INTRODUCTION

In September 2000, Bernie Lomax, president of The Percy Group, a large real estate development company in London, contemplated an opportunity that had been presented to him. Shady Pines Retirement Care Inc. (Shady Pines), a company that managed retirement homes across Ontario, approached Lomax about converting one of The Percy Groups apartment buildings into a retirement home. Lomax wanted to increase The Percy Groups revenue per square foot of rental space and thought that the retirement home project might generate long-term value from an aging asset. At the same time, he knew that the up-front investment required for the project was significant and that The Percy Group lacked experience in the retirement home industry. Lomax wondered if the project would meet The Percy Groups cost of capital and whether the potential benefits of operating a retirement home outweighed the risks. He opened a new spreadsheet and started crunching the numbers.

A widely diversified real estate developer based in London, Ontario, The Percy Group had an impressive history spanning more than three decades. The Percy Group built, owned, and managed office buildings, commercial and industrial complexes and residential rental properties. Founded in 1967 by Zachary Percy, a Polish immigrant, The Percy Group quickly grew to become a prominent player in the London real estate market. Originally renovating older homes for rental purposes, Percy gradually expanded his business into apartment and industrial rentals and later into residential and commercial land development. To date, The Percy Group had completed over 50 residential housing projects with many others in the planning and development stages. The Percy Group was one of the largest and well-respected real estate developers in London. As of 2001, The Percy Group managed 2,500 residential rental units, as well as 450 commercial and industrial units in the London area. Moreover, The Percy Group built 150 houses in 2000. The size and scope of The Percy Groups operations made it a well-known and distinguished member of the London business community. The Percy Groups brand was associated with quality, high service and trustworthiness. This was a major factor in the home purchasing/renting decision and a major contributor to The Percy Groups success. As a result, protecting the brand and maintaining a positive public image was very important to the company. In 1995, The Percy Group was selected by the Ontario New Homes Warranty Program to receive the Ernest Assaly Award, presented annually to the homebuilder who best displayed exceptional after-sales service and superior quality of construction.

RETIREMENT HOME INDUSTRY

The seniors housing industry comprised of two main segments: nursing homes and retirement homes/assisted-living facilities. Both were closely related, however, there were differences in the types of services provided, regulations, funding methods and the competitive environment. Nursing homes (long-term care facilities) provided long-term nursing (medical) care and related health and social services to seniors who required a greater level of care than was otherwise available in the community. The average age of residents was well into the mid-80s and as such, these residents required ongoing assistance and regular medical supervision. The nursing home industry was also highly regulated by provincial governments. A permit was required to build and operate nursing homes. Governments also mandated minimum service requirements for nursing homes. Retirement homes (also called assisted-living facilities) differed from nursing homes in two ways. First, the level of care provided in a retirement home was less intense (no primary level medical care). Residents were typically older than 75 years of age and needed some assistance with aspects of everyday life. Second, retirement homes were funded differently. While nursing homes were publicly funded, retirement homes were privately funded. Furthermore, although nursing and retirement homes delivered very different levels of services, they competed for some of the same customers. As a result, nursing homes were viewed by some as an inexpensive substitute for retirement homes.

REGULATIONS Retirement homes were not regulated in Canada and were treated under the law as any other residential building. As well, there were no constraints on the supply of retirement homes. As a result, the growth rate for assisted-living facilities in North America was high. The American Seniors Housing Association (ASHA) estimated that in 1999 there were 6,500 assisted-living residences accommodating 550,000 seniors in the United States. The ASHA estimated that nearly 1,200 assisted-living facilities (85,000 units) had been built in the past three years alone. The Canadian industry was experiencing similar growth trends.

INDUSTRY TRENDS Government As part of its new long-term health care program, the Ontario government committed approximately $1.2 billion in 2000 for long-term care in the province. With these funds, the government planned to add approximately 175 new nursing home facilities (an additional 20,000 long-term care beds). The government also planned to rebuild and renovate 102 existing nursing care facilities. In London, 620 new beds were projected within two years. Some analysts believed that an increase in nursing home capacity would adversely affect the occupancy rate for retirement homes. Internal Operational Issues There were certain unique issues that owners of retirement homes faced. Because the industry was unregulated, there had been rumours that unsuspecting property owners were being defrauded by managers. Managers could take advantage of property owners by using such tactics as hiring ghost employees (employees on the payroll who did not exist), exaggerating insurance benefits, and claiming excessive cleaning and food costs. Consolidation Indicators The fragmented landscape of the seniors housing industry was ripe for consolidation. With many economies of scale and the potential to reduce management costs, industry consolidation had created a small number of major players. On the other hand, many small owner-operated retirement homes still existed. The majority of consolidation was in the nursing home side of the industry. Nursing homes were a limited commodity because a government permit was needed in order to operate a nursing home. This limited supply and resulting value had driven the trend towards increased consolidation in the nursing home industry.

THE RETIREMENT HOME INDUSTRY IN LONDON Over the past 10 years, the London area had sustained a strong level of population growth, as well as economic growth. The population in the London area had grown by approximately 7.4 per cent since 1991 while the population aged 75 years and older had grown by 33.2 per cent over the same period.1 There were 15 retirement homes in London, representing a capacity of nearly 1,000 beds. The capacity of each home varied from 15 to 127 beds and there were five facilities that rivaled the size of The Percy Groups proposed retirement home: Central Park Lodges (88 beds), Chelsey Park Retirement Community (112 beds), Grand Wood Park (127 beds), Kensington Village (115 beds), and Masonville Manor (approximately 100 beds). In London, typical prices were $2,000 per month for a bachelor suite and $2,600 per month for a one-bedroom suite. These rates included rent, meals, activities and a variety of services that varied from one facility to the next (see Exhibit 1). The retirement home market in London was in a state of over-supply. According to industry analysts, there was an excess supply of 124 beds in London. Also, there were three outstanding proposals by development companies to build retirement homes (including The Percy Groups proposal) representing 320 new beds.

