Target Healthcare REIT — Resilient H122 and continuing growth

Several of the key financial performance metrics had already been disclosed in the quarterly reporting and covered in our update note published on 3 February, but the H122 results provide more detail. Although earnings and dividend cover were deferred by some delays in the deployment of £125m (gross) equity raise in the September 2022, the underlying performance can be seen in like-for-like rent and valuation growth and a six-month NAV total return of 3.4%.

Of the £191m of new investment and development commitments during H122, the most significant transaction by far was the £159m acquisition of a portfolio of 18 homes, adding £9.3m to contracted annualised rents. 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. In an arm’s length transaction, the portfolio was acquired from the maturing Kames Capital Healthcare Fund, the first fund advised by Target when it was founded in 2010, on behalf of Kames Capital. Target selected 17 of the 18 homes in the portfolio, providing it with an informational advantage in the portfolio acquisition in respect of both the assets and the tenants.

The end-H122 portfolio comprised 98 homes (of which four were under development) valued at £870.5m with contracted rents of £53.4m and let to 31 tenants. The long weighted average unexpired lease term (WAULT) was a long 27.5 years with 96% of rents subject to annual upward-only RPI-linked reviews and 4% fixed uplifts.

Performance during the period continued Target’s track record since IPO in January 2013 of consistent annual DPS growth and consistently positive NAV total returns on both a quarterly and annual basis, reflecting 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.

Exhibit 2 provides a summary of H122 financial performance.

Focusing on adjusted earnings, we note:

Target says that it has c £80m of capital available for further deployment, allowing for existing commitments, and that is all earmarked for identified acquisitions that have been approved by the board. Including the impact of this future deployment, a full contribution from previous acquisitions, development completions, rent reviews and economies of scale, Target estimates that dividend cover (on an adjusted earnings basis) will increase to a little more than 100%.

The rental income and results reported for H122 were mainly driven by the level of annualised contracted rents in place during Q421 (to end-June 2021) and Q122 (to 30 September 2021). Although Q222 annualised contracted rental income increased by £10.2m or c 24% to £53.8m, this largely reflected the portfolio acquisition1 that came in late December 2021 and contributed to H122 income for just 12 days. Current annualised contracted rents are now £53.8m (including the acquisition of a standing asset in Manchester announced on 7 January 2021), while completion of the four pre-let developments will add an additional £2.7m,2 taking annualised contracted rents to £56.5m.

Target expects the additional £80m capital deployment plus contractual rent increases to further increase annualised contracted rent roll to £63.7m. Given the advanced stage of the targeted investments, we expect most of this increase to be achieved by the end of FY22 with the exclusion of the developments yet to complete. We anticipate that three of the existing developments will remain on site with aggregate estimated annualised contracted rent of c £2.2m, while the £80m capital deployment is likely to include additional development assets (we assume £20m of commitment with aggregate rents of c £1.1m).

Our forecasts are consistent with Target’s analysis above, although the slightly lower dividend cover ratios shown in the financial summary (Exhibit 11) reflect ongoing increases in DPS.

Target has a long WAULT of more than 27 years which, combined with upward-only annual RPI-linked (96% of income) and fixed (4%) contractual rent uplifts, provides significant income visibility and protection against inflation. Uplifts are typically capped at c 4% with a floor of c 2% and although this means that while Retail Price Index (RPI) inflation is above 4%, rental growth will lag in real terms, it contributes towards rents remaining affordable for tenant operators and enhances the security of Target’s income. The company estimates that rent costs represent c 20% of gross revenues for its typical established home.

The 12-month increase in the RPI was 8.2% in February 2022, the highest rate of increase since March 1991, while the 12-month increase in the Consumer Price Index (CPI) was 6.2%, the highest rate of increase since March 1992. The Bank of England continues to expect a moderation in inflation as commodity prices stabilise, supply shortages ease and global demand rebalances, but this is far from assured. War in Ukraine and rising international tensions have seen oil and commodity prices increase further.

Although inflation has recently spiked upwards, across the sector the growth in average fees charged to privately funded care home residents has tracked or exceeded inflation over the past c 20 years, subsidising typically lower fees for local authority-funded residents. Using data provided by its operator tenants, Target estimates that c 62% of the residents in its homes are wholly or partly privately funded and 38% are purely publicly funded (predominantly local authority but also NHS).3

Energy cost pressures are acute for care homes, as elsewhere, but Target estimates that these typically account for c 2% of revenues across its homes, much less important than staff costs, typically within a range of 50–60%, and rents. We do not expect staff costs to increase as a percentage of revenues provided operators can maintain their historical pricing power and ability to pass through inflationary pressures.

