While skilled nursing operators have been battling industry headwinds for some time, interest rates are now in the mix. For example, one month LIBOR increased to 2.51% from under 0.20% in 2015. Because of this shift, skilled nursing facility operators should be asking several questions: How will this impact my ability to refinance with HUD? Will this impact the value of my portfolio and potential buyers’ ability to obtain financing? What’s going to happen to interest rates, and how do I protect myself?
Despite a volatile year in the markets with trade tensions and political news at the forefront, overall economic data for 2018 was largely favorable. Driven by a recovering economy as well as the tax cuts implemented last year, unemployment dropped to 3.7% and Q3 GDP is at 3.5%. As a result of the tight labor market, average hourly earnings have started to pick up in the last year. Optimism around the prospects for future growth appear to be diminishing as the impact of the imposed tariffs as well as the higher level of overall rates trickles through the economy.
Since the Fed embarked on this tightening cycle in 2015, borrowers have maintained an increased focus on short term interest rates. After the December rate hike, Fed Funds are now 2.5%, and market participants will continue to look for insights as to the Fed’s view on future rate hikes as well as the neutral rate.
The swap curve continued to flatten in 2018 with parts of the short end of the curve inverting in December. While the short end of the curve is currently inverted, the spread between the yield on the 10 year treasury and the 3-month T-bill is currently at 29 bps. The curve shape is tracked by market participants since some view an inverted yield curve as a leading indicator of an upcoming recession.
Additionally, HUD rates generally trend with the 10-year Treasury with the exception of movements in the credit spread demanded by investors, which can swing over periods. The 10-year Treasury is around 2.66% today, was around 2.4 percent a year ago, and reached a 12 month high of 3.24% in November. Currently, HUD term loan rates are in the mid-4% range, excluding Mortgage Insurance Premium.
In addition, with rising rates creating higher debt service hurdles, we’re seeing more discipline from HUD in their underwriting. They continue to look closely at trends and especially the trailing twelve months performance. Appraisals must be thoughtfully reviewed. The department works with lenders, for the benefit of borrowers, with flexibility and waivers and extensions where it makes sense.
On a positive note, the increase in short-term interest rates has been partially offset by a flow of bridge lenders willing to lend at lower spreads and more aggressive terms or even keep the loans on their balance sheets for longer periods of time. Buyers are still able to find debt capital at attractive terms, which has helped keep cap rates steady despite the rise in interest rates. According to CBRE U.S. Senior Housing & Care Investor Survey, cap rates for Class A SNFs have dropped 19 bps from spring 2017 to winter 2018 while cap rates for Class B and Class C SNFs have risen just 3 and 1 bps respectively.
What should operators be doing to manage interest risk? Since the hurdles to refinance with HUD will be higher with rising rates, operators should ask for longer terms on their bridge loans to provide extra cushion to get the assets to a point they are eligible for HUD. There are a variety of interest rate hedging products operators can utilize to manage interest rate risk to best fit their needs. Lastly, operators should start the HUD application process as early as possible. The queue for HUD loans is 60-75 days and a lot can happen during that time.
The credit markets and interest rate markets will continue to change. Operators should budget accordingly, look for flexible loan terms, and utilize interest rate hedging products that make the most sense for their unique goals.
Michael Waldron is the senior vice president of healthcare at SunTrust. Kristin Watkins is an investment banking associate at SunTrust. James Neil is a managing director at SunTrust.
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