortgage Corp. Private sector conduits have since been organized by mortgage insurance companies and financial institutions to issue securities backed by mortgages, credit card receivables, boat loans and other loans, without federal agency guarantee. Mortgage conduits make it easier for a large number of banks and thrifts to sell their loans to secondary market investors, as smaller lenders are not limited by pool size or eligibility restrictions.)

“It’s an overreaction to credit concerns in other sectors of the real estate spectrum,” says E. Hunter Beebe, a principal with New York-based Healthcare Real Estate Capital. “People are spooked by residential mortgages and they are taking it out on commercial real estate, which also includes healthcare real estate – painting everything with the same brush.”

Mr. Beebe then asks a rhetorical question: “Is a long-term lease on a stable MOB on a stellar hospital campus in a great demographic area more risky today than it was four months ago? Not at all. But what has happened is that there is an overreaction in the marketplace and, once things settle down for this particular asset class, people will realize that the spreads don’t need to be as wide as they have become. But riskier deals will continue to be difficult to finance in the short term.”

(The spread, or interest rate spread, is found by subtracting the federal funds rate – the rate that banks charge one another for overnight loans – from the yield on the 10-year U.S. Treasury bond. It’s the difference between short- and long-term interest rates. A larger spread suggests that lenders consider loans to be relatively more risky.)

“Money was easy to get and it was really cheap,” Mr. Beebe adds. “People were able to get financing terms that were too aggressive in the market and now we’re sort of moving back the other way. And I really don’t have any hard data showing whether there have been any defaults or an up tick on defaults in commercial mortgages or delinquencies – I just think people are spooked because of the overall market.”

As noted earlier, there are reports that quite a few deals, including at least a couple of large portfolio deals that were well on their way to closing, have been put on hold as potential property investors and lenders try to figure out where and when interest rates, cap rates and underwriting standards are going to settle. In some cases, lenders might have tried – even demanded – to renegotiate terms, which has put those deals on hold.

“Is this whole thing affecting business yet?” asks John Sweet, managing director of Milwaukee-based Ziegler Healthcare Real Estate Funds. “For us, yes it has. As a small private fund, the impact is probably more significant than with, for example, one of the large REITs. Smaller funds are usually one-off borrowers. So when we have a transaction, we’re trying to source the appropriate money for that particular transaction. What’s happened is that there’s been a big move in credit spread, probably at least 70 basis points, perhaps 100- to 125-basis point movement. One of the key reasons is: what had been the cheapest source of capital, the conduit market, has for the time being, and from our standpoint, dried up.”

(One-hundred basis points equals 1 percent.)

Mr. Sweet says: “I’m hearing from people we know, including brokers in the industry, who are talking about large portfolio transactions that have stalled. I’ve just heard this on a general basis.”

Mr. Beebe, of Healthcare Real Estate Capital, says: “A lot of bids are being re-bid. So if someone had a deal with a bank at a spread to the 10-year Treasury of 150 basis points, or 1.5 percent, meaning the bank came to them and said I’ll loan you $15 million at the 10-year Treasury plus 1.5 percent, well, now they’re going back to them and saying 1.5 percent doesn’t stand anymore, now we want 10-year plus 2 percent – they need a higher interest rate to do the loan.”

Eating the costs

Malcolm Sina, president of Palm Beach Gardens, Fla.-based DASCO, an owner, developer and manager of MOBs, says his company recently experienced complications because of the liquidity crunch during its acquisition of a two-building medical office property in Panama City, Fla.

As DASCO was preparing to close the deal this past summer, near the end of July, the investors who buy tranches of mortgages in the conduit market stopped bidding and buying altogether.

Here’s what happened, according to Mr. Sina: “We were in the midst of financing the project where we had a $20 million mortgage and we had agreed on a certain spread, and when we went to finalize the rate right before closing, the lender was unable to live up to the spread they had committed to because when they went to circle the rate, where you literally go to the trading desk to determine what buyers of mortgages are willing to pay, there were no buyers.

“The lender had no idea how to price our loan, so they priced it based upon what they thought they could sell it for when the market comes back and investors start bidding again,” Mr. Sina continues. “And that didn’t just happen to us but it happened across the industry because there haven’t been a lot of investors in commercial mortgage pools – like there were just a few months ago. So what’s happened is there’s been about a 50- to 70-basis points increase in long-term commercial mortgages. We still did our deal – it just cost us more”

How about pricing?

