ALTERNATIVES: HEALTHCARE The healthcare and care-home sector is still a small fraction of the institutional market in Europe. But fund providers believe that the demographics are in their favour, reports Maha Khan Phillips

Last year the first UK healthcare property real estate investment trust (REIT) was launched. The Target Healthcare REIT, which specialises in investing in modern, purpose-built care homes, raised a total of £95.7m (€116.5m) across three issuances. Its second issue was oversubscribed, having attracted institutional investors, wealth managers and private investors.

“The demographics are a fundamental part of why healthcare is interesting. it is obvious that the number of elderly people is substantially increasing,” says managing partner Kenneth MacKenzie. Target Healthcare is the only care homes REIT that is listed on the London stock exchange. shares have consistently traded at a premium to nAV since launch. The portfolio aims to provide a gross dividend yield of 6%. Other REIT players in the market have come primarily from the US, where healthcare real estate as an asset class, and care homes in general, are much better established. Last year, for example, griffin-American Healthcare REIT II acquired the 44-facility portfolio of Myriad Healthcare in the UK for £299m, while Medical Properties Trust acquired 11 rehabilitation hospitals in Germany from RHM Klinik-un Alterheim-betriebe, for approximately $248m (€181.4m).

“We are trying to bring long-term, moderate returns to our investors by taking a long-term position,” says MacKenzie, who points out that his business is one whose clients – care-home residents – are usually in a position of distress, or vulnerability.

There are many reasons why investors would be attracted to the healthcare property sector. The population is getting older. The amount of people over the age of 85 in the UK will double from 1.4m to 2.8m by 2033, according to Age UK.

This same pattern is occurring across Europe. “Germany has an increasing old-age dependency ratio, and there is a greater demand for healthcare provisions such as nursing homes, and assisted living facilities,” says Darren Sriharan, research analyst at Aviva Investors. “The healthcare sector has huge potential for growth, and the german government is looking for ways to increase competition. Around 11% of GDP goes on the healthcare sector.”

Aside from demand, the stability of the market is also attractive. in the UK, income returns for primary healthcare assets remained above 6% in 2012, for the fifth consecutive year, indicating that the market is fairly stable, according to the IPD UK Annual Healthcare Index. Over the five years to the end of 2012, primary assets delivered a total return of 6.3% to investors. Capital values for primary healthcare assets have shifted by just 0.2% over the period, while more volatile commercial property assets have lost 30% of their value, according to IPD.

However, secondary care properties, such as residential care or nursing homes, have fared less well. Total returns were -3.1% in 2012, although this is largely because of homes that take patients funded by local authorities, where ongoing council cuts mean many local authorities are forced to defer care home referrals and costs. In contrast, privately-funded care homes are performing strongly in the UK, according to IPD. According to one estimate, institutional allocations to the primary market in the UK stands at approximately £2bn.

“In the UK, institutional allocations to healthcare property have historically been quite low,” says Rob Martin, head of research at Legal & General Property, which completed the acquisition of 13 care homes from Prestbury Investments for just over £70m, let to Methodist Homes, in December of last year. “There are reasons for that. To a degree, it is less well understood than other core sectors. it is still viewed as an alternative form of real estate, whereas the Us and Australia see healthcare as part of a balanced exposure to property.”

In January, Legal & general also agreed to forward-fund and purchase five care homes in suffolk with Care UK for £31m. “We are orientated around partnering,” Martin says. “We would want the assets to deliver in excess of the [IPD] all-property average, and there is still a certain risk premium we would require from the sector because it is less institutionalised. We are looking at index-linked leases where rent goes in line with RPI inflation of around 3% or 3.5%.”

Consultants believe that institutions are starting to think seriously about healthcare. “We’ve done work on a particular healthcare real estate fund,” says Paul Jayasingha, global head of real estate at Towers Watson. “Some of our clients liked it, and are making commitments. The thing that attracted clients to the fund is the ability to get long-term inflation linked leases with initial yields of 6% and 7%.” But not all investors have been quick to embrace the sector. “As a long-term investment we regard it as favourable, but it doesn’t mean it is free of risk,” says Paul Richards, head of Mercer’s european real estate boutique. “You have to have a manager with a lot of expertise. Many operators have issues with the financial structure and have raised the capital, but the rents have been too high. So it really depends on who the manager is.” Mark Weedon, head of UK alternative real estate at IPD, agrees. “I don’t think there is as much interest from institutional investors as has been suggested,” he says. “I don’t think there’s as much interest in healthcare as there is in residential, for example. Perhaps it is because the scale of the market is not big enough.”

