Increasing debt being taken on by some retirement village operators makes the state of the housing market a more important factor for investors to consider, according to a detailed report on the sector by First NZ Capital.
The report looks at Ryman Healthcare, Metlifecare, and Summerset Group, analysing the accounts of more than 70 villages during the past decade.
Increased land banking and construction given the ageing population and strong sector growth in recent years will see debt among retirement village operators continue to increase, FNZC said.
Ryman, the largest of the listed operators, is likely to increase its debt to more than $800 million over the next few years from $545.9m in the 2016 financial year as it grows its landbank and builds more villages in Australia.
It wants to have five villages open in Melbourne by 2020, while still maintaining its development rate in New Zealand and could announce a further six to eight development sites between now and 2020, the report said.
Summerset's debt is likely to grow to between $400 and $500m in the next few years from $241.5m currently on core operating earnings of $15m. The company has also been growing its landbank quite significantly since listing in 2011 and is focusing on more ambitious apartment projects which require more peak construction working capital than villas. Summerset is currently targeting acquiring one site in Auckland and one outside of Auckland yearly.
FNZC doesn't say the three listed operators have too much debt, "but we do think as development focus increases, more information on headroom would be useful for the market".
Ryman says it is comfortably within its debt covenants, Summerset says it is comfortable and does stress testing, while Metlifecare has limited debt of only $74.2m.
Metlifecare has been the least active developer of the large operators in the last decade though that's starting to change. Its development pipeline is dominated by brownfield opportunities in existing villages with only one greenfield development still some years away from opening.
Retirement village operators tend to acquire land and fund new developments through debt, building a mix of independent villas and apartments, serviced apartments and care facilities. They make money off any development gains and providing care services but the big and steady profits come from Occupational Rights Agreements which incoming residents purchase in order to live in the units.
When residents leave, the operators have to repay the purchase price but make a gain on the resale of the ORA to a new resident, on a deferred management fee of 20-to-30 per cent, and on any uplift in the unit's value if the property market rises.
Despite the attractiveness of development and the operators' broader business model, FNZC said more disclosure is required as the sector takes on more debt for growth.
"Ryman did demonstrate in the last downturn that its diverse business (higher level of serviced apartments and care) positioned it well through that period which is likely a reason why the other operators are increasingly looking to replicate elements of Ryman's model, among others.
The increasing leverage that some operators are taking on means that we think the health of the property market is the more important consideration for investors to consider, particularly given that we are well into what has been a strong period of house price growth.
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"But we similarly note that not all operators across the sector - both listed and private - have demonstrated the same capability to grow without equity and for this reason we would like to see more disclosure on debt as debt levels grow again and consideration is given to how the operators are placed in a property market slowdown," the report said.
Retirement village operators are favouring more developments in Auckland and other higher value locations than in the provinces because their business model works best in markets that combine large populations with higher property valuations.
In recent years the strong property market has caused a big uplift in the value of the operators' net tangible assets, including mature villages.
FNZC notes the property market is well into the third material upwards cycle over the past 25 years and the last two strong growth periods were followed by relatively long periods in which nominal house prices were essentially flat.
"The increasing leverage that some operators are taking on means that we think the health of the property market is the more important consideration for investors to consider, particularly given that we are well into what has been a strong period of house price growth," FNZC said.
Both development cash flows through new sales and the core resale cash flows that drive retirement village businesses rely on a functioning property market in which incoming residents are able to sell their existing houses at levels they are happy with, it said.
"While it is not easy to observe, we expect a slowdown and more suppressed house prices might impact the timing of incoming resident choice - this is important to new and resales timing," FNZC said.
Mitigating factors include residents of serviced apartments and care facilities don't have much choice on moving in or not and may, therefore, still sell their houses even in a property market downturn.
Another factor, the report said, is that unlike typical property developers who can only sell once, village operators can opt to sell a unit at a lower price in a weak market, knowing they'll "ultimately capture the gain again in the future".