In an excellent analysis and summary of major issues that impact the valuation of continuing care retirement communities (CCRCs), Alan Plush, the senior partner of HealthTrust LLC, explains the necessity of recognizing that a CCRC “has many moving parts.” In other words, it is more complex than traditional rental seniors housing because it includes disparate operational platforms (independent living, assisted living, skilled nursing, and possibly memory care) under one roof, with each component having its own unique operational aspects The entry-fee CCRC combines all of the complexities of valuation of these assets, coupled with an upfront payment that offsets future ownership costs.
The life cycle of an entry-fee CCRC presents different valuation challenges depending on the point in the cycle that the valuation occurs: Residents buying units are given an interest in the property by virtue of the upfront payment, which essentially “buys down” occupancy costs during the term of their residency. The resident has prepaid a substantial portion of the capital cost of providing his or her residency, and thus has a defined, partial interest in the enterprise. After the sale of the first unit, the developer/owner position is diluted and is best described as a remainder interest. When a resident departs a CCRC, different contract options remit various portions (or none) of the initial fee to the resident’s estate.
To further complicate this exercise, CCRCs evolve over time from both a physical and operational standpoint. As residents age and units are vacated, resales occur and cash flows (based on resale revenues less refunds) occur. Depending on where the CCRC is on this time line, these resales can result in “lumpy” cash flows.
The article next examines three traditional methods for valuation of real estate assets (cost approach, sales comparison approach, and income capitalization approach) in the context of seniors housing in general and CCRCs in particular, where health care and the housing assets both incorporate an active business into the bundle of ownership rights, resulting in a market value of the going concern which includes real property, personal property, and business components.
n The cost approach combines the market value estimate for the site as if vacant, the depreciated reproduction costs for the improvements, and a measure of the developer’s profit (if not business value). But that is a static approach, whereas some of those assets are going-concern businesses. So Plush notes that the experienced appraiser will assign the cost approach the least weight, given the limited reliance placed on it by buyers and sellers in the actual marketplace for those assets. Further, once the fee simple estate has been split between resident interests and developer/owner residual interests, the conclusion provided by this approach (fee simple) does not reflect the value of the collateral in the case of a financing (leased fee).
n The sales comparison approach to valuation is disadvantaged by the extremely small pool of legitimate transactions that have occurred outside of distressed asset sales. Moreover, each CCRC may be said to be unique given their individual entry-fee agreements coupled with where they are in their life cycle. Comparing CCRCs with alternate asset classes such as rental CCRCs and rental independent living/assisted living properties is flawed, because the pricing reflects a grossly different risk profile on the income stream—that’s why appraisers and market participants alike typically don’t rely entirely on the sales comparison approach.
n The income capitalization approach might well be the most relevant for entry-fee CCRCs. Given their complexity, it is key to accurately forecast both revenues and expenses. Revenues are generally broken out into two categories:
- monthly operational (rent and service) fees, and
- unit resales.
Forecasting net revenues from unit resales requires estimation of per-unit resale revenues as well as estimation of the turnover rate—the frequency at which they will occur. Turnover rate often follows trends in the housing market within the primary market area of a CCRC, given that most seniors must sell their primary residence in order to move into the CCRC.
Once all of these various revenue sources are tabulated and expenses are deducted, an estimate of net income is derived. Appraisers should typically use a five- or 10-year discounted cash flow model, given the lumpy nature of revenues from unit turnovers. Some practitioners attempt to separate out the net entry-fee revenues from the operational net income, and then to apply separate capitalization and discount rates to each—although market data is even less available for that approach, and an argument can be made that the appraiser should correlate his or her methods with the methods actually used by buyers and sellers in the market, as well as lenders and underwriters.
To this end, the valuation process often includes judgment tempered with experience, as CCRC valuations require orchestration of many moving parts to be accurate.