Mr. Beebe notes that lenders are changing their underwriting standards “quite a bit and being less aggressive.”

“And if you think about how that works its way through value in real estate, you now have higher debt costs and less cash flow and lower returns,” he adds. “Therefore, what people would be willing to pay for a piece of real estate in the market – it hasn’t worked its way through the market just yet – but, well, it’s going to be interesting to see where things end up.”

Mr. Sweet of Ziegler says: “It all really came to a head just in about mid-August. So I don’t know that we’re starting to see cap rates rise just yet. But I would think it has to happen at some point. It takes people a little while to face up to reality. We’ve got sellers who are holding firm on their pricing – although perhaps we’ve seen some 20 and 30 basis-point movement, instead of seeing 7 cap rates you might be seeing 7.2 percent and 7.3 percent cap rates, maybe 7.5 percent. But that could just be the quality of the product. I haven’t seen anything that leads me to believe that cap rates have moved on a material basis yet. The cost of capital has certainly moved materially.”

Mr. Sina says that since debt has become more expensive, he also believes that cap rates for MOBs have risen over the last “month, month and a half. We’re still in a question mode about where things are going to settle – so there are some transactions that aren’t being finalized right now. Buyers are on the fence or they’re dropping their purchase contracts because they don’t know exactly where interest rates and real cap rates are going to settle.”

Jeffrey H. Cooper, executive managing director of New York-based Savills Granite LLC, has not yet seen a change in cap rates for medical properties.

“I haven’t seen it,” Mr. Cooper says. “And as far as foreseeing them going up in the future, you’ll have to ask Mr. Bernanke (chairman of the Federal Reserve).”

(As it turns out, on Sept. 18 – after most the interviews for this article were conducted – the Federal Reserve cut the federal funds rate by half of a percentage point to 4.75 percent. Such rate cuts are designed to stimulate lending activity.)

As for sales volume, Mr. Beebe believes the final impact of the liquidity crunch will depend on a variety of factors.

“I think a lot of it’s going to depend on credit quality – very strong assets and portfolios will still trade very aggressively,” says Mr. Beebe. “But the portfolios that are of lesser quality and are older, with more lease-up exposure … it will be tougher to finance something like that in the short term and will likely have some short-term impact on the ability to get those deals executed quickly.”

Mr. Prosky of Triple Net says he believes it’s too early to say where cap rates for MOBs will settle.

“The market hasn’t adapted yet,” he says. “But my intuition tells me they’ll be somewhere between 25 and 50 bits higher than they have been – again I’m talking about the $15 million to $20 million deals that we focus on.”

Some people in the industry say they are preparing for a change in the cap rate climate. For example, Mr. Sweet recalls the higher cap-rate environment during his tenure at Windrose Properties Trust, a rather prolific buyer of MOBs in the early 2000s. Windrose is now a division of Toledo, Ohio-based Health Care REIT.

“We operated at a much higher cost to capital environment than we do now,” he says. “That was 2002 and 2003, and if you go back you can see cap rates moving from 10.5 to 10, to 9 – as more investors entered the market, it drove down the cap rate. But it was also at the same time that interest rates were coming down. The combination of investors getting comfortable with the medical field, which they never had before, and cost of capital declining is what drove cap rates down. And now if it’s moving the other way, the impact will be on the pricing and it may become a little bit more of a buyer’s market, because it certainly isn’t right now.”

Mr. Sweet says he believes that construction loans for medical facilities could also feel the impact of the credit crunch.

“Even though construction loans are usually floating rate and they’re easily priced off of LIBOR, they’re going to be impacted because of the recent move in the LIBOR rate as well,” he says. “We haven’t seen the big spreads, but spreads have always been a little bit bigger on a construction deal than on permanent financing, because of construction and lease-up risk.

Mr. Sina agrees. “All of this will have an impact at some point because the initial returns that a developer has to have are going to increase because the cost of financing a project is going higher,” he says, “and the ultimate value of a project – when they ultimately sell the project in the future – is now less than what it was two months ago. So clearly, the peak of the value of projects is behind us now.”

One REIT’s perspective

While Mr. Sweet notes that it is currently more difficult and expensive for smaller funds to garner financing, it certainly looks to be a bit easier for certain REITs or other large investors. Those investors typically have lines of credit, plenty of cash and “other financing opportunities,” he says.

