Integrated Retirement Communities: Rising costs and the fixed fee shortfall.
by Caspar Courage, Consultant at SAY
The UK is currently experiencing the highest rate of inflation for more than four decades, we were warned this month. The rise to over 9% on the year has been steadily felt by UK consumers and homeowners and according to the Bank of England, is unlikely to peak until at least the end of the year.
But as the country adjusts its spending, what will the impact be on the Integrated Retirement Community sector, who largely recover fixed charges towards operating their buildings, and how prepared are operators to account for this risk?
For building owners and operators, and their occupiers, unprecedented cost growth is nothing new. For long before the aftereffects of Covid-support packages, tax increases and international financial sanctions, the rising cost of operating buildings has been fast and difficult to forecast.
The Grenfell tragedy caused the insurance market to overhaul the way risk was assessed, resulting in premium increases that no one could have predicted. Research published by ARMA (Association of Residential Managing Agents) showed that across a data set of 143 blocks, buildings insurance premiums for 2020-2021 were on average 374% higher than for 2019-2020. This represented an uplift of approximately £1,100 per anum, per flat[1].
The Chartered Insurance Institute are reporting that increased materials and labour costs have caused rebuild cost inflation, contributing to a forecasted rise in premiums of at least another 15% this year[2].
The energy sector is another cause for concern, with Ofgem reporting a 54% increase in the energy price cap in February 2022[3]. The average homeowners’ monthly payments will roughly double as a result.
The story is the same for salaries, and therefore the cost of staffing and operating buildings. As we already had a “severe and increasing” shortage of care workers[4], the labour cost challenge will be felt even more acutely within the later living industry.
So how well prepared is the Integrated Retirement Community (IRC) sector? And what can be done to mitigate risk?
In a traditional residential building, variable service charges with a clear and strict legislative basis, provide security for landlords in ensuring cost recovery. Budgets can be updated each year based on expenditure, with the landlord able to collect any shortfall for the previous year from their leaseholders.
The same is not true of the IRC sector. Many operators charge a fixed fee in place of a variable service charge. The cost the leaseholders will pay is often decided before the building is even completed, meaning that operators have no operational data to base the figure on. This fixed cost is often supplemented by event fees, usually payable upon the resale of the property, and based upon an agreed calculation (such as a percentage of the value of the property, per year of occupation).
The benefits of this structure have been widely reviewed and well reported. The event, (or ‘deferred management’) fees allow residents to enjoy better services during their later years, and supplement the cost at the end of their occupancy. Crucially, the structure provides certainty of cost to residents who typically have little to no future income. In an inflationary market like we are seeing today, this certainty will be invaluable to residents of IRCs, many of whom will be struggling with rising costs in all other facets of their life.
What is the impact on the owners and operators of the communities they occupy though, and to what extent does it impact the feasibility of the model?
Many operators of IRCs build a cost review mechanism into their model. An annual rebasing of the fixed charge, based on an agreed index, for example. This may typically be the Retail or Consumer Price Indexes. Operators with this mechanism will take some comfort from this, however the nature of many of the cost increases we are seeing does impact the effectiveness of the measure. Building operators have reported, for example, that the impact of new building safety requirements, amongst other factors, has caused service charge inflation to outpace CPI inflation in most cases[5]. This will, in an IRC context, mean that many operators are faced with the prospect of short-term operational cost losses, as they are unable to recover the full amount required to run their buildings.
In many cases, these short-term concerns will be tempered with the knowledge that event fee income is on the horizon, and any short-term losses will be recovered, with change. In many cases, this should be proven correct, as the potential long-term profit in IRC event fee structures is significant. Event fee modelling however, must also take account of the changing landscape for operators. According to the RICS, construction material cost increases have also reached a 40-year high[6], which is a level of inflation that will not have been predicted by many lifecycle costing exercises in recent years. This means that the long-term maintenance costs for buildings will grow significantly. In many cases, this will directly hit the bottom line of the event fee income of IRC operators, many of whom use the event fee model in the place of collecting sinking funds.
For residents who reached the minimum age for Integrated Retirement Community acceptance this year, inflation rates have not been so high since they left their teens. For this reason, the opportunity to live in communities where their property outgoings are fixed is more important than ever. It will provide significant comfort at a time when pensioners will feel the squeeze more than most.
For developers and operators of IRCs however, understanding and accurately forecasting operational costs has never been more important. Real scrutiny must be made in relation to the cost of operating buildings prior to completion, and the nerve-wracking moment where fixed fees are set. It is not sufficient to look at the rest of the market and assess what you think residents are willing to pay in relation to event fees. Reasoned assessments of long-term operational costs should always be made to ensure feasibility.
In a sector which is already reliant on patient capital to minimise short term operational cost risks; it is critical that developers are using as much data as possible and seeking advice on the operational risks they may face, to ensure the continued feasibility of the fixed-fee model.
[1] https://committees.parliament.uk/publications/5515/documents/54941/default/
[2] https://www.localinstitutes.cii.co.uk/birmingham/home/events/2022/property-insurance-understanding-why-there-will-be-15-plus-rate-increases-in-2022
[3] https://www.ofgem.gov.uk/publications/price-cap-increase-ps693-april
[4] https://www.arcouk.org/press-release/arco-response-to-severe-and-increasing-shortage-of-care-workers-finding-by-mac
[5] https://www.insidehousing.co.uk/comment/comment/as-the-cost-of-living-crisis-bites-we-need-to-talk-about-service-charges-73801
[6] https://www.rics.org/uk/news-insight/latest-news/news-opinion/construction-materials-cost-increases-reach-40-year-high/
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