ESG challenges in the healthcare and senior living sectors: Part 2

Investments into the care home and senior living markets are often structured on a propco/opco basis. This means that the investment into the property is separate to the operations of the underlying business, with investment into the property and business assets often (although not always) coming from different capital sources. The relationship between the two is often regulated by a lease.

An investor-owner may seek to achieve alignment with its ESG strategies through:

• core principles within the lease that the operator is to comply with, notably relating to best practice, HR and complaints/safeguarding policies;
• controls as to the identity of the operator as tenant from time to time;
• covenant to comply with law and regulation in the care sector and best practice; and
• a more focused selection of tenants from the outset and tighter controls on assignment of the underlying business against a set of objectives that align with the owner's own strategy;
• reporting obligations regarding its level of compliance with the above and with any requirements of the regulator (such as the Care Quality Commission in England and Wales).

The degree to which the owner seeks to impose these objectives depends on its own investment profile, the requirements of its investors and funders, its own objectives under its ESG strategy, and the relationship between the owner and the operator (is the lease agreement the only contract between them or do they have a wider relationship, for example, under a joint venture), without any one size fitting all.  From an operational perspective, it is important that the lease allows the operator flexibility to deliver its service and respond to day-to-day business needs.

Operators will have their own ESG strategies with management teams being used to addressing "S" and "G" for many years before the recent ESG focus. In the care home and senior living sectors, owners take particular care to understand their operators' business. Although their relationship may be governed by a lease, the approach to diligencing an operator's business and assessing the proposal can be akin to the work taken prior to a joint venture or other corporate relationship. ESG therefore plays a crucial role in investment selection, management and divestment, the whole lifecycle of investment in the sector.

Investments into the care home and senior living sectors can have a positive social impact, albeit this is not always straightforward to measure and report. This is complicated by the fact the social objectives in question are a moving picture in law and can (for example) depend on the nature of the operations, the identity of the parties and the locality in which the property sits.

Broadly, investor-owners are concerned with certain common social themes, including those reflected in the Principles for Responsible Investment, the UN Declaration of Human Rights and the European Social Charter (which the owner may have directly or indirectly adopted). Whilst regulation and reporting in the UK has been largely climate focused to date, developments such as the Modern Slavery Act 2015 (and its reporting obligations) and the FCA's Sustainability Disclosure Requirements (SDR) and investment labels is indicative of the general trend towards social considerations forming part of real estate investment strategy and businesses being held accountable for their contributions towards wider societal risks. In addition, where the owner has business in other jurisdictions (in particular the EU which is developing some far-reaching laws in this area), laws there may require the owner to report or manage social and governance risks – even potentially relating to its investments in the UK (see the EU's Corporate Sustainability Reporting Directive and its proposed Corporate Sustainability Due Diligence Directive). Impacts covered by the above regimes could include:

• employment and work conditions, including equal pay, fair recruitment policies, training and retention policies, and the protection of the vulnerable with anti-discrimination procedures;
• health, safety and welfare, and social well-being, of employees, residents and others affected by the conduct of the care home business; and
• good business practice such as a compliance with laws clause requiring compliance in particular with the relevant regulations on quality of care.

increasingly these obligations are framed not just by reference to employees and direct customers (i.e. residents) but also through the wider value chains of the tenant's business.

For the most part, care homes operate with a mix of privately and publicly or local authority funded spaces, improving the diversity and inclusion of its occupancy. Investor-owners may include minimum requirements over the number of publicly-funded beds within their leases, introduce requirements on the minimum spend per bed to ensure overall quality of service, and place obligations on operators to maintain a minimum Care Quality Commission (CQC) rating throughout their tenancy, reporting to the owner on any sub-standard ratings and coming under a greater level of scrutiny / control until that rating is improved.

Expert management of the care home is crucial to its success, which is why "key person" provisions often feature within care home leases. Key performance indicators (KPIs), including achieving accounting thresholds or requiring levels of repair and maintenance expenditure, are another way in which the owner mains a level of control over the quality of service that is being provided from their home.

Increasingly, investor-owners are weighing in on the social element of the 'S' by introducing requirements within leases to recruit within a certain local radius, providing employee transport facilities, paying national minimum wage and adhering to diverse and inclusive recruitment strategies. Higher-end, predominantly private care homes have also extended their social reach by allowing operators to open facilities (such as restaurants, pools and gyms) to private paying members of the public. Owners and operators will need to enter into and maintain a constructive dialogue throughout the course of the lease term to see how they can continue to satisfy the social element, anticipating the development of the UK social taxonomy .

These investor-driven requirements should also be placed in the context of the requirements of planning laws. Developments in this sector will often need to demonstrate positive social contribution (from quality of amenity space, through to engagement with local people) in order to obtain consent.

The fact that health and care is already such a heavily regulated sector helps establish a positive approach to governance. For this, owners in England and Wales defer to the Care Standards Act 2000 (CA 2000), the Health and Social Care Act 2008 (HSCA 2008) and the CQC, including provisions within leases which require operators to:

• appoint a registered manager under the CA 2000 to oversee the running of the home;
• share notices served under the HSCA 2008 with the owner as landlord;
• report incidents or investigations by the coroner or police to the owner as landlord;
• maintain a minimum CQC rating and allow owner-landlords to step in where they are not; and
• provisions which otherwise require operators to comply with best practice within the care home sector.

That is not to say that the governance expectation is satisfied simply by putting these lease mechanisms in place, or by healthcare considerations alone. The market is constantly responding to rapidly developing governance practice and expectations and will need to remain responsive to changes in legislation and UK guidance on how all parties can satisfy these and other regulatory objectives. Good governance in an ESG sense is also about how a business more generally considers and manages risks relating to a wider set of stakeholders throughout its value chain, and the longer-term sustainability impacts of, and on, the business, alongside financial ethics (such as anti-bribery and corruption and similar regimes).

It is established practice that a material breach of lease would give the owner as landlord a right to forfeit and terminate the lease (subject always to an operator's right as tenant to seek relief against this action). However, it is not yet commonplace to include or accept express termination rights for failure to comply with social and good governance clauses in leases. These are matters still largely viewed as operational and therefore private to the tenant, even in the care home and senior living sectors. Whilst we believe that the market is moving as operators appreciate the pressures on owners to demonstrate their own efforts to implement social and better governance practices, there will be nervousness in opening up the workings of the operator's business to the owner in this way for some time to come. For some, particularly larger/corporate operators, this is likely to remain unpalatable for a while.

The increased focus within the real estate market as a whole on social and good governance strategy reveals a trend that is unlikely to go away. In the care home and senior living sector, operators and owners have become used to sharing operational information, although traditionally this has focused on the trading performance of the business rather than (for example) the operator's recruitment, marketing and HR policies. The dialogue is there in general terms, but the ongoing challenge will be to get this balance right and ensure that the necessary metrics are being reported to the wider investor base. There are several challenges leases still need to surmount before being an effective tool to achieve this. This practice will evolve as the UK (and wider EU) regulatory and investment sector expectations around the "S" and "G" are fleshed out in the coming months and years.