Seeking to fill a perceived information gap in the analysis of bonds for continuing care retirement communities, Fitch Investors Service Inc. last month unveiled a list of ratios it hopes will become an industry standard.
"In terms of ratios, it has been almost impossible to compare one CCRC with another," said Edward C. Merrigan, a senior vice president at Fitch and author of the agency's special report. Mr. Merrigan said the ratios are the first to be made available industry-wide.
The world of retirement community investing has been one of the most volatile and risky in the tax-exempt market, in part because of the lack of timely and standardized financial data and the industry's relatively recent development.
When the ratios are combined with recent progress made in improving financial statement standardization "you have the ingredients for investors to make more informed investment decisions," Mr. Merrigan said. "Now you can compare apples to apples."
Several firms have developed in-house ratios they use to assess credit quality for retirement communities, but those are proprietary. The Fitch ratios are the first to be available for general consumption, market sources said.
Continuing care retirement communities are facilities set up to meet long-term care needs for the elderly, including housing, meals, medical care, and eventually nursing or hospital care. Residents usually must be in good health and pay an advance fee upon admission, as well as a regular monthly fee.
The philosophy of such facilities is to combine the independence of a retirement community with the security of knowing nursing care is available if needed.
Ratios Only One Component
Market sources said that although ratios are helpful in developing snapshots of a facility's financial situation at a particular point in time, they are limited in helping to develop an overall opinion on the credit quality of a particular bond.
"Debt service coverage could be 10 times one year and one time the next," said Barnet Sherman, an associate portfolio manager at the Colonial Group in Boston. "Ratios do not get at the root issues, which are start-up time, the speed at which they reach break-even occupancy, and how the deals are structured.
"I'll look at ratio's, but my fundamental credit issues are not entirely financial. They're demographic, actuarial, and marketing," Mr. Sherman added.
Carla Hanlon, director of high-yield research at the Prudential Capital Management Group, said Prudential has its own ratios, but plans to incorporate some of the new Fitch ratios into its analysis of well-established facilities. Ms. Hanlon encouraged Fitch to develop similar ratios for start-up operations in the preconstruction phase, where she said there is a need for improved financial analysis.
Another portfolio manager who invests in retirement community bonds said overly optimistic feasibility studies constitute one of the biggest problems he has come across in trying to analyze the bonds. Those studies attempt to predict, using demographics and actuarial data, how quickly facilities will fill up after opening, a key factor in cash-flow projections.
Mr. Sherman said that while he would like to invest in the slew of new issues, that has hit the market in recent months, no one has been able to provide an acceptable method of analyzing those kinds of credit issues.
Colonial has invested in only three retirement communities so far, he said. One has defaulted and the other two are having credit problems.
Fitch limited its effort to providing the market with a better way to assess retirement communities' publicly available financial data, rather than tackling the thornier problems Mr. Sherman described.
"Ratios are a good tool for analysis, but are only one component use in assigning a rating," the report says. "Used alone, ratios are meaningless. Other analytical factors include management, market, and security features."
Mr. Merrigan added that, given all the variables that can affect demographics and life span analysis, "If anything, ratios are the easiest thing to calculate."
The agency's report lists 16 separate ratios, giving detailed information on how each can be calculated using publicly available financial data from continuing care communities. The most important of the ratios, and according to Mr. Merrigan one of the most frequently miscalculated, is the debt service coverage ratio.
In the past, hospital analysts frequently calculated debt service coverage for retirement communities using the same process for determining hospital ratios. But that strategy ignored a key difference between hospitals and retirement facilities: the advance fees paid by residents of retirement communities upon enrollment.
Some facilities booked the fees a earnings immediately, significantly boosting bottom lines and generating misleading cash flow figures.
Others amortized the money over a period of time, usually over an actuarial analysis of life spans. But those amortization schedules also varied from facility to facility, creating further confusion.
It was "absolute chaos," Mr. Merrigan said. "That chaos was a stumbling block for any financial ratio comparison and made buying the bonds potluck for investors."
A giant step toward rectifying the mess came in 1990, when the American Institute of Certified Public Accountants published the first-fever standardized example of a financial statement for a continuing care retirement center.
The result is that fiscal data are now computed and published in the same fashion from facility to facility, making it possible to standardize ratio calculations in a meaningful way.
The standard devised for handling up-front fees is to amortize them over the expected life span of the resident based on accepted actuarial tables.
Finding Coverage Ratio
Fitch's debt service coverage ratio is based on the following formula: excess or deficit of revenues over expenses plus interest expense, depreciation expense, and amortization expense, minus amortization of deferred revenue from nonrefundable advance fees, plus proceeds from advance fees and deposits, minus refunds of advance fees and deposits.
The result equals net resources available for debt service, which is then divided by maximum annual debt service to attain the debt service coverage ratio.
The debt service ratio is sensitive to the receipt of advance fees, Fitch noted, because the cash flow from advance fees helps pay debt service obligations for most facilities.
"The extent to which a CCRC relies on this source of funds to service debt is a concern and an important factor in the rating process," the Fitch report says.
To calculate a facility's reliance or overreliance on advance fees, the rating agency developed a separate debt service coverage ratio that does not take into account cash received from advance fees.
In general, Mr. Merrigan said, facilities average slightly less than one times coverage when the benefit of advance fees is removed. If the ratio falls below zero, that should be considered a warning sign.
In addition to the debt service coverage ratio and the coverage ratio less advance fees, Mr. Merrigan said another important calculation includes operating ratio, which determines if ongoing cash revenues sufficiently cover cash expenses.
Fitch's "days cash on hand" ratio measures, in days, all cash and investments deemed available to cover daily expenses, and is an indicator of a facility's ability to withstand short-term disruptions in cash receipts.
The reserve ratio measures the strength of an organization's available cash position relative to its long-term debt.