Not a Risk We Would Typically Take’: How Developer Confluent is Handling Cost ‘Craziness’

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Somewhere in Ohio is a pile of lumber owned by Confluent Senior Living — and that is not normal for the Denver-based developer.

Stockpiling wood to use in future construction projects is “not a risk we would typically take,” and one that the developer probably won’t take again, according to Confluent Managing Partner John Reinsma. But tough times call for certain measures — and with the price of building materials at historic highs, these are indeed tough times for senior living developers.

“It was what we felt was necessary in order to continue to meet our economic thresholds and counteract some of the craziness that’s going on in commodities pricing,” Reinsma said during a recent appearance on the Senior Housing News podcast, Transform.

The sky-high cost of building materials has slowed down and even halted some of the developer’s ongoing projects. But, the silver lining of that slower pace is that Confluent was able to drill down on community design and collaborate with its project and operating partners on new ideas. One result of this work is the creation of what Confluent call its Whole Health Standard.

“What we’re really trying to do here is evaluate the design of senior housing that keeps the user and the consumer in mind and allows the operator to deliver health care and hospitality in a healthy and physically beneficial manner,” Reinsma added.

Highlights of Reinsma’s podcast interview are below, edited for length and clarity. Subscribe to Transform via Apple Podcasts and SoundCloud. The interview took place in late May.

On how 2020 went for Confluent:

It’s been a rough year and a half, to be honest.

Unfortunately, our operating portfolio was not immune to the same impacts that all the other groups across the country similar to us dealt with, with respect to occupancy and restriction issues.

I think with respect to development, we’ve really been focusing on two separate things. One was the projects that we were working on. Going into early 2020, we had four projects that we had under land control that we planned on breaking ground on. And given the uncertainty of the world and the absolute chaos we were all living in, we felt like we needed to put them on hold to see how everything was going to play out.

We successfully renegotiated three out of the four land contracts that we had. And then we have subsequently broken ground on two out of those three, with the third one to start construction in June.

So for us, this was a huge accomplishment, and something we’re really proud of. There were a lot of hurdles to pull that off. The highest I would say was probably putting together the capital stack. We had a lot of conversations with our investors, but ultimately, they came to the same conclusion that we did: that the senior housing industry was going to quickly rebound from the pandemic and the fundamentals of the asset class as an investment will hold strong once the crisis came to a conclusion, which we’re seeing right now.

So, we were able to figure out the equity side of things. The lenders were a different story.

Once we had the equity lined up, we still needed to find debt for all three deals, which as you’ve heard many times, was an enormous challenge. And I think the fact that we were able to secure three separate loans for new construction in 2020 for ground-breaks that happened early 2021 is a real testament to the leadership of Confluent — our CEO, CFO and our finance team — and their ability to leverage past relationships and use our track record. That was a tough but great thing that happened with an extreme amount of hard work and decision-making.

The second area of focus was a little a little harder, because it involved us giving up control. It was really focusing on our operators and the projects that we had under asset management or were under construction. And we learned really quickly in February and March that the best thing that we could do to support our operators was to get out of their way. Let them do what they do best, which is take care of the residents.

Since we have put all these projects on hold, we used that pause as an opportunity to reevaluate our design standards and protocols, and determine, do we need to make a fundamental change to the way that we’re approaching senior housing development and design?

We set up meetings or Zoom calls with every architect and interior designer that we’ve worked with since we started doing senior housing development, and we sat down and just listened to them. We wanted to hear what type of ideas they had, what other concepts other developers or operators were implementing. We pulled together this really pretty long list of concepts and design ideas that we heard from them, and we’ve discussed all those with our operators. That led to something that we’ve called the Whole Health Standard — we’ll talk about that later. But it’s really an innovative plan for us to reevaluate senior housing development in our portfolio across the country to build healthy spaces and buildings.

On how senior living development has become more challenging in 2021:

It’s challenging in a new way, which has to do with construction and commodities prices and all of that craziness that’s going on.

The ways that it’s still challenging with respect to the pandemic, we’re still dealing with some perception issues of what senior housing is. It’s certainly dissipating, but a lot of the stories that came out early on in the pandemic, and a lot of the confusion about the difference between assisted living and a skilled nursing facility or hospice relative to independent living — there was a lot of confusion, broadly, across the country. That has gotten a lot better.

