Truth or consequences: evaluating your true operating expenses will keep your profit margin and cash flow healthy.

Sponsors and owner-operators frequently miss the mark in properly evaluating their true operating expenses. This results in inappropriate pricing, unacceptable operating profit margins and inadequate cash flow after debt service. Many of these problems can be avoided by focusing on several important factors that define the financial envelope of acceptable senior living operations.

The Operating Expense Ratio represents total cash operating expenses divided by net revenues collected. For independent living, this ratio should typically range from 50 percent to 60 percent. The same ratio for assisted living should be approximately 65 percent to 72 percent.

Operating Profit Margin is the inverse of the operating expense ratio. This is commonly referred to as NOI (net operating income) or EBITDA (earnings before interest, taxes, depreciation and amortization). The operating profit margin typically ranges from 40 percent to 50 percent of net revenues for independent living and 28 percent to 35 percent for assisted living.

Meanwhile, not-for-profits are adopting a Net Operating Margin (NOM) concept. NOM is similar to EBITDA but excludes investment earnings, contributions and amortization of entry fees. In some cases NOM also includes net entry fee cash (unit resale dollars less resident/estate refunds).

Operating Expenses Per Resident-day is defined as total annual operating expenses divided by total annual resident days (the average number of residents times 365 days). While it is appropriate to spread certain fixed costs and overhead across various departments, it is also very productive initially to separately analyze each cost center or department and attempt to equitably allocate fixed costs (such as direct labor) to that department.

With rare exceptions, each department should stand alone financially. Resident-day expense ratios by department provide an excellent, detailed evaluation of expenses--it is the lowest common denominator for benchmark evaluation.

In many market areas, total operating expenses per resident-day should typically range from $34 to $42 for independent living and $63 to $78 for assisted living. Median benchmarks are shown in Figure 1. Note that these assisted living costs typically include basic food and shelter services and a realistic baseline menu of direct, hands-on assistance with the Activities of Daily Living (ADLs).

To avoid acuity/cost creep, higher levels of ADLs delivered to individual residents are usually addressed by an increased tiered pricing policy. Note that these ranges of financial indicators reflect significant variables that exist from project to project, and market to market. These variables include labor costs, real estate taxes, liability insurance and utilities.

Special operating expenses Management fees and reserve for replacement are frequently overlooked when projecting operating expenses.

Management fees reflect an important expense line item and a financial strategy. Even though you may not be utilizing a third-party management company, management fees should still be in your budget. That's because your lender wants to see a 5 percent management fee included as a normal expense line item, as a potential foreclosure scenario where it would be necessary to bring in a third-party manager must always be considered. The management fee pays for state-of-the-art resources for appropriate operation and oversight of your community. The fee that is expensed can range from 4 percent to 8 percent.

Reserve for replacement is a cash line item of expense that replaces depreciation (a non-cash accounting expense line item). This cash reserve for replacement is a way to technically fund depreciation; placing a specific dollar amount per unit each year in a restricted reserve account. This concept is commonly called the "Cap X" factor, an easy to remember abbreviation for capital expenditures.

For a new project, the replacement reserve is funded by directly expensing approximately $225 to $250 per unit per year. This cash is used to fund future capital investment or replacement needs. Older communities would have a higher assessment. This allocation is in addition to the normal operations and maintenance department budget, which pays for the community's routine and scheduled maintenance.

Uncontrollable expenses

For several years, rapidly escalating liability insurance premiums have been considered by many for-profits and not-for-profits as an uncontrollable expense. Some even put this expense and real estate taxes below the operating profit line. But, like it or not, these are still operating expenses that impact profit and cash flow. Appraisers, lenders, investors and buyers factor in all ongoing expenses when developing their quantitative perception of value.

Subpar profits

If revenues are too low or expenses too high, consider that the operating expense ratio shows the relationship between revenues and expenses, while the expenses per resident-day index is based solely on operating expenses. If your operating expense ratio appears high or out of line with industry guidelines, you could have a revenue or expense problem. By evaluating your expenses per resident-day you can usually zero in on your specific problem.

There are two possibilities: Your revenues are too low or your expenses are too high. For example, if your assisted living operating expense ratio is 80 percent (high), but your baseline operating expenses are $68 per resident-day (about normal), it is likely that your revenues are suppressed. (Refer to Figure 1 for median benchmarks.)

Operating expense sensitivity

This is a good news/bad news situation. When you conduct a detailed financial sensitivity analysis, you will quickly discover that, like many businesses, a major portion of your operating costs are largely fixed when you open your doors. That's the bad news. The good news is that these costs do not vary significantly as a function of varying occupancies between 80 percent and 93 percent. So, there will be a huge positive swing in operating profit because much of the new revenue from increased occupancy goes right to your bottom line. This leads to the "75/25 rule" for independent living monthly service fees needed to cover operating expenses, debt service and profit: Approximately 75 percent of your operating costs are fixed or, at best, only semi variable, while just 25 percent are truly variable (raw food, etc.). At about 80 percent occupancy, you should be close to financially breaking even--the monthly service fees are covering your fixed costs and debt service. The rule for assisted living changes from 75 percent/25 percent to approximately 60 percent/40 percent.

Financial windfall?

For every independent living unit occupied above break-even, about 75 percent of the monthly service fees collected go right to your bottom line. But let's say you have excessive vacancies in your moderately priced independent living unit. At $1,900 per month, occupying one more unit will typically increase your operating costs by about 25 percent or $500. The rest is profit, flowing dollars to your bottom line. What this means is that every vacant unit is costing you $1,400, or 75 percent, in real profit. So should you be investing more in sales and marketing resources, in strategies or in one-time incentives?

Strategic evaluation of your operating expenses results in a modern-day equivalent of Ben Franklin's old adage, "A penny saved is a penny earned." In the case of valuing independent living, using a 10 percent capitalization rate means "A dollar saved annually is worth about $10 in imputed value."

SENIOR LIVING EXPENSE BENCHMARKS--2004
Median Expenses Per Resident-Day

                           150 Units       80 Units
                           Independent     Assisted
Cost Center/Department     Living          Living

Administration             $4.84 PRD      $8.25 FED
Activities                  1.17           1.95
Assistance in Living        0.00          17.15
Plant/Security              6.32           6.50
Dietary                    12.09          13.80
Housekeeping/Laundry        2.50           4.35
Transportation              0.81           1.00
Property                    3.33           5.90
Marketing & Sales           2.70           4.75
Management Fees             3.25           4.75
Reserve for Replacement     1.45           1.50
Total                     $38.46 PRD     $69.90 PRD

Each community and market area will have a unique operating expense
profile. Accounting systems and chart of accounts formats vary and
could impact these benchmarks. The "Assistance in living" cost center
reflects a baseline level of approximately 60 minutes per resident
per 24-hour day. Your actual direct care experience may be different.

Jim Moore is president of Moore Diversified Services, a Fort Worth, Texas-based national seniors housing and health care consulting firm. He is author of Assisted Living 2000 and Assisted Living Strategies for Changing Markets. He may be Contacted at [e-mail]