Text: Matti Schenk

Measured against the demand from investors, which has been increasing for years, the supply of care properties remains scarce. In our view, the developments in the coming months and years will lead to opportunities for investors. Many of these developments are ambivalent and represent both opportunities and risks for investors. In the following, we take a closer look at some of these developments.

Despite interest rate rises and the like: care properties remain in demand in the long term
The beginning of 2022 was associated with much optimism for the real estate market: The effects of the pandemic seemed to have been overcome and many real estate investors wanted to further expand their portfolios. However, the war of aggression against Ukraine and the interest rate turnaround have noticeably dampened the mood on the German real estate market and led to significantly fewer transactions. We are currently assuming a temporary effect and a normalisation of the markets towards the end of the year. Investment pressure remains high and bond yields are still not at an adequate level despite a noticeable increase. Properties in markets with long-term positive fundamentals will continue to attract capital in our estimation.

Care property is one of the segments that we believe will benefit from an influx of capital in the long term. Since the pandemic at the latest, the risk perception of many real estate investors has changed. This manifests itself, among other things, in a more critical assessment of future space requirements. Above all, sectors and properties that are classified as systemically relevant or relatively crisis-resistant are experiencing higher demand on the investment market. These include, above all, care properties. In addition, the pandemic is acting as a digitalisation accelerator in many sectors and is leading to uncertainty among investors regarding future space requirements. In contrast to other uses, we do not currently expect any far-reaching structural change in demand for care properties due to digitalisation. On the contrary: care homes and assisted living facilities will not be substitutable in the foreseeable future. The different trends and long-term perspectives on the occupier markets should lead to more and more investors readjusting their risk assessments. In many cases, the capital to be invested in the real estate market is likely to be reallocated. Due to the structurally growing demand on the occupier markets, we assume that care properties will be among the types of use that receive increased attention from many investors.

New construction in the area of conflict between demand and cost explosion
In addition to rising interest rates, it is above all the massively increasing construction costs - caused by supply and personnel bottlenecks as well as rising energy and raw material costs - that are currently causing concern for many real estate market players. In the current mixed situation, project developments of care properties in particular must be reassessed. In order to obtain modern care properties at all, many investors have bought properties still under construction or in planning via forward deals in recent years. In 2021, such project development purchases accounted for around 570 million euros or about 20 percent of the transaction volume. It is to be expected that some construction projects will have to be stopped, postponed or cancelled. This is due, among other things, to the partially capped refinancing possibilities through the so-called investment costs (‘Investitionskosten’) to be paid by the residents. These now clearly lag behind the actual building costs. For example, the appropriateness limit for the construction costs of new buildings in North Rhine-Westphalia is a maximum of €2,478 per sq m. At the same time, a maximum of 53 sq m net floor space is considered adequate for a care place. According to this, new construction costs of a maximum of €131,342 per care place are used in the assessment of investment costs in North Rhine-Westphalia. According to the BKI Construction Cost Index, however, typical new construction costs already amounted to €150,900 per care place in 2020. Since then, the rise in construction prices has accelerated once again. According to the Federal Statistical Office, the producer prices of building materials alone rose by 10.5 percent in 2021. Further significant price increases were reported for the beginning of 2022. Due to the capping of investment costs, operators can hardly pay rents that contribute to the profitability of a project development. As a result, either the margins of project developers decline or they have to switch to more peripheral locations with lower land costs but also lower achievable purchase price multipliers. Or new projects are abandoned altogether.
 
The current challenges surrounding new construction have various consequences from an investor's point of view. Rising construction costs will reduce new construction of care properties. As a result, there will be a shortage of supply and owners of care properties can expect very high occupancy rates for their existing properties in view of the high demand in the long term and consequently stable rental income. The value of the existing stock should therefore increase relatively. It cannot be ruled out that politicians and funding bodies will react to a reduced rate of new construction in care homes and provide additional subsidies or at least increase the investment cost rates.

Because project developments have become riskier, many investors are likely to become more reluctant to conclude early forward deals. Instead, we expect competition for modern existing properties to become even more intense and prices for such products to remain high. For investors willing to bear the higher risks of project developments, interesting opportunities could currently arise. For example, some project developers may be forced to sell at conditions that are less favourable for them in order to obtain capital at an early stage. At the same time, the number of prospective buyers will probably be lower than a few quarters ago, putting bidders in a better negotiating position. Meanwhile, the market volume of project developments is considerable. According to our estimates, the construction projects scheduled for completion by the end of 2024 alone have a market volume of at least 9 billion euros. Even if many properties have already been sold to an end investor and some projects may not be realised as planned, it should still be possible to place a lot of capital in such products.

Wave of sale-and-leasebacks in sight?
Not only construction companies and project developers are affected by rising costs, but also operators of care properties. In the course of the pandemic, costs for operators have already increased considerably due to additional hygiene measures. The shortage of staff also poses a high risk, since if the statutory care ratio is not met, some of the care beds can no longer be occupied and thus income is lost. Since the operators' revenues cannot be increased at will due to the strong regulation of care cost rates, many companies are increasingly getting into economic difficulties. According to the Pflegeheim Rating Report 2022 prepared by RWI - Leibniz Institute for Economic Research and other project partners, around one fifth of German care homes were already in danger of insolvency in 2019. Around a quarter were in the red in the year before the pandemic began. It is to be expected that the number of operators at risk of insolvency has increased due to the burdens during the pandemic - and will increase further due to the current higher inflation rate. In order to obtain additional liquidity to maintain business operations, operators with own stock could increasingly divest themselves of their properties. Already in recent years, a significantly higher volume of sales by operators was observed than in previous years (Graph 8).