We have some great industry advocacy groups that have done some great work. I know you guys have covered the People of Seniors Housing (POSH) initiative. We were a supporter of that very early on. A lot of that work was crucial and made some real inroads, but we’re still dealing with a lack of full understanding of how safe our residents are in our buildings and how safe they have been over the last year and a half. So that’s an area where it’s still tough.

I want to refer back to those projects that we put on hold from 2020. I think that there’s a line of demarcation, and it’s the projects that were priced and started before the economy started roaring back; and the ones that were started [after the economy improved], where we’re at now. So on those three projects that I mentioned earlier, thankfully, two of them broke ground before lumber went crazy. And then the third one is going to break ground next month, and that one is kind of a tweener. So thankfully, we had a lot of that priced out and committed to from the subcontractors ahead of time — this is in Ohio.

But we really got hit with the lumber. I don’t know what it’s at today, but it’s certainly four to five times higher than it was when we priced the deal initially in 2019, before we put it on hold. One thing that we’ve done on that project specifically is that we will not have a guaranteed maximum price on that deal from our general contractor for another probably three weeks, but we’ve already bought the lumber.

So we now own a whole bunch of wood that’s sitting in a warehouse in Ohio ready for us to break ground and use. That is not a risk we would typically take, and one that I don’t anticipate will take again. But it was what we felt was necessary in order to continue to meet our economic thresholds and counteract some of the craziness that’s going on in commodities pricing. So that’s kind of what’s happened in the past. We don’t see this changing anytime soon.

There will be a relief valve here, we will find equilibrium again in the senior housing development world that will come from both the supply and the demand side. But as of right now, and in the near future, this is really problematic. And it’s preventing projects from being economically viable.

On what has gotten easier since the start of the pandemic:

The first thing that comes to mind is the ability to find sites and the ability to negotiate terms.

In 2019, I would say that on just purely the development side, our biggest headache and our biggest hurdle to overcome would be to find land sites that both met our criteria with respect to demographics and location and met the pro forma with respect to the cost. And even if you could figure out both of those, then you had to deal with land sellers who really had felt like, and probably did have, a majority of the control in that negotiation, and so were requiring terms and closing and escrow money that we just weren’t comfortable with. That has changed.

We just put a site under contract recently where we were able to achieve developer returns. We would not have gotten those in 2019. I wouldn’t say land has gotten cheaper by any means, but we are seeing the ability to negotiate land contracts in terms that are a little bit more favorable and give us a little bit more time to get through the process.

Another one that comes to mind as a result of the last year and a half is interaction with cities and going through the entitlements process. I think it’s become more clear than ever how important, how critical, senior housing is to the ability to keep seniors safe in the communities where they’ve lived, worked, raised families and worshipped in. I think the education has increased with cities, and they look at senior housing even more favorably than they did in the past, which is definitely a benefit.

On the relationship between developers and providers:

The relationship between the developer/owner and the operator is absolutely critical to success in this industry.

I cannot over-stress how amazing MorningStar Senior Living and Harbor Retirement Associates (HRA) have performed through this crisis. The amount of stress and responsibility that they’ve dealt with and the obstacles that they’ve overcome is absolutely astounding. Our relationship with both of those groups has been years in the making, but we couldn’t feel more fortunate to have been aligned with them.

We’ve always viewed our operators as partners, and that partnership starts at the very beginning. We don’t put a site under contract without our operator, having already looked at it and vetted it and worked on it with us.

I kind of alluded to this before, but one of our main tenets at Confluent Senior Living is that the best way that we can exceed expectations of our investors is to build buildings that set our operators up for success. And the only way we can accomplish that is really through true partnership that has the operators weighing in heavily on design and site development, but really on design, to make sure that we’re building buildings that get them what they need with respect to health care and hospitality.

As residents and families interact with a building, and they have questions about Covid — what have we changed? How are they safe if something like this were to happen again — the ability for us to have that partnership and know that we’re delivering buildings that our operators can stand behind and can answer those questions with clarity and positivity has really become more critical than ever.

I think the first and probably most critical thing [is to] make sure that you are aligned with the operator on how they are going to run the building, what the associated lease-up projections are, the margin expectations — have all of those critical conversations upfront.

There’s two things. One, is make sure that you’re on the same page that, as a developer, you understand what the hot-buttons are for your operators. What are the things that you need to be delivering, and what are the questions that you need to be asking them early on to again to make sure that you’re delivering buildings that are setting them up for success?

