Lending Focus - March 2020 – 1 / 7 观点
While different types of care homes exist, this article focuses on the financing and provision of communal living for those who are 65 or older.
Retirement homes are a broad 'church', ranging from occasional respite care; to independent living with minimal assistance; to round-the-clock nursing care. The sector is set to expand over the coming decades as the UK population ages. Clearers and alternative lenders alike are increasing their exposure to this particular asset-class.
Furthermore, we live in a global village. Australian investors, coming from a jurisdiction in which some of these markets are already rather more advanced, are becoming increasingly active in the UK market, with investment bank Macquarie getting into advanced talks to acquire Barchester Healthcare, one of the UK's top four care homes providers before Brexit concerns apparently cautioned their appetite. Similarly, AMP Capital has followed up its purchase of the Regard Group earlier this year, cementing its foothold in the UK health and social care sector by buying the Care Management Group.
Diverse business models function within the UK care homes sector. Difficulties over the last decade at the less profitable end of the market have been well-publicised. The failure of Southern Cross in 2011 was followed by the troubles of Four Seasons Healthcare, which eventually went into administration in April 2019. Unsurprisingly, nursing shortages have affected homes offering medical assistance in similar fashion to the NHS, where vacancies have been described as a 'national emergency'.
We can only imagine that, in terms of the sector's access to the non-UK workforce, the continuing Brexit uncertainty will exacerbate the problem. The introduction of the National Living Wage, changes to employers' workplace pension schemes and increased regulation have significantly augmented operating costs. The market is dominated by many smaller independent operators, which makes effective lobbying of government more difficult.
Despite these factors, investors seem bullish. The demographics are compelling: in 50 years' time, there are likely to be an additional 8.6 million people in the UK aged 65 and older. In 2018, life expectancy for UK males was measured at 80 years; it was a mere 67 years in 1960. For UK women, life-expectancy is currently calculated to be 83 years.
In the UK, not only is there increased demand due to the ageing population, but there is also a need to refurbish and replenish stock, much of which was built in the 1980s and now needs a major overhaul. This process requires external investment in the absence of large scale government investment.
Care homes can provide a stable income for investors over a relatively longer period, with thirty year lending terms being commonplace as opposed to the five to seven year terms commonly offered in other mainstream commercial sectors. Additionally, alternative lenders seek a diversified portfolio to spread their risk. For example, AXA Investment Managers acquired a portfolio of Irish nursing homes during early 2019 as part of a stated alternative assets strategy.
The UK retirement homes sector may also benefit from increasing jurisdictional inward investment. Sterling exchange rates are, and look to remain, favourable for those who are seeking to acquire property. We may find that Asian and Pacific Rim investors in particular will take advantage of these market conditions given their familiarity with the sector in their domestic markets.
For example in Australia and New Zealand, over 5% of over-65s now live in a retirement village, in comparison with only 0.6% of the UK's elderly population. In Singapore, spending on care for the elderly is expected to hit USD 49 billion by 2030. Experience and confidence may open the door to UK investment.
Broadly speaking, care homes provision consists of the following options:
Operators will often apply for dual licensing, covering both residential care and nursing home facilities on one site. It will then be possible for occupants to switch from residential to nursing home care, as and when this becomes necessary. This system at least preserves continuity of care in familiar surroundings and for couples with differing care needs to remain close.
Care homes may be funded by a local authority; or privately, by individual patients or their families paying for their residency/care. Invariably, funding comprises a mixture of both streams.
Homes that are reliant on public sector funding (or are more reliant, in that they have a larger share of publicly-funded clients) are usually operating on tighter margins and are therefore more financially vulnerable. According to a 2016 report from Grant Thornton (Care homes for the elderly: where are we now?) local authority funding for adult social care fell by 5.3% in real terms between 2010-11 and 2016-17.
This is significant, especially given that demand, costs and the number of patients requiring acute care have all risen over the same time period. The average fees paid by local authorities are 10% less than the total cost of providing care. This equates to a £200–300 million shortfall per annum.
On the other hand, homes that are privately funded seem to be thriving. The realities of living in a 'swanky retirement village' were covered by a 2019 article in The Telegraph, which noted that affluent retirees are ready to pay for a privately-owned house/apartment within a luxury community space, where a library, gym, swimming pool, restaurant and many social activities are available. Residents can expect gardening, cleaning and maintenance provision at a price as well as a round-the-clock duty manager. The fees for this are extracted via a substantial service charge and/or a large deduction from monies realised on the sale of the house, when retirees move on to places offering a greater care element.
