March 01, 1996

Financing Senior Living Facilities (1996, 10:02)

Financing Senior Living Facilities

Probate and Property, March/April 1996, Volume 10, Number 2

By Timothy J. Boyce
Timothy J. Boyce is a partner with Pepe & Hazard in Hartford, Connecticut, and is a member of the Real Property Division's I-2 (Foreclosure and Related Remedies) Committee, among others.

The senior living housing industry is poised for rapid growth. This growth will need to be fueled by, and in turn will attract, financial capital. A recent survey administered by Coopers and Lybrand indicates that lenders are increasingly drawn to the favorable yields offered by investments in senior housing. Nevertheless, this industry historically has not been well understood by many financial institutions, which may have had little prior experience in the field and may not have kept pace with today's rapidly changing market. Consequently, challenges as well as opportunities exist for those who seek to participate in this burgeoning market


The Graying of America

Several convergent trends are contributing to the growth in the senior living housing industry. The first, and most obvious, is the macro-demographic aging trend of the country's population. America is aging -- and aging fast -- as the elderly population becomes both numerically and proportionately greater than ever before. A number of statistical examples show this trend:

  • Since 1900, the nation's population has multiplied three times; during the same period those over the age of 65 have multiplied eight times.
  • In 1900, persons over age 65 comprised 4% of the nation's total population; today they constitute 11% of the population and are projected to account for 21% by 2003.
  • More than 6,000 Americans turn 65 each day.
  • The 85 and over population segment is the fastest growing age cohort in the United States census.
  • Over one-half of all people who ever turned 65 in the world are alive today.

An older population means a greater demand for housing that caters to that population; the statistics on this demand are equally dramatic. Between 1980 and 1990, the number of skilled nursing facilities, intermediate and long-term care facilities and other senior housing increased by 24%. Twenty-five percent of those aged 65 can expect to live in a nursing home at some point in their lives; this proportion increases to 50% for those aged 85 and older.

At the same time, developments in the health care field and societal pressures have combined to foster far greater diversification and specialization within the industry. The elderly used to stay in their own homes until they could no longer care for themselves, at which point they transferred to nursing homes or, for those who were seriously ill, to hospitals, until they died. This is no longer the case. The focus on managed care and the search for the lowest cost provider at each level in the health care continuum has led to pressure on the admission and staffing policies of all health care facilities, starting with the most acute and continuing throughout the entire spectrum. For example, the emphasis on shorter hospital stays means that nursing homes now see more people with chronic illnesses and people in need of intensive levels of care. This increase in turn has resulted in a specialized approach, with convalescent homes shifting from custodial to chronic and convalescent nursing care; a far slower rate of migration of patients into such facilities, except for patients who truly need an intensive level of care; and the development of many other forms of elderly housing and care.

At the same time, the elderly (and their adult children) are increasingly attracted to the less institutional and more home-like residential atmosphere that assisted living, congregate care and similar facilities offer, and they are resisting movement into more acute care facilities until absolutely necessary. As a result, the senior housing industry has now blossomed into a continuum of care, offering attractions to people at all of life's stages, with specialized facilities developed to accommodate each stage.

This explosive growth has not always been easy to categorize. Part of the confusion in the senior living market is due to the often changing, contradictory and sometimes overlapping definitions of senior housing categories. Gradations among different classes of facilities are often poorly understood. The names of the same types of facilities may differ from one state to another, and the same term may describe far different facilities in different regions. The almost limitless variety of fee payment and ownership structures, as well as the type, scope and delivery of services, further contributes to this confusion. Nevertheless, the four most basic categories of senior living facilities and their defining characteristics are:

  • Skilled Nursing Facility (SNF). In this successor to the nursing home, staff members provide licensed, skilled nursing care and related services for patients who require medical, nursing and rehabilitative services.
  • Assisted Living Facility (ALF). This senior living complex has physical features designed to assist the frail elderly, as well as staff, personnel and programs that assist residents with daily living activities. ("Frail elderly" means anyone requiring assistance with three or more activities of daily living, such as walking, sitting, dressing, feeding and housekeeping.) Units may have kitchens, but meals are provided in a central location. Medical care is not provided, although it may be available on a home delivery basis.
  • Continuing Care Retirement Community (CCRC). This senior living complex provides a range of care that includes housing, health care and various support services. Health care (i.e., nursing) services may be provided for directly in an adjacent facility or through access to affiliated health care facilities nearby.
  • Independent Living Facility (ILF). Also known as a congregate care facility, this is a multi-family complex catering to senior citizens, with a common dining facility. Units have small kitchens for casual use. Limited support services like housekeeping and transportation may be provided.

