In mid-September 2020, even as the COVID-19 pandemic continued to drive weaker occupancy rates, higher expenses, and intense media scrutiny of the senior living sector, a ten-property senior living portfolio was successfully closed in a recapitalization and acquisition deal.
Operated by Seattle-based Merrill Gardens, the portfolio of 1,508 independent living, assisted living and memory care and multifamily units, as well as 29,000 square feet of ground floor retail, attracted a $460 million loan from PGIM Real Estate. In the latest of NIC’s ever-popular Leadership Huddle events, “Deal Structures and Alignment of Interests During a Pandemic: A Case Study with an Operator, Lender and Equity Provider,” three of the principal architects of the deal (with a guest appearance from a fourth participant) got together to discuss its details and the realities of underwriting and capitalizing senior living, even in times of distress.
Bill Pettit, President of R.D. Merrill Company, the parent company of Merrill Gardens, explained that his company, an active developer and operator of seniors housing properties, aims to hold properties over the “very long term.” In 2010, Merrill Gardens financed the ten-property portfolio through a RIDEA structure with Welltower, then called Healthcare REIT. When, in early 2019, Welltower expressed interest in creating liquidity with their 80% share, Pettit agreed to support the move – but was not interested in liquidating Merrill Gardens’ 20%. That triggered a search for new partners.
A central theme of the discussion was the value of trusted, well-established relationships.
Underwriting During a Pandemic
Asked by NIC Chief Economist Beth Mace, who moderated the discussion, what it was like to bring this deal to his investment committee at the height of the pandemic, Brian Sunday, Managing Director of AEW Capital Management, explained the company’s investing philosophy. In addition to investing in some ground-up development, he said, “Our goal is to buy core cash-flowing stabilized assets, obviously with strong operating partners who we have really good relationships with.” The relationship with Merrill Gardens had already yielded several deals, dating back to 2016, according to Sunday. When this deal was presented to him, he was open to taking a closer look at it.
Sunday worked with Merrill Gardens’ team to understand how the pandemic was impacting their business, in order to be able to underwrite it. They looked at projected cash flows over the next several years and were able to “get comfortable” with those models, under the assumption that, as vaccinations come online and the pandemic eases, seniors would return to seniors housing. In investment committee, Sunday’s response to questions on the impact of COVID was to point to pre-COVID performance. “This portfolio was 95% leased for 3, 4, 5, 6 years, maybe longer, and had great NOI growth…if this portfolio doesn’t come back, then the senior housing sector in general is in a lot of trouble.”
Asked about expectations on returns, Sunday acknowledged that they were different than pre-COVID deals. “The hardest part about this deal is that we’re underwriting an NOI that is decreasing…we knew NOI was going to dip 20%-30% from where it was pre-COVID.” He continued, “We wanted a little bit higher return expectation for taking that risk. The lynch pin that really got us over here was the debt. Without the debt this thing was dead on arrival. Based on proceeds and spread and obviously, as we all know, interest rates shot down to basically zero. Where we were able to lock rate really helped us to bridge the gap of the negative NOI drop to the rebound, to make up for that increase in returns that we wanted to get.”
It Isn't If the NOI Gets Back, It's When
Trace Wilson, Executive Director at PGIM Real Estate, said, “The starting place of the conversation, on our side, wasn’t if the NOI gets back; it’s when.” His team was already familiar with the portfolio’s markets as well as the assets in question, which helped them avoid logistical problems caused by the pandemic. Like Sunday, Wilson’s team looked closely at various COVID-19 scenarios potentially impacting occupancy, expenses, and numerous unknowns raised by the pandemic. Eventually, trust was a deciding factor. Wilson said, “I think it goes back to the performance of the portfolio beforehand and confidence in Merrill to be able to do what they said they were going to do.”
Asked about alignment of interests, Sunday responded by pointing to Merrill’s willingness to put dollars into the joint venture. Pettit added that “alignment of interest, for us, is the number one objective we have when finding any partner. This industry is complex…the experience and willingness to work jointly with the operator to achieve the best result for the asset is critical.”
Developing Industry Relationships is Key
Mace then asked what happens if an operator doesn’t have a long-standing relationship. Sunday said, “that’s a great question. I think that’s why we haven’t seen a lot of deal flow get done.” Discussing how he develops new relationships, he said, “a lot of this happens over time. You’re seeing people at the NIC conferences. Even though you might not do a deal, you’re starting to build on that relationship…it takes time. Obviously, if you’re just meeting someone for the first time during COVID, during travel restrictions, it’s difficult to get that level of trust.”
Mace also asked about when the panelists see markets returning to normal. Sunday pointed out that some markets are already bouncing back, while other, more deeply impacted markets will lag behind. “It’s going to be a tale of two worlds, unfortunately,” he said, adding, “The stronger markets are going to come back quickly.”
Ryan Maconachy, Vice Chairman, Health & Alternatives Assets, Newmark, was involved in recapping and raising the debt for the deal. He also emphasized the importance of the strong relationships involved. “Fortunately, we had a great relationship to benefit from with not only Bill and Brian, from past transactions, but also Trace and Brian. Trace’s history of involvement with these assets prior to AEW’s involvement was a huge catalyst to getting this done. As Brian stated, this wouldn’t have happened without the debt, and this wouldn’t have happened without Brian and his team having a great relationship with Bill.” Like the other panelists, he expressed doubt that the deal could have been executed without established, trusted relationships.
Network, Network, Network
As with all Leadership Huddle events, the webinar was followed with an optional Zoom discussion session. In small group breakout rooms, attendees discussed how underwriting terms have changed. There was general agreement that banks have been requiring more recourse than in pre-COVID days. Some concluded that smaller mom-and-pops will now be looking to exit the space, creating opportunities for investors. But another topic of discussion centered on relationships. As one attendee said, when asked about relationships, “network, network, network.” Some things never change.
You can register to attend upcoming NIC Leadership Huddles, including both the live webinars as well as the optional, first come, first served participation in peer-to-peer discussions, within the Events tab on nic.org. Registrants are provided with a recording of the event, compliments of NIC and our generous sponsors and partners.