The Truth About Retirement Villages

Investors in retirement property companies are wary - and who could blame them? The retirement property industry has become known as something of a money pit for retail investors after very poor returns at two high-profile companies, Village Life and Primelife Corporation.

Village Life’s joint managing directors have resigned, taking responsibility for a stream of disappearing profit forecasts. The share price disappeared with the forecasts, falling from $2.79 in early January to about 45c. The fall had as much to do with profit uncertainty as the announcement of a tax office investigation into a potential $1 million GST liability.

One of the other key listed players, Prime Life, has had its own challenges: a new board; a swag of legal actions between present and past directors; and announcements to the Australian Stock Exchange (ASX) about its progress on settlements with the Australian Securities & Investments Commission. And no dividends. Primelife is trading around $1.28, up from a low for the year of 71¢ but well off its 12-month highs of $1.74.

Earlier this week listed developer Multiplex walked away from the retirement industry selling out its 45% stake in a joint venture with Prime Life and investment bank Babcock and Brown that was formed in 2004 to create new developments.

But it's not all bad news. The Queensland-based FKP Australian Retirement Homes has been going from strength to strength, a top-200 stock that is emerging as one of the new leaders in the retirement property market. FKP is trading at year highs of around $4.76, up from $2.61 a year ago. Better still, Macquarie Bank has added sparkle to the sector with a key investment: its private equity fund, Macquarie Capital Alliance (MCAG), has paid $100 million for 49% of the unlisted retirement property developer Zig Inge. The move by MCAG effectively opens the Zig Inge group to retail investors; Zig Inge will now represent about 10% of the total assets of the MCAG listing.

HOW THE INDUSTRY WORKS

The retirement property industry is split between retirement villages and residential aged care. Aged-care facilities '” hostels and nursing homes '” generally rely on government subsidies for their revenue. In contrast, retirement villages are usually resident-funded: you buy in and sell out.

Depending on the village, a resident may own a unit via a strata title, or have a long-term lease, a licence or prepay their rent. The dominant feature is that they pay up front. Like any property, there are ongoing costs. The village has administrative and maintenance staff; there are council and water rates for shared facilities; and insurance still has to be paid. Together, these can total $100 a week. Residents are charged these “service fees” or “recurrent charges” on a cost-recovery basis and any surplus or deficit is generally carried into the next year. Increases in these charges are restricted to increases in wages and the CPI, so the certainty is attractive to those on a limited or fixed income.

Gardening services, home maintenance and meals are often offered to residents on a user-pays system. The charges, called “flexicare”, usually cover the costs of providing the services or offset other village costs.

But a retirement village operator sees little of this money. So why would a Macquarie Bank fund pay $100 million for a non-controlling interest in mid-tier operator Zig Inge?

There are two reasons: revenue, and ongoing revenue. Although there is no definitive register, there are at least 1700 retirement villages around Australia. According to Robert Stimson of the University of Queensland’s Department of Geographical Sciences and Planning, at least 34,000 new units will be needed over the next 20 years for the existing population. A small increase in those wanting retirement village accommodation could push this number to 80,000. ASX-listed developer and operator Primelife is more bullish, estimating up to 360,000 new units.

Primelife gets a margin of 20% on its developments, and Peter Inge says the Zig Inge Group’s returns are in the “mid to high-20s”. With purchase prices ranging between $200,000 and $1 million, these are healthy investment returns.

However, development growth can drain a company. Primelife has engaged in two capital raisings over the past three years and has recently entered a joint venture with developer Multiplex and investment bank Babcock & Brown to develop villages. Although Primelife has the first right to purchase these developments, the venture reduces its exposure. And with almost $12 million paid out in cash for development last year, and another $500 million in the development pipeline, Primelife’s desire to manage this risk is understandable.

The opportunity to take part in this return brings capital funds to the fore. MCAG’s $100 million investment will finance Zig Inge’s development program and give MCAG access to the development profit. More importantly, each time a unit is resold it gets up to 30%.

Typically, in any retirement village all new residents sign a management agreement. The agreement outlines the operator management rights, and provides for a deferred management fee (DMF) or exit fee. The formulation differs between operators, villages and even residents, but is usually expressed as a percentage per annum of the resale price of the unit, such as “3% per year to a maximum of 10 years”. The arithmetic is simple and compelling.

