It’s a tale of two markets and many influencing factors as we move further into 2023. The capital markets remain hostage to the Federal Reserve which continues its course of tighter monetary policy and higher interest rates. Most pundits believe this will continue through mid-year 2023 until tangible evidence emerges of decelerating inflation, and in particular service inflation. Meanwhile, market fundamentals continue to improve for senior housing, with rising occupancy rates, strong demand patterns, and limited, albeit on-going, inventory growth.
Against this background is the broader economy, beset by uncertainty and risk. Today’s economy is an “economist’s dream of two hands.” On the one hand, there is a relatively strong labor market with January’s unemployment rate slipping back to 3.4%, the lowest rate since 1969, while monthly jobs increased by a very robust 577,000 positions. But on the other hand, an inverted yield curve since July 2022 has been signaling recession warnings. Moreover, recent surveys of professional economists put the probability of a recession in the next 12 months at close to two-thirds. This is a very high percentage and raises a risk of a self-fulfilling prophecy if consumers believe this to also be the case. And at this point, the University of Michigan consumer sentiment survey results remain in recessionary territory, despite an uptick in early January. And, lastly, the residential and commercial real estate markets have weakened sharply. How should one process these mixed signals in the context of senior housing?
Transactions Market. The transactions market for senior housing and care was weak in 2022, roughly returning to levels seen during the pandemic in 2020, which was the lowest volume of traded deals since the aftermath of the GFC in 2010. Preliminary data suggests that closed volume for 2022 totaled $9.7 billion, down more than 50% from 2021. Like other commercial real estate property types, much of the slowdown in transactions activity occurred in the second half of 2022 as buyers and sellers reacted to the sudden and rapid shock of surging interest rates orchestrated by the Federal Reserve. Bid/ask spreads widened as both buyers and sellers reacted to a higher cost of debt capital, more limited debt availability, and underwriting that has confounded years of standard underwriting assumptions. The shift from virtually free money in a near zero-interest rate environment to more than 4.3% for short-term interest rates such as SOFR, plus widening risk spreads, has stopped many would-be deals in their tracks as preferred investment returns have become unachievable.
It’s very likely that the debt markets will remain restrained through the first several months of 2023 as lenders wait for the so-called “pivot” by the Fed when it will signal that rates are not moving higher. And without debt capital, transactions activity will remain stalled for many, although not all, deals. Those equity providers with closed-end funds that need to execute due to the fund life terms of their contracts and those investors with open-end core funds that have redemption queues may need to transact. In addition, there will be operators that can no longer meet their debt obligations and equity requirements and will be forced to sell, creating a distressed sales buying opportunity for some investors, particularly opportunistic funds. However, the landscape will remain clouded by uncertainty, and a murky environment is not one that business decision makers generally like to operate within.
Market Fundamentals. Senior housing property market fundamentals continued to improve in 2022. The overall occupancy rate for the 31 NIC MAP Primary Markets increased 2.8 percentage points from year-end 2021 to 83.0% at year-end 2022, according to NIC MAP Vision. On a quarterly basis, the occupancy rate increased for the sixth consecutive quarter in the fourth quarter of 2022, making it 5.2 percentage points higher than at its pandemic-related nadir of 77.8% in the second quarter of 2021.
While good news, the question remains when will the overall occupancy rate return to its pre-pandemic level of 87.1%, last seen in the first quarter of 2020, and when may it return to even higher levels? At this point, there remains a 4.1 percentage point gap between the most recent occupancy rate and its pre-pandemic level. Holding it back, at least partially, has been ongoing growth in inventory. Despite a slowdown in construction starts for senior housing, the stock of senior housing units continues to expand and has grown by 6.3% (41,000) units since the pandemic began. That has been more than the market has been able to absorb on a net basis, despite relatively strong demand patterns.
Indeed, on the demand side the equation, net absorption, or the change in occupied units, has been very impressive since early 2021, with quarterly gains averaging nearly 7,500 units, three times more than its pre-pandemic historical quarterly pattern of 2,500 units. Moreover, the number of senior housing units occupied by older adults has never been stronger and reached a record high in the fourth quarter of 2022. Pent-up need, a compelling value proposition of residing in senior housing, and a relatively strong economy have supported demand.
Notably, however, demand has not been strong enough to recover the units placed back on the market during the pandemic (45,000 units) plus the new units opened (41,000). Hence, the occupancy rate, which takes supply and demand into account, remains below pre-pandemic levels.
What’s Ahead? Today’s starts will translate into tomorrow’s inventory growth, albeit with a lag. Fourth quarter starts in 2022 continued to moderate, especially for assisted living, but they were not zero, as some developers were still able to break ground on new projects. Indeed, starts totaled 7,230 units for assisted living on a four-quarter basis in the Primary Markets in the fourth quarter, and 7,435 units for independent living. These groundbreakings will take root and turn into openings in approximately two years and create new supply. And as this happens, inventory growth will exert downward pressure and limit the pace of occupancy rate improvement.
