Monday, January 24, 2011

Appraisal of the Leasehold Interest in an Australian Nursing Home

I recently returned to Melbourne, Australia, to appraise yet another “aged care home” in a corporate portfolio of nursing homes and retirement villages seeking financing in the United States. The Australian and New Zealand banks won’t finance such property types any more due to a wave of failures in this industry in 2009.

The main problem with the Australian aged care industry is that it is highly dependent upon government subsidies which have not been increasing as fast as operating costs, the most notable cost being staffing costs. Unlike much of the “Western world”, Australia has escaped recession and suffers from labor shortages in certain industries, particularly the aged care industry, which has been limited in its ability to compete for nursing talent by low operating profit margins and inadequate government reimbursements. In this respect, Australia and the USA have a similar problem.

In this particular assignment, neither the borrower nor the lender informed me that the nursing home was leased rather than owned, a fact that only became evident to me after I ordered a title report on-line from the Victorian government (Melbourne is in the Australian state of Victoria).

There was some confusion due to some slight connotative differences in the definition of “leasehold interest” between Australia and the USA – two great nations separated by a common language (English). The Australians assumed that the US lender would lend on the value of their “going concern”, which in this case was the value of the nursing home business enterprise, the bed licenses, the FF&E (Furniture, Fixtures and Equipment) and the “Accommodation Bonds” collected from incoming residents. The American lender simply thought of the leasehold interest as that interest created by having a favorable (below-market) rental rate on leased premises. This difference in the connotation of “leasehold interest” created a vast gulf between borrower and lender in the perception of what constituted adequate security for a mortgage loan.

The nursing home was “built-to-suit” in 2009 and its rental rate was structured to be close to a market rental rate. The only aspect which created positive leasehold value was that part of the rent included a $900,000 lump sum payment in 2010, leaving less subsequent rent to be paid. At an annual rental rate of $8425 per bed in an industry where most aged care facilities are leased in the range of $10,000 to $13,000 per bed, there is a positive leasehold value. Nevertheless, there remains one more $900,000 lump sum payment that closes most of this leasehold value gap.

The borrower was quite emphatic about the value of more than $6 million in “accommodation bonds” collected so far from incoming residents, but such bonds are not “free money” but are liabilities that must eventually be repaid when the residents leave (either for the afterlife or else another facility). In the US one would naturally ask why such a liability could be considered an asset, but in fairness to the Australians, these bonds serve as interest-free loans in an economy where one can actually earn a decent rate of bank interest (6% +) in the mean time. In the US, bonded indebtedness is more likely to be treated as a shameful secret that only comes to light after I read the title report.

There are good reasons, though, why accommodation bonds can never serve as suitable collateral for a mortgage loan:

1. Aged care homes are allowed to commingle bond funds with their own business operations, as they may be spent immediately for debt reduction or capital improvements,

2. Bond proceeds can be immediately spent, and

3. Individual bondholders (residents) are in superior lien position to mortgagees.

If an aged care home fails, such as we saw in my previous blog about the Bridgewater facility in Roxburgh Park, the bond proceeds may disappear in the failure of the nursing home enterprise. The foreclosing lender has no access to the bonds, and even if the lender did, the money is owed to the residents. The Australian government has a reserve fund to pay back bondholders, but not mortgagees.

There is a value to the operator for the bed licenses, too, but licenses are tied to the operator, not the real estate, and can be withdrawn by the government, too, if the facility repeatedly fails to pass inspections, such as also was the case with the Bridgewater facility in Roxburgh Park. Last summer, for instance, I appraised a facility in Albany, Western Australia, in which the operator had previously stated the intention of moving bed licenses (and therefore patients) to another facility in town, thus potentially impairing the value of the proposed collateral. The lender could have been stuck with an empty, obsolete nursing home building.

During these past six months, I have read many aged care home and retirement village valuation reports from Australian “valuers” (the US equivalent of “appraisers”), and found all reports to be valuations of going concerns. This is appropriate methodology for corporate mergers and acquisitions, of which there have been quite a few in Australia, but inappropriate for lenders, who are left with few assets to take possession of in the event of a loan default. Nevertheless, these valuation reports were labeled as being for “mortgage financing purposes”, a label I find to be dangerous.

I have seen similar types of appraisals in the USA of nursing homes and hospitals, and lender reliance on such appraisals can end up as a huge mistake. Foreclosed hospital real estate, for instance, typically gets sold for about 20% of the original “going concern” value, as by the time the loan defaults, the hospital license is lost and the facility has become vacant, and a lender cannot get a license to run a hospital. In fact, in my work with foreclosed hospitals in California and Michigan, I have never seen one become licensed again. Obsolescence plays a big role in this.

I have witnessed a lot of muddled thinking about the valuation of nursing homes and hospitals in both countries which merits more discussion about the distinctions between real estate valuation methods and going concern valuation methods.
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Saturday, January 1, 2011

Title Problems and “Lack of Transparency” in Latin American real estate

Ejido de Llano Largo, Acapulco
One reader commented to me about the lack of real estate market transparency in the Dominican Republic and particularly warned me about title problems. He referred me to his web site which contains the following warnings about title issues:

"1. Before signing any contracts or paying any money you must use a trusted lawyer to make a "deep" local title search. It's not enough to check if the title is "Clean", the ownership history must also be investigated as there has been and still is a lot of fraud with titles in the Dominican Republic.