Market fluctuations and change often present opportunities for some, notes Mr. Cooper of Savills Granite.

“I think people are flocking to investors with balance sheets, like pension funds or some of the REITs,” says Mr. Cooper. “Those investors are probably going to be active because this is a good opportunity for them.”

Mr. Beebe of Healthcare Real Estate Capital agrees.

“The people that are well-heeled with a lot of cash in the short term are in a really good position to be good buyers,” Mr. Beebe says. “Some groups might not put any hardly leverage at all and will look to do so in the future – they should be in pretty good shape competitively.”

“In the coming months the market will find its footing and will likely swing back to a more normalized underwriting and spread to Treasury,” Mr. Beebe continues. “But right now the uncertainty is causing people to use these wider spreads – when the smoke clears we’ll move back to closer to normal.”

Mr. Beebe was recently involved in the financing of an Ohio MOB acquisition by NNN/Healthcare Office REIT, a part of Santa Ana, Calif.-based Triple Net Properties LLC. The newly formed REIT basically started doing business in 2007 and has already acquired a dozen or so MOBs. It continued the buying spree by acquiring four MOBs in recent weeks alone.

(For more on NNN Healthcare/Office REIT’s latest acquisitions, please see the “Transactions” section on page xx in this issue of Healthcare Real Estate Insights^™.)

“Triple Net is being aggressive right now because they have a fundamental comfort investing in real estate,” he says. “I think they realize this stuff is really not going to impact the value of real estate in the long-term. As a REIT, they finance a little bit differently – so it doesn’t really affect them as much. I don’t know exactly what capital structure they put on that deal but it really did not have an impact on that deal.”

Mr. Prosky of Triple Net says the company’s healthcare REIT has definitely been less-affected by the credit crunch than other firms.

“I wouldn’t say that we have not been affected at all, but less-affected,” he says. “There are several reasons for that. We’re a low-leveraged buyer as our target debt rate is 60 percent, and that in itself is a big help. It’s definitely harder to get the high-lever deals done right now. We used to get 80 percent on our TIC (tenant-in-common) programs – it’s a little tougher to get 80 percent and we’re still not getting the 10-year interest-only financing like we used to get.”

Triple Net typically acquires medical properties through its healthcare REIT or through Triple Net Properties on behalf of its tenant-in-common (TIC) investors.

“We’re still able to access the debt markets relatively problem-free, yet spreads are a little higher than they were three months ago,” Mr. Prosky says. “But what’s really helped us is that our acquisitions made earlier in the year were all done with CMBS because the market was so attractive at that time. We were then in a position where we wanted to use some unsecured longer-term debt or secured shorter-term debt anyway. And we’ve had this line of credit teed up with LaSalle (Investment Management) that we wanted to use, so now we’re starting to use our line of credit, which has worked out very well for us. We had that line of credit all geared up to go and then the debt markets went all haywire and it was perfect timing for us.”

Mr. Prosky says the line of credit with LaSalle is for $80 million.

About a third of NNN Healthcare/Office REIT’s acquisitions are off-market deals, while another third are typically limited-market deals, according to Mr. Prosky.

“Another third of our deals are through the true auction process,” he says. “And we’re still seeing competition for those, and we’re seeing the competition from all of the known players – they’re still there and are figuring out ways to go after deals.”

Triple Net’s healthcare REIT doesn’t typically target large MOB portfolios because, as Mr. Prosky says, “the cap rates have traded so low. The bigger REITs tend to compete harder on those. We’re a smaller REIT and we can do the $20 million deals – we’re fine with that. I suppose as we grow we’ll start going after the bigger portfolios.”

Triple Net’s healthcare REIT is in the midst of a three-year equity raise of $2 billion, according to Mr. Prosky.

“On the smaller end deals, the ones that we target, we’ve seen cap rates start to move up a bit,” Mr. Prosky says. “And that helps offset the higher credit spread on your debt. It’s really hard to say how much cap rates have gone up.”

He adds that besides using its line of credit for acquisitions, Triple Net is using other types of financing, such as three-to five-year debt.

“We loaded up on long-term debt – 10-year – early in the year,” he says. “We wanted to get some revolving debt and shorter-term debt anyway. Our goal is to build a long-term REIT – we don’t want to do CMBS on every single deal we do. So it’s worked out to the point where all of this hasn’t hurt us too badly.”

