Guidance

Annex E: further detail on return on capital and return on operations

Updated 18 December 2023

Applies to England

Following an announcement in the government’s Autumn Statement 2022, the planned adult social care charging reforms are now delayed until October 2025.

Care home return on capital

Care home cost of care exercises will require local authorities to specify the amounts that they have allowed for both return on capital and return on operations (expressed as pounds per resident per week, or pounds per contact hour). This is different from a ‘whole business return on capital’, which includes the return on operations within the return on capital.

Return on capital is a judgement rather than a hard science, and as described below, the local authority should retain the flexibility to vary the return on capital paid to any individual provider, but the following overarching principles are relevant.

• Investment by nature involves risk. The cost of capital is the return that investors require to invest in a business. Within the care home market, return on capital payments within the care fee encourage new investors to invest in care home land and buildings, and keep existing capital invested in social care rather than investing in another business with similar risk. They may cover payments such as rent and mortgages. They are an important consideration for the full economic cost of running a care home, and apply to all care home providers as made clear by CMA (2017).

• Return on capital is an important consideration for the impact of section 18(3), as it is one of the main fixed costs in a care home and to some extent determines who is paying for those fixed costs.

• Nevertheless, return on capital is not a hard entitlement nor is it fully objective. There is judgement involved in setting the amounts included in the cost of care exercise, and further judgement when setting the amounts for any particular provider. The amounts included in the cost of care exercise are not intended to be fixed across all providers in the local authority; the amount paid to any one provider is a judgement according to considerations such as area and building type. It is important to balance spending on return on capital with other potential uses of public money in meeting care needs.

• It is important to remember that return on capital may in some cases be reinvested in the business. This can make their business more desirable to the market in future, and help the market develop more generally, for example by improving quality, improving efficiency, serving more people, or moving into new types of care.

• While they involve judgement, the amounts included in the cost of care exercise will need to be defensible, with the evidence that has informed them clearly set out. The CMA (2017) suggest the cost of capital is calculated as the product of both:

  • (a) the value of the assets invested in the care home

  • (b) the required percentage annual return on capital

• There are several approaches to estimate a) and b) above, although in general the value of assets used in the cost of capital calculation should reflect the market value of those assets. This is where local authorities may find it helpful to adopt multiple approaches to triangulate and validate their returns. For example, freehold valuations of land and buildings that reflect what those assets could be sold for as an alternative to continuing to use them within the care business.

Cost of care exercises should be clear how their reported return on capital values have been calculated. Approaches including (but not limited to) those below can inform a local authority’s overall judgment on the level of return on capital reported as part of its cost of care exercise. The methods below reflect that property prices and rents, and therefore justifiable levels of return on capital, vary substantially between local authorities. As discussed above, local authorities may wish to flex the return on capital value for different care homes in their area.

Potential approach 1

Providers should be asked to state the current freehold value of their care home, and the median freehold value per bed can then be calculated for the local authority conducting the exercise. There is a second-hand market for care homes which can provide a sense check^{[footnote 1]}. A percentage rental yield can then be applied to the freehold value per bed. For example, the commercial estate agents Knight Frank cite a 5.5% yield for core care home stock (note that it is a lower 4% for prime stock and 3.5% for super prime stock)^{[footnote 2]}. For example, consider a local authority with a median freehold valuation of £60,000 per bed. The cost of care exercise could report a return on capital of 5.5% * £60,000 / 52 weeks = £63 per resident per week.

Potential approach 2

Local Housing Allowance (LHA) is paid to Housing Benefit recipients to support the cost of rent. The rates are set as the 30th percentile of local rents. The one-bedroom rate of LHA (minus fixtures/fittings/repairs/maintenance^{[footnote 3]} can arguably be used as a proxy for the property rental element within a local authority. This is because whilst a one-bedroom flat has features which are care home does not, such as a kitchen in every flat, a care home has many communal areas which the flat would not have. The LHA rates are paid at Broad Rental Market Area (BRMA) level, and several of these areas may overlap within with the local authority’s boundaries. The rates for each BRMA are available online. For example, consider a local authority with an average one-bedroom LHA rate of £130 per week, and fixtures/fittings/maintenance of £30 per week, the cost of care exercise could report a return on capital of £100 per resident per week.​

Return on operations

The return on operations amounts to a reward and incentive for operating the care and support services in a care home, and as a reward and incentive for the whole business of domiciliary care. It is important to note that in domiciliary care, return on operations is the only source of profit (there is no return on capital nor any capital gains from property). It is therefore particularly important to understand the costs of domiciliary care providers and how they are changing, to ensure that profits remain at a sufficient level.

Return on operations can be calculated as a percentage markup on operations and head office costs.

As noted for return on capital above, providers can choose to reinvest part of their return on operations into the business. This can make their business more desirable to the market in future, and help the market develop more generally, for example by improving quality, improving efficiency, serving more people, or moving into new types of care.

Returns on capital and operations will affect entry and exit of providers

Local patterns of entry and exit of care homes and domiciliary care agencies give an idea of whether the returns on capital and operations paid on average across local authority funded and self-funded residents are adequate. Care Quality Commission (CQC) publish monthly data^{[footnote 4]}on registrations and de-registrations although some de-registrations do not represent true losses of capacity as the home is re-registered shortly afterwards^{[footnote 5]}. Department of Health and Social Care analysis suggests that at England level, both total bed entries and exits from the older people’s care home market over the past 5 years (accounting for re-registrations) have been limited, at around 1.5% of beds per annum. Both entries and exits of domiciliary care agencies are significantly greater.

1. See for example Buy a care home ↩

2. Frank Knight. See figure 6, page 6 for the 5.5% yield for core care home stock. ↩

3. Median costs of fixtures/fittings/repairs/maintenance should be estimated elsewhere in the exercise. A residential landlord would be expected to cover these costs. They should not be included in LHA-based return on capital as that would double count them. ↩

4. See the Care Directory with Filters and the Deactivated Locations file. ↩

5. The Health and Social Care Act requires some changes, such as a change to which subsidiary operates a care home, to be implemented as a de-registration followed by a re-registration. ↩