On Confluent’s Whole Health Standard for design:

We’re defining the Whole Health Standard as a holistic and innovative design approach to senior living development that incorporates innovations to ensure residents’ physical and mental health. And the end product is a healthy environment for senior staff and visitors, both physically and mentally.

This concept was born out of a design effort that we were working on with Morningstar already on two projects: one in Mission Viejo, California [pictured above]; and then another one in Observatory Park here in Denver. We were already collaborating with them to work on bringing some cutting-edge technologies into the building and making those as part of our design standards. We were in the middle of that when this pandemic hit, and so we realized that we needed to take this to the next level and figure out — with all the time that we spent with architects and interior designers — what changes we need to implement into our existing buildings and the buildings that are under design or under construction. And then, what needs to make it into the design going forward?

What’s interesting is that a lot of the factors or a lot of the highlights that we landed on are behind the walls, if you will. So, there are things that would not be immediately obvious to you when you walked into a building. For instance, with the HVAC system, we’re using this far UVC light field which helps reduce the spread of airborne mediated microbial diseases. We have antimicrobial basically everything, such as countertop surfaces, etc cetera. There’s a kiosk system for seamless and distanced sign-in. The operator Morningstar took on telehealth training for infection control. These are a lot of things that you don’t see when you walk into the building immediately.

We also made some real changes to what is obvious. The most notable one is a real focus on outdoor space for dining. We are specifically programming outdoor dining space, whereas in the past, we might have had a patio with some chairs that were close to the dining room.

Now, we’re saying, ‘Yeah, we’re going to have outdoor dining as part of our culinary offering,’ and it’s more than just an outdoor grill. Having outdoor access for residents in the form of units, patios, more indoor-outdoor space, wherever possible, that’s a real change and something that we’re already seeing a great response to from residents and from families.

So, you combine all of this, and it’s this Whole Health Standard. What we’re really trying to do here is evaluate the design of senior housing that keeps the user and the consumer in mind and allows the operator to deliver healthcare and hospitality in a healthy and physically beneficial manner.

I heard this from from Matt Turner, [managing partner] over at MorningStar: What we don’t want to do is redesign our buildings for the 100-year flood, meaning we’re not going to make these fundamental changes to the way that we approach design so that, in five years, somebody walks into one of our buildings and says, oh, man, this thing must have been designed in 2020, and look at what crazy things they did for Covid.

All of the changes that we’re implementing should be accretive to the design, and something that will be long-lasting in a beneficial way. That HVAC system and antimicrobial air filtration system, this is something that you’ll never see, but it is something that you’ll be able to talk about with residents and their families. That is not something that is going to have some negative impact on design. When we came up with this Whole Health Standard, we were very cognizant of exactly that — of not making changes now that are so short-sighted that will make our buildings obsolete in the near-future.

On the prospect of new development in 2021:

Of the three that we’re working on now, we have two under construction that are just wrapping up. One is done and waiting for licensure. Another one will be done in the next six weeks. We have the three that we broke ground on this year, which are Mission Viejo, Observatory Park, and then the third one that I mentioned in Ohio is in Shaker Heights, which is a suburb of Cleveland. That’s all we’re going to be able to pull off this year, unfortunately, because of the commodity pricing.

We had a project that we were working on where we actually just terminated the contract, because it was slated for a 2021 groundbreak toward the end of the year. And we just cannot figure out a way to make that pencil. That said, we also recently just put a new site under contract. By the time we get through entitlements and design, it’ll be a mid-2022 groundbreak. We really feel like by that point, we’ll start to see some relief.

Going back to that equilibrium comment I made earlier, we’re certainly still active. And as a response to what we heard from our investors and what we’re seeing in the capital markets, I would say, in some ways, we’re more bullish than ever on the space.

I’ll do a quick side note here: Confluent Senior Living is a subsidiary of Confluent Development, which is a larger, full-service commercial real estate development firm also based here in Denver. We don’t just view the world through the senior housing light, we also do industrial and mixed-use and retail and hospitality and multifamily, et cetera. When we look at the world of commercial real estate with respect to all the asset classes that we work in, we are just as if not more bullish on senior housing than we ever have been.

In fact, I would say we have spent the last 10 years getting ready for right now. We’ve been in the senior housing space for nine years, and we have spent those nine years preparing for what’s about to happen to us from a demand cycle right now. And that includes everything — creating long-lasting relationships with our operators and taking 20-plus buildings through the full development cycle.

