IMAPAC Retirement Living World China Conference (and China Seniors Housing in General)

Introduction

My good friend, Ben Shobert, has already posted on Asia Healthcare Blog a couple of detailed and thoughtful pieces on the IMAPAC Retirement Living World China conference that was held in Shanghai on May 29 – 30. I also attended that conference – I chaired the second day and was on two panels, including one that was moderated by Ben; and I also attended the VIP Investors Roundtable on Monday, the 28^th. My purpose in this posting is not to duplicate anything that Ben has said, but to offer my thoughts on some of what I would call the “grand themes” emerging from the conference. Some observations that I offer here are also drawn from my conversations and experience with foreign operators and investors, as well as with Chinese developers and investors.

My involvement in the seniors housing industry in China began in 2009, when as the co-head of Asia Real Estate in Hong Kong for a global law firm, I started working primarily with U.S. operators and investors, but also with Chinese developers and insurance companies, as they tried to wrap their minds around ways to capitalize on what all perceived to be the enormous potential of the market. Since that time, I have witnessed and been a part of what I would describe as a rapid progression from conceptualization to execution.

An Evolving Industry

To illustrate – last year’s IMAPAC conference in Beijing, as well as other senior housing conferences that I attended during 2010 and 2011, were mostly focused on making the case for seniors housing in China. We all know the supporting data by now: the size of the elderly population, urbanization, the “4-2-1” problem resulting from the one-child policy that is now thirty years old, and other factors demonstrating why the market will take off. In sharp contrast, the subject matter at last month’s conference was markedly different. Presenters and panels discussed deals in the planning stage – and more important, projects actually in development; as well as the specifics of business models being employed, how to provide services and other practical considerations.

Uncertainties Abound

But despite the progress that has been made in this nascent industry over the last couple of years, many uncertainties remain. For potential investors, due to the newness of the industry, there are no proven business models, so there is no real ability to determine a risk-adjusted return. Operators also face the same uncertainty as to how they can make money in the sector although the risk for them is, of course, much less than for investors, since they will typically not be investing much, if any (at this point), money in the market. Adding another layer of uncertainty to the industry, the regulatory regime governing senior housing is essentially unformed at the present. While there is a lot of general enthusiasm about the market, these uncertainties have kept most players from jumping in feet-first.

What Are the “Right” Business Models for Investors?

The questions concerning the appropriate business model or models are multi-faceted. What product type should be developed? Retirement homes, independent living, assisted living, dementia care, rehab facilities, skilled nursing, a combination of two or more of these product types or continuing care retirement communities (CCRCs)? What size should the projects be? Where should they be located? In urban centers or in the suburbs? Should they be for-sale models or rental? Should they be high-end or middle market?

The answer is that many different product types are being and will be developed. Some (most?) foreign investors express a preference for smaller projects – 75 to 100 units, in infill, urban locations, aimed at the high-end of the market and also aimed at the higher acuity end of the spectrum – i.e., assisted living, dementia, skilled nursing and/or rehab. Focusing on services that the elderly need, not services that they might or might not want, is seen to mitigate much of the risk that the product type may not be accepted in China. And, of course, starting with a smaller project limits the investor’s exposure, and allows the investor to conduct what will essentially be a “laboratory experiment,” attempting to gauge what works and what doesn’t work in the market. Depending upon the acceptability of these pilot projects, perhaps larger and different product types will be rolled out in the future. But for now, foreign investment will proceed cautiously.

Returns?

What size return will investors be looking for? The observation was made at the conference that it is far too early in the development of the industry to be thinking seriously about IRRs. The primary objective at this point will be to avoid losing money as business models are tried out. What will be the expected holding period? Again, since there is no experience with the market in China, this question has no informed answer now.

Models for Foreign Operators?

Foreign (particularly U.S.) operators are willing to invest their time and energy – but not money – in larger projects, where they will provide consulting services to domestic developers in the planning and operation of projects. Like the investor group, operators view the market as too unproven at this point in order for them to invest capital; but as successful business models are developed, no doubt operators will be willing to have some “skin in the game” in operating ventures with Chinese developers/owners. Some foreign operators, notably from Japan, are now willing to invest money in operating ventures – not a large percentage, but enough to “align the interests” of the foreign operator and the Chinese developer.

Business Models for Domestic Developers and Investors?

Most domestic developers and insurance companies seem to prefer larger projects, consisting of several hundred units or more, which would need to be in suburban locations due to the quantity of land they would require. Insurance companies are likely to favor rental models, as a longer-term asset that would better match their liabilities, which are long-term. Many developers, on the other hand, will prefer the for-sale model, which is more in keeping with the way residential developers typically do business – build, sell and move on to the next project as quickly as possible. That being said, there are developers who are focusing on smaller projects in urban locations, which will likely be rental models, allowing the developer to capture the appreciation over the holding period.

Whatever You Do, Don’t Overbuild

The guiding principle for all, regardless of what product type or location they choose, will be not to overbuild. Some projects that are currently in operation did, for various reasons, overbuild, and are struggling to break even or are in the process of being recapitalized. And a facility with a high vacancy rate has far less appeal, from a marketing perspective, than a smaller facility that is full or close to full, even though each may have the same number of residents.

The Regulatory Environment

The regulatory environment is in its early formative stage, which adds to the uncertainty surrounding this industry. The Ministry of Civil Affairs is the central government body charged with overseeing elderly issues, but other ministries and bureaus, such as the Ministry of Health, are also involved in the evolving regulatory process. Adding to the uncertainty, provinces and municipalities may have their own rules and/or their own interpretations of rules. For example, in Shanghai, an operator can obtain a business license to operate a health care facility without having obtained the requisite health care licenses from the relevant bureaus; whereas in Beijing, the health care licenses must be obtained before the business license will be granted.

