Impact Healthcare REIT — Successfully growing with tenants

Impact Healthcare REIT (Impact) invests in a portfolio of primarily residential and nursing care home assets in the UK, diversified by geography, tenant operator, home size and resident funding mix. The demand for care home places is ultimately driven by a growing population of the elderly, with increasingly complex care needs and is relatively insensitive to wider economic conditions. Meanwhile, there is an undersupply of quality care home beds. The company is externally managed by a sector specialist investment manager, Impact Health Partners (IHP). The principals of IHP bring considerable experience of investment and operation in the UK care home market, and wider alternative asset markets, of particular benefit in the sourcing of acquisitions and selection of tenants. Also, they collectively own more than 3% of Impact shares, closely aligning their interests with those of the company and its shareholders.

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. This in turn should generate a predictable and growing stream of good-quality cash flows to support dividend growth. Additionally, the homes that Impact invests in are on long, triple net fully insuring and repairing leases (weighted average unexpired lease term, or WAULT, of 19.2 years, with no break clauses), subject to upwards only inflation-linked rent reviews (capped and collared). This provides a high level of visibility to future contractual income, while risk-adjusted returns for the sector (income and capital) have historically compared favourably with most other commercial property sectors. Impact has growth DPS each year since listing in November 2017 and combining dividends paid with capital growth. Total returns have been consistently positive on both a quarterly and annual basis, averaging 7.8% pa to 31 December 2021.

In this report we review FY21 performance in detail, the Q122 report that continues with a strong performance, and provide an update on our forecasts (‘Financials’, page 10). First, we highlight several factors that have contributed to Impact’s strong performance and which we expect to support future growth. They include:

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, DPS has increased each year since 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. The FY21 DPS was 126% covered by EPRA earnings and 104% covered by adjusted ‘cash’ earnings. The Q122 DPS declared of 1.635p was in line with the targeted FY22 DPS of 6.54p (+2.0%). 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-Q122 of 47.4%, a compound annual return of 8.0%. We believe this is attractive in the low interest rate environment that has persisted since IPO, even though slightly below the company’s medium-term return target of 9% pa. Increasing inflation is positive for index-linked rental growth and assuming no change in property valuation yield, should support further capital growth. As we discuss below, the pandemic has provided strong evidence of the resilience of the sector and fee growth has historically kept pace with inflation. In this context, our forecasts imply an increase in total returns, above the 9% target in FY22 (10.6%) and FY23 (11.0%). The Q122 total return was 3.6% or an annualised rate of 14.8%.

Performance through the pandemic has provided good evidence of the resilience of the group’s tenants and of Impact’s strategy, with 100% of contracted rent received on a continuing basis, without changes to lease terms or payment schedules, and strong levels of tenant rent cover maintained. This strong performance can primarily be attributed to:

While the pandemic may not be over it has become more manageable and the key concern for the sector is now the rapid acceleration in inflation. Impact’s tenants start from a generally strong financial position, reflected in high average rent cover, while the expected further rebuilding of occupancy should provide additional support. Several additional factors mitigate the inflationary risks, to operators and to Impact’s business model. These include:

Impact’s investment manager has built a strong pipeline of near-term and longer-term acquisition opportunities. Ahead of the £40m (gross) equity issue that closed in February 2022, Impact stated that it was in negotiations in respect of a £69m near-term pipeline of assets, all with long, inflation-indexed leases, which met its investment objectives and would further diversify its asset and tenant base. A growing longer-term investment pipeline, at an early stage of negotiation, totalled almost £300m. It has since committed to c £20m of new investment, in five assets, alongside two existing tenants. Including the proceeds of the equity issue and the £38m proceeds from the second tranche of its long-term fixed rate debt private placement to be drawn in June, we estimate that Impact has more than £80m of liquidity headroom. We would not expect Impact to deploy all this; our forecasts assume an additional c £62m, taking the FY21 gross loan to value ratio (LTV) to 28.5% on a look-though pro forma basis, assuming all capital commitments are met. Discussed below, the latter include forward funding commitments and asset management projects amounting to c £27m. The former provide access to high-quality, purpose-built facilities and asset management projects, which enhance the attractiveness of existing assets to tenants and their residents and generate positive financial returns for Impact (typically a yield on capital of at least 8% with a positive impact on capital values). Impact has identified further projects amounting to £26m that it may choose to commit over the medium term.

In common with companies across the sector, Impact is giving an increasing focus to its ESG strategy. As a starting point, it has a strong and independent board and the social impact that its homes can generate is significant. Impact supports this through its investment, capex and the setting of affordable rents, which enable operators to focus on the provision of care. Work has begun on more formally defining and measuring this social value and Impact plans to produce a social impact report for 2022.

In terms of environmental sustainability, all acquisitions are screened for current and potential sustainability requirements, sustainability improvements are built into capex plans, and new leases contain environmental obligations on tenants.