We’ve gone through a handful of sales to prove the concept to our investors and understand what the returns can look like. And we’ve really become students of senior housing on the entitlement side, the construction side, the asset management side. All of that work has been for us to be ready to be an extremely forward-thinking, aggressive senior housing developer, as we prepare for this baby boomer wave that we all know has not even showed up yet.

On what capital providers are looking for in 2021:

When I hear capital, I think of both debt and equity, and they are two different animals. I’ll do my best to answer this as our CFO would with respect to debt.

As I mentioned, we’ll do three new deals this year, all three of those are with different banks. They’re all traditional construction lenders, so we did not go down the debt fund or the mezzanine route. And while terms are not as good as they were, in 2019, the gap really wasn’t that big with respect to a construction loan that we would have signed up for a year and a half ago. I would say that leverage has come down from pre-pandemic levels. Recourse has stayed the same or maybe even gone up. LIBOR floors have become commonplace, and there are still a lot of large players that are on the sidelines. So when we went through those three projects to line up the debt, we certainly received less term sheets than we would have in the past.

I believe this is starting to change. I’m hearing about more and more lenders coming back. With the existing lenders that we have, we’ve heard multiple times that they will become more selective on who they’re lending to, on which projects they’re lending on. Relationships have become even more critical. And the big thing that we’re hearing is that past performance really is becoming a gating item. So it is changing on the lending side.

With respect to equity, we’re working on one project right now with an institutional partner, which is going really well. But the rest of our projects have been capitalized through a combination of private high net-worth and family offices. And we’ve gone through three high-net-worth or private-equity fundraisers. The third one was actually completed this year, in 2021.

As you can imagine, we had a lot of questions about Covid and operations and the future of senior housing. We definitely did some educating for some of our new investors on the differences between levels of acuity and how the operators are handling the pandemic. We got that fund closed. In fact, I think we might have even been oversubscribed. And that’s something that we’re really proud of and a testament to our leadership. But I think it’s also a testament to the desire of investors to continue, or in some cases for the first time, be active in the senior housing asset class.

One thing that we heard that is a change as a result of the pandemic is that it really seems like investors are chasing and looking for yield wherever they can find it. And development is one space where they see that opportunity that they’re not finding in a lot of other real estate asset classes or real estate investments. So, that has been a change — the focus and questions regarding the yield of the projects and the cash flowing capabilities.

We were kind of already on this track before, but the high-barrier-to-entry is another capital focus that is shifted. And we are really seeing a lot of questions and a lot of demand for the high-barrier-to-entry, and that term gets thrown around a lot. We view that to mean sites and projects that are difficult to get done. That might come in the form of a long rezone of a really tight site that takes some real creative design or projects that take time and energy and investment to get them out. We’re already seeing that work and that investment results in higher NOI and lower cap rates. And that has really been a shift from our investors, to focus on those types of projects.

On the road ahead in senior living development:

The pent-up demand that everybody’s talking about is real, at least from our perspective. March and April had the highest amount of move-ins that we’ve ever had in our history. I think for the next three to six months, that pent-up demand will continue. But then after that, it’s going to slowly move back and taper off to our traditional move-in velocity.

On a 12-month timeframe, one thing I’m very concerned with is the availability of and the cost of labor in our industry. I don’t see that solving itself, and certainly not in the next 12 months. There is some technology that we can make some changes on the periphery. But that’s something that will have a 12-month-plus impact. Even though that’s on the operation side, that does flow into development, because it impacts the way that we underwrite projects and it impacts the margins. That’s a longer-term concern.

With respect to just pure development, the next three to six months are going to be really tough for all the reasons that I said before. I talked about how we had to buy lumber — and we don’t own wood, that’s not what we do. So that’s the type of stuff that has to get done in the next three to six months.

Longer-term, I do believe that we’ll find a relief valve. It’s really a question of elasticity. Construction pricing and labor can adjust so quickly and so much quicker than the ability to adjust rates and margins. It takes time to find that equilibrium. And I think that that’s a 12- to 18-month cycle.

Now that said, if we continue to see the the amount of new starts plummet as we have for the last year and a half — and it’s unlikely that will continue in the future — we may actually get back out of equilibrium within you know, the 24- to 36-month timeframe as we see demand start to outpace supply. As always, it’s a pendulum that’s swinging. But it will recover and that’s the main reason we continue to aggressively pursue new markets and new deals.