There are many further subclasses, including adult day care, but these four categories are generally the most prominent segments of the senior housing industry and encompass most of the fastest growing segments. From a financing standpoint, each of these industry segments has unique structural, regulatory and operating characteristics that markedly set it apart from the others. Lenders must be ever mindful of these characteristics when fashioning the appropriate financial structure.

Skilled Nursing Facilities -- Let the Lender Beware

Skilled nursing facilities are unique among the senior housing categories. The first unusual characteristic of an SNF is the way in which care is funded. The combination of the more intensive care typically required by nursing home patients and the longer lives of many elderly quickly exhausts the financial resources of all but the most financially able patients. In addition, some elderly persons transfer their assets well ahead of their need for nursing care. Few people can afford average nursing home costs of $160-$200 a day without depleting their savings and becoming dependent on a combination of government funded programs such as Medicare and Medicaid. One study determined that 67% of older people living alone who entered a nursing home depleted their assets within one year.

Medicare is an insurance program that pays for acute care for certain covered persons (generally those 65 or older and the long-term disabled). Medicaid is a cooperative federal-state funded program that provides medical assistance to low-income persons through reimbursement of health care providers for services rendered to those persons. Medicaid is administered separately in each state, subject to federal guidelines. Medicare provides about 7% of patient revenues, while Medicaid accounts for about 61% of all funding for SNFs, with the balance funded on a private pay basis or with some form of long-term health insurance.

From a lender's perspective, this unique feature is important because federal law (42 U.S.C. 1395g(c)) prohibits the assignment of Medicare receivables and directs the states, as part of their Medicaid plans, to develop similar anti-assignment rules for these receivables. 42 U.S.C. 1396(a)(32). So long as the lender's security interest is nonpossessory and the provider continues to receive funds directly, these anti-assignment provisions are not violated. But when control is vested exclusively in the lender, the enforceability of the lender's rights becomes a problem.

A second unique feature of the SNF is the highly regulated nature of the market, beginning with regulation of the supply of nursing home beds through certificate-of-need laws. Virtually all states have declared a moratorium on nursing home construction as a way of limiting their reimbursement obligations under Medicaid and thus controlling runaway state budgets. In addition, nursing homes are subject to extremely stringent licensing programs. These license qualification standards, and the particular agency that has regulatory authority over such matters, vary considerably from state to state. Licensure standards, as well as state reimbursement policies, are constantly undergoing review and periodic revision. Accordingly, a lender needs to have particular confidence in the operating expertise of the borrower and its managing agent. A lender must require that state regulatory standards are followed; otherwise, as a mortgagee-in-possession or foreclosing owner, the lender may have to satisfy those licensure standards to ensure the continued operation of its collateral.

Although licensing issues are a primary area of lender concern, this problem should not be overstated. State regulatory authorities, by limiting the market supply as they have in recent years, have so increased average occupancy levels that, except in the most egregious cases, state authorities have no choice but to work with the borrower (or, preferably, a deep-pocketed lender) to resolve licensing requirements. These authorities are effectively precluded from closing facilities simply because of the lack of available alternative beds to absorb the spillover caused by a shutdown.

Although SNF operators have enjoyed their protected position, this trend in artificially controlling supply cannot last indefinitely because of existing demographic trends and the aging of most nursing home facilities. Recall that nursing homes were the first type of senior housing to be developed; an estimated 75% of all SNF beds are located in properties more than 15 years old.

Because of the regulated nature of SNFs, the importance of choosing and retaining a successful operator is absolutely critical. Nursing homes are management-intensive enterprises not unlike hotel facilities. In some cases, the ratio of workers to residents may be as low as one to one. Given the strong demand and artificially regulated supply characteristics of this industry, management expertise must be focused, not so much on marketing, but rather on the operational features of the enterprise. In reality, an SNF is a combination housing facility, food service operation and significant health provider, each of which is a significant management undertaking in its own right, and all of which, in combination, require a sophisticated set of skills.

Equally important from the lender's perspective is that the financial lifeblood of the enterprise is largely, and sometimes entirely, dependent on reimbursement from government agencies. Management must be adept at both understanding and satisfying complicated and often changing reimbursement policies to assure an uninterrupted cash flow. Federal regulations permit ongoing reimbursement audits of facilities and subject current owners, under a strict liability standard, to liability for previous reimbursements erroneously made by the government in response to incorrect or fraudulent requests, even if the requests were made by a prior owner. Thus, the importance of a competent and reliable operator cannot be overstated. A bad manager not only may end up cutting off the project's revenue stream but, worse yet, may also end up saddling any lender that later takes control of a facility with the ongoing threat of successor liability for improper past reimbursements.

