Ground rent is a concept more familiar to the residential property, hotel and leisure markets than healthcare. In recent years, however, investors are becoming increasingly interested in offering ground rent deals to care home operators.
In simple terms, this involves the care home operator selling the freehold element of their property to a specialist investor. In return, a long-term leasehold agreement is put in place (generally 100+ years) with the care home operator, through which they will pay a ground rent to the investor.
As a general rule of thumb, starting rents typically represent 8-15% of the business’ EBITDAR (with RPI linked increases at defined times) and are capitalised at a yield of c.3.5%.
At the end of the leasehold term, it common that the care home operator has the option to buy back the freehold for a nominal sum.
A worked example is as follows:
A care home business generates £1m of EBITDA and is valued at £8m (representing an 8x earnings multiple);
An annual rental charge of £100k (10% of the £1m EBITDA) is paid to the investor which is RPI linked and increases accordingly;
The ground rent investor will pay a sum of £2.86m (100/3.5 x £100k) to acquire the freehold rights of the property, representing a 3.5% yield.
What are the advantages of deal structures such as this for care home owners?
Firstly, and most obviously, ground rent deals allow operators to release capital from their businesses which can be used to develop/acquire further homes or to extract value for the shareholders.
Secondly, these deal structures offer a more prudent option than the traditional sale and leaseback property model. Under a sale and leaseback structure, rental charges are considerably higher. The ground rent structure therefore provides a materially lower risk of default during periods of volatility within the business.
Next, ground rent transactions do not prohibit the care home operator from maintaining a level of bank debt in the business. Whilst selling the freehold rights will increase the risk for banks and therefore increase the price of debt, they are still willing to lend in these situations and there are several examples in the market where this has taken place.
What are the downsides of these transactions?
Investors in ground rent agreements will take a very “hands off” approach, with limited ongoing responsibility in relation to the property. The care home operator therefore continues to hold responsibility for the costs associated with the property and its day-to-day management. Whilst the ground rental charge is small, it will still deduct from the profits generated by the business which are available to reinvest into the property in the form of capex.
It’s also worth noting that all ground rent investors will look for the rental charge to be RPI linked. In most cases, the agreement will include an RPI “cap and collar”, limiting the levels of RPI that can be applied on an annual basis. Nevertheless, over an extended period of time, these RPI inflations have a material impact on the rental charge. Clearly in an inflationary environment one would hope that the care home business’ growth would more than offset the increased rental charge, however operators should be aware of the impact that these RPI increases have over time.
Finally, given the relative nascency of the ground rent market within healthcare, it remains unproven how a ground rent deal will impact on the future saleability of the operating business. However, with a growing number of leading players in the care home market having undertaken ground rent transactions themselves (including Caretech, Elysium etc.) it seems that the key trade acquirers are likely to be comfortable with the concept.