Here’s a bold prediction: I believe we can all agree that 2024 must be a better year than 2023. The reasons for optimism include:

Operating metrics are improving with occupancy levels largely back to pre-pandemic levels and strong rate increases implemented at most communities. Although rises in labor costs in the sector remain elevated compared to the national workforce - 5.6% versus 4.6% - the growth is moderating and margins improved during 2023. More improvement is likely in 2024, despite rising insurance costs. However, where cash flows ultimately stabilize will depend on the balance of supply and demand for seniors housing and care units/beds.

Changes in capital costs are leveling out; although the Federal Reserve is not ruling out raises, the chance of an increase during an election year seems small. Stable and predictable capital costs will lure some buyers back into the market and may alleviate lender concerns as well. However, most investors recognize that the historically low rates since the Great Financial Crisis are unlikely to return.

However, predicting the answer to the question that every appraiser is asked - what is the cap rate? - has never been so challenging. We are coming off a year where the only transactions were those where the seller was under some necessity to sell and the buyers could close; this reality coupled with scarce capital resulted in a depressed number of transactions and quirky ones to dissect. Adding to the complexity:

-Prices changing from LOI to closing with the volatility in the treasuries;

-Most institutional money sitting on the sidelines;

-Operators merging as smaller groups lack access to capital;

-Lenders unwilling to offer affordable debt when occupancy is below 80% or Day 1 DSCR <1.0;

-More buyers investing on a price per pound basis rather than cap rate or IRR;

-Cash buyers looking at elevated IRRs until financing is in place 18-24 months after close;

-An expected funding gap in the sector of hundreds of millions of dollars; and

-Wide ranging capitalization rates from the few transactions that have occurred.

To make sense of the disparate cap rate indications, we ask the following questions:

What is being capped? Historical (TTM) or the buyer’s proforma net operating income in 2025? Based on our analysis of over 125 sales of properties where we have both TTM and proforma, the impact on capitalization rates are summarized as shown:

Correlation of Margin Increases and Cap Rate Changes (bps)

Source: HealthComps

Understanding what is being capped and using market sales data - rather than preconceived notions of value - to adjust the resulting indication provides insight into values, especially for assets that are not shiny, new Class A communities.

Who is buying and how are they paying for it? Cash buyers who plan to leverage the property a year or two later will evidence cap rates that are 100+ basis points higher than those that are levered at closing. Institutional buyers who can access agency financing can afford cap rates that are 50 to 75 basis points lower than conventional financing.

How was the property marketed and why did the seller want to dispose? By the end of 2023, the participation on bids was higher than the dismal 15-20% levels reported by brokers at the beginning of the year. However, for much of the year with so many lenders on the sidelines, many brokers would only present opportunities to potential buyers who possessed the ability to close. Although harder to quantify than the answers to the preceding questions, a property that was not exposed to the open market will have a lower price and a higher cap rate.

Here’s a case to demonstrate this last point: Two properties built within three years of each other in the same competitive market were both under contact in 2H 2022, 2Q 2023 and finally 4Q 2023:

Source: HealthTrust / * based on buyer proforma

Property A was widely marketed in 2022 and 2023; its price wobbled with the volatility in the treasuries, but remained largely stable while the cap rate expanded by 105 basis points. Cash flows grew to sustain the stable price despite the rise in the cap rate because the operator was able to push rates once occupancy stabilized in 2022.

Property B was widely marketed in 2022 but not in 2023 where only a single buyer was approached. Management also successfully pushed revenue increases but seemed unable to keep expenses in check causing cash flows to stall at about 50-60% of the projected stabilized level. In this instance, the circumstances of the sale and management contributed to the 350-basis-point expansion of capitalization rate and the roughly 35% decline in value.

So what’s the cap rate? Following a year where closing sales required a lot of work, patience and creativity, we are now in an era when we will need to poke through the tea leaves at the bottom of the transactional cup to glean answers to what is no longer a simple question.