Assisted living's crossroads: Public vs. private rages on

Compete for capital. That is the newest mantra followed by America's assisted living industry, estimated to be a $15 billion component of the total $100 billion+ long-term care industry. While it is no secret that assisted living continues to be the hottest seniors housing segment, the impact of public companies such as American Retirement Corp. (see our profile in this issue of Continuum on pages 6-7), Sunrise Assisted Living, Brookdale Living Communities, CareMatrix Inc., Alternative Living Services, Emeritus Corp. and Capital Senior Living Corp, among others, cannot be denied.

The public vs. private corporate-structure debate ties in nicely to the industry's own public vs. private pay debate: Will the government step in with regulations, and if so, when? (Presently, oversight is primarily at the state level.)

One key to this debate is the soon-to-be-released report from the General Accounting Office (GAO) to Congress. Though the report is only expected to inform and educate Congress about issues, reaction has already been on the negative side - on Feb. 4 a major Wall Street brokerage firm suspended coverage of its ratings in the assisted living sector, causing panic for investors and some industry-leading stocks to drop by more than 20%.

Also, much has been made of the supply/demand dynamic of the assisted living industry in recent years, but our purpose here is to address the investment environment that presently exists for this seniors housing segment. Is there too much overbuilding for projected demand? Is capital still available to the industry, and how much? And what does that capital expect in the way of property performance over the short and long term?

Much will be made of these key issues later this month during the Assisted Living Federation of America's annual spring conference in Dallas, April 18-20. But to get a jump on these questions, we've enlisted the help of several noted industry professionals, including Al Holbrook, president and CEO of EdenCare Senior Living Services and current chairman of the Assisted Living Federation of America (ALFA); Paul Klaassen, CEO of Sunrise Assisted Living; Karen Wayne, president and CEO of ALFA; Mel Gamzon, president of Senior Housing Investment Advisors; and David Schless, executive director of the American Seniors Housing Association (ASHA).

RECENT LEGG MASON STUDY To set the tone for our discussion, we look to a recent study published by Legg Mason Wood Walker Inc., of Baltimore. In the firm's publication, The Assisted Living Industry: What a Difference a Year Makes!, Legg Mason says a discernible trend is occurring in assisted living, which is a shift from real estate to healthcare.

"A little over a year ago, investors could not get enough of the stocks of companies operating in the relatively nascent public market for assisted living," says the report. "Investors were attracted to real estate development and industry revenues that largely derive from private pay sources, as well as to the demographic story that this product was a potential solution for the 'graying of America.' As the industry became a public market play, investment interest ranged from real estate to demographics with some healthcare interest; over the past year, public companies within the industry have begun to act upon the healthcare service component of the industry, seeking internal growth by expanding length of stay and revenues per resident through a continuum of services and settings to support 'aging-in-place' while continuing development activity. This 'shift,' combined with investor concerns regarding overbuilding and choice of (as well as access to) financing, has caused both investor dislocation and more differentiation among companies."

So if that is the case, what types of financing are available to the assisted living sector? According to Legg Mason, "It appears that most lenders are meeting the needs of the assisted living industry via construction loans and permanent financing. At the time that the NIC [National Investment Cen-ter] survey was conducted, it seemed that investors and lenders were going to provide more funding of all types of financing in the future. We believe that the cost to the industry of this capital will rise over the short term."

The report goes on to say that financing is broken into two broad categories: Development/construction and long term.

"Much of the industry's development and construction activity has occurred off-balance-sheet to lessen the impact on the income statement due to losses generated by start-up operations. In our view, companies will continue to utilize various alternatives in order to achieve multiple objectives. Once a facility is open and reaches predetermined operational targets, the property is usually converted to a longer-term financing tool, such as sale-leaseback, sale-management, synthetic lease or conventional structures. Sometimes a particular type of lender, such as a real estate investment trust, can provide both development and construction and long-term financing. Over the long term, however, we believe ownership of assets is more positive as it provides flexibility for companies to recycle capital and realize the value created in the real estate."

THE INDUSTRY SPEAKS The Legg Mason report provides a good tee-up for several industry leaders to speak out on the state of the assisted living sector. Continuum asked key executives to give us their thoughts, and here is what they had to say.

AL HOLBROOK PRESIDENT & CEO EDENCARE SENIOR LIVING SERVICES INC. Q: What types of capital sources are now available to the assisted living industry?