Moving on within the same 'independent living' provision, care homes that are mainly privately-funded are also holding their own. Such operators can also expect to be attractive to debt financers. Nick Sanderson, Chief Executive of Audley Retirement, has said that demands for his company's care homes is so great that he cannot build homes swiftly enough.
Given the demand-led growth in the sector and the consequent requirement for external funding, from a lender's perspective the range of opportunities is vast, with potential borrowers from single site owner/operators to borrowers owning and/or operating vast portfolios.
As with all asset-classes, each type of Borrower is accompanied by its own advantages and disadvantages for credit purposes. Lenders that can be flexible in their lending models hold the upper hand. However, all lenders must ensure that their interests are protected through the careful structuring of the deal, due diligence, documentation and the security package.
At the simplest level, a borrower could be a single site freehold property owner and operator with simple funding requirements. Structuring this type of deal is straightforward. However, on the financing of a portfolio of care homes, lenders can expect to see Opco-Propco structures, third party management and/or operating vehicles, offshore jurisdictions and various funding streams (whether intra-group or a third party) that need to be considered at an early stage.
If the financing involves the construction of a care home, the parties may opt for a forward funding structure (where the borrower purchases the land and a developer contracts with the borrower to carry out the development), since this offers a tax incentive for the borrower in the form of reduced stamp duty land tax.
Also in this scenario, the developer will receive payment (for the land which is to be developed) as soon as the empty site is sold to the borrower, rather than having to build the property and sell it before recouping on its investment. Tax advantages/benefits will play a key part behind any structure and any borrower or lender should ensure they are properly advised in this regard.
Sale and leaseback models are commonly seen (given the benefit of the release of capital) and, so long as due diligence is undertaken to ensure that the terms of the lease are market facing, can be easily bankable. Market sentiment and activity indicates that REITs are using this route to expand their care homes portfolios.
However, some conservative lenders are veering away from financing sale and leaseback properties, given the perceived maturity of this economic cycle and the deferred priority of payments under such leases ahead of third party creditors on insolvency. The long income/income strip products (forward funding arrangements that are then sold back to the occupier at the end of the lease) that are quickly growing in the hotels market are not yet commonly seen in the care homes sector but once a precedent is set with an institutional investor, this could change, impacting debt financing models in this space.
Economies of scale are a key factor to any successful care home business and the numbers of beds to be offered will be considered by lenders when they are reviewing the prospective borrower's business plan. From a financing perspective, any fewer than 50 beds is often considered inefficient. Lenders will also want to ensure that the relevant companies required for the day-to-day operation of the care home are security providers or, as a minimum, enter into a duty of care agreement with satisfactory step-in rights.
Certain care homes within a portfolio may be funded by third party lenders or there may be a senior lender and a mezzanine lender at portfolio level. In the usual manner, the priority arrangements and/or intercreditor principles should also be negotiated at an early stage to ensure that the overall deal is palatable for the relevant lender(s).
Although any loan agreement in respect of a care home financing will be based on core corporate and real estate loan agreement principles, bespoke provisions should also be incorporated. At a business level (and non-specific to care homes), lenders should be open to making available a range of different facilities to borrowers, such as development facilities and/or investment facilities with incorporated capex lines.
In growing or transitional portfolios, the borrower’s ability to designate certain care homes in a portfolio as 'investment' properties or 'development' properties with the right to re-designate during the term of the loans provides borrowers with the flexibility they need to operate a profitable care homes business. Development facilities that flip into investment facilities on practical completion are common.
On the financing of care home portfolios, allocated loan amounts (ALAs) and release premiums should be considered carefully. In this context, as homes within the portfolio are sold, lenders will require some or all of the disposal proceeds to be applied in prepayment of the loan(s). Such a prepayment of proceeds will be a condition of such disposal being permitted under the loan document. An ALA is the portion of the total commitment which is allocated to each asset in the financing.
Whether all or a portion of the disposed proceeds are prepayable, the minimum amount that the borrower will need to prepay is expressed as a release price, which in simplest terms is calculated as a percentage of the ALA (eg 110%). This may be a blanket percentage applied to each home, or a variable percentage (larger percentages may apply to 'trophy' homes). The difference between the ALA and the release price is known as the release premium.
Lenders will need to stipulate figures which allow borrowers to operate within their business model, whether that means disposing of care homes not delivering the required return (so they can focus on more profitable homes), or disposing of certain assets to provide financial support for the remaining assets or new acquisitions. Flexibility here can benefit both borrowers and lenders but as with any portfolio, care needs to be taken from a lender perspective that they are not left with a portfolio 'rump' (see comment on 'trophy homes' above).