Will the U.S. Experience be Helpful to China?

The depth of experience in the U.S. and other jurisdictions, from both an industry and a regulatory point of view, is may provide useful guidance to regulators in China as it attempts to strike a balance between encouraging private investment in the sector and maintaining the public benefit of providing housing for the elderly. In the U.S., regulations governing facilities that render care of some sort – assisted living and nursing care – are quite detailed and are promulgated on a state-by-state basis. The regulations are primarily intended to provide protection to the elderly residents.

In addition, accreditation programs are administered by non-profit, industry-supported groups. These groups visit facilities periodically and rate their performance, which not only provides a guide to prospective residents, but also serves to set standards that are higher than regulatory standards. Participation in the accreditation process is voluntary, but failure to participate would most likely harm the facility’s ability to attract residents.

There are also industry organizations in the U.S. that hold annual or semi-annual conferences for their members, which provide a forum for industry leaders to share best practices. These organizations also publish research papers that address issues of concern to the industry. All of these measures – regulations, accreditation programs and industry organizations, serve to improve the industry and provide better facilities for elderly residents.

What Does the Future Hold for Foreign Investors and Operators?

So, with all of the uncertainties, what are foreign investors and operators thinking? Is it better to be a first mover, an early mover, or hide in the weeds until the industry matures a bit? Not surprisingly, there are differences of opinion on this matter as well as on the preferred product types. Some want to be in the first mover category, focusing on building their brand and readying themselves for when the market takes off. In the case of the hospitality industry in China, once an inflection point occurred, the industry grew very rapidly, with the first movers in the prime position to benefit from the expansion. The first mover advocates believe the same thing will happen in senior housing in China. The early movers believe that the industry will be sufficiently large that being among those in the leading edge will serve them well enough. I doubt that many will be hiding in the weeds. They may proceed cautiously, but the opportunity to build a brand early in what promises to be a very large industry has too much appeal to ignore.

Domestic Capital Will Mostly Fund the Industry

Although foreign investment will enter the market, it is likely that domestic capital will provide the lion’s share of the capital in this industry. Foreign investment in the sector is being encouraged by the central government, but with the large amounts of capital available from domestic sources, foreign investment, even if at robust levels, will account for a small proportion of the overall investment. Domestic insurance companies like the senior housing product, as noted above, and developers are well aware that their customers are aging – not to mention that incorporating senior housing into a development will probably help the developer obtain the land, and perhaps at a favorable price compared to the price for a standard residential development.

Segmentation of the Market

Foreign operators will target the high end of the market, the high end will develop first and the foreign operators will dominate this segment. The domestic players will dominate the mass-market product. This is exactly what happened in the hospitality industry in China. Once the international, five-star operators came into the market and introduced best practices, the mid-market had a model that could be emulated, with modifications, of course, as needed for the market.

Foreign Participation in the Market

Most recognize the desirability – and need – for foreign participation in this industry. The senior housing industry in the U.S., for example, is more than thirty years in the making, and much can be learned from the mistakes made along the way as the industry matured. The participation should not be limited to the operation of the projects – these are purpose-built facilities, and input from experienced operators in the planning and development of the projects is essential to their efficient and cost-effective operation. A number of U.S. operators and operators from other countries, such as Japan and Australia, have been lending their expertise to Chinese developers in the planning of their senior housing projects.

Likewise, foreign investors and operators will need Chinese partners in order to succeed in the industry. Developing real estate in China is a complicated and tricky business, and a good domestic partner can help a foreign investor navigate the shoals. Also, the Chinese partner will provide a competitive advantage, with relationships with the local governments, market knowledge and access to land.

The Big Question – Acceptability of the Product in China

Will senior housing be accepted in China? Will the Confucian doctrine of filial piety hamper the development of the market?

Most believe that current senior generation will not readily accept senior housing, but that those born after 1955, who now number 450 million, will. China’s rapid urbanization has left many elderly citizens behind in rural areas, where they experience loneliness and isolation, making them more likely to accept a senior housing alternative near their children.

A survey commissioned by Merrill Gardens of the U.S. suggests that acceptance varies from city to city. There appears to be ample demand for top-end senior housing, particularly among seniors whose children are relatively wealthy. To them, service is of uppermost importance; and they strongly prefer international operators, partly due to the negative perception of the current supply of senior housing in China, which is characterized by poor service and ill-trained staff. Merrill Gardens favors an intergenerational housing model, where seniors and their children can live in the same community.

Danger of Over-supply?

As more and more players move into the market, some worry that there will be a large amount of over-supply of product. From an investor’s perspective, though, a well-conceived and executed business model should prevail over projects of lesser quality, even in the same market area. Senior housing is a complicated business, and much of the projected over-supply will likely be projects built by developers who view it as a real estate play, not as the operating business that it is. Many of the early failures in the U.S. industry were projects built by developers who failed to understand the intricacies of planning and operating senior housing, and I expect that the same will happen in China as the industry starts to develop.

Conclusion

This is an exciting industry to be involved in, at a time when it is just beginning to gain traction. The rules are being made up as we go, which provides both risk and opportunity. The opportunity lies in being part of the formulation of the rules, with projects that local governments can see provide clear benefit to China’s elderly population. The risk, of course, is in the lack of clear rules to play by. However, the way things work in China, particularly in the real estate realm, you often see the policies taking shape after the project has been completed. In this environment, there is no substitute for being “on the ground” in China, working with a good domestic partner, with good relationships with the local governments, as projects take shape. With the right approach, the opportunity to build a brand in the market is ripe; and the market is tremendous.