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Senior and Post-Acute Healthcare News and Topics

Financial Tests Before Additions, Renovations or New Construction

A frequent, recurring question that I field, especially for CCRCs and seniors housing providers is “what” financial feasibility tests are most important before a project is started or for that matter, financed.  Given that capital is still relatively tight, project feasibility and key financial tests are today, critically important to assure the best financing terms available plus, project viability.  Below, I’ve broken out the initial “best” feasibility tools/tests to work through once a scope and general cost is known.

  • Revenue Efficiency: This is very simple: How much of the proposed project square footage produces revenue?  The more square feet tied to revenue generating functions, the more revenue efficient the project is.  For seniors housing, the factor or test is very important.  Too often, I see proposed projects that allocate way too much space to commons and other areas that aren’t related to revenue production.  While groups will argue that these spaces are necessary to attract prospective renters/residents, the reality is that smaller, more efficient is better from an operating standpoint and frankly, even from a marketing standpoint.  Too much space can give the project a “vacant” feel while driving up costs related to heating/air conditioning, maintenance, furnishings, etc.  Ratios of revenue producing square feet to  common or non-revenue producing square feet of 70/30 or less, tend to work best from a feasibility standpoint.  I’ll tie this point tighter in subsequent segments.
  • Prospective Rate Test by Square Foot: While rate charged is a function for many providers of market or other perceived and financially tied projections, a first basic test should involve a simple equalization model based on project square feet.  In fact, this test is an easily built model that can be used for many rate setting exercises and revenue pro formas.  First, total the revenue producing square feet in the project.  Next, determine the project’s projected or known, fixed costs, variable costs and desired margin.  Finally, decide at what level, stabilized occupancy will occur (e.g, 85%, 90%, etc.).  Hint: Amounts or levels greater than 95% are not realistic.  Once the aforementioned data is determined, divide the total of fixed, variable and margin (annualized) by the total revenue producing square feet, divided by 12 for a monthly factor or 365 for a daily factor.  Finally, multiply this result by the stabilized occupancy percentage.  The result is the gross revenue per square foot required by the project to cover the fixed and variable costs plus generate the desired margin.  To equate this number to prospective rates, multiply it by the unit square footage for each unit type in the project.  Next, analyze the results compared to market.  Are the rates calculated attainable?  If the rates are ultimately not, can the revenue be picked-up elsewhere via a shift among unit types?  Are the costs too high?  Back to the first point, is too much of the project square footage not tied to revenue production?
  • Occupancy Tests: Knowing what the projected gross revenue is on a square foot basis provides a basis for conducting some simple occupancy tests via adjusting fill-rates, overall occupancy rates, payer mix, etc.  Using the same formula above but varying the occupancy, it become easy to see the relationships between square foot expenses, particularly those that are fixed and the revenue levels required to cover these expenses.  I like to analyze the ratios between each or, how much occupancy do I need to cover fixed expenses (percentage) and where can I massage variable expenses based on occupancy levels or payer mix.  Typically, once a simple spreadsheet with square foot costs and revenues is built, it is fairly easy to do assumptive modeling and analyses.
  • Payback Testing: An important analysis or test too often ignored or, assumed to be tied to a debt service amortization schedule, is payback testing.  Payback should be factored to occur on or before the point in the project’s useful life, when major improvements need to occur.  The point here is that the project ideally is paid-for before major improvements occur, commonly known as the period of re-building.  At this point, one shouldn’t look at a scenario of re-building when the original debt or expenditure (if equity is the source) isn’t already recovered or substantially defeased.  If this doesn’t occur, the capital improvement process is akin to building the project twice (or major portions thereof).  In simple theory, new buildings or new construction provides a window of time where capital infusion for improvements is minimal if almost non-existent.  This period is where incremental cash (assuming proper pricing at sustainable occupancy levels) can accumulate, allocated for payback (either via faster current debt repayment or investment for future repayment when the arbitrage is positive).  My preferred methodology for this analysis is to develop a cash flow analysis where revenue is netted against cash expenses, including debt service.  I set my targeted payoff period as that time in the future where projected improvements via major system, structural, etc. upgrades will occur – typically by years 12 to 14.  I also will net my annual cash flow by anticipated or projected capital improvement expenditures that use “cash”.  For inflation assumptions, or investment assumptions, I try to use actual or historic data and I err on the side of conservatism.  Two methods can be used in this approach.  One that negates principal repayment in “real-time” and one that incorporates incremental principal repayment.  If debt is involved and on an amortization schedule with principal repayment incorporated, its easiest to assume a declining balance for the payback analysis.  If the source of funds is equity or a combination of  debt and equity, I assume equity repayment at a current cost of capital rate and while I may not create an amortization schedule with imputed principal payments (equity repayment), I will assume a “balloon” effect by imputing a cost of capital return assumption on the equity.

Ideally, this type of analysis is done sufficiently ahead of project finalization.  If such is the case, the project can be adjusted to conform to a proper payback period, be optimally efficient, and have a rate/revenue structure that fits within the target market.

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March 16, 2012 - Posted by | Assisted Living, Senior Housing, Skilled Nursing | , , , , , , , ,

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