Target Healthcare REIT — Operational progress and positive returns

Target recently announced that it had reached an agreement with the incumbent tenant/operator of seven of the nine homes that it had previously indicated it was seeking to re-tenant. Having reaffirmed its long-term commitment to the homes, that tenant, accounting for 6.2% of group total contractual rents at 30 June 2022 (£55.5m), has settled all rent arrears, has pledged additional security from another group company and will remain in place. Reflecting the previous receipt of partial rental payments, the settlement of arrears to end-FY22 results in the group rent collection ratio for the quarter to March 2022 (Q322) increasing to 95% from the originally reported 92%, and for Q422 to 94% from 90%. Furthermore, all rent due in respect of the current quarter to September 2022 (Q123) has been received, as has penalty interest in respect of all overdue rent.

We believe that the decision of both parties to continue the tenancy reflects the more positive trading outlook for the homes, following the challenges that had been presented by the COVID-19 pandemic, and the quality of the assets.

In its Q422 NAV and trading update, Target reported that the re-tenanting of one of the two homes operated by a second tenant had already been completed.

We estimate that the rent arrears recovered from the seven-home settlement amounts to c £1m and that a similar amount of rent provision write-backs will be reflected within the income statement during Q123. Resolution of the contractual arrears at the additional two homes should further improve rent collection (included in our forecasts) and generate addition provision write-backs (not included). Our forecasts assume a material improvement in FY23 rent collection and provisioning.

Since its initial public offering (IPO), active management of the portfolio and tenants has been an important element of Target’s strategy. Most homes in the portfolio are mature, stabilised and capable of sustaining high levels of occupancy under normal trading conditions. However, with its focus on asset quality, Target also invests in completed newly opened homes and commits to acquire pre-let developments at completion, often forward funding the development phase. Under normal trading conditions, newly opened homes typically require up to 36 months to establish occupancy levels and reach mature levels of financial performance. However, the pandemic has increased pressures on home operators across the sector and has lengthened the time required for new homes to reach maturity, especially for homes where private fee-paying occupancy was slower to recover.

Where performance problems arise with a tenant, as an engaged landlord, the investment manager leverages its extensive industry experience to work collaboratively with its partners to support and deliver the best long-term solution. In some cases, the optimal solution is to re-tenant the assets to a stronger operator and, as Target’s portfolio has increased in size and diversity, there have been several examples of this being successfully achieved, with no negative impacts on home residents or Target’s financial returns.

At the core of Target’s strategy is its unwavering focus on asset quality. Its investment thesis is that best-in-class properties in local areas with positive demand/supply characteristics and prevailing rental levels that are sustainable will always be attractive to existing or alternative tenants. The quality and appeal of Target’s assets contributes significantly to income security. The successful re-tenanting of a minority of Target’s assets, the tenant recommitment to seven assets described above, and the firmness of valuation yields all provides tangible evidence of the continuing strong investment demand for care homes as an asset class and for modern, high-quality EPC-compliant assets.

At 31 December 2021 (H122) 88% of Target’s portfolio was EPC rated A-B1 and 100% were rated A-C Non-English homes converted to English equivalent rating. This is well ahead of Minimum Energy Efficiency Standards (MEES) regulations that require all properties to be EPC C rated or better by 2027, increasing further to B or better in 2030.

Also included within the range of indicators that guide Target’s investment decisions is full ensuite wet room provision. At end-H122, 96% of portfolio rooms met this standard, with plans in place to upgrade the balance, compared with just 28% of all rooms across the UK2.

The COVID-19 pandemic has presented many operational financial challenges to home operators and although it may not be over, the effects have become considerably more manageable. The key concerns for the sector are now the rapid acceleration in inflation and staff shortages. In this environment, increasing occupancy and strong fee growth are mitigating inflationary cost pressures and the withdrawal of government pandemic financial support. We note the additional factors that we believe will support operators in the current environment:

With the H122 results, Target reported that rent cover3 had remained at c 1.4x for mature homes (those that have had the same operator for a three-year period or more, therefore excluding newly developed homes not yet stabilised). While occupancy and fee increases should continue to support operator profitability and rent cover in the second half of the year, the net impact of inflationary cost pressure remains uncertain.

To fund portfolio growth since IPO, Target has steadily increased its capital resources, both equity and debt capital, sufficient to take advantage of opportunities in the market while avoiding excessive gearing and mitigating any drag on returns. The company targets moderate gearing within a range of 25–35%. Target last issued equity in September 2021, raising £125m (gross) through the issue of c 109m new shares (c 21% of the previous total outstanding) at 117p. End-FY22 borrowings amounted to £235m from total facilities of £320m, c 77% or £180m of which was fixed (inclusive of interest rate swaps). Total facilities also include £140m of flexible variable rate debt, of which £55m was drawn at end-FY22. The gross loan to value (LTV) was 25.8% and adjusting for cash held, the net LTV was 22.0%.

