By Jack Cumming
On LinkedIn recently, Dan Hutson wrote of senior living, “We either initiate our own creative destruction and emerge stronger than before, or we play it safe and go out of business.” That deserves some thought.
It would take a lot for senior living to go out of business altogether, though today’s business models may wither into insignificance. Every generation will have old people. If anything, the future will mean more old people. They will need services.
Operators, working with their investment bankers and development advisors, are central to determining whether demographics is the industry’s friend. Many people share Dan’s wisdom that change is needed if senior living is to fulfill its potential. In Part 2 we’ll consider what financial change could be beneficial. In Part 1, we’ll examine why change can be beneficial.
Financially Speculative
Widespread financial practices have evolved, particularly in the not-for-profit sector of the CCRC industry, that create a rationale for mistrust. While the public, and regulators for that matter, may not fully grasp what’s “off,” there is widespread skepticism about the industry. Adapting to dispel that skepticism is in the industry’s best interests.
Most consumer-oriented publications describe current practices without evaluating whether they are sound or in prospective residents’ best interests (examples 1, 2, 3, 4, 5, etc.). At least three controversial financial premises, which should give prospective residents pause, are widely accepted in the senior housing industry:
- Balance sheet deficits
Many CCRCs, especially those that are not-for-profit, operate with balance sheet deficits. This first issue arises from the often undisclosed use of entrance fees as though they were at-risk equity capital. Since the entrance fees prefund deferred obligations, the result is a balance sheet deficit.
The question is whether a balance sheet deficit means a CCRC is financially impaired. The answer from provider advocates is that impairment only occurs when there is no longer cash to satisfy the debt providers, regardless of the weakening of the financial security of residents. This has long been condoned by accountants who are hired and paid by providers. Click here for an example. This is not a new impairment of resident security.
The reasonable position for residents is that impairment occurs when there are no longer sufficient resources (assets) to meet the lifetime commitments made to them (liabilities). In other trust industries, such as life insurance and bank deposits, provider enterprises are required to have a balance sheet surplus and risk-based capital requirements above that as a cushion for the unforeseen.
Moreover, customers — life insurance policyholders and bank depositors — are further shielded financially by guaranty programs, NOLHGA, and FDIC. CCRC customers — residents — have no financial protection and, in almost all cases, are legally at the bottom of the scale in the event of insolvency.
- Use of entrance fees as equity
For most populations, the solicitation of risky investment funds is regulated, primarily with extensive disclosure requirements and prohibitions, such as the SEC’s prohibition of Ponzi schemes. Most GAAP financials assume a “going concern” expected to operate unimpeded for the indefinite future.
For those enterprises that don’t meet that test, there is “liquidation accounting.” Logic suggests that liquidation accounting is appropriate for any balance sheet with a net asset deficit. This is particularly true for a debt-burdened balance sheet, as is often the case with capital-intensive senior housing.
- Cascading “refund” obligations
The promise of “refunds” can be magical. It sounds like, “You get all this and your money back.” Who can resist that? But, isn’t it misleading if the “refund” depends on a successor resident who isn’t a party to the contract? Even if the contingency is fully understood by the purchaser, it’s still highly speculative.
GAAP only partially recognizes the liabilities for such refunds. Since the liabilities should flow from the contract, and the reoccupancy contingency is both speculative and involves a payment from a successor who is not a party to the contract, the current accounting, even after the 2012 FASB revisions, is not definitive.
If residents were owners, they might choose among themselves to invest speculatively to bootstrap a communal living corporation. It’s customary for those who accept equity risk to have ownership. Even not-for-profit providers could make their equity investors voting members. Most senior housing not-for-profits have no members, or there is a single corporate member in a conglomerate, thus avoiding resident members. This practice is one factor in a growing movement toward cohousing.
Bootstrapping
At a recent LeadingAge event, one panelist advised the provider audience, “You should raise equity through profitable earnings.” Another admonished that residents need to understand that they are paying entrance fees so that later generations can benefit. The idea is that early residents are and should be required to pay more to benefit later oldsters. I’m not naming names here to preserve the confidentiality of the event.
As with resident ownership in cohousing, residents may accept this call to future-benefitting generosity. In all fairness, the panelists urged full disclosure of these intergenerational transfers in the residency agreements. Contract reviews, though, generally come late in the sales process. Still, the notion seems duplicitous to suggest that the party benefitting from pay-it-forward generosity by the adhering party should mandate that involuntary generosity.
Picture the scene. A salesperson puts the agreement in front of the prospect with the direction, “Sign here,”… pointing … and “Sign here” and “here and here.” Quickly said and quickly done. Consumer contracts often have little consequence until there is a dispute. Is it a valid contract if the accepting, adhering party doesn’t fully grasp the content?
In Part 2, we will offer suggestions for what the industry and its advisors might do to make CCRCs more trustworthy. The takeaway from this is that the not-for-profit industry has relied heavily on contractual and financial devices that undermine public trust. While most members of the public may not put it as baldly, they increasingly sense that something is off. That damages the industry’s wish to be “the trusted voice for aging.”
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All to brief but highly thought provoking. We need more insights like these.
It is not clear why: “Since the entrance fees prefund deferred obligations, the result is a balance sheet deficit.”. If the journal entries for receipt of a repayable upon reocupancy are:
Debit: Cash $1,000,000
Credit: Refundable Entry Fees $900,000
Credit: Deferred Revenue $100,000
Looks like Assets = LIabilities thus no balance sheet deficit.
What am I missing?
Both contingently “refundable” entry fees and nonrefundable entry fees are consideration for a contract providing lifelong benefits. The difference is that the “refundable” portion is promised to be returned to the resident and the resident’s heirs. If the”refund” were a noncontingent refund, the refundable portion of the entry fee would be tantamount to an interest free loan, and thus, the revenue to the facility would be earnings from the investment of the refundable entry fee proceeds in the interim between receipt and when the deferred performance obligations are fulfilled and the revenues earned. But, then there’s that contingency that an unknown successor, not a party to the contract, will speculatively appear to pay the “refund” to the prior resident. Because of that speculative future revenue under a new contract, not the contract of the prior resident, the accounting profession has allowed some part of the “refundable obligation” to be recognized as revenue. FASB tried to fix this but the AICPA issued guidance that a lifetime CCRC contract is really a monthly renewable contract and so the double counting — taking into current revenue a portion of the funds that are also promised as a refund — results in troubling accounting but also in a GAAP deficit. But, as a disclaimer. I am not an accountant nor am I a lawyer. I’m just looking at the commonsense of the transaction. Correct me if I’m wrong and explain to me why the failing communities are largely not-for-profits because they have no at risk equity capital investors to absorb the financial shortfalls and to demand that the management handle the finances so that the investors have assurance of fair dealing.
Thank you for your reply. I am inclined to think that balance sheet deficits are most likely caused by: 1) Operating losses in the early phase of the community when occupancy levels are below 90% 2) Net Losses (realized and unrealized) on the Investment portfolio over time 3) An inability or unwillingness to raise monthly fees sufficently to cover rising labor and material costs over time.
As to why failing communities are largely not-for-profits, I note that Example #1 referenced in the article states: “Ninety-seven percent (97%) of CCRCs are not-for-profit facilities”, given that, wouldn’t it make sense that the majority of failing CCRC would be “not-for-profit” regardless of the cause?