Reg's Blog

Senior and Post-Acute Healthcare News and Topics

When and Why Projects Go Bad: Traps and Pitfalls to Avoid

Creeping slowly out of a period of recession where financing was nearly impossible to get, providers, operators and developers are starting to look favorably at new development and refreshment of existing properties and infrastructure.  Though capital is less than free flowing, money is entering back into the long-term care and seniors housing world fluidly enough that projects once parked in the “back of the lot” are edging closer to the front.  Having watched significant failures occur over the past three to four years and/or counseled organizations through some of the rough times, now is an appropriate time to pass along some “learnings” from the failures and struggles that I have seen.  Importantly, as the industry and the methods for financing have fundamentally and permanently changed, so have the markers for assuring project (new, redevelopment and remodeling) success.

As a primer or if you prefer place to start, there are three basic elements critical to project (new construction or renovation) success: Market demand, cash flow margins, and project cost.  Too many new projects failed to meet occupancy projections simply by misunderstanding market demand dynamics (market demand is not demography).  While not universal or sacred to only non-profits, misunderstanding regarding cash flow margins is a common failure item.  For example, I don’t know how many projects I’ve looked at, especially on the substantial remodeling side, that incorporated no expectation of new revenue or improved operating margins (either this element was missed or worse, not present/expected as a result of the project).  Finally, project cost should always be less a function of funds available but more a function of payback.  I’ve seen too many projects that suffer from “scope creep” simply because funds, either via debt or equity, were available.  Being able to afford something doesn’t necessarily make it “affordable”, especially when the long range economics of a project are critically analyzed.

Avoiding the common traps, pitfalls, etc. that lead to project failure or in some cases, poor performance, is a function of being clear and knowledgeable about the core feasibility requirements.  Being clear up front means not just “knowing or providing lip-service to” but actually investigating and working through each element.

