ESG and lending – what care providers might need to know.

Jimmy Johns: It’s a very positive sector from a funding perspective.

A lot of the funders and lenders and High Streets do like to lend in the social sector space. But it is fraught with challenges. So there’s a lot of due diligence that lenders will do at an early stage, and they do all like looking at proven and competent operators so, can sometimes become frustrating. But overall the healthcare market and the healthcare sector is a very good and vibrant space for lenders to be involved in.

I think from a, what we’re going into around the ESG side of things, it does help from a social policy perspective in when they’re lending to care home operators. So overall there is a desire to support the sector. There’s a need to support the sector, and the lenders will look positively on it. But coupled with that, it’s one of the few sectors that is probably as heavily regulated as it is. So there is a large focus on the quality of the management, the quality of the operator, and then that goes even down into the quality of the asset that they’re trading from within that care home. So that’s probably a added challenge within the sector that, that quite a few other sectors do not have. But ultimately lenders are positive on the space.

Jimmy: It’s sort of put into two camps, I think. So you’ve got your proven operator with an established portfolio, and they may be looking to make an improvement on their stock or extensions. So therefore ESG, certainly from the environmental side of things, comes into play quite a bit. What improvements those operators can make on the assets that they already own.

The other side to it will be, if you’re building from the ground out, so you’re building new purpose-built care homes, then very, very much the focus will be on the E of the ESG, the Environmental. So what can they do to make that building very sustainable. As getting close to carbon neutral as possible. From a social perspective, how it will fit in with its community and surroundings and how the staff will operate within it, which leads into Governance and how they can ultimately manage the operation.

So it really, from a traditional stock or traditional care home or trading or established care home, it’s, it’s how they can improve it and new build, they’re just trying to get ahead of the curve. I don’t know, Jon, have you got a view on that?

Jon Hodgkins: Well, I think the focus is very much on the S and G, the Social and Governance aspect. As a valuer and from a lenders perspective, the CQC inspection report and the rating, if the rating is good and all the other outcomes are good, it meets the social aspect and it should- therefore there’s a good correlation between social outcomes and just looking after your staff, looking at making sure that the residents have a beneficial life and are living well, and if that’s good, it feeds through into the ratings and there is a correlation between ratings and better operating margins.

So banks will be looking at the CQC rating and using that as a gauge, whether indirectly they’re meeting the S and G aspects of ESG. And for that reason I think it is important there, the environmental aspect, which we will no doubt come onto a bit more, is probably not so explicit. It obviously feeds through into utility costs and how high the utility costs are as a percentage of turnover and therefore how is it affecting the operating margin, and whether you’re meeting the bank covenants, and the operating margin is acceptable.

Jimmy: As I alluded to, if you’re building, if you’re, if you’re doing a heavy capital expenditure project, or so you’re building an extension to a, an existing home, then certainly the environmental side of things will be looked at.

Does it form part of a funder’s decision-making process? Well, that could vary from lender to lender. There is an overarching part to that which Jon sort of touched on then, is that if you’re going to do any extension to a building, then by nature you will be looking at how you can make efficiencies and that could be through retrofitting the home already with uPVC or, or solar panels or ground source heat pumps. But everything you can do to improve that environmental side of things will be beneficial to your business from a sort of profit margin perspective and therefore a fund is going to be, or the funding will be easier to obtain.

But is it a question on a list from a bank? It probably is. But it’s very much at this stage still a tick box, has it been considered. It will always form part of- I would suggest any operator that looks at extensions and things like that, very much looks at the retrospect fitting and what can they do to improve the environmentals. Any new build then, it will form a major part of the decision-making process, because a lender will want to know that they are lending on an asset that is coining a phrase that’s kicked about a lot, future proof. So part of that future proofing is being driven by the ESG criteria. So trying to get ahead of that curve would be every kind of new build operators aim.

Jimmy: It’s a lender’s ability to lend for probably more in the social care space, I’d say more towards the environmental side of things. So the ability to lend to large capital expenditure projects that are going to improve the efficiency of the building. If one lender in particular looks and defines the criteria as 90% of that overall funding must be towards certain environmental projects, and then if you’ve qualified for that, you might get a small discount in the interest rate.

So the issue with the green loan at the moment is it’s not massively publicised. It’s probably quite challenging to get and if you took an extension or a development and that was going to be your capital expenditure project, then not all of that money that you may borrow would go towards the environmental criteria, because if you’re building out the ground, clearly there’ll be a debate about how much of that ticks the environmental box.

