Understanding Exit Fees
Hi there!
In this tutorial I want to help you understand the Exit Fees that are usually associated with buying a retirement home.
The Exit Fee is also known as a Deferred Management Fee or DMF. Most of the homes sold in retirement communities around the country use a deferred management fee arrangement.
DMF schemes have been structured to work within the state retirement village legislation, while seeking to appease our cultural need to “own property”. This is in contrast to the retirement living sectors in the US and Europe where the population is much more comfortable with renting.
You might also hear a DMF contract referred to as a “Loan/Lease” or “Loan/Licence” scheme. In essence, it is an annual fee charged to the resident for each year of occupancy in the village, capped at a set number of years, and calculated as a percentage of either the original sale price or subsequent re-sale value of the home.
The original intention of a DMF scheme, some 30 years ago, was to allow retirees to buy a unit for 20-30% less than the market value of an equivalent freehold unit. The village owner would then make that discount back over the resident’s occupancy through the accrued fee. Unfortunately today, retirement village owners charge residents the full equivalent freehold value of the unit as well as the deferred fee.
Exit fee contracts are structured around a long-term “right to occupy” in the form of a lease or licence, which the resident of an individual unit executes with the village owner. This is a long-term contract between the owner and the resident, and commits the resident to paying a management fee that is deferred until such time as they vacate their unit. The fee is accrued over the duration of the resident’s tenure in the property and is physically received by the operator only upon departure of the resident. The fee is usually retained from the proceeds from the re-sale.
Under the DMF scheme residents also pay a weekly, fortnightly or monthly fee to the owner, to cover the costs of operating the village, such as insurance, rates, utilities and staffing. The owner of the village also contributes to these costs on behalf of the common areas and in new complexes, any units yet to be sold. Legislation prevents operators from making a profit on service costs so weekly fees are set at the level of total costs, including the owner contribution.
Additional services may be offered to residents such as meals, laundry and cleaning. The charge for these services to residents may include a profit component, although this is generally held within a reasonable, commercial range to encourage utilisation of the services by residents. These services may be provided by the owner or outsourced to third parties. Some services may even attract a government subsidy.
It is important to note that under a deferred fee scheme the resident does not actually own the freehold title to their unit – this remains with the owner of the village. Instead, the resident purchases a “Right to Occupy”, in the form of a lease or licence. This Occupation Right is similar to freehold title in that it costs the resident around the same level of cash to acquire it, and they enjoy rights of occupation similar to that of a tenant in a community-titled residential complex, such as a block of flats.
Strengths
Exit Fee scheme do have quite a few good things going for them. For Starters, they are usually larger, better complexes with more facilities.They enjoy better funding and are typically owned and operated by larger, professional organisations.
Some complexes offer to buy your property if it hasn’t sold within an agreed timeframe and the on-site operator will typically manage a refurbishment of your unit for you when you leave and re-sell the unit.
DMF schemes are the most common purchase arrangement around and as such offer a wide variety of accommodation and pricing options.
Weaknesses
The downsides of deferred fee contracts is that they feature a heavy fee structure. Freehold title remains with the Owner, and is not bought by the Resident.
Due to the volatile nature of the cash flows, there is substantial owner/operator sustainability risk.
Re-sales typically the responsibility of the owner/manager, whose interests may not be aligned with yours. Refurbishment obligation is usually on the Resident at the end of occupation.
There is an ongoing liability to the resident from village owner, who may go broke, and upon exit, there is an ongoing liability for resident to continue funding village fees until such time as the unit is re-sold.
Calculating the Exit Fee
As mentioned previously, the DMF is an annual fee charged for each year of occupancy, capped at a set number of years, and calculated as a percentage of either the original purchase price or subsequent re-sale value of the licence. The fee is accrued annually at each anniversary of the resident’s commencement at the village, and paid out to the village owner from the proceeds of the re-sale of the unit. The fee varies between villages, within villages and also between states.
An example of typical DMF model is shown here in this Table.
In this example, we will use a contract known as a 25 over 10, that is, a 25% Deferred Management Fee accrued over ten years.
We assume that the fee is spread equally over the ten-year period, so 2.5% is accrued each year and after ten years, a total fee of 25% has been accumulated. This is just an example however, and total fees can range anywhere from 20% to 40% or more.
Under a DMF scheme a resident is actually free to vacate the unit at any time, but would be liable for the accumulated portion of the fee, if the departure occurs prior to the capped fee year. In this example, if a resident departed in year five they would be liable for the fee accrued to date of 12.5%. If they were to leave in year twelve, their obligation would remain at the capped amount of 25%.
Some village operators, particularly those with a short average length of stay, front-load the fee into the first few years of a resident’s occupancy instead of averaging the fee equally over the accrual period. Under a 25 over 10 structure, a village operator might make the first year 8%, the second 5%, and every year thereafter 1.5%. This ensures that a resident in occupation for only three or so years ends up paying the majority of the deferred management fee.
So let’s look at an actual calculation of this fee, using the same assumptions of a 25 over 10 contract:
The resident purchases a unit for $450,000. After ten years of occupation they exit and sell the unit for $750,000. Under this contract they are obliged to split the capital gains on exit equally with the owner, and we will discuss this in more detail shortly.
At exit, the deferred fee component payable, calculated at 25% of the Entry Price, is $112,500. The capital gain of $300,000 is shared equally between the resident and operator and comes to $150,000 each.
So the Total Return to the resident is: $487,500, and the Total Return to the Village Operator is $262,500.
Note that the resident has only just broken even after ten years of capital growth, although this doesn’t include outgoings such as sales commissions or village fees.
Retirement village sales agents will usually dismiss this away by saying that this purchase is a lifestyle decision and not an investment. In a way, they are right – you are no longer at the asset accumulation stage of your life and now is the right to be spending the fruits of your labors from the past fifty or sixty years. However, we see no reason not to apply the same level of financial analysis and due diligence to this purchase as if a person was 30 years younger.
DMF Summary
The Deferred Management Fee scheme is the subject of much angst and bad feeling from retirement community residents. I think this is not so much from the unfairness of the contract, but rather from the lack of understanding of how the contract works, which results in unpleasant surprises for the resident when they consider moving.
However there is no denying that Deferred Fee schemes weigh heavily in favour of the village owner. Village owners and developers have invested many thousands of dollars with accountants and lawyers to design contracts that work within the appropriate state and federal laws, yet maximise the profit and tax outcomes for owner.
But is this necessarily a bad thing?
It is wrong to assume that village owners who use deferred fee contracts are profit-minded vultures that don’t care about their residents. Many not-for-profit operators such as church groups or benevolent organisations also use deferred fee contracts.
You know, at the end of the day, successful villages are those with well-funded, interested owners. If an owner is making money from the enterprise, they will be more inclined to spend money on the upkeep of the community facilities to keep the complex looking fresh and attractive. No-one benefits when a retirement village owner goes broke.