The Southern Cross risk

It could also be because investors have not forgotten the southern Cross debacle, the private provider of health and social care services that operated 751 care homes. The company’s rent bill of £240m became unaffordable in 2011, and, with public cuts leading to fewer referrals, it was forced to negotiate to reduce its rent, eventually breaking up, with its market value falling from £1.1bn to around £12m. With just under £1bn in annual revenue, southern Cross received 80% of its income from either local authorities or primary care trusts – a model which consultants believe is not sustainable.

Southern Cross also came under pressure for alleged mismanagement and institutional abuse. More recently, official figures released under the Freedom of information Act to the Daily Telegraph revealed that 1,158 care home residents suffered dehydration related deaths. It means that reputational risk is a key concern, and that comes down entirely to the operator responsible for the care homes. “There are a number of challenges in this business,” says MacKenzie. “You are exposed to operator risk. In the past, institutions and the financial investing community have tended to invest in single operators. So part of the challenge with southern Cross was that it was single operator risk. One of the advantages we have is that not only are we an investment manager, but we diversify the risk, and we will use a number of different operators.”

One important factor will be the business models that people choose to use. Last year, IPD warned that the downward pressure in occupancy levels for residential care homes would lead to difficulties for leveraged care home operators, which in turn leads to less confidence from investors. “Demographics are very much in favour of this sector,” says Alan Patterson, head of european research and strategy at AXA Real Estate. “But the more you move into specialised property, the closer you have to look at the business model. Does the business model make sense? if care home operators struggle to make it work financially, then there is a good chance that it could be a problem.”

Mike Adams, chief executive of the MedicX Group, says it is important to understand where income is coming from. “You have to understand the nature of the people paying the income. Is it local authorities, private wealth or foundations? The mix of these determines whether the rent is appropriate for an operator.” Patterson suggests that the sector is going through a settling-in phase. “This business model is going through a period of settling down into what services you can provide, for what money, and how you make it work for all parties. The challenges are not fatal, as this business model has to be made to work anyway.” AXA Real Estate has invested in care homes in Germany, and Patterson says that, despite the challenges, the UK remains attractive. “From our perspective, demographics are operating in the right direction. it is a long-term investment, which we like, and it should be a steady income. We will, at some point, invest in these types of assets in the UK.”

Costing of the services is an important issue as well. According to the ‘Care Homes review 2013’ report by Colliers international, keeping costs down while delivering high standards of care is an ongoing issue for both the long-term elderly and for specialist sectors.

The report said: “Occupancy levels are down across the sector, due in part to government policy. Pay levels in the sector will continue to be an issue, with operators perhaps seeking to limit pay increases in line with the national minimum wage. This could be a false economy as staff, especially senior staff, have to be incentivised and rewarded for maintaining high care and amenity standards and effectively marketing the homes’ services.” In fact, there is a variation of fees between the privately funded market and the publicly funded market. Privately funded care homes were reporting fee increases of 4% per annum, while increases of the publicly funded market (where there had been increases) were below the rate of inflation. “We are looking closely at reputational risk and how it is managed,” says Jayasingha. “You can do a lot of quantitative assessment of care home operators in terms of their profitability. But some of the more qualitative aspects, such as how well they look after their underlying clients, the quality of the food, the proportion of staff that is on the payroll, as opposed to temporary staff… all these things are what we expect a manager to do – to look at the qualitative aspects as well as the quantitative financials.”

Adams suggests investors must research the market. “Investors are concerned about reputational risk, but the key is to invest with their eyes open, and to use a manager who does the legwork and monitors the operators and makes sure they are qualified.” MedicX offers two funds. The MedicX Fund has been listed since 2006 and has a market cap of £300m and assets in the portfolio of approximately £458m, as of september 2013, says Adams. it is a specialist primary-care infrastructure fund, and invests in modern purpose-built primary healthcare properties in the UK, primarily general practitioner (GP) services. it has 122 properties in its portfolio and has delivered an average total return of 10% per annum over the last five years. it is funded entirely by institutional money. “Most institutional investors are chasing yield at the moment,” Adams says. “Anything that can deliver 10% IRR over the medium term is very attractive. There are high-quality real estate assets.”

The MedicX Health Fund I and II invest in modern, high-quality healthcare property let on long-term leases to operators, including elderly care, diagnostics and dialysis, intermediate care and rehabilitation facilities. Adams believes that extra care housing will be the next big trend in the market. “We have an ageing population. A lot of people live in their own homes until they can’t cope, and they end up in a care home. in the Us and Australia you start seeing people moving into retirement communities, and moving into a community of other people in a similar stage of life. importantly, what they haven’t delivered to date is much care attached to them.”

So, care homes with healthcare facilities, perhaps? For the UK, much development will need to occur before such facilities become mainstream. But providers are confident that demographics are moving with them, and that it is only a matter of time.