Guest blog: Valuing schools and nurseries – an art, not a science
Morgan Allen, Partner at Gerald Eve, reflects on the considerations involved in valuing educational property assets, including independent schools, special schools and nurseries.
Firstly, it’s important to consider the current market conditions three education sub-sectors:
Early years sector
The early years sector’s highly buoyant activity of 2021 and 2022 has reduced somewhat in 2023. Despite the recent flurries of consolidation, it is still a highly fragmented sector with plenty of opportunities for consolidators and investors. That said, the consolidators have been less aggressive in 2023, which is likely due to the cost and availability of debt and a greater focus on quality assets.
The sector is still a buoyant market in affluent locations, due to a lack of good quality supply – but overall, buyers are increasingly discerning. This is in the wider context of a severe staffing crisis, which is the biggest challenge facing the sector, with few operators unaffected. Furthermore, the cost of living crisis is predicted to effect occupancy levels, which will compound the effects of increased operating costs on profit margins.
Against this is the backdrop of widespread uncertainty surrounding the government’s pledge to increase funded hours and the unknown future impact this will have. There will likely be further nursery closures – we anticipate mainly of smaller settings with lower occupancy levels and resulting lower profit margins, as those operating on lower margins will have no buffer against increasing operating costs, rising minimum wages or a potential fall in occupancy levels. On the plus side, whilst very sad for the children, families and staff, local closures would be expected to have positive effect on occupancy levels at nurseries which do stay open.
Buyers are still attracted to the sector due to its strong fundamentals and the fact that the property often underpins trading values (in affluent locations). Obsolete property is a big risk going forward.
The market for independent schools in 2023 is still pretty active. Inspired acquired most of the Alpha Plus schools, which was the biggest transaction over the summer. Gerald Eve is selling three schools, and we are also advising on the due diligence and valuations of at least three more acquisitions, with more expected throughout the year.
The independent school sector is highly fragmented. Approximately 70% of schools are within the charity sector, offering plenty of opportunities for consolidators. We predict further consolidations from groups. Operator and investor demand is still reasonably good for schools with strong characteristics, whilst there is very muted demand for turnarounds. In 2023, we have seen new entrants entering the UK market (such as Concept and Education in Motion). Overseas buyers’ demand is mainly for boarding schools.
A Labour government is looking increasingly likely. If elected, Labour plans to add VAT to school fees. If they are successful, this measure is very likely going to: strain parents' finances, which would lead to a decline in enrolment and fast-track school closures; increase schools’ administrative burdens (collecting VAT and remittance); potentially limit the availability of scholarships and financial aid, which would impact on diversity and inclusivity in the pupil bodies; and drive consolidation, which could be a positive outcome.
On the other hand, closures are expected to have a positive effect on enrolment at stronger schools which stay open, which would strengthen the trading activity (i.e. “Last Man Standing”).
The SEN school market is a rapidly emerging sub-sector which benefits from exceptionally strong fundamentals. There is a national, chronic undersupply of SEN school places which, coupled with ever increasing demand, means SEN schools generally have very high occupancy levels when mature. Tuition fees are also high, which results in generally high profit margins.
Tuition fees not affected by wider economy, as local authorities continue to refer and pay fees. Furthermore, there is no requirement to be situated in leafy affluent (and expensive) residential locations, unlike mainstream independent schools. This means that rents and property prices are more affordable (perhaps also salaries), whilst fees remain high regardless of location.
In our view, SEN schools are highly resilient when compared to other sub-sectors within education.
Valuation rationale – schools
Schools are incredibly rewarding assets to value. They can have a unique ethos, fascinating histories, and can include Listed buildings in attractive settings.
Transactions of trading schools fall into two categories:
1. Profitable schools selling to for-profit providers under which the Fair Maintainable Operating Profit (FMOP) is capitalised, commonly, for freehold schools, at YP multiples of between about 8 times and 13 times (inside London), pre-central management costs and sustaining capex. The higher multiples would tend to be London prep schools and affluent Home Counties.
2. Asset sales out of a charitable trust where the school is operating at a very low margin or loss-making (some of which are operating at a huge deficit and funding trading losses via reserves). In this instance, we find that the key driver of the value as a trading entity is the underlying vacant possession value of the property assets, making deductions for working capital and investment requirements to transition the business to expected levels of profit.
