Impact Healthcare REIT — Performing well in a challenging environment

In this note we provide an update on the factors that mitigate inflation risks for both Impact and its tenants, and our expectations for Impact to build further on its existing strong financial and operational performance. For an in-depth discussion of Impact Healthcare REIT’s strategy, please see our May Outlook. In that report we highlighted the strong fundamentals of the care home investment market, uncorrelated with the wider economy, and the predictability and sustainability of cash flows, supporting fully covered progressive dividend growth.

The H122 results were reported on 16 August 2022, followed by the Q322 update on 21 October, discussed in detail later in this report. Despite the building headwinds of increased inflation and interest rates and economic and political uncertainty in the UK, tenant operators have seen their occupancy ratios continue to recover towards pre-pandemic levels, with strong growth in the underlying fees they charge for the care they provide; and they have been managing underlying cost pressures effectively.

In brief, H122 income grew strongly, driven by portfolio investment and inflation-indexed rent growth. Compared with H121, cash rental income increased c 16% year-on-year and including interest on property investment via loans, total income grew 28%. Compared with H221, the half-yearly growth rates were 7% and 15% respectively. With portfolio growth delivering economies of scale, adjusted ‘cash’ earnings increased by 28% versus H121, to £13.8m, and by 12% versus H221. H122 adjusted EPS of 3.66p (H121: 3.26p) covered DPS of 3.27p (+2% vs H121) by 112%. On an EPRA basis, DPS cover was 129%. Property revaluation gains, driven by rent uplifts and asset management initiatives, drove EPRA NTA per share growth of 3.3% in the period to 116.1p.

On an annualised basis, H122 contracted rents had increased from to £42.0m from £38.0m at end-FY21, and increased further, to £43.2m at end-Q322. In contrast to more mainstream UK commercial property sectors, the underlying valuation yield remained stable (EPRA topped-up net initial yield of 6.7%) with indexed rent growth translating into a 0.8% like-for-like valuation uplift. EPRA NTA per share increased 0.3% in the quarter to 116. 5p (IFRS NAV of 116.6p includes a positive interest rate derivative balance) and including DPS paid the EPRA NTA total return was 1.7%.

The end-Q322 portfolio was valued at £581m, including £38m of investments via loans. Including assets where acquisition contracts have been exchanged and assets under construction, this comprised 134 care homes and two healthcare facilities, let to 14 tenants. All rents are inflation-indexed (with caps and collars) with a weighted average unexpired lease term (WAULT) of 19.7 years. Just after the quarter end, as part of its active asset management programme, Impact sold a non-core for £2.7m, 4% ahead of the end-Q222 book value.

The COVID-19 pandemic 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, Impact’s tenants have remained resilient, with increasing occupancy and strong fee growth mitigating inflationary cost pressures, supporting rent cover and the payment of rents in full.

Impact has built a strong track record of identifying attractively priced assets, mostly off-market, with an average gross yield on acquisitions of 7.4% since its initial public offering (IPO). At current interest rates, acquisitions remain accretive, but with money markets recently volatile and indicating a peak in the SONIA benchmark interest rate at between 5–6% (before declining) we expect a highly selective near-term approach to acquisitions (our forecasts include none).1 As a long-term investor, as interest rates begin to decline and, perhaps, with vendors also adjusting downwards their pricing expectations, we would expect acquisitions to resume from the significant pipeline of opportunities that have been identified. Meanwhile, rising market rates will have a negative effect on existing drawn variable rate debt, although we would expect Impact to seek opportunities to extend its interest rate protection or even refinance floating rate debt with fixed-rate, longer-term debt (but this is not assumed in our forecasts).

No change to DPS forecasts with strong cover maintained, despite increased funding costs

Exhibit 1 shows a summary of our revised forecasts. Despite the increase in interest rates and our reduced expectation for acquisitions, our DPS targets are unchanged and remain in line with Impact’s rent-growth linked dividend policy. Our forecasts for net revenue, comprising net rental income plus interest on investment via loans, are reduced for both years, primarily due to lower acquisition activity, partly offset by increased monetised capex, and modelling adjustments. The inflationary impact on administrative costs is limited by the significant weight of investment manager fees, linked to the level of net asset value. Higher borrowing costs are partly offset by lower average borrowings (the flip side of lower acquisition spend) but in FY23 the effect is particularly marked as the higher interest costs have a full impact and a £25m interest rate swap matures (see below).

In building and diversifying its tenant base Impact has sought to identify quality operators with which to partner and grow over the long term, targeting those that are most likely to provide good care, while running a sustainable and profitable business. A key element of this sustainability has been to set rents at an affordable level, typically representing 11–15% of home-level revenues. Allowing for development completions, we estimate average capital value per portfolio bed at c £80k and the average annual contracted rent per bed at c £5,800.

Occupancy has continued its steady recovery from its low in March 2021 (c 79%) and by end-Q322 had reached 87.3%2 (end-H122: 85.4%). A continuation of the average rate of improvement since March 2021 would see occupancy approach pre-pandemic levels (c 90%) by the end of 2022, but this is not a given.

