John Erickson is on a roll. He just completed a 1,700-unit senior housing project in Springfield, Va. By the end of 2005, he expects to finish Ryderwood Village, a $425 million complex in Silver Spring, Md. The new development will be the largest of its kind in the country, providing assisted living and other accommodations to about 3,000 elderly residents. Ryderwood will be a small city with its own church, dry cleaner and medical center.

Erickson, who is CEO of Baltimore-based Erickson Retirement Communities, has big plans. Currently operating 13 projects, he expects to go on a building spree in the next five years that will raise his total number of developments to 40. Erickson started his private company in 1983, scrambling to finance the first senior project. But in the past several years, he has assembled a collection of finance sources, including banks and investment houses such as Morgan Stanley.

Such sophisticated lenders have become convinced that Erickson will benefit from growing markets. Part of what inspires confidence is that Erickson's veteran projects have waiting lists of customers eager to buy. A development in Baltimore currently boasts a list with 1,300 names. “There is a huge demand for the products that we build,” says Erickson.

In the fragmented senior housing category, Erickson is unusually aggressive. But the business is healthier than it has been in years. Occupancy rates are climbing and loan defaults are rare. At a time when many sophisticated investors are turning their attention to real estate, more institutions are discovering the appeal of senior housing and are hot on the acquisition trail. While capitalization rates for prime apartments and offices are dipping to 6%, and in some cases even lower, independent-living facilities are boasting rates of 9.1%, according to the National Investment Center for the Seniors Housing and Care Industries (NIC), a Washington, D.C.-based nonprofit organization.

Along with tempting yields, many top properties boast solid track records for maintaining occupancy and delivering returns. Institutional investors report that assisted-living facilities rank as one of the top-performing real estate categories of recent years. John Dark, a principal with Prudential Real Estate Securities in Atlanta, says his senior-housing investments have produced double-digit returns in the past two years, easily outperforming apartments and other segments. The big returns can be traced to relatively rich yields and property appreciation that occurred as the markets revived from their downturn.

Painful lessons learned

The improving fundamentals in the senior housing sector are a stark contrast to a few years ago. The problems began in the mid-1990s when Wall Street fell in love with senior housing. Convinced that an aging population would crave new retirement properties, senior housing companies went public and sold stock. Throughout the country, flush new operators went on a building spree. “People thought that you could just build it, and they would come,” recalls Tony Mullen, director of research for NIC.

While some of the new developments offered independent living for self-sufficient seniors, many projects focused on assisted living, where the elderly receive meals and help with daily activities. Excessive supplies of assisted-living facilities appeared, and occupancy rates collapsed, hitting a low of 83% in 2002, according to NIC. The wave of vacancies forced the industry to go through a painful adjustment.

Since 2001, new construction has stayed below an annual pace of 30,000 units, sharply down from the 65,000 units built in 1999, according to the American Seniors Housing Association (ASHA) based in Washington, D.C. Big developers, such as Marriott and Wyndham have exited the business. With new demand absorbing excess supply, occupancy rates for assisted-living facilities climbed to 87% by January 2005. NIC says that in many of the 30 largest cities, rates have reached 94%.

Now that markets are stronger, will developers once again overbuild? The answer is an emphatic “no” in the short term. “Lenders and developers are wiser and more experienced now,” says Mullen of NIC. In the 1990s, developers were intoxicated with the idea of a growing elderly population, Mullen says. But now builders and lenders understand that the potential market is only growing at an annual rate of less than 3%. Elderly people don't consider senior housing until they reach the age of at least 75, Mullen says. “The big wave of baby boomers won't begin hitting this market for another 15 years.”

Faced with moderate demand, developers have even stopped new construction in some areas. Thomas Grape, CEO of Benchmark Assisted Living, a developer based in Wellesley Hills, Mass., says that there is no major new construction in the six New England states. Part of the problem is that construction costs have skyrocketed. “It is cheaper for us to buy existing facilities instead of building new projects,” says Grape. Benchmark recently acquired Village Retirement Communities, nine projects in southern New England.

Bidding up prices

Healthy returns are attracting pensions and other institutions that previously never considered investing in senior housing, says Dark of Prudential. In the past, institutions perceived the sector as small and immature. Data on the category was hard to find, but that's changing.

Now trade groups such as NIC and ASHA are providing data on occupancy rates in major markets and the average purchase prices that residents are paying. At the same time, developers and financial institutions have a more sophisticated understanding of what works in the sector. “More institutions are learning about the industry, and they feel more confident about investing in it,” says Dark.

