Description
A new reality for investors and operators
In 1995, the German legislative assembly decided to withdraw all regulatory control from the field of care for the elderly and to allow it be regulated by free-market mechanisms. For the first time, nursing homes no longer needed to fulfil statutory-driven planning requirements and certification conditions, the assumption being that by lowering the market entry threshold this would lead in the long term to a healthy balance of supply and demand. The drawback was that this meant that operators needed to rapidly learn how to live with economic risk. Today, nursing care institutions in Germany are free to determine their own package of care provisions, as long as they fulfil statutory quality requirements, and to offer these on the market. They bear the responsibility as well as the risk – for profits and for losses. At the same time, most federal states in Germany reduced the level of state funding for nursing institutions, on the one hand to avoid skewing the market and on the other due to the fact that state budgets were no longer sufficient to provide such funding.
The free-market regulation of the nursing care industry led to a further change. Property of some form or other is generally the foundation for care for the elderly and this requires sufficient capital. Accordingly, only those with enough capital will therefore be able to offer care for the elderly. The withdrawal of the state as a backer for property acquisitions after 1995 opened up a key role for institutional and private investors. The so-called “institutional investors” – a broad term encompassing financial institutes, banks, funds (closed-end or open-end), pension funds and insurers – are now of particular importance in the nursing care industries. There are many different reasons why institutional investors invest in property or institutions in the care industry,and these motives depend on the readiness, or resistance, to take risks. Institutional investors can differ here quite considerably.
The greater the risk for the investor, the higher the risk premium, i.e. the return on the investment, should be. The expected return on investment for the investors is also influenced by the refinancing conditions as these institutes commonly invest in a combination of own and borrowed capital (pension funds being an exception). If conditions for borrowed capital worsen, the expected return has to rise so that the return on own capital remains constant. Although banks do not differentiate between own and borrowed capital in calculating their return on investment, the refinancing conditions also play an important role for banks as they define the “acquisition costs” of the bank’s capital. The higher the interest, the higher the financing conditions for the bank.
In Germany, the branch is relatively new, and more experience with financing and collaboration with institutional investors still needs to be gathered. Since its beginnings in 1995, the nursing care industry has not seen constant development. A phase of initial enthusiasm after the introduction of long-term care insurance was followed by a phase of disillusionment at the end of the 1990s accompanied by a series of spectacular failures and significant bad investments. In the years 2001 to 2005 the market more or less ground to a halt. The institutional investors – despite attractive yield premiums – were no longer willing to invest in the nursing industry as they remembered only too well the losses of the preceding years. By mid-2005, the reticence had evaporated and indeed the reverse situation arose. In 2006 the nursing industry was suddenly awash with a flood of capital provided by domestic as well as foreign institutional investors. The risk premiums shrunk to a hitherto unknown dimension and investments in nursing and nursing care institutions were suddenly the talk of the day.
Investments by institutional investors (billion Euros)
Following the general liquidity crisis which has gripped the financial markets since mid-2007, investments have since slackened as was to be expected. However, the nursing care industry has been less affected by this than other property classes. The reason for the large-scale investments by foreign institutional investors in particular has less to do with the care industry itself and more with the overall liquidity of the financial markets during this period. The high level of liquidity meant that the profits in primary property classes, such as housing, offices and retail, were very low due to the high flow of capital, and that secondary property classes, such as hotels, logistic property or nursing care facilities were more attractive as the return on investment was considerably higher. After the flow of capital also began to sink considerably in the secondary property classes – with the exception of the care industry – investors saw an opportunity to increase mean returns by including nursing care facilities as a component of larger mixed property portfolios. Institutional investors still expect investments in the care industry to perform better than other kinds of property and accrue a greater return.
Every investment in a property in the nursing industry has to consider two “layers”. The relative weighting of these determines the degree of risk and the overall estimation of the property investment, including expected profits for the investor. At one end of the spectrum, there are investments where physical property is the dominant aspect of the product, for example housing schemes for the elderly. These are in essence very similar to normal housing projects except that they are specially equipped to fulfil the needs of the elderly (according to the German norm DIN 18025). Typically no or only a low level of services are provided. The higher costs are a product of the requirements of the DIN, which results in 10-15% higher rent income. At the other end of the spectrum one finds the typical institutionalised nursing home, in which property features as just one of a series of “hygiene factors”. Whether or not the property is of great importance for the product, its primary constituent is the service and with it the operating concept. The larger the role of the services, the more the profits depend on specific “soft” factors such as operator and concept.
Between these extremes there are other forms such as sheltered housing or senior residences whose profitability consists of a combination of property and services in differing proportions. In general one can assume that the greater the focus on services, the older the customer, in this case the resident, is likely to be and therefore the more dependent they will be on these services. Because of the need to protect the interests of the particularly vulnerable residents, these institutions are subject to a greater degree of statutory regulation by state agencies. The long-term care insurance covers a large part of the financial cost of care and accommodation. The regulatory framework of the state and the economic dependency on the state are considerable. Since the introduction of long-term care insurance in Germany, institutional investors have focussed more on fully institutionalised nursing care facilities despite the fact that these are more dependent on monetary support from the state. In fact, this tendency has increased over the past few years. There are a number of reasons for this which reflect the different evaluations of inland and foreign institutional investors.
A widespread opinion is that as a result of state funding this class of property has a firmer footing than other property investments for the elderly lacking such state support. Many investors are also of the opinion that demographic changes point primarily to a greater demand for fully institutionalised care facilities. Although these views are still the subject of much discussion, the advantages of fully institutionalised care facilities (demographic factors, state support and high return on investments) are easily communicated and understood, and many institutional investors are attracted to them as a result. Less interest has been shown in investments for housing for the elderly, for sheltered housing schemes or communal housing.
