How to value retirement property

'Prime Trust is a robust and well-established player in the retirement market ... Our focus is long-term asset ownership and we know that requires patient and diligent management of capital.' So said the chairman of Prime Retirement and Aged Care Property Trust in his introductory letter to the trust's glossy 2007 prospectus.

'Robust', 'well-established', 'long-term', 'patient' and 'diligent' ... and three years later, the trust was calling in the administrators.

Investing in retirement property seemed so promising. Australia's ageing population appeared to guarantee as much. At least, that's what many thought. Favourable demographic trends spurred a boom in retirement living in the 2000s. Companies such as FKP, Lead Lease, Becton Property Group, Stockland, Macquarie Group and even Babcock and Brown (a warning bell in itself) all scrambled for a piece of the action. But most failed, dusting investors' cash and turning punters off the sector.

Now, however, the industry has recapitalised and valuations are more reasonable—yet investors remain wary. And it's situations like this when bargains can emerge. Indeed, the superficial signs are promising, with those remaining in the sector trading at 30%-50% discounts to their net tangible assets (NTA).

But before rushing in there's a couple of peculiar accounting issues that any investor in the sector needs to understand.

Deferred management fees

Those moving into retirement villages face two basic options. You can either rent a unit or purchase one via a 'deferred management fee' (DMF) contract. Most for-profit retirement operators focus on this latter option.

DMF contracts are structured as a 'loan and a right to occupy', with the operator retaining ownership of the properties. In a practical sense they are very similar to directly owning a property but are treated differently for accounting purposes, which causes most of the confusion.

Another important part of DMF contracts are the fees racked up by the resident which are payable when they vacate the unit. These fees are typically 3% of the exit price each year for a maximum of 10 years. It might work something like this...

Assume a retired couple buys a retirement unit for $250,000 from Stockland—Australia's leading provider.

The $250,000 retirement unit remains on Stockland's balance sheet as a $250,000 asset. The $250,000 the couple pays to Stockland is banked and a corresponding current liability is recorded under 'retirement living resident obligations'.

Each year the couple remains in the unit a fee of 3% of the sale price of the unit accrues. This 'fee accrual' is capped at 10 years, entitling Stockland to up to 30% (10 x 3%) of the sale price of the unit (note the average age of Stockland's residents is 81).

If in year 10 the couple decided to move out, Stockland would get 30% of the sale price and the couple would get 70% (see Table 1, where the sale price is assumed to be $400k).

Assuming the unit had increased in value to $400,000, Stockland would get $120,000 ($400,000 x 30%), and our couple would get $280,000 ($400,000 x 70%). Typically this cash would come from an incoming resident.

These contracts are a form of delayed payment and operators, such as Stockland, aim to make a slim development profit on the original sale and then share in any upside in the value of the property.

Other operators use variations on this theme. Table 1 details how different contract conditions could impact the DMF payable. In general, higher fees mean higher profits. Further, contracts that are pegged to the entry price tend to be less favourable to the developer in a rising market, and explain why most contracts are pegged to the exit price. [You can download this spreadsheet to model your own assumptions.]

The purported benefit of the DMF model is that residents are able to live in a high-quality home at below market rates, freeing capital to spend on their lifestyle. Or so the theory goes. Research from Jones Lang LaSalle has demonstrated that many retirees would be better off renting. No wonder developers have been keen to flog DMF contracts.

From DMF contracts to asset values

A retirement operator typically has thousands of DMF contracts and these form the basis of valuing its retirement property assets.

Unlike typical property valuations, where current income is capitalised, DMF contracts are valued according to a complex 'discounted cash flow' calculation;  involving assumptions about the expected future cash flows over the life of each contract based upon the life expectancy of the tenants and future property price appreciation.

Helpfully most operators provide a table of assumptions in their annual results presentations. Typically property prices are expected to rise at between 3% and 5% a year and the future cash flows are discounted at between 13% and 16% a year. A higher growth rate or a lower discount rate will lead to higher valuations. Many companies use different methods so it is worth checking before comparing.

So the structure of retirement property contracts and how they are translated into asset values is very complex, so buying a stock in the retirement property industry based simply on identifying a seemingly large discount to reported net tangible asset value could be a major mistake.