How much longer?

At a recent conference in New York concerning the liquidity crunch, Bob Corry, managing director for New York-based Gladstone Commercial (NASDQ: GOOD), said – he was quoted in Commercial Property News (CPN) – that the CMBS market will be at a standstill for some time. “Fifty-four billion in inventory in CMBS has to be re-underwritten, re-priced and blown through,” Mr. Corry said. “Unless you have cash and are willing to take some interest-rate risk, it’s hard to get a deal done.”

Mr. Beebe says the typical deal cycle lasts about four to six months.

“So if this is a problem that works its way through the system in next couple of months, this will just be a blip on the map and no one will be the wiser,” he says. “But if it goes longer and becomes the new norm for the industry – lower loan-to-value and no more interest-only loans and higher interest rates – then we’ll have to see some fundamental shift in the way people are looking at real estate. From my perspective, volume seems to still be very high and many people are just keeping their heads down and getting things done. You don’t get out of the business because business is being done differently.”
Mr. Sweet of Ziegler says: “I think it could take six months to a year before you see the conduit market coming back on any kind of a regular basis.”

Mr. Prosky of Triple Net says things could “start to get better before the end of the year. I don’t know if we’ll get to the same point we were at in the debt markets in April, but I think we will get to 70 percent, maybe 80 percent, back to where we were by the end of the year. Who knows?”

When the capital markets eventually do stabilize, as key industry veterans believe they will, they say that acquisitions and development deals will certainly continue, perhaps at higher costs and with tighter credit analyses.

“I kind of see things returning – at least for a period of time — to what they were like pre-2003,” Mr. Sweet says. “Coming out of 2000 and 2001 you had a little bit more severe credit analysis being done. But within a couple of years there was very little in the way of due diligence materials being looked at by these firms. They were so happy to get their hands on a piece of product that they could throw into a new security that they took very little time to review these things.”

Long-term is good

Several sources note that even though the current credit crunch is having an impact on medical real estate, medical real estate in no way caused the problem.

So while the credit crunch is causing a state of flux right now in healthcare real estate, experts say the long-term prospects for medical real estate remain strong.

“I think medical has become and will continue to be a real attractive investment in the real estate world,” says Mr. Sina. “So I think there will be less of an effect on medical than on other product types. But for the next couple of months it will be a wait-and-see attitude about exactly where the values and where interest rates end up.”

Mr. Cooper, of Savills Granite, says, “I will say this, from a development standpoint, medical is right at the top of the most-favored areas because, particularly on-campus buildings, a lot of these buildings are substantially pre-leased before a shovel even goes in the ground. And you’ve got, in many cases, high-grade hospital systems, not-for-profits and generally investment grade hospitals – strong fundamentals … People buy into the fact that medical is recession proof.”

Mr. Sweet notes that the fundamentals of healthcare in general remain strong.

“And healthcare services are the source of capital to the tenants of medical offices,” he says. “So the ability of tenants … to pay rent has not been affected. And things look fine for hospitals, too. We’re with B.C. Ziegler & Co., one of the country’s largest underwriters of tax-exempt bonds for not-for-profit hospitals. And while there’s been some movement, the tax exempt markets have not been materially impacted in the way taxable debt has been impacted.”

“So in that respect you’ve got the same characteristics you’ve always had for medical offices,” says Mr. Sweet. “Buildings are not getting built on spec, they’re getting built against built-up demand, and they have higher occupancy and lower turnover than a general office building. All of those things make it a good reason to invest – at the right price – in medical.”

In the meantime, Mr. Sweet says Ziegler’s healthcare funds will continue to do business, as he expects others who are serious about the industry will do as well.

“We might just start using a little more equity and a little less debt – or do floating-rate debt and then right-size the capital structure once the interest rates settle in,” he says.

Of course, experts say much depends on the future actions of the Federal Reserve Bank in tweaking interest rates.

“Absolutely, that is going to have an effect on pricing of debt and the pricing and value of real estate,” Mr. Sina notes. q

Note: We’d love to hear additional feedback from readers on the credit crunch issue facing commercial real estate and healthcare real estate. Please see the Editor’s Letter on page 2 for more information, or simply e-mail Editor John B. Mugford with a few sentences (that we may use as quotes for our next issue) at editor@hreinsights.com.