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Last month, I heard something unusual on Welltower’s (NYSE: WELL) Q4 2024 earnings call: CEO Shankh Mitra referring to “underpants gnomes.”
The reference came up as he was describing the “fundamental misunderstanding” that senior living developers seem to have when talking about opportunities ahead. He compared their plans to those of the underpants gnomes – small fantasy creatures featured in a 1998 episode of South Park.
In the episode, the gnomes secretly steal underwear and stack them in a huge pile. When South Park’s protagonists ask the gnomes why they steal underpants, the gnomes reply they have a simple, three-phase business plan:
- Phase 1: Collect underpants
- Phase 2: ?
- Phase 3: Profit
In a similar way, Mitra said, senior living developers see the demand for senior living in the years ahead and believe they stand to profit from it, but don’t have a good plan for developing new communities in the short-term.
In his mind, phase 1 is demand from the incoming baby boomer generation, and phase 3 is profit. But he believes phase 2 is still a big question mark.
“The economics don’t work. That’s the problem,” Mitra told me in a recent interview.
I think Mitra’s humorous comparison is backed by some compelling financial math. And development – or the lack thereof – has been on my mind since I hosted a panel at the Spring NIC Conference a few weeks ago. On stage, I asked the panelists how they felt about the “underpants gnome fallacy.”
Matt Derrick, managing director at developer Confluent Senior Living, joked that he has “a better pro forma than the gnomes.” But on a more serious note, he’s concerned about how that disconnect between demand and development could hurt senior living in the long-term.
“I’m concerned that this industry is about to hit a crisis point. We are not putting shovels in the ground,” he said. “This is a needs-based industry, and if we do not meet the demand, our industry is going to suffer.”
He does think the financial math required for new development will work at some point in the future.
“I firmly believe in it, and I’m betting my career on it,” he said.
In this members-only SHN+ Update, I reflect on my recent interview with Mitra, my panel at NIC and other industry trends to offer the following takeaways:
- More on the rationale behind Mitra’s underpants gnomes comparison
- What senior living developers are doing now to accelerate their plans to grow
- Why Mitra believes a senior living Manhattan Project is needed
Inside the ‘underpants gnomes fallacy’ of senior living development
Underpinning Mitra’s argument is the fact that senior living development is just too difficult and costly to pencil out in 2025.
There were fewer than 22,000 units under construction in the fourth quarter of 2024, representing the lowest level of new construction since the first quarter of 2014, according to the latest NIC MAP occupancy report.
Interest rates for construction loans – if one can find such a loan right now – are as much as twice as high in 2025 as they were in 2019, he said. And even if one could start a new project today, the time from start to stabilization has risen to as much as seven to nine years.
At the same time, construction and labor costs have risen while industry rents remain well below levels to make new projects feasible. Assuming a development cost of $450,000 per unit and a stabilized yield on cost of between 8% and 9.5%, senior living companies would have to achieve a revenue per occupied unit (RevPOR) of between $11,000 and $13,000 to make the project pencil out.
For example, Mitra said that a hypothetical project in the Chicago suburb of Winnetka, Illinois, with an assumed cost basis of $1 million likely would balloon to development costs of $1.3 million to $1.4 million. He estimated the community would have to charge far higher than average industry rents – as much as two times – to make the math work. “Good luck” achieving that, especially given the relative financial constraints of the boomers, he said.
As Mitra has noted before, a developer might build something today on a cost basis of a dollar and sell it for 70 cents down the road – certainly not a good business outcome for companies that make money selling assets at a higher price point than it took to build them.
I do think senior living developers have a similar mindset. During the panel I hosted at NIC, Derrick told me Confluent is being “very cautious and conservative” in its underwriting with any new deals.
“The last few years have been some of the most difficult that we’ve ever encountered in this space,” he said.
That said, the company has built up a development pipeline of about $400 million over the last couple of years and is moving forward with ambitious plans to expand.
“Most of those deals are about two years old, which means I spent a lot of my time renegotiating land contracts,” Derrick said. “We are definitely seeing more interest in development over the last six months than we have over the last two years. We are now full-steam ahead on design and pre-development, really gearing our portfolio up for ground breaks later in ‘25 and ‘26.”
But even so, I don’t see any of these conditions changing in the immediate future. As long as communities trade below replacement cost, equity will target acquisitions. If developers can get a project in the ground now, they might be doing so with risky capital stacks.
Where development deals are getting done, Mitra noted they are often funded by what he calls OPM – other people’s money. A typical development capital stack might be structured with 80% coming from borrowed funds, with the rest coming from other investors. Only a small percentage of funds comes from developers themselves – that is where the problem lies, he said.
“[The developer] also charges at least as much of their own equity as fees. If you think about the economics, by the time they go into the ground, [the developer] is good. They have no money in play,” Mitra said.
That disconnect between financing and execution can lead to bad capital structures that set up projects to fail at the end of the day. For companies like Welltower, this is not a bad thing. Mitra shared an example of a senior living developer that had priced a portfolio of communities at as much as $600,000 per unit in 2019 – a price he did not agree on at the time.
“I ended up buying 20 of the best assets at 50 cents on the dollar from the lender in the last 15 months,” he told me.
Societal implications
While Derrick warned of a coming industry crisis, Mitra described a crisis in the making for the country as a whole. Bad senior living deals mean communities end up in the hands of the banks that funded them, which can’t easily foreclose on them.
“One day, the FDIC will come and take these assets and ultimately, the taxpayers will pay,” he said. “I’m saying that we should not be engaged in an economic activity where the benefit goes to the private sector and the losses go to American taxpayers.”
Another societal problem is the resident rates required to make senior living pencil out. While the incoming group of older adults is large, the boomers don’t have as many pensions, savings or adult children as the generation before them. Affordability could be a big barrier for them, and in turn hurt operators’ ability to grow their services for a wider group of customers.
“There could be demand for the product, but not the ability to pay for the product,” Mitra said.
Mitra’s analysis paints a dire picture of the industry’s ability to adequately meet the growing demand for its services. As NIC MAP CEO Arick Morton pointed out at the NIC Spring Conference, the industry “needs to develop about twice as many units as we’ve ever developed, every single year in aggregate for the next 20 years” to keep up with demand.
At the end of the day, Mitra said he has no good solution in mind that would quickly fix senior living development. But he stressed that the solution will not come from the public or private sector alone, but from both sides working together. What the industry needs now is a kind of “Manhattan Project” for senior living, he said.
“Bring a bunch of smart people in a room and say, ‘What is required and how do we afford it?’” he said.
