RSM Australia

Managing capital in aged care: how much difference does it make?

There is an acknowledged need for significant new capital investment in residential aged care assets. Investment decisions are driven by the expected return on investment. We postulate that the ultimate measure of this is return on equity.

The 2012 amendments to the permitted use rules applying to lump sums received by approved providers from residents, and the 2014 changes to the accommodation charges provisions of the Aged Care Act, directly impact both earnings and the capital investment of operators of residential aged care facilities.

In the ACFA's 7th report on the impact of the 1 July 2014 financial reforms released in April 2015, it was noted that, “a projection using the average monthly growth rate of about 1.45% between July 2014 and December 2014 reveals that lump sum payments would increase by about $3.0 billion this financial year over last financial year”.

This is consistent with modelling undertaken for the aged care financing authority.

While some of this increase is from higher levels of lump sums and increased supply of places, much relates to the extension of lump sum options to what were formerly high care residents. To the extent that those previously paying a daily accommodation charge have opted to pay their accommodation via a lump sum, approved providers are deriving less accommodation income. 

While some operators may use the increased lump sums to reduce debt and save on interest costs, we anticipate that the combined effect of the liquidity standard and the permitted use rules will result in many providers retaining these additional lump sums as increased liquidity on their balance sheets.

As operations are funded by a mix of debt and equity, managing equity directly impacts the return on investment. Typically corporations manage excess equity through; their use of debt, dividend policy and/or capital returns.

As noted above the interaction of the permitted use and the accommodation charging rules can restrict the capacity of operators to manage equity. Furthermore as liquidity increases, accommodation revenue is reduced without a compensating reduction in funding costs which can ultimately impact net income (return) available to operators.

The following hypothetical examples demonstrate the possible effect. In this example we are looking at two (2) 5 bed facilities which have cost $2,500,000 to build.

One has used 30% equity and 70% external debt to fund its infrastructure, while another has used 70% equity and 30% external debt to fund its infrastructure. 

Assume that both facilities admit 5 residents who chose to pay the average accommodation lump sum of $296,000 (equivalent to a daily charge of $52 per day). 

The first operator uses the lump sums to reduce debt to $270,000, saving interest on the loan. The second operator completely pays off his bank debt and then places $730,000 on deposit.

While the operating earnings for both operators in the above example are similar, the first provider is earning 2.3 times the return on equity of the second provider.

In real life the situation is more complex. If you would like to know more about strategies and models to manage debt, equity and lump sums click here.

Both operators can improve their position by investing the excess liquidity/borrowing capacity into additional aged care assets.

If this is allocated to new places, then overall supply is increased, however if it is used to acquire existing places, then we may see asset price increases. Of course price increases are limited by the return on capital that can be derived.

Based on information gained from clients we work with, the For Profit and For Mission sectors take very different approaches to managing equity and liquidity and this appears to be reflected in overall operating performance. While providers will have differing models for debt and equity, those who are more focused on managing the mix of debt and equity used to fund their assets appear more likely to contribute to increasing the supply of residential places.

Do you agree?