Investing with care
For better or worse, the care sector is still widely regarded as a defensive investment. With the headwinds of Brexit, currency fluctuation and a perpetually shifting political environment, investors are attracted to the demographic burden of the UK’s ageing population.
With an estimated £1.5 trillion of housing equity locked up in English over-55s, and political pressure to adequately fund social care increasing, there are indeed positive signs for the market. For those active at the sharp end of the sector, however, the picture is more complex.
Following the entrance of the US REITs to the market, there has been a sustained move towards businesses focusing on private pay. With a number of the larger players in the market already acquired by US investors, the remaining quality assets coming to market are accompanied by increased vendor expectations on deal multiples, making pricing at times eye-watering for investors.
At the other end of the market, there is once again a drive towards consolidation, with increasing regulatory scrutiny and rising staffing costs forcing smaller operators out of the market. However, this is leading to increases in occupancy rates for larger providers and alongside a modest uplift in funding, this is providing much-needed relief for operators targeting local-authority funded residents.
In this complex and shifting environment, how should investors approach the care market? With evolving models of care and regulatory requirements increasing, how can those deploying capital be sure what makes sense on paper today is still fit for purpose tomorrow?
To address some of these issues in more detail, HealthInvestor UK and the law firm Druces hosted a round table discussion on 12 October in central London to debate what sustainable investment means in an unpredictable environment.
Vernon Baxter: Healthcare has historically been seen as a defensive sector – Tom, do you think it still deserves this reputation?
Tom Morgan: There are two trends we are seeing. One is at grassroots level, where there is a lot of talk of operational pressures, fiscal pressures and regulatory pressures. However, what we and the majority of competitors that trade single care homes around the country are actually finding is that the market is holding up pretty well. It is liquid and pricing remains strong as long as the underlying business is viable. If you look at the other end of the spectrum, property investors are looking at real estate as a means to invest rather than just through the operational business. There are multiple sub-sectors of the market but it all comes back to the position of the asset within its economy, and how aware the investor is of the health and social care market and how the market actually functions.
Vernon Baxter: Jason, are these the questions Welltower asked itself before it entered the UK market?
Jason Myers: Our number one investment criteria was always finding the best operators. Because of the nature of our business being private-pay focused, we knew what our investment criteria was and that was relatively high wealth areas, good assets and critically, leading operators. But as Tom was saying, you need to understand every individual asset in its local market. In terms of pricing, we had our own guidelines in the US and how we looked at risk when pricing transactions. So when we came in, clearly it did a little bit of a reset on the market because we were paying prices that people hadn’t typically seen and underwriting in a way that people hadn’t seen before.
Tom Morgan: That was the fascinating dynamic at the time, as it was fundamentally underwriting operational businesses from the perspective of a healthcare investor first, and a real estate investor second.
Vernon Baxter: Andrew, as an institutional investor, how compatible is the care sector with your criteria? Is it getting easier to do deals?
Andrew Ovey: The fundamentals are hugely compelling. People talk about supply and demand but the ageing demographic to me is not demand, it’s need. What you’re identifying when you make a sustainable investment is the cash will follow the need, and in two different positions, our investment strategy is widely different. In the long-term positioning of assets that can’t change, the longevity of health care real estate is extraordinary. Something that was a hospital 100 years ago will be a hospital in probably 100 years’ time. The fabric of the building doesn’t really matter. It’s what happens inside it. If you make a reasonable investment at the start and you support the operational business within it, you actually have that understanding as a partner, but then you’ve got the opportunity from really pretty ordinary real estate for making a sustainable investment. Now the flipside of that is that if you look at the fact that there is not the capital in the world to support the ageing demographic in a way that we’re funding it at the moment, then what you have over the course of your demographic change, a 20-year period, is the requirement for extraordinary change in the way we deliver healthcare. There is no question that a change in the provision of healthcare must happen because we cannot afford a doubling in the cost of the system unless we fundamentally change the way we fund it. So, you’ve got the opportunity to invest wisely across the existing system but if you break the wrong point in that cycle, then you can lose an extraordinary amount of money.
Jason Myers: You’ve got to underwrite the capital support to make the investment sustainable. We did that at HC-One for every transaction, and it’s worked out relatively well for us, but if you don’t, you’re going to have a big problem long-term.