Average rent cover3 was 1.85x over the 12 months to end-H122 and 1.73x at the end of the period, compared with c 1.90x before the pandemic (Exhibit 2). With the Q322 update, the investment manager had received operator trading data for 88% of the portfolio for July and August and based on these early indications anticipates that Q322 rent cover will have increased versus Q222. This would be in line with the seasonal pattern of rent cover evident from Exhibit 2, typically driven by operators agreeing and implementing most salary increases in December or January, while fee increases are mostly agreed during Q2, taking effect in Q3. In addition to seasonal factors, the reduction in rent cover from Q321 to Q222 reflects the following:

Occupancy and fee increases should continue to support operator profitability and rent cover in the second half of the year, but the impact of inflationary cost pressure remains uncertain.

Additional factors that mitigate the inflationary risks to operators include:

At end-Q322, borrowing costs on 77% of the £130.6m gross drawn debt were fixed or capped, comprising £75m of long-term, fixed-rate debt and a £25m nominal interest rate cap at 1% (ie, capping the SONIA benchmark rate at 1%). The cap matures in June 2023 at the same time as a £30m floating rate facility with Metro Bank (of which £15.3m was drawn at end-Q322). Impact has sufficient liquidity to repay this and is engaged in positive discussion over the arrangement of incremental facilities. While interest rate exposure on drawn debt is less than £30m, this would increase with further borrowings, based on the current debt structure. Total debt facilities (drawn and undrawn) of £206m are 48% fixed or capped. Meanwhile, gearing is prudent, with an end-Q322 gross loan to value ratio (LTV) of 21.4%, below the company’s c 25% medium-term target and well below the 35% maximum specified by the company’s gearing policy. Including exercise of the extension options9 the end-Q322 average debt maturity was 5.8 years.

Capturing the effect of the September 2022 increase in the Bank of England base rate to 2.25%, the average running cost of drawn debt at end-Q322 was 3.9%. The cost of undrawn debt is at a margin of over SONIA, which closely tracks the base rate, which in September 2022 increased further to 2.25%. The market expectation, reflected in the forward curve, is for base rate/SONIA to increase much further, but has recently been volatile, anticipating a peak of between 5% and 6% by mid-2023 followed by a steady decline to a long-term 3%-4%. Our forecasts are based on 6.0% through FY23, which may prove to be conservative. On an annualised basis, a 0.5% shift in the benchmark rate is equivalent to a c 1.5% movement in adjusted earnings. We expect Impact to seek opportunities to extend its interest rate protection or even refinance floating-rate debt with fixed-rate, longer-term debt but this is not assumed in our forecasts.

Exhibit 4 provides a summary of Impact’s debt portfolio at end-Q322, including strong borrowing covenants. On a blended basis, the Q322 interest cover ratio (ICR) was more than 900% against the covenant requirement of 239%. On the same basis, the blended LTV of the banking facilities (excluding the private placement) was 19% versus a maximum limit of 48%. End-Q322 unsecured assets and cash amounted to £52.9m.

Impact aims to provide shareholders with attractive and sustainable returns, primarily in the form of quarterly dividends, with the potential for capital growth. Supported by strong cash flow, covered DPS has increased each year since Impact’s IPO, with a clear and progressive dividend policy that targets growth in line with the inflation-linked rental uplifts received in the preceding financial year. Dividends paid have driven the consistently positive quarterly total returns since the company listed in 2017, with aggregate NAV total return (adjusted for dividends paid, but not reinvested) to end-Q322 of 52.5%, a compound annual return of 7.9%. We believe this is attractive in the low interest rate environment that has persisted since IPO and the headwind of the pandemic, even if slightly below the company’s medium-term return target of 9% per year.

Across the commercial property sector, income returns have historically shown less volatility than capital values, which have displayed material swings. Healthcare property returns have been less volatile than mainstream sectors. Despite the recent sharp increase in market interest rates and the cost of capital, we forecast continuing dividend growth, fully covered by adjusted earnings, in turn supported by index-linked rental growth. With government bond yields significantly higher than at the start of the year10 there is a widespread expectation that the widening of property valuation yields (decrease in values) that is already apparent across much of the UK commercial property sector will spread. When reporting the H122 results the investment manager said that it had observed some signs that valuation yields had begun to increase, from very low levels (less than 3%) at the very high end (super-super prime) of the market, but that it did not expect any material change in its chosen market segment where yields are already much higher. For Impact’s Q322 external property valuation, there was no change in the underlying valuation yield although our forecasts for FY22/FY23 allow for a c 0.35% widening, in aggregate, over the period. In this context, we expect NAV per share to be relatively flat through H222 and FY23, with an NAV total return in FY22 of 8.7% (H122: 6.2%) followed by 5.6% in FY23, all driven by dividends paid.

