Description

Notes: All $ are NZ$ (including above) unless otherwise stated.

This is a two-part thesis.

The short-term thesis is that the market is punishing RYM for Coronavirus (CV) effects, but CV will not hurt this business. Two days ago, NZ announced new cases of CV after being supposedly CV free for over 100 days. RYM fell another 5+% and is currently down over 25% from its pre-CV levels. I have never expected NZ to remain permanently free of CV. That was always a pipe dream as we simply do not know enough about CV latency and transmission. It could have easily been passed from asymptomatic carrier to asymptomatic carrier for months. However, the disruption to NZ has been and will be less than anywhere else because it is a small, socially cohesive, island nation. RYM also has a small percentage (about 10%) of its Retirement Villages in the Melbourne area of Australia, and while I am not as optimistic regarding Aussie real estate, it is not a large percentage and the effect of CV on RE will not be a disaster there.

CV will help the NZ RE market and Retirement Villages like RYM. NZ is uniquely positioned to deal with CV as its only real negative quality, its isolation, has become an asset. NZ citizens abroad are moving back to New Zealand due to CV, and non-citizens who can buy housing (thru relatives, etc.) are doing so. The residential real estate market is not suffering. In specific U.S. locations, like Aspen, CO or Jackson, WY, residential real estate is soaring as these places are viewed as ideal U.S. boltholes. Well, NZ is viewed as the world's bolthole and CV will only push demand for its real estate.

The medium-to-long-term thesis is that RYM is a wonderful way to play the long-term popularity of NZ real estate, in general, and 

retirement villages (due to demographics), in particular. Living in NZ becomes more attractive as technology reduces its isolation and its lack of societal problems contrasts with the rest of the developed world. And the demographics of NZ are such that the number of age 75+ residents will grow at a 4% per annum clip for the next two decades.

A brief word about RYM vs Summerset. I own Summerset as well, and there are pros and cons of each. Summerset is cheaper on most metrics, but RYM has several advantages: (1) They have a much larger and more integrated care bed structure in place. This creates a more stable business model as end-of-life healthcare concerns are a strong draw for these customers versus only lifestyle; and (2) They have proven their ability to expand into Australia while Summerset will not open its first Aussie Village until next year. In terms of the NZ ops, I view RYM as a more expensive but less risky investment, and they have proven their operations and brand in Australia and so arguably have significantly more growth potential long term than Summerset; and (3) RYM has scale versus SUM. SUM has staked a slightly more upscale brand, but that can cut both ways as swimming upstream to expand penetration of 75+ is probably not possible. Swimming downstream towards more middle class is possible as many NZ baby boomers have considerable home equity even if they are otherwise on a fixed income.

Interestingly, RYM has lost more of its value due to CV than SUM while I would have a priori expected the opposite. This makes the short-term prospects of RYM more interesting.

The financials of NZ Retirement Villages are confusing and difficult to understand. I am happy to discuss the nitty-gritty details of all the public financials of RYM and SUM, but first a high-level overview of the business.

The basic idea of the business is:

- RYM builds a retirement village (villas, apartments, and care beds) for $100mm including land, buildings, common areas, and cost of the capital they borrow and the equity. They borrow about 4/5 of the capital required. 

- At completion, RYM pays back the $80mm construction loan (and returns the $20mm of equity plus cost of capital) and then borrows $100mm from "lenders" at 0%.

- They then "lease" the units to elderly people (average age of new lessee: 79) at about a 3% cap rate (so $3mm rents on $100mm property). The exact terms are 4% per year for the first 5 years and then nothing thereafter. The tenants live there until they die (usually) and the average stay is 6-7 years. Note: This is a bit simplified as the care beds have different financial terms because life expectancy is much lower, but I will keep simple.

- The twist here is that the "tenants" are the new "lenders." In order to live in a unit, the resident must lend money at 0% to RYM. The size of this Occupancy Advance (known as Resident Loan to Summerset) is determined by a free market. For obvious reasons, the OCA for a given unit is highly correlated to the price of outright purchasing a similar home in the same area. However, note that residents are NOT allowed to borrow any part of their OCA and the economics mean that that speculation would make no sense. And further, once a resident has "leased" a unit, they do not move out until they die (except intra-community moves are encouraged, mainly for deteriorating health). Thus, I expect these three factors (no leverage, no speculation, and sticky tenants) to dampen OCA level volatility versus normal res real estate.

