Roy Davidson, 30 June 2017

Rising property prices have provided a major tailwind to the New Zealand retirement sector. However, a cooling housing market will weigh on earnings growth, sentiment, and valuations. In this note, we explain how retirement sector earns revenue and explore how the change in the housing market might affect this model.


Property prices have been a tailwind to the sector, but set to dissipate

The standard model for a retirement village operator is to sell a right to occupy a retirement villa/unit (known as an ORA – or occupation rights agreement). This gives residents the right to occupy a unit for life or until they decide to move – for example, a resident may choose to move in to a different section of the village, as they now require higher levels of care. When a resident moves on, the operator on-sells the unit before repaying the resident’s ORA.

Once a village is developed, retirement village operators earn the bulk of their profits via:

  • Deferred management fees – calculated as a percentage of the cost of the ORA and paid at the end of occupation. Typically, a maximum of 20-30% of the
  • Resale gains – when reselling a unit, operators make a profit on the difference between the price of the old ORA and the new
  • Care fees – from the provision of aged care

This increasing value of ORA’s is a key profit driver. Prices for ORA’s are influenced by property prices in the surrounding area. Note, that this not a linear relationship, and the difference between housing prices and ORAs has expanded in recent years providing some headroom should property prices fall.

As a result, as property prices rise, so to do the prices of ORAs. This leads to greater resale gains as units are on-sold, and higher deferred management fees in future as the value of the ORA increases. Profits of retirement village operators is therefore sensitive to property prices.

The basics of the ORA model, with a hypothetical example using RYM’s pricing model (deferred management fee of 20% after five years for an independent unit), is set out below. In this example, with an ORA value of $300k, RYM earns a $60k deferred management fee after five years, and a gain on resale – in this case $80k. $240k is returned to the resident. The next deferred management fee will be based on an ORA of $380k ($76k assuming a five year stay).

According to REINZ data, New Zealand house prices have risen by an average of 10.8% per annum over the last five years with Auckland prices growing by 12.9% per annum. This has provided a strong tailwind to the sector.

However, recent data has demonstrated a clear slowdown in the housing market, with growth rates slowing and time to sell expanding. Over the last three months, New Zealand house prices have stayed broadly flat, while Auckland prices have fallen by 1%. Days to sell has increased by five days to 37 days nationally, while in Auckland it increased by eight days to 40 days.

As a large share of earnings are generated through the resale of retirement units, lower (or negative) house price inflation should reduce the growth in these earnings. The inability of potential residents to sell their existing home in a timely manner may also impact the time taken to resell a unit, while new developments may take longer to be fully occupied, pressuring cash flows.

The sector is driven by a powerful demographic trend which is really only just kicking in (the 75+ population is set to more than double in the next 20 years according to Statistics New Zealand), and we remain attracted to the highly effective business model. However, falling house prices represent a material risk to near-term earnings growth, sentiment to the sector and valuations, and we temper our near-term view on the sector.

Continuum of care model and share of aged care

We continue to have a preference for operators utilising a continuum of care model (i.e. an integrated village from independent living through to aged care and hospital level care). This makes the decision to enter a village more ‘needs based’ with a resident knowing that aged care facilities are available when needed down the track, as opposed to it being a lifestyle choice to moving into a village. This results in more defensive demand for units, waiting lists, and generally a later age of entry into a village.

Operators with a greater share of aged care are also more insulated from a property downturn as funds are largely provided by the government with demand again needs based.

Geographic spread

We also see geographic spread as important with those with portfolios diversified away from Auckland preferable given the ramp up in prices in that market.

Quality management and track record

Finally, we place more faith on management teams with superior track records to manage a property downturn.

Please note: This is an abridged article. The full version of this article, including our preferred exposures is available to Craigs Investment Partners clients via the Client Portal. To view this article, login to the Client Portal.