As to the financial covenants that lenders test against: debt service cover ratios; leverage; debt yield and loan-to-value covenants are commonly seen. However, given that the payment terms for residents vary between care homes (although equal monthly payments are common), account must be taken for the possible 'lumpy' nature of income as a result of advance payments, any standard ongoing payment terms and/or the turnover of residents.
For example, a resident purchasing a leasehold interest in a retirement village will commonly pay a deferred management/exit fee linked to RPI and the number of years residing at the property on the sale of that leasehold interest. Residents deem this preferable to building such fee into a monthly payment and care home providers are comfortable that the fee is effectively secured.
Care home income is not rental income as one would see on any tenanted real estate financing. Consequently, break clauses or tenant contributions are not relevant when calculating income. Instead, 'operating income' and EBITDA are key, and, given the uneven cash-flow profile, lenders may, for the purpose of financial covenant calculations, choose to adopt a blended rate (eg nine month look back, three month look forward, allocating income to future calculation periods or requiring a reserve for finance costs over 12 months).
As to how any advance payments are treated once a client no longer resides at the care home, this will depend on the payment terms of the care home. However, if a care home retains any advance payment, the borrower will want this to be treated as income rather than as a capital payment.
Given that any care home can only operate if it is authorised to do so by the Care Quality Commission (CQC) (which monitors, inspects and regulates all health and social care services), it is key that any loan agreement contains covenants as to the standard to which the care home is operated. These would include maintaining a minimum standard for CQC purposes (which ranges from outstanding to inadequate), usually with 'good' as the minimum.
Mechanics can be included in a loan agreement around improvement plans and increased reporting obligations in the event that a care home's rating is downgraded to 'requires improvement' rather than having an immediate event of default. However, it would be advisable for any lender to detail the following as additional events of default: the termination of a CQC registration; the termination of any registration in respect of a nominated individual if he or she is not replaced within a set time period; any failure to implement CQC recommendations. 'Key-man' provisions may also be appropriate.
Other general undertakings would cover 'care related' covenants to ensure minimum staffing levels, the maintenance of contracts for the day-to-day operation of the care home and requiring any relevant capex spend levels. Ensuring the management of the care home(s) and the operations behind them meet a minimum standard is vital to ensuring profitability. The amount of time a room is vacant between a departure and the room becoming available for occupancy and overall occupancy levels critically impacts cash-flow, so having hard covenants in this respect are also advisable.
Likewise, permitting specified capex works on the basis that only a certain number of beds across the portfolio are affected at any one time. This is also common, given the ongoing maintenance requirements associated with care homes. An obligation on the borrower to have quarterly meetings with the lender to update on the care home's business and operations provides lenders with an additional ability to monitor the performance of a loan. Given the competitive nature of the care homes sector, non-compete covenants are also seen and should be considered.
The usual REF conditions precedent are relevant to a care home financing but a lender would also want to be comfortable with care home-related conditions precedent (eg a standard form care service contract between the operator and a resident in acceptable terms together with regulatory-related conditions precedent etc).
The basic security package in any care home financing does not differ from any other financing – the usual all-asset debenture, share security and assignment of any subordinated debt and duty of care agreements and collateral warranties (each as applicable) are generally always required by lenders.
Lenders must ensure that they are properly advised and thorough due diligence is undertaken to ensure that the security structure would deliver as expected on an enforcement scenario. Guarantees at parent/sponsor level can also serve to make the loan more creditworthy. The usual methods of enforcement apply to any care home financing. However, liquidity can be of concern for lenders, which stems from the lack of operators in the market to buy (the majority of the market is made up of independent operators).
If a sale of the operating business is structured as a business/asset sale, any buyer would have to be registered with the CQC. The CQC would also have to approve the business sale. While this is not an insurmountable issue, it can delay a sale and it is within the gift of the CQC to block any sale (although given the current market and the need for care homes, it is hard to see why it would choose to do so when the potential buyer is CQC registered).
A sale can be structured by way of share sale which then avoids the CQC sale requirements, but any buyer would need to be comfortable with the liabilities left in the borrower/borrowing group and mindful of the ongoing CQC regulatory requirements. The fall-back position would be to close the care home and realise the value in the property itself and any assets that could be sold to interested buyers although alternative use options may be limited either by planning or local policy positions.
Given demographics, global investor trends and the search for portfolio diversification amongst lenders, the UK private care homes sector seems likely to expand. Asia and the Pacific Rim are ahead of the game, and international investors are beginning to take a firm interest in the UK market. There are nuances to be aware of in funding against this asset-class. However, carefully crafted documentation will seek to mitigate and protect against the risks.
A version of this article originally appeared in the January 2020 edition of Butterworth's Journal of International Banking & Financial Law.
作者 Cheng Bray