During 2021 Impact completed an EPC8 audit of the portfolio and commenced work on TCFD9 risk and opportunity analysis in preparation for full reporting from 2022. It has assessed the capital cost of improvements to achieve EPC band B or better for each home by 203010 as an aggregate c £5m, a relatively low c 1% of the c £500m portfolio value.

Significant portfolio growth since listing in 2017 has generated increasing economies of scale and diversification. From its initial £149m portfolio the value of its investments had reached c £533m11 by 31 March 2022 (end-Q122), comprised of 128 assets let to 13 different tenants. Impact has since exchanged on the acquisition of three assets for c £8.1m to be leased to an existing tenant on completion. The end-Q122 annualised contracted rent roll was £39.4m12 with a WAULT of 19.2 years. Less competitive portfolio acquisitions, often off-market, have been an important contributor to portfolio growth, with acquisition yields consistently in the range of 7.5% (before costs) compared with the end-Q122 EPRA ‘topped up’ net initial yield of 6.71%, unchanged over the past year. As discussed below, Impact plans to increase its participation in forward funding the development of new, pre-let homes,13 adding much needed high-quality new capacity to the market, while portfolio acquisitions are often an attractive source of value-add asset management opportunities.

In diversifying its tenant base Impact seeks 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. Impact has typically identified operators that meet these criteria within the growing mid-market segment of the care home market. Selective growth in the number of Impact’s tenants has seen a steady decline in the share of income accounted for by the initial tenants, Minster and Croftwood, now c 41% compared with 100% at listing. We expect this trend to continue and over time we would expect Impact to target any single tenant exposure to be no more than c 30%.

The value of Impact’s investments increased by c 19% or c £78m in FY21, including acquisitions and loan investments of c £62m in 16 additional properties, reflecting a blended average gross yield of 7.2%. This included a 12-home portfolio, which has been initially invested in via a £37.5m loan to Holmes Care Group, and a second forward funding commitment for the construction of a new home in Norwich. The 12-home Homes Care investment reflects the introduction of a new loan structure into Impact’s investment process, covered in the next section. It enables tenants to take immediate control of properties rather than waiting for regulatory re-registration of the operations, a process that can take up to six months.

During Q122 Impact:

In addition to the financial and operational benefits of these investments, they demonstrate Impact’s strategy of growing alongside selected tenants. Electus now operates five of Impact’s homes, all in Northern Ireland, while Holmes Care has increased the number of Impact homes that it operates to 22 and Welford to nine.

The loans to Holmes Care (£37.5m) in late FY21 and Welford (£11.1m) in Q122 have enabled each company to acquire the businesses that owned and operated the respective portfolios. In each case the owners of those businesses were retiring. Impact has the option to acquire the property assets14 once the regulatory approvals have been received (we assume by the end of 2022 in each case), and we expect it to do so. Meanwhile, Impact receives interest payments on the loans which net of tax are equivalent to rents agreed, generating immediate income. The loans have been structured to include protections for Impact’s shareholders, including security over the homes and operational covenants. New 30-year leases have been pre-agreed, on Impact’s standard terms.

Growth has been achieved while maintaining a moderate level of gearing and has delivered a steady decline in the EPRA cost ratio. Ahead of the February 2022 £40m equity raise, end-FY21 gross LTV of 22.3% was a little below Impact’s medium-term target of 25% (maximum 35%). The FY21 EPRA cost ratio15 continued to reduce, falling to 15.8% versus 17.1% in FY20, a trend that we forecast to continue. The FY21 TER16 was 1.55% (FY20: 1.53%), increased by capital raising ahead of deployment. We expect this to decline as funds are invested into portfolio growth. Investment fees represent c two-thirds of the administrative cost base and are set on a sliding scale that will see the marginal fee rate fall to 0.7% from 1.0% on average net assets of above £500m.

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. Asset management benefits operators and their residents alike, enhances the sustainability of the portfolio and offers enhanced risk-adjusted returns, typically generating a yield on capital of at least 8% pa and, in many cases, increased capital values to reflect the asset enhancement. Projects are led by the tenants, but are identified and agreed with Impact in advance for newly acquired properties. Investment is directed at those projects that can create value for both parties, with tenants benefitting from the potential to enhance or extend facilities, broaden their appeal to residents and increase earnings, with Impact benefitting from higher rents, improved rental cover and in many cases, capital value uplifts. As the group already owns the land and the tenants have existing central services on site, the marginal cost of adding beds is lower than the cost of greenfield development and the risks are easier to assess.

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.

In the period since listing in November 2017, Impact has committed c £39m in capital expenditure, adding 349 beds (145 completed) and increasing the rent due by £3.1m, and it is keen to do more, both through asset management and development. Underlining this, the investment adviser team was joined in August 2021 by David Gould. He was previously the development director at Assura, where he was responsible for the delivery of more than 20 primary healthcare developments and led an in-house investment team.

