The vacant studio dilemma: Lower gross revenues versus higher permanent losses. (Seniors Housing).

ONE OF THE BIGGEST CHALLENGES IN SENIORS HOUSING TODAY is the growing obsolescence of many physical plants that were developed during the past 15-25 years. What started out as a new stylish Oldsmobile-building in the 1980s is now perceived as a vintage Chevrolet or Pontiac by today's marketplace.

Many sponsors and owner-operators have become accustomed to the financial rewards from these older physical plants. Simply stated, our operating expenses and debt service frequently require us to at least try to continue to charge Oldsmobile prices for what are now Chevrolet-style communities. But senior consumers and their families are gradually offering increasing resistance to these older, sub-par physical plants. (See "Communities also age," May 2001 CLTC, page 33.) Increased consumer discretion in the marketplace is focusing more and more on newer state-of-the-art designs offering a superior mix of product, price, and value.

The result is the emergence of a classic "dog unit' category that plagues many communities that are at least 10 years old. These dog units are frequently small studios with either limited or no kitchens in independent living. These small, austere units worked well as an acceptable, affordable product in the '80s and early '90s. Now, many of these smaller units suffer chronic vacancies for extended time periods.

Many sponsors and owner-operators are gradually coming to the conclusion that the solution to some of their chronic vacancies might be combining two small 300-square-foot studios into a single, 600-square-foot, one-bedroom unit. Sounds simple-until you pencil out some lost revenue and the total cost of conversion-including transforming one studio's bathroom into a functional kitchen. The costs of retrofit will vary from $12,000 to $15,000 per combined unit or higher.

A common challenge is the fact that some of these studios may have a random distribution of occupancy, which further Jim Moore is president of Moore Diversified Services, a Fort Worth, Texas-based national senior housing and health care consulting firm. He is author of Assisted Living 2000 and, most recently, Assisted living Strategies for Changing Markets. complicates the conversion strategy. Some sponsors are dealing with this occupancy challenge by combining only those adjacent units that become vacant on an attrition basis. Others are offering one-time financial incentives to get certain residents to free up the needed adjacent unit and move to another unit in the community. Still others are selling certain residents-who can afford it-on the advantages of upgrading to the larger retrofitted unit.

A look at a real-world example

Assume you plan to combine two 300-square-foot, vacant studios priced at $1,300 per month into one 600-square-foot, one-bedroom unit. However, the competitive marketplace revenue for the converted unit will probably not yield $2,600 per month (2 x $1,300). The competitive market rate might be approximately $1,800 per month- representing a revenue yield loss of $800 per month-or a net loss of about $700 per month after adjusting for lower operating expenses for single person occupancy plus the new debt service cost on the retrofitted unit (see "Lost revenue yield from combining units," left).

Combining two small studio units into a one-bedroom unit will likely improve marketability and occupancy, but the resulting cash flow will probably be reduced by $700 per month or $8,400 per year. Before you reject this as a bad idea, take a sobering look at your realistic alternatives. You must consider the much larger opportunity cost for two chronically vacant studio units that, due to heavy fixed costs, will incur about 75 percent of their operating expenses when vacant. That's a total opportunity cost of approximately $1,370 per month or $16,440 annually. The decision to combine may well be the lesser of two evils.

For any two studios, your long-run decision boils down to this: What is the probability that you are better off reducing your theoretical gross potential revenue by $8,400 per year vs. facing the very real possibility of continuing to lose $16,440 per year? Just about all the empirical evidence and market leading indicators point to biting the bullet on unit conversion. At the very least it may be worth a limited experiment with two or four studios before launching a more extensive conversion throughout your community.

Lost revenue yield from combining units


                                COST IMPACT

Independent living monthly
 service fee
 Two 300-square-foot studio          $2,600
 units
 One 600-square-foot one-           (1,800)
 bedroom unit
Loss of revenue yield                   800
 Adjust for reduced expenses          (210)
 (less meals, etc.) (*)
 Add debt service for $15,000           110
 retrofit cost (+)
Net lost revenue/cost impact           $700
Versus opportunity cost of two       $1,370
 vacant studio units (++)

(*)Typically one resident in the larger unit.

(+)8.0 percent interest, 30 year amortization.

(++)At 75 percent of operating expenses of $30 per resident day x 2.

SOURCE: MOORE DIVERSIFIED SERVICES INC.