Learn the proper valuation techniques to value any senior living investment
By Scott McCorvie, CEO, Enhance Senior Living
About Enhance Senior Living
Enhance Senior Living is a national senior living broker firm specializing in nationwide senior living investment brokerage solutions including active adult brokerage, independent living brokerage, assisted living brokerage, memory care brokerage, and skilled nursing brokerage. Learn more about our senior living broker and operational improvement solutions by contacting us today.
If you like this news article, be sure to subscribe to the Enhance Senior Living Podcast. The show is on all podcast platforms including Apple Podcasts | Spotify | Amazon Music
Senior Living Valuation Methodology
Senior living (senior housing) valuation is unlike any other commercial real estate asset, as the valuation and community value is largely based ‘market’ operational financial performance and business value. Unlike other real estate sectors, switching the property management (operator) can drastically change the financial performance and results. This does not happen in multifamily, retail, office, industrial, self-storage, etc. Therefore, strong ‘market’ operational knowledge, supported by industry comparables, is required to accurately value senior living. In this article, I’ll discuss the appropriate valuation methodology for any senior living community.
Business Valuation (Going Concern)
Since senior living valuation is largely based on the business entity operating within the real estate, the valuation is largely based on the income approach – or, the potential income the investor expects to receive given the purchase price of the community. In appraisal terms, this is referred to as the ‘going concern’ value — since the valuation is largely based on the business entity and business valuation.
Real Estate Fundamentals
Although senior living is valued as a business, traditional real estate fundamentals still apply. The individual market, market demographics, competitive supply, quality of the building / improvements, age, offered amenities, community design (unit mix, unit size, etc.), and site location all play into the overall financial performance and value. However, the operator’s experience, specific knowledge in sales and marketing, market reputation, staffing ability, and operational efficiency play a huge role in the overall valuation.
In all commercial real estate valuation, appraisers generally rely on three approaches to value – the income approach, the sales approach, and the cost approach. All three approaches to value can still apply to senior living. However, since most of the senior living is ‘for profit’ and purchased and/or developed for an expected return, the income approach generally receives the most weight in the valuation conclusion.
The Income Approach
The income approach includes the direct capitalization and yield capitalization (discounted cash flow analysis) methods in estimating value. Both methods include projecting the cash flow (net operating income) over future years. The senior living community’s historical and budgeted financials are analyzed per department (per-resident-day) to create the go-forward financial projections (proforma). However, since the current operator may not be performing at market standards or operator equivalency, the proforma should be compared and supported to industry comparable data. If the operator is failing in certain areas or departments, go-forward adjustments should be made.
The Direct Capitalization Method
The direct capitalization method is most appropriate for stable or near-stable senior living communities, while the yield capitalization (discounted cash flow analysis) is most appropriate for new development or communities that expect large shifts in occupancy and income over future years. Both methods can be applied to any senior living community. However, the direct capitalization method is most used by senior living brokers and/or senior living investors that aren’t educated on yield capitalization methodology.
For the direct capitalization method, the value is based on dividing the expected Year 1 NOI (Income) by the market capitalization rate (cap rate), or V = I / R. The Year 1 Net Operating Income is projected from reviewing and analyzing historical / budgeted financial statements (supported by expense comparables) and the capitalization rate is extracted and estimated from industry surveys and comparable sales.
Capitalization Rate Extraction
Just as the value can be estimated and derived from dividing the NOI by the Cap Rate, the Cap Rate can be estimated previous sales — dividing the investor’s NOI from the Price / Value, or R = I / V.
The extracted capitalization rate indicates what an investor is willing to pay for the specific senior living community based on the expected Year 1 income. Since investors want a higher yield for higher risk, the capitalization rate also includes the expected risk of the investment. Therefore, the cap rate increases with acuity and age.
Active Adult has the lowest cap rates while skilled nursing has the highest cap rates. This is a direct correlation of the operational and litigation risk associated to the higher acuity. If you would like to know cap rate ranges for each acuity type, please contact me.
The Yield Capitalization Method
The yield capitalization (discounted cash flow analysis) includes projecting the Net Operating Income over a specific holding period (typically 10 years) with a reversion (future sale of the community) at the end of the holding period. The cash flow per year over the holding period, including the sale of the community, are discounted back to current dollars using a specific discount rate.
An appropriate discount rate can be derived from industry surveys and/or interviewing investor peers. But, in general terms, the discount rate is the overall annual return an investor expects to receive over the holding period (including the time value of money). Again, the discount rate includes the risk of the investment – since higher risk warrants higher reward. Therefore, the acuity, age, market, size, etc. all play into an appropriate discount rate.
The Sales Approach
The Sales Approach is generally given secondary weight in the valuation of senior living. This approach includes researching recent sales of similar senior living communities (similar location, age, size, and acuity) and dividing the sales price by the number of units or beds.
Since senior living sales are less prevalent than other real estate assets, and each community offers different acuity mix, unit mix, location, age, quality, and offered amenities, it’s more difficult to to find truly comparable sales and make comparable adjustments. However, adjustments should be made given superior or inferior aspects of each comparable sale to the subject property.
The reconciled value per unit should then be multiplied by the number of units at the subject property to derive a total value via the Sales Approach. Although this approach can provide an estimate of value, it’s generally used more to support the income approach of value. If the income approach value per unit is much higher or lower than recent comparable sales, the valuation variables, assumptions, and methodology should be reviewed.
The Cost Approach
The Cost Approach is most appropriate for new development and newly constructed senior living communities. This approach includes estimating the replacement cost of the community (including the land value, hard construction costs, soft costs, and developer incentive) and estimating a depreciation (effective age divided by the total economic life) to be subtracted from the replacement cost to conclude on an estimate of value.
Since senior living requires large capital expenditures each year, and investors generally purchase senior living for specific investment returns, this approach is given less weight in the final conclusion. However, this approach is appropriate to analyze new development and recently constructed senior living communities.
Senior Living Valuation Summary
Overall, senior living is unlike any other real estate sector – as the financial performance (and value) is largely dependent on the operational knowledge and operational efficiency. Therefore, operating experience, knowledge, and industry-benchmarking is required to provide accurate valuations. Since senior living is a business entity held in real estate, and largely purchased for an investment yield, the income approach is given the most weight. However, the valuation should be based on ‘market’ operations as adjustments to current performance could impact future value. Additiionally, all three approaches of value can be applied to reconcile a final value.
If you would like to learn more about senior living valution, or the current and/or future value of your senior living community, contact us and learn more about our investment solutions.
By Scott McCorvie, CEO, Enhance Senior Living
About Enhance Senior Living
Enhance Senior Living is a national senior living broker firm specializing in nationwide senior living investment brokerage solutions including active adult brokerage, independent living brokerage, assisted living brokerage, memory care brokerage, and skilled nursing brokerage. Learn more about our senior living broker and operational improvement solutions by contacting us today.
If you like this news article, be sure to subscribe to the Enhance Senior Living Podcast. The show is on all podcast platforms including Apple Podcasts | Spotify | Amazon Music
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