Senior Housing Development Feasibility

posted Jul 8, 2014, 7:44 AM by Scott McCorvie   [ updated May 6, 2017, 7:42 AM ]
By Scott McCorvie, Senior Living Growth Advisors - www.srgrowth.com.
With the increasing number of seniors housing transactions trading at a large premium to the replacement cost (sometimes double), along with the increased availability of construction debt, there seems to be a renewed energy in the seniors housing development space. However, what makes a seniors housing development project feasible?

Simply put, a development project is feasible with the expected returns are greater than (or equal to) the weighted average cost of capital (WACC). But, what is the WACC of each project, and how is it calculated? As an equation, the WACC is a percentage-based average of the cost of debt added to the cost of equity (WACC = (% debt x cost of debt) + (% equity x cost of equity)). Since the equity is in a riskier position then the debt (remember, the debt holder will always be paid first), the cost of equity is always higher than the cost of debt.

Let’s say you receive a 75% loan-to-cost construction loan with an effective (inclusive of loan fees, etc.) interest rate of 6%. Also, let’s say you were able to secure the remaining 25% equity from an investor expecting to make a total return of 20%. Multiplying these together will give you the implied WACC of 9.5% ((75% x 6%) + (25% x 20%)). In other words, you would need an unleveraged internal rate of return (IRR, or annualized total return) higher than or equal to 9.5% for the project to be feasible.

Since the internal rate of return includes a holding period assumption and uncertain exit cap rate (to be discussed in a later article), another simpler way to analyze the feasibility of the project is to measure the WACC to the stabilized yield-to-cost. The stabilized yield-to-cost is similar to a cap rate, but divides the expected stabilized net operating income by the total development budget (YTC = stab. income / dev. budget). The development budget should include all fees and costs needed to fully stabilize the project (including pre-marketing costs, development fees, and lease-up/interest reserves). So, for a senior housing development project to be feasible, the stabilized YTC must be higher than the WACC. Also, the selected market rates, care charges, and operating margin should be carefully analyzed to determine the suitability of the proforma assumptions. Since the annual income drives both feasibility metrics, an unrealistic proforma model can artificially inflate or deflate the returns.

Last, one of the most important metrics to determine the feasibility of the seniors housing development project is to analyze the total development budget on a per unit basis. If the development per unit cost is too high, there is risk that another developer will construct a less expensive seniors housing project down the street, be able to charge lower rates/fees, and most likely drive down your operating performance. But, what is an appropriate development cost per unit? Unfortunately, this varies from market-to-market (varying land costs, entitlement, licensure, CON, construction costs), and operator-to-operator (varying pre-marketing costs, management fees, lease-up reserves), but generally can be compared on a segmented basis by allocating the land costs, hard costs, soft costs, FF&E, contingencies, developer fees, pre-marketing costs, and reserves. Feel free to e-mail me at scott@srgrowth.com. www.srgrowth.com.

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