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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1 comment:

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