- Direct comparisons are difficult (due to community buildings), but OCA tend to be about 75% of the cost of a similar unit with normal title ownership. We can also see this approximate number via construction costs versus original OCAs. In the very strong NZ market of the past few years, the original OCAs have been a slight bit greater than the all-in construction costs. So, in our $100mm example, the original OCAs would total $105mm. But if they had built a "normal" neighborhood of villas at the same time, they would have sold them outright for over $125mm. Warning: when they report margin on new construction of high 20%, that is because they are not including common buildings and common areas. When they count all-in costs, it is single digits.

- This Retirement Village business model is well established in New Zealand (and has been introduced to Australia, esp the Melbourne area). The economics are interesting from the perspective of the residents. Residents are there for lifestyle and peace-of-mind regarding end-of-life care. They are willing to give up the real estate upside of owning a normal house in their final years, and Retirement Villages are very popular among the upper-middle-class in NZ. I have read many online message boards discussing NZ retirement villages, and the people who dis-like them are the residents' children: "If mum and dad had lived out their days in their house rather than moving to [Retirement Village], the estate would have had $100k more as the value of their house went up by that much between when they sold it and when they died." But the well-run RVs (esp RYM and SUM) are well-liked by their residents. One thing to note: The fee structure and the economics are not terribly difficult to understand, and there are many disclosures for would-be residents as well as specific laws and regulations. My point is that there are no surprises and this is not a model of trickery. There is very little ambiguity about the cash flows and expenses going forward.

Financials:

The financials are relatively complex but the unit economics are very simple. It is one of the few investments where setting up a spreadsheet can be useful.

Let's got thru the unit economics. I will assume 3% CAGR in OCA prices. A resident "leases" a new unit for 6 years and lends $600k against it. The resident pays $600k * 20% at the end of Year 6. Also at the end of Year 6, the new OCA market price will be $600k * (1.03)^7= $738k, and RYM will collect $138k in cash. As well, including all corporate overhead and other expenses averaged across units, RYM pays out about $600k*1.33% per year. It is actually a bit higher but we will see operating leverage going forward.

Let:

g = growth rate per year of market OCA (3% in example); m = deferred maintenance fee (i.e. 20% divided by number of years in unit) (3.33% in example); e = expenses including all corp overhead (1.33% in example); r = NZ tax rate (28% in example)

If you run the math, you'll see that buying this cash stream for $600k at time 0 will have an IRR of g+80%*(1-r)*(m-e) = 4.2% in above example. I expect 80%*(1-r)*(m-e) to be about 1.2%. Note: the 80% is an approximation due to the timing mis-match of m vs e cash flows. But this cash flow will grow at rate g so that over the next 6 years (years 7-12), we will receive a return of $600k*((1.03)^6)*4.2%.

So we have a yield of 4.2% growing at 3%. The g enters twice, both as a cash flow and as growth of cash flows. As a perpetuity, the return would be 2*g + 1.2%. This 2*g is the result of infinite leverage and re-leverage.

But the real key to the upside with RYM is understanding their ability to add units (let u = unit growth per year) with very little equity capital tied up for a short period of time. Once they have completed a new project, they lease the units and cover their costs, interest on the loans, and even the cost of the equity capital involved (which is $100mm in total in my running example). Thus u simply grows the OCA amount. So, if we buy the single unit for $600k, each year we receive the economics on a marginal u units. So now our g+1.2% is growing at g+u. And in perpetuity, our return will be 1.2% + 2g + u.

What separates Retirement Villages from an ordinary apartment lessor?

- lower "rents"

- but infinite 0% leverage on existing units and new unit construction -- this is what adds the "free" g+u.

How does the unit model line up with the current whole-company situation? 

The basic idea is that if one purchases such that TEV = Pro Forma Gross OCA (PFGOCA), you will get the (1.2% + g) unlevered yield growing at g+u. 

PFGOCA is the OCA if all re-set to today's market levels. This is my term, but they vaguely allude to such a concept when describing the CBRE valaution.

Warning: RYM (and all the Retirement Village operators) report a GAAP valuation from CBRE on their investment properties. Various other numbers in presentations and reports are dervied from this number. This number comes from an opaque methodology, and I strongly advise against using it. Follow the cash flows and build a unit model and then a total model.

To go from the basic mkt cap = PFGOCA model to reality, we need to adjust for the following:

1) RYM has $1.7bn of net debt, but it also has $1.1bn of real estate and work-in-progress buildings. As well, it has a large value in care beds that are not under OCA agreements. The debt obviously applies to this as well, and this complicates matters. I tend to think that $1.0bn of the debt applies to the real estate and work-in-progress. I then assign $0.7bn to the care beds. One reason for this is that this lines up the RYM and SUM financials since SUM does not have non-OCA care beds. I do not subtract the $100mm of equity assigned to the future developments from TEV although it has historically earned a handsome return.

