The income statement.

The "financial engine" for assisted living

AN ASSISTED LIVING COMMUNITY'S INCOME STATEMENT IS frequently viewed by operators, investors, and lenders as a cash-producing black box. But Since the "black box" term has fallen out of favor with most Wall Street analysts, let's say that very sensitive revenues and expenses make up the high-performance financial engine of your assisted living community.

Assume for the moment that your assisted living financial engine is much like those that power a high-performance aircraft. With you as the pilot, you'd like to experience at least three favorable outcomes: (1) operating your machine in an efficient manner, (2) not constantly flying at the edge of the envelope, and (3) always having a soft landing!

Operating in an efficient manner means striking a delicate balance between the revenues you collect and the expenses you must pay--resulting in a reasonable profit margin. What is reasonable? Well, many industry experts can't seem to agree on a consistent set of benchmarks. But the key financial ratio that many are shooting for in assisted living is a direct operating expense ratio of 60 percent with a corresponding operating profit margin of 40 percent. This margin is defined by dividing operating profits by net revenues collected. It is commonly expressed as Net Operating Income (NOI) or for public companies, the fancy term of Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). Many industry analysts now feel that there's no way to consistently achieve an operating profit margin in excess of 35 to 37 percent. The 40-percent margin is seen as an elusive, moving target--primarily due to resident acuity creep leading to operating cost creep. But whether you're a for-profit or not-for-prof it operation, you must come close to at least a 35-percent-plus operating profit margin. If you don't, you'll find yourself flying at the edge of the envelope with an unstable aircraft--and you will not have a soft landing!

A "soft landing" can also be described as a graceful exit strategy. Happiness is not just positive cash flow--it means sufficient positive cash flow. Let's say you want to either sell or refinance your assisted living community. A potential buyer or lender will evaluate the performance of your financial engine by focusing on that income producing black box; paying you about 9.5 times your net operating income (a capitalization rate of 10.5 percent). They'll put your financial engine under their microscope; making sure that you've also expensed: (1) management fees (5 percent), (2) reserve for replacement ($250/unit/year), and (3) overall expense contingency (5 percent). These safety margins will keep your lender comfortable, a potential buyer motivated, and help you avoid flying at the dangerous edge of your performance envelope.

You should always evaluate your financials in terms of dollars per resident day. It's the most useful common denominator. Operating expenses per resident day in assisted living are defined as total annual operating expenses (or expenses by each major department) divided by the number of residents times 365 days. Total operating expenses per resident day should typically range between $50-$55 in most market areas. These costs include basic shelter services and a realistic menu of assistance with the Activities of Daily Living (ADLs)--approximately 45-60 minutes per resident per 24-hour day for direct, hands-on care. But many of your residents will likely need increased assistance with ADLs above the base level. They must be charged incrementally higher fees. This is the area of highest risk of eroding profit margins.

There's another big catch--your lender or buyer will want at least $1.30 in annual operating profits--NOI--for every dollar to be paid in annual debt. And you as a borrower or your buyer will probably require a debt concentration at about 75 percent of project value. Making these deals work is a juggling act. It's easy to see how your numbers and your soft landing can start to unravel if you drift very far away from that operating profit margin of 35 to 40 percent.

Assisted living has a high-performance financial engine that can deliver excellent financial results--but it burns a lot of fuel (monthly service fees). As the example box shows, and as many are now painfully aware, there is little margin for performance error.

Jim Moore is president of Moore Diversified Services, a Fort Worth, Texas-based senior housing and health care consulting firm, and author of Assisted Living 2000.

                            How the engine runs
                          Income statement for an
                             80-unit community
                             Input assumptions
Number of units                80
Cost per unit            $120,000
Base monthly service fee   $2,460
Operating expenses PRD        $55
Total cost (in millions)     $9.6
   Equity @ 25%              $2.4
   Debt @ 75%                $7.2
Loan interest rate             9%
Amortization (years)           30
                                 Cash flow
Gross annual income   $2,534,400
Vacancy factor @ 7%    (177,408)
Net rental revenues    2,356,992
Other revenues            46,886
Net revenues           2,403,878
Operating expenses   (1,485,550)
NET OPERATING INCOME     918,328
Debt service           (695,520)
CASH FLOW               $222,808
                           Key financial ratios
Debt service
 coverage (DSCR)         1.32
EBITDA                  38.2%
Operating expense ratio 61.8%
Cash-on-cash return on
 equity (1st year)       9.3%
Internal rate of return 17.9%