The end-Q322 EPRA ‘topped-up’ net initial yield of the Impact portfolio was 6.7%. In addition to the yield widening reflected in our forecasts, we estimate that a 10-basis point increase/decrease in yield would decrease/increase FY23e NAV per share by c 2.4p.

Impact’s business model is focused on forming long-term relationships with selected tenants, investing in suitable properties that those tenants can efficiently and profitably operate, while providing a good quality of care. With its equity raise in June 2022,11 the company provided details of a strong pipeline of potential acquisition opportunities12 and we understand that this continues to be the case. Impact also has available liquidity for acquisitions, which we estimate at c £78m, comprising cash and available undrawn debt less outstanding commitments.13

However, given the significant recent increase in the cost of capital, we anticipate that Impact will take a highly selective approach to acquisitions, even where these offer attractive operational and strategic opportunities. In most cases we believe care home operators that may be seeking to exit the sector are yet to adjust their pricing expectations to the increased cost of capital that must be borne by investors, and we assume no additional acquisitions in our forecast period to end-FY24.

Where attractive terms can be agreed, perhaps because of vendor willingness to accept lower prices, a decline in interest rates or the potential for innovative financing solutions, acquisitions may still be possible.

Exhibit 5 provides a summary of the H122 financial performance arranged to show a breakdown of adjusted ‘cash’ earnings and a reconciliation to EPRA and statutory IFRS earnings.

Looking first at adjusted earnings, the key highlights of the H122 financial performance were:

Exhibit 7 shows a summary of the Q323 financial performance, provided by Impact. With IFRS smoothing adjustments netted off against revaluation costs. The ‘remaining contribution to reserves’ excluded non-recurring issuance costs related to the July 2022 equity issuance and was above the quarterly DPS paid. Adjusted ‘cash’ earnings adds back amortisation of loan arrangement fees and other non-cash adjustments, and allowing for this, as well as the increased number of shares, we estimate that DPS was well covered, consistent with our FY22 forecasts. Meanwhile, adjusting IFRS NAV per share of 116.62p for the positive mark to market impact of interest rate derivatives, EPRA NTA per share was 116.46p.

During H122, Impact completed the acquisition of seven homes and exchanged contracts to acquire a further three, for a total consideration of £55.2m. In each case these transactions were in line with Impact’s strategy to grow partnership with selected tenants. The end-H122 portfolio was diversified across 13 tenants, operating 134 homes (including properties under exchange), providing more than 7,000 beds. On 22 August, Impact announced it had exchanged contracts to acquire two additional homes for £14.0m (before costs), at an accretive gross yield of 6.4% and operated by a new (14th) tenant to the group, Belmont Healthcare. One of the homes is purpose built and offers asset management opportunities, including realising the potential of its large site. The other has been recently refurbished. Both are rated EPC B.15

While we forecast a pause in acquisition activity, we expect asset management projects to continue. Asset management is led by tenants and directed at those projects that can create value for both parties: tenants benefit from the potential to enhance or extend facilities, broaden their appeal to residents and increase earnings, while Impact benefits from higher rents, improved rental cover and, in many cases, capital value uplifts. Impact considers asset management to be one of the most attractive strategies available to it for the deployment of capital and for enhancing returns beyond a pure ‘buy and hold’ strategy, typically generating a low-risk yield on capital of at least 8% pa and supporting capital values. With the H122 results, the company reported that four projects had been completed since the beginning of 2022, with a further 15 projects started or in planning.

In addition to asset management of existing assets, Impact also forward-funds the development of pre-let, modern purpose-built facilities, bringing new capacity to market in attractive locations with good structural demand-supply balances. During H122 it achieved practical completion at a 94-bed development in Hartlepool at a cost of £6.1m and an expected annual yield of 7.8%. A £1.9m (30%) valuation uplift was recorded. Detailed planning continues for the construction of an 80-bed home in Norwich that will provide a range of residential, nursing and dementia care, at a total cost of £10.5m. Impact expects to start construction before the end of the year.

Impact’s FY22 target DPS of 6.54p (+2.0%), fully covered, represents an attractive yield of 6.6%. Meanwhile the shares trade at a 15% discount to the end-Q322 EPRA NTA (NAV) per share of 116.46p and appear to already anticipate a weakening of property valuations. The valuation is now similar to that reached at the peak of pandemic uncertainty in 2020, which proved to be an attractive entry point, with the robustness of tenants subsequently confirmed.

Exhibit 7 shows a summary of the performance and valuation of a group of real estate investment trusts (REITs) that we consider to be Impact’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.

Impact’s shares have outperformed the peer group and the broad UK property market over the past one and three years. Its trailing yield is now below the peer group and its P/NAV is above the average, albeit of a wide range, and has converged on the rating of the primary healthcare investors, Assura and PHP, long recognised for the security and predictability of income. In our view, Impact’s valuation will have benefited from a robust performance during the pandemic, providing investor confidence in the sustainability of its growing stream of contracted rental income, a combination of the long weighted average unexpired lease terms and upwards-only, triple net leases, and rents mostly linked to RPI.