At end FY22 the blended average running cost (excluding the interest rate swap) of the £180m of fixed rate debt (including swaps) was c 3.0% with an average maturity of 11.6 years. The blended margin (over the SONIA benchmark rate) on the £55m of drawn variable rate debt facilities was c 3.4%. The 30 June SONIA rate of c 1.2% did not capture the August 0.5% increase to 1.75% in the Bank of England base rate, closely tracked by the SONIA benchmark rate, while the market is pricing in expectations that rates will increase further by c 2.5% before trending downwards again. Target is exposed to this anticipated increase, although the impact is mitigated by a moderate level of gearing. Our forecasts are based on a SONIA rate of 4.0% throughout FY23 and FY24.

Allowing for all outstanding capital commitments, the company said that it had £49m of available investible resources (cash and undrawn debt) fully allocated but not yet contractually committed to pipeline acquisitions. With a prospective marginal borrowing cost of c 6.2%, we expect the company to be highly selective in acquisitions until anticipated borrowing rates decline and/or acquisition yields widen, although there is yet no sign of the latter. The end-FY22 portfolio topped-up net initial yield of Target’s existing portfolio was 5.82%. With a focus on the most strategically attractive assets, especially where this reflects growth alongside existing tenants, we assume further acquisitions of £30m, a reduction of c £25m on our previous forecasts. Including existing capital commitments (mostly forward funding commitments), we expect debt to increase by a further c £55m by end-FY24. We assume this to be variable rate debt from existing tactical revolving credit facilities, although we would expect the company to consider fixing the cost of a proportion of this through refinancing into longer-term fixed rate debt or interest rate hedging.

At end-FY22 Target’s portfolio was valued at £911.6m and comprised 97 operational care homes and four pre-let sites, which are being developed through capped forward-funding commitments with established development partners. The portfolio value increased 2.8% in Q422, including acquisitions, development investment and a 0.9% like-for-like increase driven by indexed rental growth. Contractual rent increased 2.6% to £55.5m, including the effect of acquisitions, development completion and 1.0% from 23 inflation-linked rent reviews concluded at an average 3.8%.

The 2.0% unaudited Q422 NAV total return4 took the FY22 total to 7.8%. 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.

An aggregation of the unaudited quarterly data provides an indication of the full-year change in FY22 NAV, subject to rounding and allocation differences on a line basis. The annual change in NAV reflects a positive revaluation movement, partly offset by acquisition costs, with dividends paid exceeding the movement in revenue reserves. The movement in the revenue reserves is equivalent to EPRA earnings excluding non-cash IFRS smoothing adjustments. Adjusted earnings additionally include licence fee income earned in respect of development assets.5

Based on the quarterly data above, we have made modest uplifts to our forecasts for FY22 adjusted earnings and NAV (Exhibit 4). Included within this is a reduction in net interest expense despite rising interest rates, due to lower capital deployment than we had assumed and lower overall borrowings.

Our reduced capital deployment assumptions have a negative impact on rental income but the effect of lower borrowing provides some offset to increased borrowing costs.

Our forecasts for EPRA earnings and adjusted earnings are reduced by c 10% for both FY23 and FY24, slowing the path to dividend cover. However, we do expect earnings to grow as a result of inflation-indexed rent uplifts, further capital deployment (albeit at a reduced level) and development completions, a reduction in rent provisions as a result of the asset management discussed above, and a general improvement in market operating conditions. We now assume unchanged DPS for both years compared with FY22, 0.92x covered by adjusted earnings in FY24.

Aggregate FY22 DPS of 6.76p (up 0.6% versus FY21) represents an attractive yield of 6.3%. Although DPS was not fully covered (we estimate 0.72x), a lower DPS (or higher) would have had no impact on the NAV total return of 7.8%. The shares now trade at a c 5% discount to the unaudited end-FY22 22 NAV per share of 112.3p, compared with an average premium since IPO of 7% and a high of c 11%.

In Exhibit 6, we show a summary of the performance and valuation of a group of real estate investment trusts 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 dividend yield is clearly above the group average, while its P/NAV is slightly below the average. There are several positive indicators for future share price performance including a combination of the long WAULT (with no break clauses) and upward-only, triple net rents, mostly linked to RPI. These provide considerable visibility over a growing stream of contracted rental income, in turn supported by the resilience of most tenants through the pandemic, a long-term trend for operator fee growth to at least keep pace with inflation, and a proven ability to re-tenant properties where this is appropriate.