By Jack Cumming
Finances and ownership are intrinsic to the trust challenges that have impacted the entrance fee CCRC industry. In Part 1, we outlined some of those challenges. In this part, we suggest what financial advisers, developers, and financial officers might do to make the industry more trustworthy.
Dispelling the Myth
There is a myth, reflective of the thinking of Milton Friedman, that not-for-profit and government funding are antidotes to the greed of business. Many in senior living speak of a not-for-profit advantage. Despite that common pretense, there are clear advantages to less tax-favored forms of organization.
That means that Milton Friedman got it wrong. The purpose of business is to give benefits to customers. Profit is necessary for business continuation, and breakthrough customer benefits can increase enterprise value, but there are public service benefits to taxable enterprises that ought to be embraced.
The For-Profit Advantage
First, we’ll look at an advantage few know of or are willing to acknowledge. At least two family-owned entrance fee CCRC operators give the “refundable” portion of the entrance fee a first deed of trust (a mortgage) claim against the assets. This means that, if the enterprise fails financially, the residents succeed to the ownership.
Closely held owners can do this because the owner-investors provide the equity capital to secure the debt. This is not common, however. No not-for-profit provider does this, at least not to my knowledge. With the shaky authorization of IRS Revenue Ruling 72-124, the market-priced CCRC industry is dominated by not-for-profit providers. In fact, the industry’s trade associations are categorized by whether their member senior living enterprises are investor-funded or not-for-profit.
Knowing that they will become owners if the governing operator fails financially is a material benefit for residents who pay entrance fees.
What’s the Alternative?
The possibilities for creative financing suggest that conventional owner-equity funding may have advantages over not-for-profits despite the nonprofit mythology. There are several advantages. Investors can ensure that the enterprise has a positive net worth from the beginning, thus giving residents, prospective residents, and their families greater financial security with a strong balance sheet.
Also, residents can be empowered by giving them ownership of their homes. Investor-funded communities pay taxes and help support local, state, and federal government. Those are considerable public service benefits. Residents invest in homes they own, thus lessening the appearance of a dilapidated community.
The rationale for not-for-profits is that they don’t distribute profits and that they claim to be more socially minded. Of course, likewise, many for-profits don’t distribute profits. Both not-for-profits and for-profits can be criticized for paying their executives outsized compensation packages. Many for-profits and a very few not-for-profits have internalized Milton Friedman’s premise to enrich top executives beyond all reason.
Covenanting
What is touted as the not-for-profit advantage can be achieved more directly by covenantal articles of incorporation and bylaws. If market-based senior housing is willing to pay a fair share of taxes, many options open up to put the industry on a sound, equitable financial footing. The advantage is that there will no longer be a need to divert contract proceeds to risky protection for debt providers. Residents depend on promises of lifelong sanctuary.
The simplest approach is to adopt investor funding with a binding commitment to reinvest gains over a fair return to benefit residents. This might be accomplished by issuing only preferred stock as sole equity or using another financial instrument. Investment bankers are skilled at developing financial instruments to fit specialized needs. Naturally, the industry’s investment bankers would be central to any conversion from pure tax exemption.
My personal preference would be to convert to a covenantal investor-funded enterprise. Priority for investing could be given to the residents who could, thereby, gain an ownership stake. Most residents, though, would, I expect, prefer to continue merely as residents with a residency agreement. The covenant restrictions to maintain a not-for-profit philosophy would last for the life of the enterprise or in perpetuity, if longer.
Mutual Association
Another straightforward way to preserve not-for-profit values while gaining investor benefits could be through mutual corporations. However, like tax-exempt senior housing, mutual corporations lack ready access to the equity markets.
Typically, the start-up of mutual companies begins with civic-minded people who contribute the initial equity capital, often in the form of surplus notes. Like preferred stock, surplus notes pay a fixed return and can be redeemed as retained earnings build a positive net worth.
Taking mutual life insurance as an example, policyholders know that they pay higher premiums initially in the expectation that they will later receive “dividends” to give them insurance at a lower overall cost than would be the case if they bought from a conventional for-profit insurer.
Cooperatives
A cooperative is a for-profit enterprise that doesn’t distribute profits to investors other than the cooperative’s members. It’s an ideal model for converting today’s not-for-profits to a more public-serving concept. For investment bankers or developers, it involves refinancing tax-exempt debt to conventional financing and then “sponsoring” the conversion to collective, cooperative ownership.
Initially, the “sponsor” owns the corporation with shares allocated to each residential unit. Those residents who elect to buy the shares allocated to their unit receive a “proprietary lease,” allowing them to occupy the unit for 99 years or until earlier death or relinquishment. Those who don’t elect to own, remain in occupancy with ownership by the sponsor.
Many laypeople think such a cooperative is comparable to a condominium, which it’s not. Residential units in a cooperative can pass smoothly to a successor resident at death, while a condominium can be tied up in the estate for years. Especially for senior housing, that is a material advantage favoring cooperative ownership.
Like cohousing, cooperatives give residents ownership and a voice in governance. The primary difference is that cohousing requires a group of prospective residents to come together spontaneously to create a community from the ground up. Cooperatives allow developers to sponsor the community and to gain development rewards by developing or converting a community, which they can then sell to residents at retail market rates.
As the cooperative’s ownership share shifts toward residents, governance shifts from sponsor-named directors to directors elected by residents. The sponsor usually remains as the managing agent for the corporation. Directors elected by residents need not be residents. Resident advisors with particular skills, e.g., attorneys or engineers, are often included.
Commonality
Central to all of this is the idea of commonality. For now, there is a divide between those who found and promote communal living and those who live in the resulting “communities.” That bright-line separation is beginning to blur. Now, there are two cultures — the corporate culture and the resident culture — but one day soon, we may have a single culture of people helping each other as we age together.