Regarding demand, the combination of a potential recession anticipated for 2023 (albeit a mild one), along with a collapse in residential home sales, waning consumer confidence, rising interest rates, fear of inflation and eroding purchasing power, and a plunge in the stock market all pose threats to continued strong net absorption patterns.
Further, the threat of operational reputation risk is growing. Negative performance at a few properties by a limited number of operators has the potential to hurt the entire reputation of the industry and to create ancillary risks for all operators and their financial partners. This may especially be the case for the one-third of senior housing properties in the Primary Markets (1,788 properties) that had occupancy rates below 80% in the fourth quarter. The ability of the operators of these properties to service debt (in a more stringent debt environment), maintain margins (in a very inflationary environment), grow census (in a weakening economic environment), and provide quality resident experiences (of utmost importance) is difficult. The combination of these factors will add further stress to operators despite two years to date of broad pandemic recovery.
Taken as a whole, it is likely that we will see additional stress on operators in 2023, until at least mid-year, when the Federal Reserve may slow or even stop interest rate increases. At that point, the Fed may have sufficient evidence that inflation, and especially service inflation, is moving back toward its 2% target range. The Fed has indicated that it is particularly mindful of core service inflation less housing. A slowing economy, rising joblessness, employee layoffs, and slowing wage growth will be other considerations of the Fed, should it decide to “pivot” and reverse course on rising interest rates. Already, the most interest-rate-sensitive sectors of the economy have screeched to a halt, including the manufacturing sector which has weakened sharply due to a pullback in consumer demand and the residential and commercial real estate markets.
Wage Growth Slows, Job Growth Improves. On the plus-side for the senior housing and skilled nursing sectors is evidence of slowing wage growth and improvement in hiring. Indeed, the assisted living industry had recaptured and rehired 100% of the employees who had left the sector as of December 2022 (note that these positions may not be being filled by the same people). For skilled nursing, employment increased during the last eight months of 2022 for a gain of 33,000 positions. This remains well below the pre-pandemic peak, however, with another 13% of those vacated positions still needing to be hired.
Wage growth is beginning to temper a bit as hiring improves. In November, average hourly earnings for assisted living were up by 7.8% from year-earlier levels, higher than the 4.8% seen for the broader economy, but a sharp deceleration from the 10.7% annual increase seen in May 2022. Similarly in nursing care, wage growth decelerated to 8.0% in November from year-earlier levels, down from 11.7% in March 2022.
Wrap Up. The ability of the Fed to steer the economy into a so-called “soft landing” to avoid a recession is difficult if history is any indicator. And even if a recession is averted, the pain of rising interest rates and high inflation has been evident already to most businesses, consumers, and workers. For senior housing operators and capital providers, there are certainly near-term challenges, uncertainties, and risks ahead, but there are myriad promising opportunities as well, if the proverbial crystal ball can extend beyond this near-term business cycle.
As always, I appreciate and welcome your comments, thoughts, and feedback.
This article has been updated since its initial publication in the February edition of the NIC Insider Newsletter.
About Beth Mace
Beth Burnham Mace is the Chief Economist and Director of Outreach at the National Investment Center for Seniors Housing & Care (NIC). Prior to joining the staff at NIC, she served as a member of the NIC Board of Directors for 7 years and chaired NIC’s Research Committee. Ms. Mace was also a Director at AEW Capital Management and worked in the AEW Research Group for 17 years. While at AEW, Ms. Mace provided primary research support to the organization’s core and value-added investment strategies and provided research-related underwriting in acquisition activity and asset and portfolio management decisions. Prior to joining AEW in 1997, Ms. Mace spent ten years at Standard & Poor’s DRI/McGraw-Hill as the Director of the Regional Information Service with responsibility for developing forecasts of economic, demographic, and industry indicators for 314 major metropolitan areas in the U.S. Prior to working at DRI, she spent three years as a Regional Economist at the Crocker Bank in San Francisco. Ms. Mace has also worked at the National Commission on Air Quality, the Brookings Institution and Boston Edison. Ms. Mace is a member of the National Association of Business Economists (NABE), ULI’s Senior Housing Council, the Urban Land Institute and New England Women in Real Estate (NEWIRE/CREW). In 2014, she was appointed a fellow at the Homer Hoyt Institute and was awarded the title of a “Woman of Influence” in commercial real estate by Real Estate Forum Magazine and Globe Street. Ms. Mace is a graduate of Mount Holyoke College (B.A.) and the University of California (M.S.). She has also earned The Certified Business Economist™ (CBE), which is the certification in business economics and data analytics developed by NABE. The CBE documents a professional’s accomplishment, experience, abilities, and demonstrates mastery of the body of knowledge critical in the field of economics and data analytics.
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