2. If you are buying land you must use an independent surveyor to re-measure the land and confirm the position (the lawyers know which one to use in the area). Do NOT buy any land with squatters on it and make sure that no squatters are moving into your land as it's impossible to remove them later on."

The US Department of State has issued its own warning about the DR:

"Real estate investments in the Dominican Republic require a high level of caution, as property rights are irregularly enforced and investors often encounter problems in receiving clear title to land. Consultation with an attorney is recommended before signing documents or closing on any real estate transactions. Real estate investments by U.S. citizens have been the subject of both legal and physical takeover attempts. Absentee landlords and absentee owners of undeveloped land are particularly vulnerable. Investors should seek solid property title and not just a “carta de constancia,” which is often confused by foreigners with a title. An official land registry measurement (also known as 'deslinde' or 'mensura catastral') is also desirable for the cautious overseas investor. Investors should also consider purchasing title insurance. Squatters, sometimes supported by governmental or non-governmental organizations, have invaded properties belonging to U.S. citizens, threatening violence and blocking the owners from entering their property."

Market transparency

A transparent market is a market where relevant information is fully and freely available to the public. Jones Lang LaSalle, a major international brokerage (and former employer), published a Global Real Estate Transparency Index 2010 ranking countries according to the transparency of their real estate markets. Canada (no. 2) and the United States (no. 6, impaired by numerous “nondisclosure states”) ranked high in transparency and led the western hemisphere, while the Dominican Republic ranked 77th out of 81 countries and ranked last in the western hemisphere. (This list is not necessarily comprehensive; I once had to turn down a valuation assignment in Liberia, Africa, which is not ranked and seems to suffer from title anarchy.)

Squatters and "land reform"

In countries like Peru and Brazil there are vast shantytowns (AKA “pueblos jovenes” in Peru and “favelas” in Brazil) that are illegally erected on private land and extraction of squatters can also be legally difficult, as it is in the Dominican Republic and Mexico. The DR has also recently had a problem with an influx of Haitian refugee squatters after the earthquake in 2010. As Latin America has finally shaken off fascist governments, the new reality is that democratically elected governments are often more sympathetic to squatters and their alleged rights.

The government of Mexico, in carrying out land reform after the Mexican Revolution, re-instituted an Aztec agrarian communal system of ownership called the “ejido” in which campesinos share ownership of a large tract of land, land which is usually expropriated from the previous owner. A resident of an ejido is known as an ejidatario. Ejido parcels in Mexico cannot be sold, mortgaged or rented. The Mexican Constitution of 1917 promised to restore ejidos, and the expropriation of land for ejidos began in 1934 and continued until 1991, when President Carlos Salinas abolished the practice in order to ratify NAFTA, as American companies did not want to build plants on land that could conceivably be expropriated.

Llano Largo, Acapulco

As an example of the title issues inherent in the ejido system, I once appraised a parcel of land within the city of Acapulco, a few hundred meters north of the Boulevard de las Naciones which bounds the prestigious Zona Diamante section of town. The evening before I was to meet the landowner, I hired three Mexican real estate agents, including one appraiser, to accompany me to the property and share their opinions. While present on site, we were soon approached by several peasants from a neighboring shantytown. They politely asked what our interest in the land was and then claimed that the land belonged to them as part of an “ejido” granted to them. That introduced the possibility of a title problem. What was further perplexing was that the government had placed a sign on the property declaring it to be a “Reserva Ecologica” (ecological preserve).

The next morning the landowner/loan applicant drove me to a parking lot on the Boulevard de las Naciones and then pointed to his property across a grassy field. “Why can’t we go to it?” I asked. He reluctantly drove me to the western edge of the property, the only accessible edge, and when we disembarked, we were immediately approached by ejidatarios. Instead of talking to them, the landowner immediately summoned me back into his truck and we drove off. He called the ejidatarios “squatters who will be removed soon.”

The landowner further damaged his credibility when he presented me with an “Uso de Suelo” (a document certifying the permitted land use) for another parcel instead, a parcel described as being right on the Boulevard de las Naciones.

The need to use attorneys and title insurers

It is essential to use an honest, local attorney that has been carefully vetted. Several years ago, for instance, a Venezuelan friend of mine sold his business in Houston in order to retire in Costa Rica. He selected a house/restaurant on a cliff and was guided through his purchase by a local Costa Rican attorney. Unfortunately, he did not buy title insurance and the attorney he hired was in league with the swindler who claimed to own the property. My friend lost his life savings and ended up having to sleep on other people’s couches.

Two American title companies, Stewart Title and First American, now offer title insurance in Latin America. Be sure to specifically ask for coverage against squatters, too, or you may face years of litigation in a foreign land.

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