Most business advisors would say ‘no’ and recommend other, faster and less risky residential developments.
Retirement village operators make big profits, right? Especially with the big deferred management fee (DMF) they charge when the resident leaves…?
Well, actually they do not make big profits, and judging by the emails we have been receiving after our article, “Good times roll for retirement village residents”, this will surprise many village residents – and their families.
Here is why. There are two times that the village developer makes money. One is when they build and sell the homes for the first time – this is called the ‘developers’ profit’. The other time is when a resident leaves the village and the developer collects the DMF. Let’s look at each of these.
Understanding the developer’s profit
As a rule of thumb, the developer looks to make a profit of 15-20 per cent on the sale of each home they build. Stockland, Australia’s largest home builder and third largest village owner, made an average of 16 per cent per village home last financial year. On a $400,000 home that is $64,000, which sounds like a lot of money but they have a lot of not so obvious costs, plus the burden of time.
It takes four to five years to find a block of land, get council planning approval, bank finance and then build the first homes. And all that time the village developer is having to pay out of their own pocket most of the expenses. Banks will only start lending when all the preparation work has been done.
On a 100-unit village, the developer will need to spend about $4 million in the first four years to get up to the first building stage. The banks will then join in to build, say 20 houses – what is known as Stage One. Another $1 million is required by the bank from the developer to share the construction and marketing costs. At the end of year five they have built and sold 20 homes, giving the developer $1,280,000 profit at 16 per cent against $5 million invested.
However they can’t take that money. They have to reinvest it in building the community facilities – the meeting centre, the pool, the landscaping, the roads, which is normally valued at 20-30 per cent of the finished village. If it is a 100 unit village this will equate to $8-12 million, in addition to funding another 20 homes for Stage Two.
All of the profit from Stage One has to be reinvested along with increased bank debt. With the new community facility the sales rate and building rate increases. The village should be finished say four years after it commenced – a total of eight to nine years for the project and finally the developer collects their ‘developer’s profit’. Around $6.4 million if all is going well.
So they invested $5 million at the beginning and spent, say, eight years making no income, to get their money back plus $6.4 million.
Normal domestic housing is far faster, doesn’t need the $8-12 million in community facilities and when the residential project is finished, they can simply move on.
You can appreciate most developers will not wait this long or take the risks – risks like the possibility of a recession. Normal domestic housing is far faster, doesn’t need the $8-12 million in community facilities and when the residential project is finished, they can simply move on.
Not an investment for the faint-hearted
So why do developers build villages? Because they have the opportunity to make a second profit from the deferred management fee (DMF) and because they still own the village – it’s an asset that has value.
While this sounds good, most property developers are not interested. Why? Because again they have to wait around five to eight years to make their second profit when the first residents who moved in to the village start leaving.
The village operator is not allowed under any Retirement Village Act to make a profit from the daily operations of the village – so no income is received for those five to eight years.
At the same time, the legislation and regulations impose heavy responsibilities on the management of the village as a business and the care of the residents. This is becoming even more complex with the growth of home care services into villages.
So the owner of the village has to commit time and energy to overseeing the village while not earning any real return. They can use the village as an asset to borrow funds from banks to do other developments which is handy, but be aware that banks lend on a low ratio for villages.
Once the village hits about 10 years of age the owner starts receiving a steady DMF income. On average 10 per cent of homes resell per year after this point – but some years it may be six and the next 14. It is variable. With this turnover, the target is to achieve a return of about 14 per cent on the value of the village – which is calculated on a complex formula called its ‘discounted cash flow’ based on the future DMF income. For our 100 unit village the 14 per cent could be around $750,000 a year. That again sounds good but the owner had to wait eight years after finishing the village with little or no income to start earning it.
In summary, the village developer and operator had to invest $5 million for eight years to make $6.4 million and then had to wait another eight years to start receiving an income of $750,000 a year. Throughout this time they are responsible for the residents with no income return.
Are they making ‘big profits’? Most business advisors would say ‘no’ and recommend other, faster and less risky residential developments.
You be the judge.
Please note, ‘Frank’ (Chris Baynes) has no financial interest in any retirement village or village operator.