Aged care providers have been sold off heavily in recent months following a government review of its Aged Care Funding Instrument (“ACFI”; a government subsidy) as well as Estia Health Ltd’s (ASX: EHE) recently publicised earnings downgrade.

Given the long-term tailwinds of the industry, as well as the attractive funding made available through the Refundable Accommodation Deposit (RAD) system, aged care providers should be sitting pretty. Unfortunately they’re not, due to high levels of debt, aggressive use of RADs to fund highly priced acquisitions, and vulnerability to government pressure on fees.

Estia Health in particular looks like trouble, and I would encourage investors to steer clear of this one entirely. The recent departure of its managerial team combined with high debt and the recent earnings downgrade should be considered strong warning signs. New management is moving in the right direction, but there could easily be ‘more cockroaches in the kitchen’. In Estia’s favour, it claims a lower error rate on its ACFI documentation of 1 in 14, below the industry average (more on this below). I could not find a recent instance of Japara or Regis reporting these figures.

Japara Healthcare Ltd (ASX: JHC) is my preference, thanks to its mixed status as both an aged care facility and retirement village operator. It also carries significantly less debt than Estia and appears to have been less aggressively run, with some of its acquisitions carrying a lower cost per bed than those made by similar businesses. Japara appears cheaper, while unlike Regis and Estia it also has a positive Net Tangible Asset (NTA) value of ~25 cents per share. In other words, its assets are worth more than its liabilities should the company be liquidated.

Regis Healthcare Ltd (ASX: REG) carries a higher level of debt, and its liabilities are valued at more than its tangible assets. After recent share price reversals in the sector, Regis is now the company with the highest apparent price tag although it also has significantly better operating cash flows than its two competitors (even if we exclude the RAD benefit, which is reported as ‘operating’ cash flows for some reason). With a higher price and higher leverage, it’s less suitable than Japara, but also appears less risky than Estia.

The problem with the aged care sector

I think the sector as a whole has been run too aggressively. Management teams have gone wild with their RAD funding and bought everything that could have a price tag slapped on it. ACFI subsidies also appear to have been abused, with % growth rates in these per resident well above the indexation applied by the Commonwealth. The government has specifically stated that the increase in ACFI fees is well above its budget, and ‘cannot be explained by increased frailty of residents’.

The amount of errors in the sector for ACFI documentation is also rising, currently 1 in 7 (~14%) in 2015-2016, up from 1 in 8 (~12%) in the prior year. This is a high error rate – by contrast, approximately 3% of taxpayers were contacted by the ATO regarding errors on their tax return (a similarly complex documentation task) in 2014.

As a result, investors should demand a higher margin of safety in their investment than they’re getting at current prices. Japara remains my favourite for reasons listed above, but as a result of the myriad risks facing the sector, I’m not interested in any of the above companies at today’s prices.

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Motley Fool contributor Sean O'Neill has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.