To assure adequate adherence to applicable guidelines and continuity of competent management, the lender will first want to create far more detailed covenants in the loan documents than are typical; establish extensive audit rights to check on ongoing compliance; and fashion realistic remedies (sometimes called subacceleration remedies), such as penalty fees, to assure that the borrower's attention is engaged short of threatening a total default. If a third party provides management, the lender will want an assignment of borrower's interest in the management agreement and an ability to accept or reject the management agreement following foreclosure.

Surprisingly, given the monopolistic position it currently enjoys, the SNF industry has not proven to be immune to economic forces. First, the primary source of revenue for nursing homes today is Medicaid reimbursement. Medicaid, however, provides little or no profit to a typical provider. In the past, private pay patients made up the shortfall through a higher daily rate structure. In recent years, the private paying segment has been shrinking and, because these patients contribute disproportionately to profits, the effect of this loss on the bottom line has been dramatic.

Second, both market forces, local code regulations and state and local statutes require continual upgrades in facilities and services. State building codes and the Americans with Disabilities Act govern all details of construction; many of the resulting requirements are far more onerous and extensive than when many older nursing homes were built. In addition, in the face of newfound competition with ALFs, nursing homes have tried to upgrade their facilities to make them appear as noninstitutional as possible. Adding space for administrative activities and lounge areas, however, also adds to costs.

Third, Medicaid reimbursement systems continue to become more stringent as state governments focus their budget tightening gaze on these reimbursement systems. As a result, SNFs now seek to attract Medicare patients. Until recently, it was rare for facilities to accept Medicare patients at all because of the complexity of the program, notwithstanding that Medicare typically pays higher rates than Medicaid. This trend has changed as facilities search for Medicare patients as an offset to the decline in private pay patients and the continued pressures on the Medicaid system.

In short, the operation and financial viability of an SNF, despite guaranteed high utilization rates, is far from simple. Accordingly, lenders must be sensitive to the unusual nuances of the income stream, regulatory environment and management requirements at all times to ensure that their loans are protected to the maximum extent feasible.

Assisted Living Facilities: The Up and Comers

ALFs are probably the hottest growing segment of the senior housing market. Revenues generated by assisted living facilities are expected to increase from $12.5 billion in 1990 to $30 billion in 2000. With the skilled nursing market caught in a construction moratorium and the demands increasing for facilities that provide assistance in daily living, it is inevitable that this market will provide lucrative opportunities for entrepreneurial operators. More elderly persons and their children are looking for home-like residential settings with access to health care and supportive services. Moreover, except in a few of the most populous states, these developments are still subject to very little regulatory oversight. In contrast to nursing facilities, ALFs remain almost overwhelmingly private pay, typically on a monthly fee basis, although forms of rental/buy-downs, endowments and equity ownership also exist. Some governmental authorities recognize the advantages of keeping a portion of the indigent elderly out of nursing homes by approving reimbursement for services rendered in ALFs.

As with SNFs, operator expertise is critical. On a purely business level, it is important that the lender be comfortable that the operator's pricing strategy makes sense. Services can be sold on a flat fee basis, … la carte or on the basis of ranges of fees for packages of services. It is imperative that the operator fully understand its marginal cost structure to prevent the introduction, for example, of amenities that are not cost effective. The loan documents should contain covenants prohibiting material changes in the existing pricing or packaging of amenities to prevent a sudden erosion of revenues in the future.

Marketing expertise becomes significantly more important to the owner and operator of an ALF. Lease up of newly constructed ALFs can be quite lengthy; normal absorption trends of one or two units a month are not unusual. Poorly run facilities, once stigmatized, have an extremely difficult time shaking their reputations. Moreover, ALFs typically experience high annual turnover rates (35% to 40% is not unusual), requiring constant and varied marketing approaches. Although hospitality-type chain operations, such as Marriott, Hyatt and Holiday Retirement, have made significant inroads in the industry, independent owners and mom-and-pop operations still account for 70% of the industry. Accordingly, covenants against management changes and assignments of third party management agreements are in order.