In the future, this could lead to an additional offer for real estate investors on the market. However, such products are likely to appeal primarily to investors with a higher affinity for risk, as operators forced to sell have a poor credit rating. Here, too, investors who have their own operator competencies or have entered into a cooperation with a cost-efficient operator have an advantage.
 
The growing insolvency risks on the part of the operators, on the other hand, will further limit product availability for very risk-averse investors. As a result, care properties with long-term leases from operators with strong credit ratings are likely to become even more sought-after. Sooner or later, it is inevitable for society to spend more money on care services. It remains to be seen, however, when and in what form adjustments will be made, for example, to social long-term care insurance. Until then, a close examination of the economic performance and staffing of an operator remains one, if not the most important component of due diligence.

New regional care home legislation in sight
Investors in care properties operate in a highly regulated market environment. In the case of care homes, the equipment and thus also the usability depends very much on the respective care home legislation of the federal states (‘Landesheimgesetze’). In recent years, there have been various amendments to the laws. For example, existing buildings in North Rhine-Westphalia must have a single room quota of 80 percent since 2018. For new buildings, even 100 percent single rooms have been stipulated in the course of the amendment of the legislation. A single room quota of 100 percent has also been set in Baden-Württemberg. The owners of care homes usually have several years to implement the changed framework conditions. In any case, the adjustments mean conversions in many existing properties and thus considerable investment needs.

Amendments to the care home legislation in Lower Saxony and Hesse are currently on the horizon. In Lower Saxony there is no binding single room quota so far, and in Hesse the protection of existing buildings will expire at the end of the year. In Hesse, single rooms are already the standard for new buildings, although requests for double rooms can be taken into account. The exact form and date of entry into force of the two amendments to the law cannot yet be estimated as of June 2022. However, in our estimation, it is likely that single room quotas will be set for existing buildings. This should soon result in additional investment needs in these federal states as well. In view of the already heavy financial burden on many landlords and care providers, it can be expected that some owners will want to sell their properties to developers or attract investors as joint venture partners. Thus, there are prospective opportunities for investors in these two federal states. Currently, the estimated market volume of existing care homes in Lower Saxony and Hesse is 14.2 billion euros and 8.6 billion euros respectively. In total, there are more than 2,250 existing care homes in both federal states.

Where is ESG in care properties?
In addition to regulation by the federal states and cost units, the European Union's Taxonomy Regulation, better known by its acronym ESG, is likely to have a growing influence on market activity in the future. ESG regulation has led to a massive shift of capital in the European capital markets into investment vehicles declared as sustainable. According to a PwC survey in September 2021, 79 percent of investors surveyed said ESG is relevant in their investment decisions. Furthermore, PwC predicts that by 2025, half of institutional financial capital in Europe will be allocated to ESG-compliant products. The topic of ESG will therefore also gain in importance in the investment market for care properties.

For investors, care properties offers both opportunities and risks in this respect. At first glance, the social and governance aspects - the S and G in ESG - should be quite easy to comply with in the case of care properties. The social aspects are aimed at positive interaction with employees, residents and the neighbourhood. Many providers of care services are likely to take these aspects into account out of self-interest, in order to have satisfied residents or to be attractive for new employees. The provision of real estate for care services or assisted living also has a high social benefit per se. Satisfactory governance is also likely to be very important for the reputation of care providers. Nevertheless, corresponding measures and activities need to be identified, documented and made measurable. Challenging here could be the different expectations and responsibilities of landlords and operators. For example, the operator has a significant influence on many aspects of the ESG performance of a care property. Measuring and processing the relevant data means additional work for the operator; in many cases, however, the information obtained is primarily useful for the property owner. In order to regulate the provision of ESG-relevant data and information, corresponding clauses could increasingly be included in lease agreements in the future. At present, however, it can be difficult in many cases to provide evidence of good performance in S and G.

It is likely to be even more challenging to comply with the ecological aspect - the E in ESG. Also due to the low investment cost allowances, high energy building standards are often not available for care properties. Assisted living facilities are often likely to perform better. Even if they do not guarantee ESG compliance, many investors currently look for a sustainability certificate when selecting properties. But care properties with such a certificate are almost non-existent in Germany. The major certifiers DGNB, LEED and BREEAM have so far only awarded a sustainability certificate to four care properties in Germany. By comparison, there are currently more than 3,200 certified properties in Germany. This could lead to ESG-compliant investment vehicles in other types of use, such as office or logistics, finding it easier to obtain appropriate properties. It is possible that buyers who are actually interested in purchasing will refrain from buying care properties in the future.

In view of the lack of certified buildings, investors have the opportunity for a so-called manage-to-green strategy, i.e. for the purchase of existing properties and the subsequent refurbishment and possible certification. When selling such a property, an intense bidding war between investors with sustainability goals and high achievable purchase prices can be expected.

In order to prevent ESG from becoming a massive barrier to investment in care properties, landlords and operators should begin to develop appropriate ESG strategies as soon as possible. Furthermore, data necessary for ESG due diligence should be collected and processed. This will make it easier to approach ESG-compliant investors.