2) Continuing the above analysis, we have care beds with no OCA. The economics of the care beds are similar to those of OCA units except that the there is no 0% loan but that the care bed business does not have the large downside in event of real estate drop as previously non-residents will fill. The company assigns the care beds $800mm of accounting value using an outrageously high cap rate average of over 12%. These are worth $1.5bn or more, less the $0.7bn of debt assigned to them.

3) So we have a Mkt Cap = $6.3bn but we then subtract $0.8bn (for the care beds) and get Adj TEV = $5.5bn. The Gross OCA reported as of March 2020 was $3.7bn, but we need to adjust this as the market has strongly appreciated for the average unit. If all OCAs were to be re-set to today's values, the PFGOCA would be 25% higher, or $4.6bn. Note that in the case of SUM, the average tenure in its units is much shorter than that of RYM and so the appreciation versus contractual OCA is lower.

4) we are not at time 0 on average. We are at year 2-3 on average. This slightly favors us versus unit economics above because closer to first deferred management fee payment.

5) At the current Adj TEV ($5.5bn), we are buying at a premium to PFGOCA ($4.6bn).

6) The rise in NZ/Aus real estate (and market OCA rates) during the life of existing residencies is much greater than 3%. So the Gross OCA value of existing residencies (as of 3/31/2020) was $3,700mm. But as I describe above, if these leases were to re-value at today's prices, they would re-value to about $4,600mm. If they had only risen by 3%, they would be at about $4,100 today. This $500mm difference will come back as cash flows to the company in a 3% steady state model. The reason is that the gains on re-leases will be higher than given by a 3% steady state model since inception. Note that if we use a 7% steady state model, then we will not get this $500mm difference (but we'd get a much higher return).

This is confusing and it is important not to get confused with mkt cap versus PFGOC. This has nothing to do with the stock price. Technically, this $500mm difference should be subtracted from the TEV for an adjusted TEV if using g=3%.

7) So now our adjusted TEV is $5.0bn vs PFGOC of $4.6bn. This means we can expect a yield of 4.6/5.0(1.2%+g) growing at g+u. Or in a perpetuity: 1%+1.9*g+u. So, if g=3% and u=7%, IRR will be 14%.

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Enough with the math. The keys are what will g and u be. If you think that NZ will suffer a multi-year real estate bust, then this is a silly investment. Unit growth will be minimal and the market prices for OCAs will drop.

Why am I optimistic regarding NZ real estate?

- NZ's strengths and even its one historical drawback (isolation) have become exceptional assets in today's world filled with CV and societal disintegration.

- To many, NZ is the greatest country in the world with one notable exception. It is wealthy, safe, with awesome outdoor spaces, a harmonious society, etc. The white (largely English/Scotish) immigrants and indiginous Maori have had much better and equitable relations than any other large European colony of which I am aware. The white majority recognized Maroi culture and rights long before it became fashionable in the rest of the world.

The one notable exception to the greatness of NZ is its isolation. Many people assume it is "part" of Australia, but it is a 3.5 hour flight from NZ to the Eastern shore of Australia (Sydney is the closest city). NYC is closer to Omaha, NE than NZ is to Sydney.

- NZ's safe haven status will create a strong demand for real estate. And this demand pre-ceded the current world strife. The ease of air travel plus the advent of the Internet has reduced the isolation of NZ over the past decades. The shrinking of the world will erode NZ's special-ness, but it will increase RE prices.

- Because of rising RE prices, NZ passed a law forbidding non-citizens or non-legal residents from buying property a few years ago. This was expected to tamp down on speculation and slow price growth and I agree we will not see the 7% per annum price growth that we have seen in past years.

- However, there are 1mm NZ citizens that live outside NZ. The population is only 5mm. So there are 1mm people that can return to NZ today with only a two-week mandatory quarantine stay. And there has been lots of evidence that many ex-pats are returning. Many houses are being sold sight unseen by the to-be residents.

https://www.stuff.co.nz/life-style/homed/real-estate/300059168/covidfree-new-zealand-tempts-foreign-property-buyers

- Citizens of Australia and Singapore are exempted from this law, and these are big exceptions.

- There are anecdotes in the media about buyers not eligible for real estate using family members or others to buy NZ real estate.

- Wealthy people can move to NZ via investor visas and buy property.

- And there are always loopholes: just last week, the NY Post ran a cover story about a RE agent selling a house in NZ that had been re-zoned commercial (foreign buyer rules does not apply).

https://nypost.com/2020/08/08/million-dollar-listing-broker-eyes-new-zealand-real-estate/

- Immigration (esp from Asia) has been strong. The Asian population has tripled since 2000 and now make up 15% of the population. We may see stronger immigration numbers due to the current world climate.

