The collapse of Southern Cross raised some serious questions, but investors should not be deterred from the healthcare sector, says Tim Bolot
In early 2011, following a sustained deterioration in trading, Southern Cross, the largest care-home operator in the UK with 751 homes, the vast majority of them leased, faced a severe liquidity crunch and was unable to pay its March rent quarter in full.
Southern Cross was therefore forced, at short notice, to request an average rent reduction of 30% from its 80 landlords over the summer as it worked through restructuring options. At the end of the period, an agreement was reached between the 80 Southern Cross landlords and other major creditors, to break Southern Cross up.
The 751 care homes previously operated by Southern Cross were split across 40 operators while 32,000 residents transferred to the care of these new operators - it was one of the largest healthcare transactions ever undertaken in the UK. As chief restructuring officer of Southern Cross over this period, the restructuring process and subsequent work out of the care home assets have highlighted a number of key issues that are likely to be of continued interest to property investors in the future.
• Not all government-backed funding is equal
One of the key attractions of care homes leased to Southern Cross for property investors was the fact that the rental stream was government-backed. Southern Cross, a business with just under £1bn annual revenue, received 80% of its income from either local authorities (70%) or primary care trusts (10%). For investors in the care home properties, this was seen as a huge positive in terms of covenant strength on two counts: the underlying credit quality of Southern Cross's customers, and the seemingly endless demand for Southern Cross facilities.
The flow of funding from government through Southern Cross is illustrated right. However, while this worked well when state spending was increasing with the number and rates for residents placed by local authorities rising annually, when government spending came under pressure, this drastically reduced the government-backed funding flows to Southern Cross. As local authorities in particular started to cut back the rates at which residents were placed and the numbers of residents placed, there was a sharp deterioration in Southern Cross's top line (the government funding). Given its largely fixed cost base, this significantly affected the company's ability to pay rent - and property investors in the care homes were exposed directly to the inability of Southern Cross to pay.
It is interesting to note that in other sectors of the healthcare property market, the government backing for property costs is far more direct. For example, in the primary care sector the contracting lessee is often the primary care trust for general practitioners (GPs), and so the government backed funding is far more secure. It is no surprise that property values in primary care have held up much more strongly than the care home sector, since the covenant is with the primary care trusts.
Investing in government-funded industries, therefore, still needs to take into account the name on the lease, and the path by which that funding makes its way to the property owners.
• Long leases cannot defy gravity
Another of the key aspects of the Southern Cross care home portfolio was the long average maturity of the leases into which it had entered. Typically the leases on Southern Cross care homes were for 25-30 years. While this may be appropriate in some industries where the asset life matches or exceeds the lease, it is arguable that in the care home sector, where the life of the asset is probably closer to 15 years, it left the operator extremely exposed to shifts in the market and obsolescence.
There were numerous examples within the Southern Cross portfolio of homes that had been rendered uncompetitive by the entry of new, superior stock nearby or, alternatively, where the physical configuration of the home had become obsolete by changes in care regulatory requirements. In these cases, Southern Cross was forced to operate the home at a significant loss or, if the site was closed, was left with the significant commitment to pay the unexpired lease for many years. While this could have been deemed sustainable when only involving one or two homes, once the problem spread the financial burden became intolerable. The Southern Cross situation illustrates that a long lease does not necessarily protect the landlord against the operational realities of the underlying business and the useful economic life of the underlying property.
• Theoretical rights of enforcement are not always real
Under non-payment of rent, property investors in care homes have a set of legal rights immediately available to them. In an industry where the majority of revenue is derived from the government, where government regulates provision and providers, and where many of society's most vulnerable members are involved, strict enforcement of legal rights may not be possible in the short term. Because of the absolute size of Southern Cross, an uncontrolled insolvency of the group was hugely unattractive. Furthermore, it was not immediately evident who would fund the process. This is why the workout of the Southern Cross assets was agreed by major creditors on a solvent basis, to enable the orderly unwind of the group and preserve the continuity of care for the residents. While certain landlords explored repossession and insolvency, ultimately none decided to enforce through these routes, which indicates that strict legal rights, suitable in other industries, may not apply so well to care homes (on a large scale).
• Landlord committees are only appropriate in certain circumstances
The informal landlord committee worked in the Southern Cross case because there were 10 major landlords with enough invested in the group to justify supporting the committee process with the significant costs associated. In other cases, where one landlord dominates, it is unlikely that the same process will work since minor landlords do not have enough invested to commit to the process and the industry is not so sensitive.
The unique set of factors that brought about the collapse of Southern Cross should not deter institutional investors from investing in UK healthcare property. The underlying demand for healthcare services and hence modern healthcare facilities remains strong. However, Southern Cross does raise some important lessons for investors about the need to differentiate different revenue streams within the market and also to properly consider an effective exit should market conditions change. This is a difficult task given the politically sensitive nature of healthcare and the complications this can create when it comes to restructuring.
Tim Bolot is managing partner at Bolt Partners