Real estate investment trusts and foreign buyers are purchasing top-tier properties, bidding aggressively and pushing up prices. For assisted living, the cap rates have dropped from 11.7% in 2001 to 10% now. “The decline in cap rates has accelerated in the past 12 months,” says Bob Kramer, president of NIC.

Prime properties command particularly low cap rates. In October 2004, Kuwait Finance House, a public financial company with $11.5 billion in assets, announced that it would participate in a $148 million deal involving an 11-property package owned by Benchmark Assisted Living and AEW Capital Management. Investors estimated the cap rate at 8.25% for the properties, which are located in six New England states. “The acquisitions market is red hot,” says Mel Gamzon, president of Senior Housing Investment Advisors, a broker in Fort Lauderdale, Fla. “We are seeing cap rates at historically low levels.”

One of the most active acquirers of late has been CNL Retirement Properties, a private real estate investment trust based in Orlando. In 2004, CNL paid $537.5 million for a portfolio of Horizon Bay Senior Communities, which includes 19 properties with 3,400 units in Alabama, Arizona, Texas, and other states.

Another notable acquirer is Carlyle Group, a Washington-based global private equity fund with $16.2 billion under management, which is famous for its big-name executives, including former Secretary of State James A. Baker III and former Secretary of Defense Frank C. Carlucci. The fund is known for focusing on venture capital and other glamorous investments. But recently Carlyle has begun buying high-quality senior housing. In 2004, the Washington fund bought an assisted-living facility in Queens, New York, for $25.5 million at a sky-high figure of $188,000 per unit. Developers say that building typical new units in New York costs around $150,000.

Acquisition criteria

While the big players have bid ferociously for some deals, institutions are only interested in the high-quality investment-grade properties, which account for about 10% of the 21,000 senior projects nationwide. Most of the industry includes family-owned operations and bare-bones facilities run by nonprofits. Prices of second-tier properties have remained relatively flat, with cap rates exceeding 10%.

Cap rates for independent-living units have traditionally been about 300 basis points higher than for apartments. That gap is narrowing as investors come to see senior housing as a safer bet. But senior housing is always likely to provide a somewhat fatter yield because the field comes with unique challenges. Many owners and operators of senior housing aim to provide either independent living or assisted living. While tenants in independent living facilities may still be active, the projects must include bathrooms and halls that are suited for frail tenants. Many projects serve up to 30 meals a month.

Operators of assisted-living projects must go even further, helping tenants with daily tasks, such as bathing and taking medication. The business of supplying such services can be risky. The history of the senior housing industry is filled with players who went bankrupt because they could not deliver the quality of assistance that customers expected. Assisted-living projects do not depend on the vagaries of Medicare funding, but the extra health services provided by developers — and the risks that come with them — help explain why assisted-living properties tend to yield 100 basis points more than independent-living facilities.

Steady demand

For all the operational difficulties of senior housing, observers expect the sector to continue enjoying modest growth this year. “Demand will steadily increase, but I don't think we will suddenly see a boom,” predicts Mark Schulte, chairman and CEO of Brookdale Living Communities, a Chicago developer. Despite the challenges, some top builders are finding financing and forging ahead with new projects.

One of the most aggressive owners and operators is Holiday Retirement Corp., which plans to build 12 projects in the next year with about 1,400 units. Based in Salem, Ore., the private company runs 294 projects with 34,962 units, ranking second in the ASHA 50 list of top managers. Occupancy for the portfolio is at 92%, up 1.5 percentage points from a year ago. With demand strengthening, the company has been able to raise its average rents 3% in the past year to $1,775.

Holiday recently completed one of its typical developments, Lighthouse Point, a 115-unit project in Chesapeake, Va. The three-story, garden-style building includes 35 studios, 65 one-bedroom apartments, 15 two-bedroom units and is 75% occupied. To keep such buildings full, the company works hard to provide the personal touch. The developer employs two couples who serve as live-in managers. Residents can call for assistance 24 hours a day. The project provides meals and maid service that are aimed to please customers. “The best way to attract people into the building is by winning referrals from customers who feel at home,” says Mark Burnham, who is senior vice president of Holiday Retirement Corp.

Economies of scale

Erickson Retirement Communities, one of the most innovative builders and managers, ranks 9th on ASHA's 2004 list of top managers with 11,664 units. Erickson's strategy is to achieve some of the lowest industry costs through economies of scale. Each project is essentially a small city with 2,000 units on one campus. Residents need not travel anywhere for services. Located on the campus are doctors, convenience stores, a pharmacy and a bank.

