Will the retirement village market trigger the next financial crisis?

It is common in the Australian retirement village market for retirees to sell their family home after the kids move out and buy into a smaller (and cheaper) retirement village unit. The ‘profit’ that was made from downsizing like this could then be used to pay periodic management fees to the village for the upkeep of its facilities (community centres, gardens, recreation facilities, village/ medical/ security staff, etc.), with enough ‘profit’ left over on which to live for the rest of their retirement. Fair enough, right?

However, the majority of retirement villages in Australia (I don’t know about the rest of the world) are allowing something called ‘deferred management fees’ – where these periodic payments don’t have to be paid until after the retiree leaves the village and the unit is sold. The village would collect these deferred management fees from the proceeds of the unit’s sale.

Not having to pay all upfront and ongoing costs straight away makes the initial entry into retirement more affordable. It also supposedly encourages villages to be well run and managed and maintained so that these units keep appreciating in value, and can eventually be sold for enough to cover these costs. And if prices keep appreciating, more and more retirees can be temporarily forgiven from paying larger and larger components of their management fees/ unit purchase costs, because the village can simply recoup it later upon sale of the unit – as long as the unit prices keep appreciating.

However, what if there’s a crash in the retirement village market? Maybe through overinvestment in construction of retirement villages based on overly-optimistic demand projections. Subsequently, retirement unit prices will drop to correct for this over-supply, and through no fault of the village operators, their units may not sell for enough to cover these deferred management costs, forcing them to put more of their units on the market at even further reduced prices just to guarantee a sale and cover these losses, causing unit prices to fall further, and down the rabbit hole we continue to spiral until the entire market collapses.

Let’s illustrate this with a couple of simple examples. Ideally, deferred management fees would work as follows: ·        A retiree buys into a $300,000 retirement village unit, paid upfront (a small and affordable unit price by recent Australian capital city standards) ·        Deferred management costs of 2% per year are incurred for 10 years (a relatively standard return and term recently) ·        The unit appreciates in value by 5% per year – twice the RBA’s inflation target, so a good return, and yet still very conservative compared to the rate at which Perth residential prices grew during their recent mining boom years ·        After 10 years o    The unit sells for $488,668 o    The retiree owes $60,000 in deferred management fees o    Therefore, the retiree walks away with a net $428,668 ·        Everybody’s happy Now let’s change some of these numbers in a not-impossible manner: ·        A retiree buys into the same $300,000 unit, but is allowed to pay nothing up front (something that actually occurred with zero-deposit sub-prime mortgages before the GFC) ·        Deferred management fees of 12% per year are incurred over 10 years, in order for the village to recoup the $300,000 deferred purchase cost plus still earn a 2% return on the value of the unit ·        The unit appreciates by o    5% per year for the first three years o    2% per year for the next two years as the market gets adequately supplied (below expectation but still near inflation) o    Then the market crashes and loses 25% of its value over the final five years (precisely what happened to US house prices in the GFC, so not an impossible scenario) ·        After 10 years o    The unit sells for $270,988 o    The retiree owes $360,000 in deferred management fees and purchase costs o    The retiree loses all of these proceeds and, depending on the contract, may have to incur/ share a further loss of $89,012 If losses of this scale are sufficiently widespread, retirees and villages alike could suffer enormous consequences, as well as the whole economy.

Is this not hauntingly reminiscent of the sub-prime mortgage market crash that triggered the GFC? People being lent huge sums of money that the banks/ financial institutions would only get back if the person paid it (unlikely with sub-prime mortgage holders) or the house prices kept increasing sufficiently so that a defaulted house could just be foreclosed and sold off without loss (or even with a profit). As soon as house prices started to slow/ fall, the banks/ financial institutions couldn’t recoup their losses from their bad loans (because the houses were worth less than the loans), forcing them to sell even more assets to cover these losses, thereby causing the problems to spread to the whole world – even those parts not directly invested in the crashing market (this is a downside of globalisation – crashes can be globally contagious).

Moreover, these deferred management fees are now being securitised and sold off in pieces to investors all over the world. This kind of securitisation of debt has been going on at least since the 1960s, and has largely been an effective way of bringing additional liquidity to traditionally illiquid markets like housing. But when they started using it on sub-prime mortgages in the early 2000s, additional risks started accumulating not just in the risky market itself, but everywhere that was indirectly invested in it.

I’m not sure what regulations are in place to manage the amount of these fees that can be deferred (and for how long), but it seems that there is quite a bit of discretion between the retiree and the village to write their contract how they like. And as the retirement village sector becomes more and more significant with Australia’s ageing population, is it not a big risk that retirees would be allowed larger and larger amounts of their management fees (even their unit purchase costs) to be deferred (especially if, for social reasons, government encourages villages to do this so that everyone gets an affordable retirement)?

Then, if (when) the market takes a turn, villages won’t be able to recoup these deferred costs just by selling off the units, and the whole market/ economy/ world could feel the shock. Especially if the retirement market booms like it might.

The true extent of these problems will depend on how large the retirement village market becomes, and how carried away they get in terms of deferring more and more of the costs. The market is still growing and likely to be quite profitable for many in the near future. I just hope that self-control on the part of the retirement village market and/ or regulatory restrictions keep the system closer to the optimistic scenario above, and not the pessimistic one.