In the current climate, we have seen there is materially less demand for turnaround situations and a greater divergence of values i.e. good demand for well-performing schools and perhaps only several buyers (if that) for failing schools operating with a huge deficit.
Having a “Red Book” valuation prepared by a valuation firm that is embedded in the schools market is key. We provide a brief overview here of the various approaches taken for valuing schools.
We tend to value vacant properties having regard to the limited transactional evidence and cross-checked against residuals for alternative use and development. As a further cross-check, we would assess of the trading potential, making an allowance for the time it takes to mature a school business. We would also consider potential realisable value from a sale and leaseback.
A particular challenge for valuers is the dearth of comparable transactional evidence, which means that we tend to have regard to transactional evidence over a wide geographical area and date range, than for say residential and commercial sectors. There is plenty of rental and capital value evidence in London, but outside of London, there is virtually no evidence of rents from arm’s length transactions of very large school properties. The small number of transactions means a far greater degree of professional judgement is required, than say for other mainstream commercial sectors.
In the absence of rental evidence, we adopt a “rent cover” approach. This approach analyses the trading potential, and arrives at a rent which is an appropriate fraction of the sustainable EBITDA. A sustainable rent would be somewhere around a maximum of 30% of EBITDA for nurseries and up to say 50% for a well-performing school. This means that even if EBITDA falls, the rent is still sustainable in the context of the trading activity.
- Age/ condition/ capex required
- Potential to expand premises – planning environment and physical characteristics
- Tenure – some buyers would only consider freehold acquisitions whilst others have pursued a sale and leaseback model
- Quantum is granular – there can be higher demand for groups which can achieve a premium
- Over/under performance
- Fees, Discounts & Occupancy – potential to enhance via a targeted marketing campaign
- Staff costs and potential to reduce duplicated functions if a school is brought into a group
- Benchmarking KPIs
- Analysis of the trading history, the current year budget and forecasts. We then make our own assumptions to arrive at an assessment of “fair maintainable trade” (FMT)
If acquiring via a sale and leaseback:
- Do NOT over-rent… (as tempting as that might be for investors)
- Sustainability of the rent is key
- Expect index linked rent reviews – investors prefer annual uplifts, whilst operators prefer 5-yearly rent review provisions
ESG is no longer just aspirational; increases in energy costs are biting hard. Parents and also pupils want to know what schools are doing to address environmental concerns in their longer-term planning. For example, new projects will need to be sustainable in the widest sense by being flexible and accessible to all.
There is far less demand from investors and lenders for properties with poor EPC ratings. Some lenders are insisting that their borrowers provide a clear programme indicating how they will improve the sustainability of the property. We are aware that some lenders are providing “EPC loans” (or similar). The worst case is that a lender will not refinance due to a poor EPC rating and a borrower would be forced to refinance elsewhere, probably on far high interest rates.
The question for the school or nursery operator is whether increased expenditure (or not) on sustainability required would make the business unviable in the near future.
- Continued buyer appetite – albeit pricing uncertain currently (although we expect this to simmer down once interest rate hikes plateau)
- Proven resilience – which is generally expected to continue
- Flight to quality – greater demand for well-performing education businesses and less for weaker performing assets
- Pricing – values will hold up for very good quality assets but fall for inferior quality assets, with a divergence of values as the price expectations of buyers v sellers are misaligned.
The cost of living crisis is biting. Struggling nurseries and schools will seek mergers or external third party investment, or be forced to close due to the perfect storm of a cost of living.
If a potential Labour government removes charity status for schools and adds VAT to school fees, there will be an increase in closures and mergers. On the plus side, this could lead to more opportunities for investors and consolidators.
We predict a wider pool of investors, who are attracted to the sector which is needs-based and underpinned by property values (when compared to more traditional asset classes such as offices, retail and industrial which are facing their own challenges currently).
We anticipate that buyers will have a greater focus on:
- Underlying property value/ alternative use potential
- Affordability of fees
- Stress-testing financial forecasts to include VAT on fees and full Business Rates
- Sustainability of rents in the context of the trading performance
- Catch-up CAPEX requirements with a planned programme of maintenance
- ESG and sustainability characteristics
This is a fascinating time to be involved in the sector. Demand is still there for the right assets and the fundamentals remain strong despite the lingering effects of COVID-19, threat of VAT on school fees, and the unknown impact of future funded hours in early years.