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Over the long-run, I expect NZ real estate to see steady growth due to its quality-of-life attractiveness versus the rest of the world combined with a reduced sense of isolation as air travel and Zoom/FaceTime/Skype/WhatsApp close the virtual distance of Kiwis to the ROW.

But what about Retirement Villages (RV) in particular?

At present, there are about 350k age 75+ in NZ. A bit less than 15% are in RVs, including RVs where residents own their unit outright. The population of 75+ will more than double over the next two decades, growing at a bit over 4% per year. for the next two decades.

I expect greater penetration than 15%, but this will cap out at some point because not every 75+ has $500k in cash/home equity to do the OCA. However, even many middle-class baby-boomer Kiwis have a lot of home equity because housing prices have quadrupled since they bought their houses 30+ years ago. But I expect penetration to add 1-2% of unit growth per year. Total NZ unit demand (entire market) will grow 5-6% over the next two decades.

And then I expect RYM to expand its market share as it has a strong brand and by far the most well known. The market is surprisingly non consolidated, but RYM and SUM will capture a far higher % of new units than lower scale, higher cost competitors.

I am confident that RYM can grow NZ units by 7% per year for two decades.

Finally, there is the Australian market. I am not as optimistic about Aussie real estate in the near term or long term. But it does provide RYM enormous growth potential over the medium-to-long run. Victoria alone has 20% more population than all of NZ and a similar ratio of age 75+. The baby boomer demographics apply to Australia as well. If Australia continues to work, RYM will see HSD unit growth for the next two decades.

The market for OCAs will surely be tied to the overall RE market in NZ (and Aus). However, I think a few facts favor the OCA market versus similar owned units.

1) Due to baby boomers reaching age 74 this year, the age structure of NZ will change similar to the entire developed world. The age 75 cohort will make up an increasing percentage of NZ's population. In the past decade, the % of the NZ population age 65+ has gone from 12.8% to 16.0%. Ages 65+ will make up almost 20% of NZ's population in another decade. As the baby boomers (I will arbitrarily define as two decades after WWII (1946-65)) are ages 54 to 74, the % of NZ ages 75+ will explode from its current 7% to almost 12% in two decades.

2) OCAs cannot be funded from loans. As well, due to their structure, they make no sense as a speculative vehicle. They are consumed like any leased unit. Finally, due to the upfront nature of the Deferred Maintenance Fees and the payment upon exit, there is very little reason to leave. This does not insulate the OCA market from the broader residential real estate market, but it should dampen its volatility.

One question is what happens if the OCA market collapses. When does RYM go under because the cash flow required to pay out exiting residents is so much greater than new, lower OCAs?

The answer is we would need to see a drop of about 30% (and remain there for years) for them to come close to the line. Remember that the average unit OCA has increased 25% over its current tenancy and that we have a deferred manintence fee asset that will be collected at the end of the tenancy.

Risks

The short term risk here is the small number of publicly traded NZ stocks, esp the Retirement Villages, have become speculative vehicles for CV risk.

At one point in March, RYM equity was down over 60% from pre-CV levels. This implied a significant amount of default risk. There was no evidence that residential real estate was plummeting and even the most dire predictions were for a 15% drop in prices. In reality, housing prices remain strong as transactions resumed in June.

The long term risk here is that residential real estate will stagnate or even drop over the long term. NZ median home price to GDP-per-capita (about 8x) is high by U.S. standards (about 4x), but not coastal states like California or coastal areas like Long Island. And due to its geography, the median NZ housing stock is much better compared to San Diego county rather than Des Moines county.

Denmark (probably the closest country I can think of to NZ) median housing price to GDP-per-capita is a little over 6x, but Denmark housing stock includes far more rural, non-coastal villages on average than the NZ housing stock and the Copenhagen area ratio is higher than 8x. Australia is similar. The Greater Melbourne area ratio is over 8x.

One mitigating factor is that NZ residential real estate is not extremely levered. New Zealand housing stock is worth $1.1tr but only has mortgages for less than 25%. At the highly levered end, it is possible to borrow up to 95% LTV but only on a primary residence. This reduces the sort of levered speculation we witnessed in the U.S. in the early 2000s.

Catalyst

The short term catalyst is RYM new unit sales and resales remain strong and the broader NZ residential RE market remains strong. The stock has priced in a 20% drop in prices and as evidence comes in that this is not the case, the stock will rally. SUM reports next week, and RYM will react to that news.