  • Market Demand: The presence of age and income qualified individuals is not demand; it is supply.  The supply of potential customers only assures that potentially, a large enough universe of people exists that meet the broadest elements of “potential consumers”.  Recognition that only so many of this universe will be actual consumers of any long-term care or seniors housing product at a given time is critical to developing the initial framework for market demand.  For example, less than 10% of all seniors reside at a nursing home at any given time, whether for short or long-term care purposes.  If occupancy rates within the existing supply of facilities are average to low, building more units within such a market is a big step toward potential failure.  Simply adding units, even if they are different in size, amenities, etc., doesn’t change the core demand for the product.  Success of such a project in such a market is thus fundamentally hinged on “taking existing customers” from an established facility; a risky proposition at best.  Even in markets with good demographics (customer supply) and minimal to average supplies of like products doesn’t guarantee that demand is present.  This is particularly true for seniors housing where demand is very price elastic.  The same is true, though not as directly, for SNFs when demand is correlated to payer source (e.g., a private-pay only facility in a market with primarily a Medicaid demand).  Without factoring in price and overall costs plus location and unit features and benefits, demand cannot be truly gauged or determined.  The mere presence of a suitable supply of age and income qualified individuals doesn’t guarantee any occupancy of a new project, save that the new project at a given price, given location, with given features and benefits fits an unfulfilled need or want within the universe (supply) of qualified customers.  Summarily, no matter how much money someone has or how age appropriate someone is, if that person (or persons) does not possess or find a need for a given product at a given price with desired features and benefits, the mere presence of the product within the market will not promote consumption (or occupancy). 
  • Financial Feasibility: Interconnected with a fundamental understanding of demand is pricing.  Pricing, as I have written before, has two key components.  The first is the derivation of price based on the formula of Fixed Costs + Variable Costs + Margin = Price.  The second component is strategic, tied to market.  In any given market, the supply of like products and programs will dictate the amount of elasticity that exists across the pricing continuum.  No longer is “me too”or matching the market a viable strategy for pricing.  This said, true financial feasibility is mostly tied to the first pricing component.  Where projects tend to struggle is when three core elements are misinterpreted or, over (or in some cases under) estimated.  The first core element is fixed cost.  Feasibility which doesn’t properly capture the key fixed cost elements of debt, debt repayment and depreciation has the potential for quickly turning a project from possible to impractical.  Specifically, I recommend the following approach to structuring the fixed cost portion of the feasibility.
    • Debt assumptions, especially those involving floating rate scenarios, need to be conservative and reflective of the true interest rate risk across as lengthy a horizon as possible.  Fixed rate scenarios are ideal but terms for the fixed period are generally less than the amortization schedule for the debt.
    • Following the point above, debt repayment on a schedule that is more aggressive than the amortization schedule is a must.  New projects or substantial remodeling projects carry the mindset that depreciation is a non-event in the initial years; minimal cash outlays.  While this may be true, depreciation picks-up rather quickly in terms of cash needs by year 5 and becomes more acute by year 10.  By year 15, substantial repairs and upgrades to major elements are a common theme.  Carrying debt across a normative amortization cycle without more aggressive repayment means that by year 10, the project is being substantially replaced by the need for upgrades and repairs, all while the first phase is still being paid for at a premium cost (interest on the original debt).  I have seen all too often, providers struggle with competing cash needs; debt service vs. capital maintenance.  Once maintenance becomes deferred, the ability to compete successfully is hampered.  Cardinal rule here: Work the feasibility numbers in terms of pricing to include a debt repayment plan no longer than fifteen years, regardless of the amortization terms, and incorporate a laddered assumption of cash needed (reserves) to replace equipment, upgrade units, etc. within the fixed costs assumptions (cash funding depreciation).
    • Margin is the devil in the details.  Too much fixed cost and/or too much variable cost eats at needed margins or stresses occupancy assumptions to unrealistic and/or unsustainable levels.  Ideally, a forty percent or higher “top line” margin is the target for Assisted Living and Independent Living (marginally higher for Independent).  When debt and depreciation (cash funded) is added below the line at stabilized occupancy, the project can create sustainable cash earnings/returns on equity.  Lower leverage (debt) levels and lower interest costs can aid in thinning top line margin levels but remember, equity contributions instead of debt still bear a cost in the form of opportunity cost.  Repayment of equity infusions need to be factored with an opportunity cost (interest factor).  Depending on current interest rate environments, the arbitrage on equity cash can be positive (debt cost is higher) or negative (debt cost is lower).  Not always does the provider get to pick the amount of equity participation required as lenders today are far pickier on leverage levels and loan to value relationships.
  • Project Costs:  Project costs should always be built around the assumption of revenue required to substantiate the project.  Renovations that do not incorporate opportunities for new revenue or enhanced revenue (new product/service lines, better payer mix, etc.) will almost exclusively be paid-back through depreciation funding and life cycle cost assumptions.  In short, no new money, the project scope needs to be tight.  Rarely have I ever seen the purported “efficiencies” used in renovation justifications materialize to the extent that the gains justified the project scope.  I also am always wary of renovations that incorporate enhanced or improved occupancy levels.  Again, rarely does the cost justify the outcome and almost always, the adage of “we are not marketable” is more a function of other organizational issues (bad reputation, pricing, average care, etc.) than it is a justification for an expensive renovation project.  In new projects/new development, building efficiency is the key to adequate payback.  Allocating too much space to common areas and non-revenue producing areas increases project costs in terms of building and furnishing (not to mention heating, air conditioning, maintenance, upkeep, etc.) and places more “dead space cost” burden into the pricing equation.  Objectively, a building that maximizes the majority of square footage for revenue production pays back investment far faster.  In an Assisted Living project or Independent Living project, I think a 65% revenue allocation vs. 35% common allocation is reasonable.  Higher allocations to common space strain pricing and definitely, require higher occupancy levels to create break-even and payback targets.  Similarly, more common space consumes more “furnishings”, often minimally used. Good focal space done right and space with a multi-purpose use is preferrable over space with singular use or no real defined use at all (i.e., lounge
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April 5, 2011 - Posted by | Assisted Living, Senior Housing, Skilled Nursing | , , , , , , , ,

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