MDS

If You Need To Know The Senior Market

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A Two Generation Company - Serving Clients For Over 39 Years

Strategy of The Month for December 2009

ARE YOU PROPERLY PLANNING FOR THE FUTURE?

          In previous newsletters, I suggested that you evaluate an exit strategy hypothesis.  I suggested you ask and answer these five sobering questions:

1.      How competitive would an objective third party perceive your property or campus to be in two time frames: now, and over the next five years?

2.      If a knowledgeable observer was scoring you and your competition on scales of 1 to 10 for product, service, price, and value, how would you measure up?

3.      If you were on the other side of the negotiating table and about to purchase your community, what concerns would you have?

4.       As a potential buyer of your community, are there any flaws or shortcomings that would cause you to reduce your price?

5.      Based on your answers to the first four questions, what should you change over the next 18 months?

            Developing a sound exit strategy doesn’t necessarily mean you’re actually planning to get out of the senior living business.  It does mean that you think it’s prudent to objectively evaluate your individual project or portfolio of properties to determine their true value and overall competitiveness while identifying any potential weaknesses. 

Little Things Mean a Lot

            Little things will make a big difference as our industry matures (and recovers), so your operations must be based on sound fundamentals.  Further refine your exit strategy planning by answering five more questions:

1.   Do you have a proactive sales and marketing program, or are you just waiting for prospective residents to show up?

2.   Are there any emerging trends that could alter your current resident and professional referral patterns?

3.   How is the aging-in-place of both your residents and your physical plant likely to affect your competitiveness over the next five years?

4.   Are you accumulating and using appropriate reserve funds to improve living units and public spaces while maintaining competitive pricing?

5.   Have you optimized occupancy and effectively addressed direct care cost creep?

            Keeping up with the changing market means also investing constantly in such things as advanced computer software, training and education, and capital equipment.  Whether you are a self-contained, internally operated for-profit or not-for-profit organization, charge your community a management fee of approximately 5 percent of net revenues.  Lenders and investors expect to see such an assessment as a normal line item under operating expenses.

Use the Resident-Day Concept to Evaluate Your Expenses

            To run a quick check on your financial performance, compute your total resident days by multiplying the number of residents you have times 365 days.  Divide your total operating expenses (not including interest, taxes, depreciation, or loan amortization) by the total number of resident days to compute operating expenses per resident day.  Compare this number to my suggested assisted living 2008 benchmark of $75.00 to $103.00 per resident-day.  This is a baseline operating expense before incurring the added costs for high acuity residents.

Operating Expense Ratio

            Now divide these same total operating expenses by net revenues collected from occupied units. This yields your operating expense ratio, which should be approximately 70 to 75 percent. The inverse of this ratio would now be the operating profit margin which should average approximately 25 to 30 percent of revenues. Figure 1 summarizes some of the more important assisted living benchmarks.

            If your operating expense ratio is higher than 75 percent but your operating expenses per resident day are “normal,” chances are you are collecting abnormally low revenues, and it may be time to rethink your pricing strategy.

             If both your operating expense ratio and your expenses per resident day are above the high end of the range, take a long, hard look at your operating expenses, department by department.  To conform with industry norms, your total staffing should average approximately .45 to .55 FTEs per unit for assisted living, and somewhat higher for special care/dementia.

The Cost Creep Dilemma

            Develop cost accounting and pricing systems to compensate for cost creep that results in significant profit erosion resulting from the steadily rising cost of providing uncompensated care to residents as they age in place.  Make sure that each department or service – like direct care – is a stand-alone cost/profit center.  Develop accounting systems that appropriately allocate direct labor and other costs.  Make sure pricing strategies treat each resident and their families fairly, while fully recovering the total cost of their care. 

Operating Profit Margin – An Elusive Target

            If operating expenses and revenues are in line and revenues are appropriate, you should realize an operating profit of approximately 25 to 30 percent for an efficiently operated assisted living community of at least 80 units.  All of these ratios should continue to improve the longer your assisted living community has been in operation at high stabilized occupancy.  Current occupancies for assisted living are averaging approximately 88 to 90 percent.

            It should be noted that even many of the most sophisticated assisted living operators in the United States today are still chasing elusive EBITDA operating profit margins in excess of 30 percent. It’s become a frustrating target to realize because of operating cost creep.

Debt Service Coverage

            If you have typical debt on your community of about 75 percent of its total value, your lender is likely to require a debt service coverage ratio of approximately 1.25 to 1.30.  To determine this metric, divide your net operating income by your annual debt payment.  This means that after paying all of your annual operating expenses, you must have about a $1.30 in available cash for every dollar of required annual debt payment (both principal and interest).

Capitalization Rate Determines Value – They key value indicator for your community is your net operating income.  As a hypothetical exit strategy, a buyer will generally look at your community as an income producing “black box”.  In today’s market, these potential buyers (or lenders) are likely to value your assisted living community using a capitalization rate of approximately 9.0 to 10.0 percent.  This means that, in the short run, they are willing to initially realize a 9.0 to 10.0 percent return on their cash invested.  Thus, dividing your net operating income by between .09 to .10 tells you and potential buyers and lenders how much cash they can afford to invest for these appropriate returns.  These “cap rates” may change as we get deeper into the “credit crunch”.  The actual determination of value is more complex, but these are the basics.

Putting It All Together

            The simple exit strategy rule of thumb for value indicates that, for every extra dollar of annual net operating income you realize, the value of your community increases by almost $10.  This can be accomplished by either enhancing revenues or decreasing expenses.  Remember, cash flow is the “lifeblood” of your community; whether you are a for-profit having to answer to lenders and investors or a not-for-profit struggling to fund an ongoing charitable mission.

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