Andrew Ovey: The scary thing about healthcare real estate investment, is that the expectation has got to be that you’re going to get the keys back from the operator. One of the things I’ve admired about the US entrance into the UK healthcare real estate space is the expectations of the US market that you’ve brought with you is one of completely understanding what’s going on.
Vernon Baxter: Jeremy, as someone looking to lend more money to the sector, how do you manage that as a risk?
Jeremy Huband: In the past, where we lost money is probably backing inexperienced people doing new things. So, we’re trying to back people who are experienced in doing what they’re doing, and we back them to do more of what they do. We’ve got a selective appetite for care homes but we tend to speak to the people who know what they’re doing. One of the major things is re-investment in your asset – it’s not rocket science, but when we see homes that don’t get capex we know there’s going to be an issue.
Patrick Grant: As an investor in care, you’re investing in a social need. But for the last 20-30 years, no other sector which has such sound fundamentals has made such a bad job of serving that demand. The sector has continued to make problems in some places for itself, particularly through lack of capex. Whatever the issues are, what we shouldn’t lose sight of is the underlying demand – it will only continue to grow, so it’s about finding a way of partnering with the operators and actually trying to find something that solves a need for them. The key issue is being able to get long-term partnerships.
Christopher Axford: One of the things that we’ve seen over the last five to 10 years is there’s a common thread when things do go wrong. It’s not just some of the marvellous structures that people have placed to get financing through – it’s also when people forget that it’s a care business and they lose sight of that because their drivers aren’t delivering care. That’s when things can go wrong quite quickly because they lose their credibility with the CQC.
Rachel Brown: We’re certainly seeing this on the distress side, where it is often the case that debt financing hasn’t perhaps been managed properly by management teams and they’re overextending themselves. With the cost pressures in the market increasing, minimum wage and so on, it can just tip over the edge. But there are still many assets out there where you can get a good operator with a good track record that can go in and make efficiencies, and who can innovate, and they can actually turn those businesses around and return them to profitability. You see that in terms of smaller homes and the larger homes. So, it is not necessarily about the size of the business. It’s just about their return.
Christopher Axford: It’s also about different geographies. In the North East, our typical buyer for a distressed asset is probably a good operator that is already in that area and wants to upscale. In the South, there are some funds that are looking at picking up assets with a turnaround plan to get them back to an operating term to where they are getting a profit.
Vernon Baxter: Tom, where else are you seeing developments and innovation in the market?
Tom Morgan: There is no doubt in my mind that the integration between health and social care and public and private is an agenda that’s gaining momentum. We’re beginning to see some really interesting business models looking at how the independent sector or the social care system can alleviate some issues from the healthcare universe – particularly things like the growth of rehab, transitional beds and stepdown.
Rachel Brown: We’re seeing private investors that are interested in this part of the market because actually, if you’ve got a good operator with a good track record and they’re willing to innovate and make efficiencies and develop their business model, then there are good returns to be made.
Andrew Ovey: Innovation can be an absolute minefield. You look at examples where you try to bring a new model to market, or government has tried to introduce change in the system and it is extraordinarily difficult. When you look 20 years ahead, you know it’s going to change, but when you look at the people that are making the decisions, they can’t get past five years – and that is a mismatch.
Vernon Baxter: Nick, with Audley’s retirement village model, you’ve had to go against the grain for many years – is the market now changing?
Nick Sanderson: What underpins all this is the scale of the demand – or the need, as Andrew rightly described it. It’s just too big and it allows bad models to be run by bad management who have the odd crisis but can still survive. We sustain a system which is fundamentally flawed because the whole infrastructure around it, whether it’s the funding or the commissioning, is stuck in its ways. The difficulty about running a business like mine is that we’re always working with innovation. It’s very hard for me to persuade Jeremy or Jason or anybody else that it’s going to work, because it’s not been done before. My job is to turn a non-institutional grade asset into an institutional grade asset, that’s all I do. So I have to get scale, I have to have demand – I have to build a management team to convince people that it’s safe to go into the water. Of course traditional elderly care will still work, because the need and the demand is so great, but it is in danger of disguising what it is the market would really like to see. It needs people like us and others to be brave enough to innovate to change.
Jason Myers: I totally agree that we need to understand the value propositions that the buyers really want and that 20 years from now, there is going to be a set of senior housing solutions that don’t exist today. I had a meeting two weeks ago with a large residential senior housing group in the US that is very interested in coming over here too, and they are doing the exact same piece of work, which is surveying seniors over here, trying to identify what is it that people really want.
