Value-added financing: leasehold vs. mortgage financing in seniors housing

During the past three years, real estate investment trusts (REITs) have emerged as a ready source of capital for rapidly expanding assisted living companies. Attracted by the allure of little or no equity investment required in the facility and the REITs' strong demand for healthcare product, assisted living operators have been increasingly using REITs to develop and expand their portfolios. REITs have thus become a primary source of capital to the industry.

Typically, assisted living operators enter into an operating lease with a REIT via a sale/leaseback transaction. Base lease payments are then set at 300 to 500 basis points over the 10-year Treasury bill rate and allow the REIT to participate in the performance of the facility through annual escalator payments. Escalators are typically in the range of an additional 20 to 30 basis points compounded annually. In comparison, a conduit lender will finance 80% of the facility's value at an interest rate ranging from 180 to 300 basis points over the corresponding Treasury bill rate and does not participate in the upside of the operations of the facility.

Given the early stages of the growing assisted living industry, REIT financing is an attractive alternative to many start-up operators, who comprise a majority of the industry. Sale/leaseback transactions allow these operators to maximize their limited supply of capital, due to the zero equity requirements associated with these transactions. However, the REITs typically charge a premium for the low equity requirement, typically ranging from 15% to 25% over the interest rate charged by conduit lenders. To the extent that the public equity markets continue to value assisted living companies as a multiple of cash flow, understanding the benefits of mortgage financing vs. leasing is imperative to the financial success of the assisted living operator. Companies that are leasing their facilities are at a higher risk of receiving a lower valuation in later years, when the amount of the lease payments is likely to exceed the mortgage payment for the same facility, negatively impacting cashflow.

In an effort to understand the aggregate effects of owning the same facility via a conduit loan vs. leasing the property from a REIT, the following example is suitable.

In the case of the lease, an adjustment to cashflow would be made in the form of interest income as a result of the reduced cash investment associated with a REIT lease. In both cases, the equity requirements associated with the first year are considered, and it is assumed that the facility has been fully stabilized during a 10-year period. The net present value of the mortgage payments would be lower than the net present value of the lease payments. Further, the incremental increase in the value of the building being financed over the 10-year term loan reverts to the lessor in the sale/leaseback transaction vs. the owner/operator in the case of a mortgage loan. For instance, assuming an increase in the value of the building at a compounded growth rate of 3% annually, the net present value (discounted at 12%) would be $2.62 million. Therefore, the mortgage results in approximately a $3 million cost benefit over leasing the same facility from a REIT.

The economic benefits clearly point to the benefits of real estate ownership vs. operating lease transactions. The benefits of ownership should allow the operator more flexibility in meeting future financing needs for expansion. This is done by providing an asset that can be further leveraged through refinancing. Assisted living providers could better ensure their long capital value by maximizing their ownership of facilities operated rather than leasing the same properties.

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