Holbrook: A wide variety of equity/debt services are still available for successful private and public companies. The public equities market is currently not favorable for "small cap" stocks. Therefore, we should not expect additional initial public offerings or major secondary public offerings of assisted living companies until these markets change.

Recently, several opportunity funds have been created to merge and/or acquire strategic assets. Conventional loans and mezzanine financing are available for well-capitalized performing companies. The HUD 232 Board of Care Program as credit enhancement to capital vehicles are available in many areas of the country.

Q: Which has the advantage in today's marketplace, private or public firms? Holbrook: Well-capitalized, well-managed public and private companies with deep intellectual resources hold the best advantage.

Q: Is overbuilding a concern?

Holbrook: The fundamentals of this business have not changed. This is and will continue to be the driving force which will avoid; major overbuilding. Yes, there are markets which are currently saturated, however, this product will rapidly be absorbed for a number of reasons. There is an exponential increase in demand variables. Recently the supply of capital has been "shut off" to small, inexperienced operators, stopping many planned communities from being constructed. The age of the "consumer" is moving customers to choose assisted living communities over skilled nursing facilities. And the recent demise of the nursing home industry in combination with their general financial inability to replace and upgrade physical plants is driving many customers to assisted living alternatives.

Q: What new concepts in AL are catching your eye?

Holbrook: Wellness centers/spas contiguous to assisted living communities. Also disease protocols for chronic care conditions incorporating integrative medicine. And expanded memory impairment programs.

Q: How real is the reimbursement issue today?

Holbrook: We will see a movement toward a new chronic care reimbursement system. As long as the monies for such a system are controlled by a third-party payer and not the customer, we all lose. In the case of a government system, we must lobby for an assisted living voucher program which has reasonable cost caps and allows for families to subsidize their loved ones for additional services as desired.

MEL GAMZON PRESIDENT SENIOR HOUSING INVESTMENT ADVISORS Q: What types of capital sources are now available to the industry?

Gamzon: There is no question that the financing environment has changed dramatically during the past six months. Both equity and debt have become more difficult to procure. While this situation has yet to impact the value of real estate transactions in our industry, it is likely that the cost and availability of capital may, in the near term, begin to erode property values and accelerate consolidation, which has already begun.

On the equity side, venture capital and real estate opportunity funds have intensified their interest in the assisted living business. Likewise, pension funds and their advisers have begun to make investments in the industry. Armed with stringent underwriting standards, these new sources of equity are "cherry picking" only the prime investment opportunities.

Debt sources are also driving a tougher bargain than six months ago. The flight to quality and safety has effected transaction costs to borrowers. Deals are still getting done, but the terms have tightened considerably.

Also, while the public equity markets remain optimistic about the prospects for industry growth, we anticipate accelerated activity in this important financing sector as we approach the new millennium.

The interest in IPOs will likely heat back up within the next 12-18 months in response to compelling demographics and the shakeout of under-capitalized assisted living entrepreneurs.

PAUL KLAASSEN CEO SUNRISE ASSISTED LIVING Q: Who has the advantage today, public or private firms?

Klaassen: If there is an advantage for the public company, it's the cost of capital. Public companies tend to be able to raise considerably cheaper capital. For example, Sunrise has raised $400 million in the public markets within the last three years. When I raised capital as a private company from limited partners, they wanted a pretty high rate of return. So cheaper capital is probably the biggest advantage a public company has over a private one. Also, it became a little easier for us as we got bigger to obtain construction lines rather than project-specific financing, and this allows us to move a bit quicker.

Having run a public company and a private company, I can say that a public company has the advantage of the discipline that comes from being a public company. Public companies tend to have to budget very well and plan very well. I believe we plan better because as a public company we are more disciplined with our budget process, our forecasting, our training and the activities we plan.

Q: Who is creating affordable models?

Klaassen: The biggest problem with building an affordable model is that the cost is not tied up in the building, but rather in the operating expenses.

The cost of assisted living is in the operating expenses, and that's why unless there's a third-party source of labor or a completely free building, you're not going to be able to really serve lower-income residents the way other forms of real estate can by building a cheaper building.

This is a very important distinction between housing and the more complex assisted living business.

For more information about the Legg Mason Wood Walker report, contact Vice President Jerry Doctrow in Baltimore at 410-454-5142.

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