Tom Morgan: That is a really interesting point, because actually a lot of the innovation is being delivered by smaller operators who by definition can be more flexible and creative in their thinking. They are actually coming up with some of the solutions that possibly the service user or the customer would require, but historically have struggled to get the sort of funding that makes it financially viable to deliver it. What is going to be interesting in the next five years is whether we begin to see the trend we have seen in the residential care market begin to take place with more innovation, and with different financing partners or financing structures so that actually we can all work to what the customer ultimately wants.
Nick Sanderson: We raised £285 million last year but I couldn’t have raised £285,000 when I started. Everybody said ‘well, who’s going to buy these nine bungalows? Where is the evidence? Show me. Where is the market? How sustainable is it? Will we be able to resell?’
Andrew Ovey: The fascinating thing about the return of a village and particularly the longevity of the sustainability of capital, is that from first build to change of ownership, that village matures. A lot of the same people buy the first unit. Over the course of sort of five generations of owners, you end up with quite a different scheme, because the average age has moved from people that are making decisions to people that are recognising what is there and what the village actually does. If you look at some of your older schemes, the people that buy now are completely different from the people that originally invested in their home because the nature of that village has changed.
Vernon Baxter: If we look ahead five years, to what extent do we believe supply will have caught up with demand?
Jason Myers: My feeling is there is no way it is going to catch up. There is such a huge opportunity here with the obsolescence of assets falling out of the market and the social care funding limitations not increasing and more people having to pay privately – there is so much need that we can build to essentially right now, that we are going to be focused on that. I don’t see us being able to catch up with the opportunities in five years for sure.
Tom Morgan: I would agree with that, which clearly from an investment perspective is fantastic. I think there were two things we haven’t touched on. I think there is a lot of momentum behind the scenes, and the creation of an estates programme board that brings together Department of Health, Cabinet Office, Treasury, NHSI and a few others is a fantastic start. It’s recognition that you can’t do it in silos. The other point is that the planning system needs fundamental change to enable the innovation, expertise and the capital to meet demand.
Patrick Grant: The most worrying thing is not just the actual meeting of demand, it is meeting demand with the right quality because we are already at a stage now where there is so much substandard quality of care out there and the demand is only going to increase from today moving forward. We are already playing catch up where we are at a point where we are just about coping and actually, as the demand grows in terms of demographics, how we keep up and maintain quality is going to be by far the biggest issue in the market.
Rachel Brown: I don’t think the supply will actually meet demand but I think it will be an interesting market in five years’ time. It is obvious that the system needs to change and there are a lot of people wanting to invest in the market. If companies can demonstrate to investors that they have a good underlying business model and they are able to innovate and achieve efficiencies, then there will be growth and it will be interesting to see how it adapts.
Nick Sanderson: Absolutely, I don’t think we will scratch the surface unfortunately and even if all the capital I can see coming in does materialise, it may just replace what needs to be replaced, not even actually grow the sector at all.
Christopher Axford: I think there is a tipping point almost for the residential care model, and we will still see a lot of pressure in the market. The question is whether we’ll ever catch up?
The above is an edited transcript and is not reported verbatim. The panel met in central London on 27 September 2017.
For further information on Druces’ healthcare team, please contact +44 (0)20 7216 5557
We were delighted to host this round table event and would like to thank our knowledgeable and experienced guests for participating in the debate around the table on this interesting topic.
The role of sustainable capital in healthcare has divided opinions within the sector. There has been capital deployed in traditional healthcare models for a number of years, and the returns on that investment can be viewed positively on the whole.
There was a broad consensus arising from the debate that demand, or as Andrew highlighted, ‘need’, will continue to outstrip supply in the sector for many years to come. This produces clear investment opportunities which will continue to exist for the future, but it was also noted that the sheer scale of the sector and the way in which care is currently delivered in the UK has produced a requirement for innovation in the delivery of supply.
There was also acknowledgement that there is ever more integration between the delivery of health and social care between the public and private sectors, and this is providing more opportunities for investors. The panel made the point that underlying real estate assets are important, but it is the operational business that needs to have careful focus from investors, and that those operations with the delivery of quality care at their centre, in fit for purpose, well maintained assets, should prove a sustainable investment.
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