From the viewpoint of institutional investors, care properties have the following inherent risks:
• Fungibility, i.e. little or almost no possibility of reuse through third parties;
• Limited transparency with regard to the operators;
• Different functional concepts;
• Lack of independent consultants (brokers often call themselves “independent” consultants but have an inherent conflict of interests).
Despite the above risk factors, investments in this branch have developed spectacularly over the last few years. As mentioned earlier, for the institutional investor it is important to achieve a reasonable return on investment where the risks involved are as transparent as possible. As a result, the following key aspects of a care facility play a decisive role in the decision whether or not to invest.
1. Location
After several attempts in the 1990s to build nursing facilities on greenfield sites, investors realised that isolated facilities are rarely successful. Whether the location is urban, at the outskirts or embedded in a residential area depends in part on the clientele it aims to attract. Residential schemes for the elderly or sheltered housing for clients (residents) who are still sprightly and relatively active will need to provide a greater variety of recreational activities than a nursing home whose residents are generally no longer as mobile. For old people’s homes, locations in residential areas can be advantageous in order to be near to one’s relatives. Connections to other health care institutions such as hospitals, rehabilitation clinics or medical care centres are favourable. It is essential to ascertain the realistic demand for the planned location. In recent years opinion has changed. Up until 2005, institutional investors assumed that net demand was the most important determining value for the choice of macro location. Since then, a more aggressive competitive approach has proven that it can also be successful.
2. The operator
The spectrum of operators on the German market is very fragmented. The largest segment, representing nearly 55% of the market, are independent non-profit organisations, while private operators currently make up around 37% and rising. The remainder of the market is shared among municipal operators who are increasingly being forced out of the market. This fragmentation at the level of the operator means that very few operators are able to entirely safeguard against failure, either through their financial standing or as a result of the size of their organisation. An investor will need to examine how competent the operator is and assess their professionalism. A number of factors are relevant including the quality of the management, links to the local market, particular strengths, a convincing operator concept and not least previous track record.
3. Lease agreement
The lease is in a manner of speaking the clasp that binds together property and operator. It has to clearly and transparently regulate the distribution of rights and obligations for both parties. The lease must also take into account that for operator-managed facilities a large part of the value of the property lies with the operator itself. Given the high degree of fragmentation in the market for operators, the lease must regulate what happens should the operator fail, in order to ensure that the value of the property is affected as little as possible or ideally not at all. The lease must reflect the investor’s need for security.
At present, institutional investors tend to prefer small facilities with a minimum size of 60 to 80 beds. Larger institutions with 150 or more beds have become much less attractive in recent years. Investors are most interested in facilities with a high proportion of single rooms, with 60% being the lower limit. The size of the individual units should likewise not be too small. The average expectation is at least 40 m² net floor area per apartment or suite. With regard to the risk of an operator going out of business, a shift has become apparent over the last two years. From 1996 to 2005, institutional investors clearly preferred working with the few big players on the market. Today, investors are also willing to work with smaller operators who run between three and five facilities. A reason for this is that in their endeavours to net the “scarce” larger operators, the investors often had to accept a painful cut in profits and less favourable lease terms. Higher profits and more favourable lease terms can be agreed with smaller operators. Most investors have since realised that they can compensate for the risk of a possible operator failure with the higher returns possible with smaller operators.
4. The development of profits
After the introduction of long-term care insurance in Germany from January 1995 to the end of 2004, the returns on investment for nursing care facilities were surprisingly homogenous and robust. The average return on investment during this period lay by 8% for contracts where the tenant bore all costs except for maintenance to the roof and external surfaces. As a result of the massive flow of capital, the situation changed dramatically from the end of 2005 onwards. Almost overnight the return on investment sank to between 6 and 7 % and more or less regardless of the quality of the property concerned. From mid-2007 onwards the situation readjusted somewhat and by autumn 2008 the return on investment lay by on average 7.5%. From the viewpoint of the seller of such properties, it is a problem that the realisable return on investment is not affected greatly by the quality of the investment. According to our calculations, the difference in return on investment between a good and a poor object on the market lay by less than 0.75%, a value that is extremely small in comparison to all other classes of property (in housing the difference can be as much as 4 to 5%). The reason for this low differentiation between good and poor properties with regard to return on investment is the investors’ comparatively homogenous opinion of care facilities coupled with their unwillingness to accept a low return on investment given that any involvement in this market bears a higher risk.
Outlook
The professionalisation of investments in care facilities has led to a considerable flow of capital on the one hand but also made the nursing industry more dependent on the general cycles of the financial markets. This has become ever more apparent since the third quarter in 2007. The key new features of the long-term care insurance scheme (introduced with the Pflegeweiterentwicklungsgesetz in 2008) have yet to impact noticeably on the disposition of the investors. In fact, the increasing investment in the nursing care industry has led to greater competition in many locations, which in turn exacerbates the risk of operators going out of business. Investors must examine the core business of the operators in greater detail and the investment product itself is becoming ever more complicated. Future investment activities will also depend on how the returns on investment in other alternative property classes change, which for most investors are easier markets to access than care facilities. One can expect investments in the care sector to be accordingly volatile.
The reticence among investors to invest in housing or sheltered housing schemes for the elderly could disappear as soon as suitable investment products appear on the market. A prerequisite for this is that such products should hold their value and that investors can readily see this without the need for excessive analysis, which at present is not the case. As a result of the proposed shift in emphasis towards outpatient care, as heralded by recent legislation, the demand for such products is likely to rise dramatically, representing a chance for investors too. It is, however, down to project developers and operators to devise concepts that are oriented towards the needs of the investors.
Originally published in: Eckhard Feddersen, Insa Lüdtke, Living for the Elderly: A Design Manual, Birkhäuser, 2011.