A resident may have bought a property for $150,000 10 years ago. When they sell for $300,000, the operator collects his 30%, or $90,000. And waits for the unit to sell again.

“There are variations and hybrids,” says Peter Inge. “There are some who front-end it a bit; there are others who take a share of capital gain on top of it. That 3% per year for 10 years is probably now at the more conservative end of the exit fee spectrum.”

The more aggressive structures may give the operator 50% of the capital gain '” $75,000 in the example just given '” plus a special 7.5% fee in the first year of village residence. On a $300,000 resale, the operator would receive $97,500, and then be ready to start again with the next resident.

“When we first started in the industry, we had [actuaries] saying, 'Your average resident will live for seven years’,” says Inge. “Our residents are living for probably 12 years.”

Most residents leave for a higher level of personal care, or they die at the village. The maximum level of the exit fee, therefore, should match expected lifespans. If it peaks after residents leave the village, then the operator is not maximising its revenue. If it reaches its maximum before the resident leaves, then there are years of forgone profit after that peak.

THE PAYOFF

As a deduction from the resale price of a property, the exit fee is a relatively high cost imposed on residents. But all residents who enter retirement villages clearly accept these terms. Moreover, exit fee is the touchstone for any operator '” it’s the profit engine of the retirement industry.

Peter Inge explains: “It locks us in; we don’t get paid until the resident leaves '¦ so we’re always running in arrears. Our interest is that '¦ people want to live [in the village], it’s well managed, and it enhances resale price. Resale price enhances the deferred fee '¦ We have an alignment of interests. The negative from the investment viewpoint is that it’s a very long-tailed asset. You don’t see any cash for quite a few years.”

With an average turnover of 12 years, that’s correct. However, the company recognises part of the fee every year as revenue. The total DMF portfolio is valued every period, and discounted back to recognise the time before the cash is received.

Some operators are allowing for expected increases in property prices and others are relying on the last sale price of the unit. When property prices are increasing, the last sale price is very conservative.

This difference hints that there may be some upside for operators as exit fees are realised. It gives another reason why funds may be attracted to established village operators. Where an existing operator offers an established DMF or exit fee portfolio and a good development pipeline, a fund can cash in on a company’s need for capital as well as its positive growth prospects, both planned and unplanned.

Of course, there are limitations to the industry’s growth. Development sites are becoming increasingly sought-after as retirement village developers compete against medium-density developers willing to pay more for the same land. Informed purchasers are demanding more “style” for their “lifestyle choice”. And developers are under increasing pressure to recognise broader social planning issues, such as a person’s desire to age in their own community.

Similarly, village managers are fighting increasing regulation. Self-funded villages are required to submit annual reports to their residents, and residents are encouraged to partake of oversight activities. A recent review of Victorian legislation has given Consumer Affairs Victoria the right to enter any village to ensure compliance.

In spite of this, Inge is certain that governments are supportive of the operators: “They need to be, because the people who live in our villages are people who have taken decisions to fund their own retirement, and in that way take a significant burden off the community.”

That burden is readily measurable. The National Centre for Social and Economic Modelling calculates that the ratio of one retiree per 7.3 workers in 1960 dropped to 1:5.6 in 2000, and will drop to 1:2.4 by 2040. The financial strain on each worker is increasing.

Despite the need for more villages, entering the industry is almost impossible. “If you started developing a greenfield portfolio today, you’ll make your development returns, but you’re not going to get that good, smooth annuity income for [up to] 10 years,” says Inge. “I think there will be consolidation, because people do need bulk.”

That consolidation is happening, if MCAG’s investment in Zig Inge is an indicator. There are rumours of large players waiting to announce acquisitions, and there are news stories of managing directors resigning in recognition of disappointing results and compliance issues. And the consolidation may work well, with economies of scale offering operators the chance to focus on industry-specific tax and legislative regimes.

Retirees will benefit from more experienced operators who are focused on service delivery for their high net-worth individuals rather than coping with massive expansion plans.

However, the real winners may be the investment funds. Not necessarily the first time that a development profit is recognised, and not necessarily on the first recognition of a DMF. No, they’ll be winning every time. Time after time.

Russell Emerson is a retirement property industry executive and journalist.