So a lot of the funders will offer green loans, but the challenge will always be to access them. The main way would probably be on a pure, I’m going to go over my care home fit double glazing, put solar panels on it, look at a ground source heat pump and everything else that goes with that. You would then probably be able to qualify for a green loan. I don’t think it comes into the kind of mainstream lending, so to speak. So if you buy a care home, you wouldn’t necessarily look at it for a green loan, and I don’t know what impact that would have from a valuation’s perspective and the overall value of that asset by spending a lump of money on the green loan scheme. I don’t know, Jon, have you got a view?

Jon: Yeah, I think it’s perhaps potentially a source of capital, if there are improvements that need to be made to the building. For example, as a valuer, we might identify certain capital expenditure areas that would benefit and those might be explicitly stated in the EPC, as recommendations for improvements, and if those can be linked to improving the overall building.

For example, you might have 1980s double glazed windows that are failing, or no longer fit for purpose, and you replace those with modern uPVC windows, double or triple glazed, you might be able to get some access loan on that, in that respect, but then again it’s got to be monitored and made sure that those are actually installed as part of the overall process.

So, is the benefit of accessing this green loan potentially offset by the costs of implementation and monitoring? I think it’s not something as valuers as we come across a great deal. We’re aware of it, but it’s not mainstream lending it would be fair to say isn’t it Jimmy?#

Jimmy: Yeah and I think if you sit back and you picture the majority of care homes across the UK and you get that image in your head when you start thinking about, “okay, well how can I, how can I access a green loan” or “how can I improve my care home alongside the ESG criteria”,  you’ve got physical things that you put on as we’ve touched on – all the heating and the electricity and the utility side of things.

For the S and the G, for the Social and the Governance side of things it’s challenging because you’re looking at: okay, well you provide a service which is, which is socially responsible from a care home perspective. So, you’re already firmly in the airspace but how can you improve that internally? Well, again, physically, if you’re looking at improving staff, benefits and the staffing environment, which will then provide, hopefully, a better care service, or then, you’re really looking at how you can physically improve that building and that could be making better staff facilities, leaning on how they get to work, whether you look at bike schemes and their social, and the benefits towards them and their wages, that isn’t necessarily something that you could borrow for, and then from a governance perspective, as Jon’s alluded to, CQC will have a lot to play in that.

But equally, for me, if you’re managing the physical building, wider corridors, better day space, you’re looking at all of those things to improve the aesthetics of the building, which can be a challenge with some of the stock in the UK. So, a lot of operators have to box really clever, to try and make their application for a- particularly a green loan cover as much of that as possible and sometimes it’s just not physically possible or not commercially necessarily viable.

Jimmy: I think, as we’ve alluded to, there is a drive. It’s the right drive from government policies and white papers to improve businesses as a whole. So, I think ESG is a good policy for lenders to try to adhere to wherever possible.

I think sometimes there is an issue about sector specific- so, how much can ESG influence certain sectors, and I think within the healthcare space, as I’ve said, the physical side of things from a building is relatively easy.

The Social and the Governance part is slightly more of a challenge because they’re already governed by CQC or CIW. But, but it does help the lenders from their social responsibility perspective, being able to focus on a sector which at its heart, is socially responsible. So that goes back to why lenders really want to be involved in the sector.

Jon: And the shareholder pressure from on banks to meet their ESG targets and requirements, they’re feeding it through to what they lend to, who they lend to, and if a care home is having social, the staff turnover is lower, the occupancy levels are higher, and the fees are potentially higher because of the reputation is higher, and therefore also the building is more future proof, it has lower operating costs.

These are all- they tick boxes and they feed through to the overall valuation picture. As valuers, we only value to the market. We can’t actually lead the market, but it does reflect that it’s going to be a more attractive business to the market and hopefully therefore value up better, and therefore if banks are lending on it, they can be more confident or secure in that by meeting ESG requirements, they’re going to have a better asset on their loan book.

Jon: And it’s worth bearing in mind as well that certain lenders have certain leaning on the ESG so there are a pool of lenders which are, you would probably coin as more ethical lenders and at the heart of their funding book is the fact that everything they lend to is ethically or or socially responsible.

Care as a sector or healthcare sector does provide that to them, but they will have different levels of due diligence on that and some will look at it from a purely a care home ticks the box and others will look at it more granular on the basis of well. We want to know what staffing policy they have and what they’re trying to do to strive towards being outstanding from a from a regulatory perspective, as well as the investment that the operator may have towards the environmental side of things.

