Target Healthcare REIT — Capital deployment and positive returns

In September 2021 Target completed an upsized £125m (gross) equity raise, the proceeds of which have already been more than deployed. Including available debt capital, enhanced by the recent £100m fixed rate long-term debt facility, and allowing for all capital commitments, Target estimates that £82m of capital remains available. This is all allocated to identified investments in late-stage due diligence. Completed and future capital deployment will be a significant driver of earnings growth and dividend cover, and we forecast that by FY24 DPS will have increased further and will be effectively fully covered1, as acquisitions and development projects fully contribute to income and earnings.

The £173m deployed during Q222 comprised the 18-home portfolio and the acquisition of a pre-let development site in Weymouth for a maximum commitment of £14.3m. It has since completed the acquisition of an operational home in greater Manchester for £7.2m. In aggregate, these acquisitions bring five new tenants to the group (now 33) and increase the number of homes to 99, of which four are under development.

The portfolio of 18 operational care homes adds more than 1,200 beds and generates annual contracted rent of £9.3m, 100% of which has been collected throughout the pandemic. All the properties are purpose-built care homes with an average age of c 11 years providing high-quality modern facilities including full ensuite provision, the vast majority of which (96%) benefit from wet rooms. The portfolio is spread across eight tenants, three of which are new to Target, including national operator Barchester Healthcare, as well as two regional operators.

Target Fund Managers, the investment manager for the group, has unparalleled knowledge of the individual assets within the portfolio, having sourced 17 out of the 18 care homes on behalf of the vendor and provided asset management services over the past 11 years. The properties each benefit from long-term occupational leases with RPI-linked caps and collars, with a weighted average unexpired lease term of approximately 22 years. The commercial terms of each of the occupational leases are consistent with equivalent leases in place across the group.

It is expected that the development site in Weymouth will reach practical completion in June 2022, providing 66 beds. Upon completion it will be leased to experienced, regional operator Chanctonbury Healthcare, a new tenant to the group, on a 35-year, full repairing and insuring lease.

The modern, purpose-built care home acquired in Westhoughton, greater Manchester has been trading for seven years and Target notes an attractive track record of care/service, occupancy and profitability. It will be operated by Harbour Healthcare, new to the home and a new tenant to the group, and comprises 55 bedrooms with full ensuite facilities. The property is leased on a 35-year term with RPI-linked increases, subject to a cap and collar.

The 1.0% Q222 NAV2 total return3 takes the H122 total to 3.4%. Adjusting for the Q222 property acquisition costs incurred, we estimate the Q222 total return would have been 2.2%. Consistently positive returns since IPO in January 2013, on both a quarterly and annual basis, reflect the resilience of the sector and of Target’s strategy. The average annual compound return over this period has been 6.0%, of which c 80% reflects dividends paid.

The Q222 NAV movement reflects a positive revaluation movement slightly ahead of acquisition costs, with dividends paid exceeding the movement in revenue reserves. The difference between the movement in revenue reserves and dividends paid is not equivalent to the dividend cover ratio, which may be based on EPRA earnings or adjusted earnings. EPRA earnings includes non-cash IFRS smoothing adjustments while adjusted earnings excludes this but includes licence fee income earned in respect of development assets4. FY21 dividend cover was 80% on an EPRA earnings basis and 81% on an adjusted earnings basis. Our forecasts indicate 83% and 86% respectively in FY22, increasing steadily to full cover in FY24 as acquisitions and completed developments fully contribute to earnings. Target itself remains confident of achieving this despite near-term dividend cover having been depressed by the September 2021 equity issuance in advance of acquisitions.

The portfolio value increased by 23.9% during Q222 (not including the Q322 greater Manchester acquisition) to £870.5m, mostly due to acquisitions (23.9%) but also a 1.3% like-for-like uplift driven by inflation-linked rental uplifts and 1.1% from investment into the development portfolio and capex.

The 23.6% increase in contracted rent to £53.4m (passing rent after lease incentives £51.1m) was also driven by acquisitions (21.5%) but also included inflation-linked rental uplifts (1.0%) and asset management initiatives (1.1%). The 17 rent reviews completed in the period were at an average 4.0% uplift, similar to the average rent cap across the portfolio.

We have made no changes to our forecasts, which include the full deployment of the remaining capital (comprising cash and undrawn debt) by the end of FY22, as detailed in our November update. The first full year rent contribution from all assumed investments and development completions is thus FY24.

Target estimates this available capital at £82m, all of which is allocated to late-stage pipeline opportunities. It says that all else being equal, on completion of these acquisitions and the developments currently in progress, the pro forma loan to value (LTV) would be 32%, up from 20.7% at end-Q222. Debt facilities of £320m include the new £100m long-term fixed rate facility put in place in November 2021 at an attractive blended rate of 3.14%. The new facility complements the group’s long-term leases, locking in a positive spread versus the asset yield, which should increase over time with inflation-linked rent increases. Fixed rate debt now represents more than 80% of drawn debt (£223m) and 56% of total debt facilities, including the flexible variable rate revolving credit facilities. The weighted average term of the drawn debt has increased to 7.4 years at end-Q222 versus 4.6 years at end-Q122, with a slight decrease in the average cost, to 3.09% from 3.16%.

The current year DPS target of 6.76p (up 0.6% vs FY21) represents an attractive yield of 5.9%. The shares trade at a modest c 3% premium to Q222 NAV per share of 110.8p, similar to the average since IPO but below the high of c 11%.

In Exhibit 3 we show a summary of the performance and valuation of a group of REITs that we consider to be Target’s closest peers within the broad and diverse commercial property sector. The group is invested in the primary healthcare, supported housing and care home sectors, all targeting stable, long-term income growth derived from long-lease exposures.

Target’s share price yield is clearly above the group average while its P/NAV is slightly below the average. There are several factors that suggest a continuing positive outlook for the shares including a combination of the WAULT with no break clauses and upwards-only, triple net rents, mostly linked to RPI, which provides considerable visibility over a growing stream of contracted rental income. Rent indexation also offers considerable protection against inflation at a time when inflation expectations are increasing.5 The resilience of Target’s business model during the pandemic, with no interruption to quarterly dividends, is a further positive indicator for the rating of the shares.