In the Q3 2014 edition of Global Insight, we discussed the merits of bankruptcy sales for distressed hospitals in the United States. In many ways, the challenges facing healthcare companies in America have been mirrored in the UK care home sector in recent years. Unlike the US, the majority of health service provision in the UK is via the publicly funded National Health Service. An exception exists however in the provision of residential care to the elderly which has seen large scale private sector involvement.
CONSIDERABLE RISKS FOR PRIVATE INVESTORS
Increased demand for residential care driven by an ageing demographic and improved mortality rates make this sector attractive for private investors. Nevertheless, the sector remains beset by issues, not least because a high number of residents in private sector care homes are funded or referred to the care home by the National Health Service.
The financial risks inherent in the UK care home sector were exposed in the summer of 2011 with the hig-profile collapse of the Southern Cross group. A sale and leaseback programme implemented some years earlier had funded an aggressive expansion programme but had resulted in annual rents of £240 million per year. This rent burden proved unsustainable as the number of residents referred to Southern Cross by the public sector was reduced due to public sector spending cuts. Ultimately, the landlords of 750 care homes were forced to step in and take control in order to safeguard the group’s 31,000 residents. Most recently, the Mimosa chain of 22 homes and over 1,000 residents collapsed in April of this year, illustrating that the issues faced by those operating in this industry have not abated. Indeed, a report published by Company Watch this year found that:
- Nearly 25 percent of the 4,872 companies that operate the circa 20,000 care homes in the UK are financially vulnerable
- About one third of those operators were in their warning area, indicating heightened risk of insolvency or a major restructuring
- 682 of those operators are “zombie” companies with liabilities greater than their assets
- Across the entire care home sector, borrowing is equivalent to 75 percent of net assets (an abnormally high level which would appear to make the sector particularly exposed to the widely anticipated rise in interest rates during 2015) and
- The average annual profit earned by the care home operators was only £52,000 (which, set against average gross assets of £2.44 million per operator seems like a low return for the risks involved).
Against this backdrop, the risk for investors and lenders to the sector seems considerable.
KEY FACTORS FACING RESIDENTIAL CARE HOME OPERATORS
Funding inequalities and future uncertainty
Across the UK a resident of a care home will have their costs met by the state unless they own property with a value in excess of £23,250 (England and Northern Ireland), £24,750 (Scotland) or £24,000 (Wales). Crucially, real estate is included in this assessment, which has resulted in year on year growth in the proportion of privately funded residents compared to state funded. For the care home operator, the level of fees charged for private residents is often significantly higher than those paid by local authorities.
However, asset values do not necessarily mean that residents have liquid funds available to meet their costs. As a result care home cash flows can be severely impacted particularly when the funding from personal assets is exhausted and the state has to step in. Fees can drop from an average of £750 per week (privately funded) to £500 per week (publicly funded). In the worst case scenario, the state may relocate the resident to a less expensive provider.
In addition to the current financial dynamic, the imminent introduction of the Care Act 2014 (which comes into force next April) will impact on local authority funding with implications for both local authority care budgets and, of course, for care home occupancy rates and capacity constraints.
Property market slump
Owning real estate will render most people ineligible for state support as they will have capital in excess of the maximum amount permitted for state support and as a result, the real estate will need to be sold to meet the cost of care.
Although a recovery is now underway, the housing market slump resulting from the global financial crisis has caused several issues for care home operators:
- Residents’ savings have to meet the funding gap during the period in which their home is sold. These savings may prove insufficient given lengthy sale lead times. If this occurs, the state will be required to pay for care which may result in lower fees and possibly care relocation.
- Falling real estate prices has exacerbated the lack of funding available at the outset of care.
- The state will provide 12 weeks of free support for permanent residents. However, any further payments beyond this point are only made once security is granted over the resident’s real estate, reducing the available funds once sold.
Minimal margins and spiralling costs
With resident fees remaining relatively fixed in the short to medium term, business models for care homes are often dependent on achieving occupancy levels of 85 percent or higher. Anything below this can turn a profitable business into a significant loss-making operator (Southern Cross, for example, had occupancy levels of 84 percent prior to its collapse; down from 92 percent).
Even for care homes operating in a desirable area with a good catchment of potential residents, non-occupation time lags must be built into any business model. Skilful management of cash flow in such situations becomes vitally important, especially for single care home operators.
The most significant overhead for these businesses is staff costs, typically accounting for 60 percent or more of turnover. Industry practice historically has been to pay staff the minimum wage (currently £6.50 for those aged over 21), which has increased by nearly 20 percent since the global financial crisis (including a 3 percent increase in October of this year), with further cost increases from the use of more expensive agency staff to cover absences. Of the remaining costs, regulatory requirements for increased training of staff, coupled with rises in food and energy costs, have squeezed already tight EBIT levels.
The Care Quality Commission (CQC), the care home regulator, determines the ratings for care homes and if a care home fails to meet the minimum industry standards, the CQC has the power to revoke the company’s operating licence.
A reduction in CQC rating will often be the driver behind the state reducing their own rating of the care home and ultimately the price they are willing to pay to fund residents and the number of referrals made to the home.
In many cases the state will no longer place residents in the lowest rated homes and, at this point, the chances of a turnaround for underperforming businesses are severely diminished.
A high maintenance sector
Industry opinion suggests that buildings converted into care homes, rather than purpose built care homes, are often more likely to fail due to the higher long-term maintenance costs required to ensure that the home complies with ever-increasing regulation standards. In addition, converted buildings are unlikely to deliver, to the same extent, the occupancy requirements of present day residents and may therefore not be as attractive to residents or their families.
If a distressed care home business cannot be rescued solvently, placing it into insolvency brings specific problems, in the form of:
- Adverse publicity to the lender
- Political pressure from local members of parliament to keep the home open
- Higher insolvency costs due to the complex regulatory regime requiring specialist advice in any process and
- Sometimes lengthy timeframes between the appointment of administrators and the sale of the home due to purchaser licensing requirements and the delay in procuring these from the CQC.
It has been, and remains, a challenging and uncertain period for the UK care home sector. This is likely to continue in the medium term.
Opportunities for consolidation do arise and there are reasons for optimism. Research published by property agents Knight Frank reveal that 80 percent of the property deals completed in the UK care home market in the two years prior to 2013 involved an overseas investor, many of them US real estate investment trusts lured by the long leases prevalent here and a saturation in their home market. Also, some UK financial services businesses are buying into care home properties, with the insurer Legal & General purchasing the freeholds of 13 care homes operated by Methodist Homes for just over £70 million.
Most recently, in November 2014, it was announced that HC-One, which took on 240 care homes when Southern Cross collapsed, has been sold along with its parent company for £477 million.
However, failure to address the key issues facing the industry will result in distressed situations rapidly escalating and the options available to lenders narrowing. External professional advice should be sought as early as possible if the warning signs highlighted above are evident, in order to enhance the chances of a turnaround and maintain stakeholder positions.