The lender must carefully scrutinize the nature of the revenue stream to assure the lender's perfected security interest in these revenues. Because there are no comparable anti-assignment statutes governing most of these revenues, perfection of a security interest should not prove overly difficult. In the event of a bankruptcy by an ALF, however, the situation becomes considerably murkier. After all, in the hotel industry, bankruptcy courts could not reach any consensus on whether such revenues were rents, and therefore subject to a continuing post-petition security interest (assuming the security interest was properly perfected pre-competition), or accounts, which typically are not subject to a continuing post-petition security interest.

Part of this ongoing intellectual debate arose from the inability of courts to decide whether these payments were really payments for shelter or primarily for services rendered. This question becomes far more complicated in a senior living facility, where both shelter and significant services account for the overall monthly payment. Whether the rent stream is characterized as a flat fee for all services rendered or as a payment for basic shelter with   la carte price offerings for all other services can significantly affect how courts might view the revenue stream in a bankruptcy. At least one court has decided that entrance fees paid by residents in a CCRC were rent security deposits and residency agreements were rental agreements under state law. M & I First Nat'l Bank v. Episcopal Homes Management, Inc., 1995 Wisc. App. LEXIS 767 (June 21, 1995). (The conundrum for hotel revenues was finally solved in favor of rents by the Bankruptcy Reform Act of 1994; the Act did not, however, address revenues generated by senior living facilities, and the meager case law on the subject is inconclusive.)

Continuing Care Retirement Communities

A CCRC attempts to solve the problem faced by any SNF, ALF or congregate care facility that operates on a stand alone basis: how to reduce turnover by meeting a wide range of needs without providing increased levels of medical or other assistance in violation of the law or bringing in outside caregiving that would entail a loss of control. The CCRC does this by providing three levels of care on the same campus, or on different wings or floors of the same building.

Although CCRCs offer various fee structures, probably the most important is the "lifetime contract." This concept originated in the religious convent tradition of donating all of one's assets to the church or monastery in return for a lifetime of support. It requires the payment of a large up-front fee (often derived from the sale of the patient's previous home), together with a relatively low and fixed monthly fee. The benefit to the patient is the guarantee of a level of services and a place in the health care continuum from fully independent living through medical care in an SNF. Many individuals fear being unable to obtain access to a desired SNF when and if the time comes. This guarantee provides significant peace of mind and allows the operator to retain customers throughout the remainder of their lives.

Because of the unusual payment structure, lenders must be fully comfortable with the borrower's business plan and its underlying assumptions. Many early CCRCs failed because (1) the sponsor's assumptions regarding longevity were incorrect, seriously undermining the resulting initial fee/ongoing fee pricing model; (2) health care costs exploded and could not be recouped; and (3) absorption rates were driven by need and not overly susceptible to marketing.

With a large up-front fee structure, adequate control arrangements are necessary to ensure that funds are not squandered. This could be accomplished with some type of escrow agreement. This issue becomes more complicated if the funds become refundable in whole or in part. In essence, whose money is it? If fees are refundable, a lender may find it difficult to seize them free and clear on loan default. Just as important, use of these accounts is increasingly coming under statutory control, which may further inhibit a lender's ability to gain access to these funds. Refundable fees also necessitate sizable reserve requirements to account for fluctuations in occupancy. Covenants to this effect should be added to the loan documents.

Congregate Care

Congregate care completes the senior housing continuum. The term is misleading: congregate care housing does not really provide any "care." Rather, as an independent living facility, congregate care offers housing for seniors with a variety of amenities, such as housekeeping, transportation and social activities, but no assistance with daily living. These facilities cater to the more independent resident and are structured as either rental, fee-simple purchase or sizable entry fee with subsidized monthly charges. Age, physical condition and creditworthiness often dictate entry requirements.

Congregate care most closely resembles standard apartment living, although it is specifically targeted to the elderly. As a result, few special issues require attention by the real estate lender. Licensing is virtually nonexistent. The absence of unusual personal services, in favor of amenities not unlike those offered at many apartment complexes, mitigates concerns over how the payments would be characterized in bankruptcy. Nevertheless, the lender must check that no endowment or flat fee-for-services arrangements exist. Management skills are important, but perhaps no more important than in any multi-family housing investment. For these reasons, congregate care facilities are the favorite projects of the lending community.


Clearly, the senior housing industry is not "apartment living with hand-rails." The industry is an operating business, and the business acumen of the owner/operator must be as important -- if not more important -- than the quality of the underlying real estate. Beyond this truism is the fact that the senior housing industry also shares a unique set of regulatory, operational and other constraints that influence how the industry is financed and how those financing transactions are structured. The lender that is mindful of these unique characteristics will be able to protect its interests to an optimal degree and yet participate in a burgeoning and attractive market.