Jimmy: So, I think there’s really two different kind of non-bank funds. You’ve got your private equity fund and then you’ve probably got your real estate fund or your REIT.

Your private equity fund will be very similar to that of a bank around looking at the income and being able to pay back the investors. Now there’ll be a variance in private equity funds that might lean more towards socially responsible investments. So therefore care homes and what that money’s going into the business to do i.e. improve the environmental or the social, the governance side of things. There’ll be private equity funds that will focus on that, and then there will be private equity funds that are really just in for that return on income and return on investment.

The real estate investment funds, or the REITs, which can be made up of pension funds, they will be much more focused on the asset. So the building of, of that operates the care home. Now they will have an integral say on the quality of that asset. So the quality of that asset, if it’s being built from the ground up, then they are really looking at future proofing it, getting ahead of, getting as far ahead of ESG as they possibly can because they’ll be looking at leases with operators that are 30 to 40 years and and the income that they’ll get from the rent that they will charge will be going into long term investments, i.e. pensions.

So the REIT market will focus far more on ESG than that of the private equity market. There’ll be a small fraction of the private equity market that will look at it, but the REITs will, will focus on that and they’re the ones outside of banking or banks that are probably funding the care space more than others. Jon, you’re probably a bit closer to REITs?

Jon: Private equity, they will be focused on, if ESG is aligned with producing the returns that they require, and so they, they will, if it helps meet and keep margins at the level that they want and produce the return that they want, then it will help. They will focus on the ESG aspects.

The REITs, as Jimmy said, they’re looking at sustainability and they’re looking at making sure that the rent can be paid over the term of the lease if and perhaps longer, and is it relatable and you know, some REIT’s like Welltower who are big investors in the UK are very focused on that and they produce reports on it and a lot of other REIT investors in the wider care sector that focus very hard on that aspect.

But when it comes to private equity, I think the ESG has got to be aligned with helping them sustain and maintain the returns that they require from their investment.

Jon: I think there’s going to be pressure from you know, the new Labour government has got far more green policies than the previous Government and I think there’s going to be more pressure from the government to meet the net zero targets, and their policies are going to be driven towards that and you’ve got the CQC as part of their you know, new assessment framework.

They’re looking at sustainability within care homes. So they’ll want to know how a provider is working with trying to meet the net zero and improve, reduce the carbon emissions, reduce waste, work it, how staff are involved in it. So there’s pressure indirectly there to show that they’re moving in that right direction.

It would be difficult to measure in pure KPIs, but there is a subjective assessment to see what is going on there. The government obviously has EPCs; you’ve already got to meet the certain standards in terms of EPC levels and, you know, there’s a move towards B Standard by 30, and so these pressures I think are going to come increasingly more on operators to try and, and meet these targets.

How it’s going to be implemented is still slightly up in the air and how people, how operators will be able to be encouraged to do it, whether it’ll be more government loans to help them meet environmental targets because I don’t think they can do it explicitly, and as we were talking about the green loans, it’s it’s got to be built into an overall improvement program and to explicitly invest in something like photovoltaic panels etc., is very expensive and not necessarily a good, the cost benefit is not readily available.

Jimmy: And I tend to agree with that. I think the concern certainly within the sector from a financing side of things is that whatever plan or whatever direction the government tends to take, funders and lenders will be straight on the back of it. So we’ve seen from other sectors where they put deadlines in place around being net zero or no longer selling petrol cars and, and you think that’s, the ideas are good and the direction is, is where we want to be heading. I think the the concern is always, well, from a private operator, if you’ve suddenly got to retrospectively retrofit your building or do something that is effectively quite expensive, how are you going to achieve that, and it will by nature resort back to funding or lending of some description, and banks and lenders will always look at the commerciality of any project. So can the business sustain the level of debt, or will any improvements improve the margins enough to be able to again sustain the level of debt?

So it does always revert back to that commerciality, and that’s where I think any continued push on the ESG path has to be thought through from a grant perspective or access to better terms and rates and the green loan is a step in that direction. I just think it is still slightly restrictive and slightly difficult to access for every single operator. So to continue down that route, I think we’ve just got to be mindful that, how we approach it.

Jon: I think there’s a- the government does need to perhaps give a clearer plan of how they’re going to, if they want the care sector to move to net zero. How they’re going to help them to do that.