Meanwhile, tenant performance has remained resilient despite the continuing impacts of the pandemic. Rent collection was 96% in H122 and although the rapid spread of the Omicron variant punctuated the trend of recovering occupancy in portfolio homes,4 the rent cover ratio has remained at c 1.4x5 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). This comes despite the gradual withdrawal of government financial support during the peak of the crisis.

The improvement in home occupancy that began during the second half of 2021 is not obvious from the 12-month rolling data shown in Exhibit 5. However, having dipped by more than 10pp on a ‘spot’ basis to less than 70% at the low point earlier in 2021, occupancy for mature homes has since improved to c 80% currently. Where homes were affected by the winter pick-up in COVID cases, predominantly Omicron, admissions at affected homes had to be put on hold, although none of the tenants has reported significant excess deaths. With cases receding again (19 cases across five homes), enquiry levels remaining strong, and staff shortages beginning to improve the prospects for a resumption of occupancy growth and increase in rent cover towards a normal level of 1.6x, appear positive.6

H122 included c £1.1m of provisions against rent receivables, which Target describes as prudent (c 5% of rental income in the period versus the 96% collection rate). Most of the recent rent arrears have primarily related to two tenants across four of the homes and, although not helped by the pandemic, reflect more fundamental performance issues. Asset management initiatives aimed at addressing these were delayed by the physical restrictions in place during the lockdowns but have recently completed. For one tenant, a new operator of two immature homes, trading performance has improved. The position with the other tenant has been resolved with outstanding rents partially settled and the homes re-tenanted. On a much more modest scale, Target says it prudently budgets for a certain recurring level of provisioning to reflect the challenges that continue to face the sector. It is currently negotiating the re-tenanting of four homes managed by a national operator which it believes would be better suited to a smaller regional operator, despite current performance being satisfactory.

Financing during H122 increased available debt, increased the share of long-term fixed-rate debt, and extended average duration with a better spread of maturities. In an increasingly inflationary period, this provides significantly enhanced protection against further increases in market interest rates. The long-term, fixed-rate borrowing locks in a positive margin between rental income and borrowing costs and this will increase with inflation-indexed rental growth. More flexible, low-cost variable rate debt remains undrawn to support further portfolio growth and may be replaced with equity or refinanced at some later date.

At the end of November 2021, Target agreed £100m of new fixed-rate funding in two tranches, at a cost of 3.14%, with a weighted average maturity of c 13 years. Including this, end-FY22 total debt facilities amounted to £320m, of which c £223m had been drawn. Including interest rate swaps, £180m of the drawn borrowings had been fixed at an all-in rate of 3.22% (including amortisation of arrangement costs) at least until November 2025 and mostly (£150m) until January 2032.

The remaining £140m of total debt facilities, of which c £43m had been drawn at end-H122, carry interest at a variable rate based on an agreed margin over the SONIA7 benchmark rate. Including amortisation of arrangement fees, the average cost of this variable rate borrowing at end-H122 was 2.44%.

The end-H122 net loan to value ratio (LTV) was 20.7% and, when fully invested, Target expects this to increase to c 28%, a level with which it is comfortable.

The changes to our forecasts are relatively modest. Despite the acquisition timing delays, based on H122 performance, our forecast for cash rental income is increased, but offset by higher H122 rent income provisions. The slight reduction to FY23 adjusted earnings is primarily driven by a correction to our estimation of licence fee income8 in respect of the balance sheet value of properties under development.

There is no change to our DPS growth forecasts, and we expect dividends to be well covered by EPRA earnings (including non-cash IFRS rent smoothing adjustments) as capital deployment takes a full effect, with full cover on a ‘cash’ adjusted earnings basis (excluding IFRS adjustments but including licence fee income on development) by FY24.

In line with Target’s guidance of available capital, we assume £80m of new investment commitment by end-FY22. This includes £60m of completed assets and £20m of forward-funded developments, all at a net initial yield of 5.6%. Our other forecasting assumptions include:

The current year DPS target of 6.76p (+0.6% versus FY21) represents an attractive yield of 6.1%. The shares trade at a small 1% premium to the H122 EPRA NTA per share of 110.8p, below the average c 6% since IPO and the high of c 11%.

In Exhibit 10, we show a summary of the performance and valuation of a group of REITs that we consider to be Target’s closest peers in 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. Compared with the average, Target has a clearly longer WAULT and trailing dividend yield with a similar P/NAV.

In terms of average share price performance, the peer group has trailed the overall UK property sector and FTSE All-Share Index over the past year, as less defensive, more cyclical areas of the sector rebounded from the impact of pandemic lockdowns. Over the same period, Target’s share price performance has been in line with the average for the group.