The overall occupancy rate of retirement homes in London was 89 per cent. This had climbed slightly over the past two years from 87 per cent. Londons occupancy rate was the same as the provincial average (89 per cent) and was similar to rates in other cities in Ontario (Toronto 93 per cent, Hamilton 91 per cent and Ottawa 84 per cent).

THE PROPOSED PROJECT THE LONDON RETIREMENT VILLA Early in 2000, Shady Pines Retirement Care Inc., a company that managed retirement homes across Ontario, approached The Percy Group about converting one of The Percy Groups apartment buildings into a retirement home. Under the proposed agreement, The Percy Group would maintain total ownership of the facility while Shady Pines would assume all of the management responsibilities.

Shady Pines was an experienced, well-respected management company that had a proven track record of operating successful retirement facilities in southwest Ontario. In exchange for a management fee, Shady Pines would provide its managerial and marketing expertise in seniors retirement care and would administer the many value-added services that were unique to retirement homes (i.e., activities, meals).

The site of the proposed retirement home, the London Retirement Villa (LRV), was an apartment building located in south London at 247 Evergreen Lane. The apartment building was conveniently located across the street from one of Londons largest shopping malls and within walking distance to a public library branch, a hospital, and numerous churches and temples. Lomax felt that the excellent location at 247 Evergreen Lane represented an advantage over competing retirement homes in the London area. The building was also demographically attractive, as most of the residents were either at or near the age of retirement.

The nine-floor building consisted of 126 rental units that paid an average monthly rent of $550. The Percy Groups annual expenses of maintaining the building were $350,000. The annual expenses did not include depreciation, as the 30-year-old building had already been fully depreciated for several years. Both the revenues and the expenses of the existing building were expected to increase by five per cent annually. If the proposed project was not undertaken, the existing building was expected to continue operating indefinitely with minimal annual improvements.

Under the Shady Pines proposal, three floors (38 suites) of the existing building would be converted into 72 renovated assisted-living bachelor suites. The remaining 88 units would serve as transitional suites, for seniors who didnt yet require assisting-living suites but could still take advantage of some of the LRVs value-added services. Lomax estimated the conversion cost to be $2,400,000.

Shady Pines also proposed building an adjoining building that would house an additional 22 assisted-living bachelor suites, 16 assisted-living one-bedroom apartments, as well as facilities for meals and activities. The cost of building the adjoining building was estimated to be $5,500,000. Once the decision was made to go ahead with the project, Lomax expected that it would take approximately one year to renovate the existing apartment building and build the adjacent structure.

Based on the rates of competing retirement homes in London, Shady Pines believed that the Percy Group could charge $2,000 per month for the renovated bachelor suites, $2,100 per month for the new bachelor suites, and $2,500 per month for the new one-bedroom apartments. Bernie thought that the rental rates for assisted-living suites would rise by three per cent each year. Although the rent of transitional suites would be $550 per month during the year that the LRV was being constructed, Lomax expected that the average rent would increase by $50 per month each year until it stabilized at $800 per month.

Shady Pines believed that higher rental rates were justified given the value-added services that the LRV offered. In addition to the annual operating expenses of $350,000 (expected to increase by five per cent per year), the LRV project would require several incremental expenditures. Shady Pines estimated that the costs for salaries and benefits for the administrative and support staff would be $750,000 per year. These costs were expected to be incurred beginning in the second year, and were expected to increase by three per cent each year.

Also, Shady Pines anticipated that the additional costs of running a retirement home (food costs, activities costs, additional maintenance, etc.) amounted to 20 per cent of the revenues generated from assisted-living suites (not including the transitional suites). Additionally, Shady Piness management fee would be five per cent of the revenues generated from assisted-living suites (not including the transitional suites)

. Lomax expected that the Percy Group would spend $150,000 in initial marketing and advertising costs in the first year while the LRV was being constructed.

Although the occupancy rate of 247 Evergreen Lane had always hovered around 100 per cent, Bernie noticed that the average occupancy rate for retirement homes in London was 89 per cent. He estimated that occupancy in the LRV would initially be 70 per cent, gradually increasing by five per cent each year until stabilizing at 90 per cent.

Lomax also felt that the LRV project would significantly raise the value of the property at 247 Evergreen Lane. Rental properties were valued based on a multiple of their operating income before taxes, depreciation and financing costs. In London, buildings generally sold for 10 times the value of their operating income before taxes, depreciation and financing costs. Bernie felt that the cash flows of the LRV would stabilize by the end of the seventh year of the project, at which time the LRV could be properly valued.

Finally, The Percy Group would have to vacate three floors of 247 Evergreen Lane in order to do renovations. The company would either have to wait for tenants to voluntarily move from their apartments (turnover in the building was approximately 33 per cent per year), force tenants to leave once their leases expired, or offer compensation packages to tenants who insisted on staying. Furthermore, renovations would cause some disruptions and inconveniences for the remaining tenants.

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