If, to use an analogy, the national minimum standards, when they were introduced in the early noughties 2002, there was a requirement to move to bedroom sizes in England at 12m² for all wheelchair users, minimum ten square metres, then ensuite facilities, low and behold, because of the people couldn’t meet those standards because their physical environment wouldn’t allow it and the investment required. So the strength of the residential property market meant that homes started to close, and the realisation came that it was easier for people to exit than actually try and meet these standards.

So the standards were dropped, and not dropped in Wales or Scotland but it, and I think the analogy there, if you forced operators down and it’s just they haven’t got the surplus cash to invest in these areas, I think we’ll say well, “I can’t meet it”. It’s, “I’ll just have to perhaps exit the sector” and so there is probably needs to be carrot as well as stick.

Jimmy: Okay, agree, I think that’s the major, major issue, is what steps are or what decisions are made? Because what I don’t think is ever contemplated is having worked alongside funders for many years when the room sizes were talked about, it had a massive impact on lending decisions.

So lenders would get a valuation done by someone like Jon, and the room sizes would be a topic of conversation, and the fact that maybe two or three of the rooms weren’t over 12m² would be an issue for the lender. However, again, as I said earlier, if you look at the stock in the UK, and what can physically be achieved, you can’t make a blanket approach like that because you would lose a lot of rooms overnight and we know that the sector is in high demand and under pressure.

So any decisions around how you influence or get ESG moving has to be really carefully thought through. So operators can go through a journey to get to a higher ESG position without causing them to exit and further sustain pressure on the sector which which there already is.

Jimmy: I think the E is the easiest one, isn’t it? It’s, it’s physical.

You can, you can literally walk around a care home, and you can identify “well I can put panels on, I can do this, that and the other and I can put a number on it so I can put a cost on it and I can achieve it”. So it’s very, very easy, and I think operators can go through that E journey really, really quickly providing they’ve got the ability to borrow or fund it effectively.

The S and the G within this sector I think is is more of a challenge. There are lenders that will look at the employment training scheme and employee benefits and, and how they create an environment from a staffing perspective that is highly positive and, and I think there needs to be more of a focus on that, without going too far down that road and costing and incurring further overheads, because ultimately your staffing side of, your staff is your biggest cost within a care home and you need to retain them and keep them at a high standard to provide a good level of care and it is a cost.

So I think that side of things will become more of a focus, the S. The, the G, the governance when it’s a highly regulated sector. We could have a whole other podcast on CQC and the regulator, but I think ultimately funders will always look at the governance through the CQC’s eyes.

And that has never changed and probably will never change, and a good operator which should have good governance in place, and you’ll start to see that through the staffing environment. And certainly when I go out and visit homes and operators, you can see a better operator with a strong level of governance as soon as you walk through the door.

Jon: I would totally agree that that is a value. We obviously, before we do an inspection, we pull up the CQC inspection report and go, not just to the current one, but go back through several inspection reports just to get an idea of how a home is run and when we do an inspection it’s not just the physical inspection of the building.

It’s also talking to the operator and the manager and how understanding, how the home is staffed, how it is managed, how long, and what experience the management staff have got in place, and it all feeds through to painting a picture of how sustainable that business is in, and also in that property so you’re not, while it necessarily explicitly looking at the S and G, it’s we are taking these aspects into account because we’re looking at, are the wage rates sustainable? We value on the basis that there’s a reasonably efficient operator taking over the business, and how would they operate? Are the staffing levels sufficient, relative to other comparable care homes that we’ve operated a similar style of operation, is the occupancy level sustainable? What is the fee levels rate? Are there, is there enough margin there for them to reinvest into the property and invest in training and pay the staff, perhaps a higher wage than competitors to make sure that they retain staff?

So perhaps the S and G is not explicitly looked at, but they are a part of the overall mix and that we take into account when appraising a care home for.

Jimmy: And I think it will, it will come in, it might come in a little bit more as we go down. I think if you look at the care sector and you perhaps looked at the hospitality sector again, it’s quite easy from a, from the environmental side of things to do the same thing on a care home as you do on a hotel, photovoltaic and all of, all of that.

Again the S, you can follow the journey through the supply chain, and you can look at where your food comes from for a hotel, or there’s no reason why a care home couldn’t start looking at those kind of avenues for, for the social side of things.

Will lenders start to focus on that? I think some of the more ethical ones will ask the question, but fundamentally we’ll fall back to, can you sustain the debt that you’re asking for? So there is a good side to the S and the G already within the health care space.

Jimmy and Jon, thank you very much for your time.