The development offers a wide range of classes, ranging from art to lectures by university professors. In contrast, most competitors build projects with about 200 units. By spreading costs among many tenants, Erickson can charge $125,000 for a unit, underselling competitors that typically charge $200,000 or more. “We can reach the broad middle class, while other companies can only market to people with incomes in the top 10% of the population,” says Erickson.

Partly because of the low costs, Erickson can fill its developments quickly, sometimes absorbing as many as 50 new tenants a month. Besides providing low prices, Erickson offers easy financial terms. Early in his career, Erickson decided to make entrance fees refundable. This was sharply at odds with the policy of many competitors.

In a traditional arrangement, a community might charge an initial fee of $125,000 and then collect monthly rent. Departing tenants might be refunded 80% of the initial fee, or a sliding amount based on the number of months they stayed. But Erickson agreed to return 100% of the initial fee — no matter how long the tenant stayed. This reassures tenants and their children who worry that the elderly resident may only stay a short time before dying or moving to a nursing home.

Another element of the Erickson formula is to combine independent and assisted living in one development. That way if a tenant becomes incapacitated, he or she can simply move 100 yards down the street to an assisted-living facility. For couples, the structure is comforting.

This blending of different kinds of senior housing product types on such a large scale contrasts sharply with many developers who build only specialized projects that are exclusively for independent living or assisted living.

Brokers say that more developers are likely to follow the blending strategy pioneered by Erickson and others. Studies by NIC show that developers can charge $500 a month more for an independent-living unit when assisted living is present on the same campus. “People are very determined not to move again,” says Mullen of NIC.

Studios with elbow room

Elderly consumers have become increasingly demanding about the kind of apartment they will accept. Customers want help with transportation to cultural events and a full range of activities at their projects. Brokers report that customers are seeking bigger rooms with full kitchens. Tiny studios are much harder to sell than big apartments of 1,000 sq. ft. or more. “In assisted living, many projects traditionally have offered a 300 sq. ft. room,” says Mullen of NIC. “Now customers are saying that they want at least 400 or 500 sq. ft. and a separate bedroom.”

Brokers report that some of the strongest demand comes in traditional retirement areas, such as California, but that assisted living is thriving in many parts of the country. Most often, elderly tenants want to be near their long-time homes and families. “This new generation of retirees is active, and they are more willing to consider senior housing,” says broker Gamzon. “They want computer access and part-time employment opportunities. Developers who can provide the right environment will do well.”

Stan Luxenberg is a New York-based writer.

Brookdale carves out niche by going upscale

To stand out in the crowded market for senior housing, companies are offering more sophisticated amenities. Some developments offer swimming pools, health clubs and a full range of classes. A leader in catering to fussy customers is Brookdale Living Communities, a Chicago company that specializes in serving upper and upper-middle income consumers.

Brookdale's flagship unit is a 37-story tower on Chicago's tony Lake Shore Drive. Customers pay an average of $2,700 a month for a unit in one of Brookdale's independent-living facilities. That compares with the industry average figure of $2,100. To receive help with bathing and other chores in an assisted-living facility, Brookdale residents pay an average of $3,300.

Some of Brookdale's most elaborate units are located in Hallmark of Battery Park, a 14-story building in lower Manhattan that resembles a stately hotel. Residents pay average monthly charges of $5,500. Many of the 241 units boast commanding water views. Uniformed waiters serve meals in dining areas with white tablecloths and elegant furnishings. “This is not the traditional old folks' home,” says Mark Schulte, chairman and CEO of Brookdale Living. “Our customers are used to staying at the Four Seasons and expect that level of service.”

Brookdale serves 8 million meals a year in restaurant-style settings. To maintain its reputation for high-quality dining, the company spends on food research and development. With 62 properties and 11,499 units under management, Brookdale ranks as the 10th largest manager of senior housing and 12th largest owner in a listing complied by the American Seniors Housing Association.

In the past year, occupancy in the Brookdale portfolio has climbed 2 percentage points to 94%. But the private company has decided to put new construction on hold until markets strengthen. Instead, the senior housing owner plans to focus on improving its properties and winning new management contracts from other owners. Brookdale recently won a management contract from Cypress Senior Living to run eight properties in Dallas, Tulsa, and other cities.
Stan Luxenberg