End-FY21 asset management commitments amounted to c £9m across nine projects and of the c £17m commitment to the two development assets of c £17m, c £16m was still to be deployed. A further c £26m of capital expenditure across 11 projects has been identified, to which Impact may choose to commit over the medium term.

In FY21 Impact commenced construction of a new-build ‘link block’ and internal refurbishment at two adjacent homes at Fairview in Bristol, with a total expected cost of £3.5m. The two homes will be linked, with the older accommodation reconfigured to upgrade facilities for residents and staff, adding a net 11 beds and improving the EPC ratings of B and C on the existing buildings to A on completion.

The 94-bed home in Hartlepool being developed in partnership with Prestige at a cost of £6.1m is due to complete in H122 and during FY21 Impact committed to forward fund the construction of an 80-bed home, which will provide a range of residential, nursing and dementia care, in Norwich at a total cost of £10.5m. Impact expects to commence on site in Q322 with delivery planned for Q423.

Notable previously completed projects were at Diamond House, Leicester and Freeland House, Oxfordshire. At both, new specialist dementia care facilities were developed within the footprint of the existing homes, offering specialist care and support to existing residents of the homes who may develop dementia symptoms and providing places for 76 new residents with dementia needs.

The FY21 results showed a strong positive trend which has continued into Q122. With income growth driven by portfolio growth and index-linked rent uplifts, FY21 profitability was further enhanced by economies of scale. With rents continuing to be collected, dividend growth is underpinned by strong cash flow and dividend cover. Rental growth also had a positive impact on property valuations and NAV, generating an 8.4% EPRA NTA total return in FY21 and a quarterly return of 3.6% in Q122.

We highlight the following aspects of the FY21 performance:

The Q122 report points to continuing strong cashflow while unaudited EPRA NTA increased by a further 2.5p to 114.9p. A dividend of 1.635p was declared, in line with the annual target off 6.54p. The Q421 DPS of 1.6025p that was paid during Q222 was 1.07x covered by the 1.71p per share ‘net contribution to reserves’. The latter excludes gross revaluation gains and IFRS rent smoothing adjustments and broadly reflects Adjusted earnings.18 EPRA earnings include IFRS smoothing adjustments and is higher than the net contribution to reserves. The like-for-like movement in property revaluation was 2.9%, equivalent to 2.38p per share, driven by indexed rent growth and asset management activity.

The FY21 results showed strong growth, very much in line with our expectations published on 9 February 2022 and shown above (Exhibit 9).

Our FY22 and FY23 estimates are updated for the £40m (gross) equity raise and associated capital deployment, as well as the FY21 results. The key changes to our forecasts are:

We assume that our assumed acquisitions/investments are completed by June 2022 (end-H122) at a 7.25% yield on consideration. This makes some allowance for the continuing strong investor interest in care home properties, although this may prove to be conservative; management hopes to achieve yields consistent with the c 7.5% historical trend (Exhibit 4).

Our other income statement assumptions include:

We expect revaluation movements will continue to be driven by rental growth and asset management initiatives in combination with ‘buying well’. Our forecasts allow for asset valuations to increase in line with our rental growth assumption.

Impact has funded its strong portfolio growth using a blend of new equity and debt while keeping gearing at a moderate level. Given the strength of the acquisition pipeline we expect LTV to increase a little above the company’s c 25% medium-term target but to remain well below the 35% maximum specified by the company’s gearing policy.

Most recently, new equity of c £40m (gross) was raised in February 2022. This was part of a placing programme that was approved by shareholders and allows for the issue of up to 300m new shares (c 264.9m remaining) during the period 22 February 2022 to 26 January 2023. Also, during FY21 Impact added new debt funding of £101m while continuing to diversify its lenders, enhance and extend its maturity profile and fix the cost of a significant portion of its debt. In addition to a new £26m revolving credit facility (RCF) with NatWest, with an accordion option to increase the facility size to £50m, the company made its first transaction in the institutional debt market. The £75m of new, long-term fixed rate debt comprises two tranches at an attractive blended average rate of 2.97% and a weighted average maturity of 14 years. The first tranche (£37m) was drawn in late December 2021 and the second tranche (£38m) will be drawn in June 2022.

Including the second tranche of the private placement FY21 debt facilities were a pro forma £206m with an average maturity of 6.3 years and weighted average interest cost of 2.93% (3.54% including amortisation of loan arrangement fees). Within the total facilities, £75m is fixed rate while an additional £25m is hedged with an interest rate cap that protects against a rise in Libor above 1%.

With its full year results, Impact indicated that including the second tranche of the private placement and allowing for acquisitions at that date and all capital commitments, it had available liquidity of c £90m. Allowing for subsequent investment commitments we estimate that this is now c £83m. We would not expect Impact to deploy all this, and our forecast assume an additional c £62m, taking the FY21 gross LTV of 22.3% (Q122 was 19.4%) to pro forma 28.5% on a look-though basis, assuming all capital commitments are met.

Impact has a progressive dividend policy and has increased annual aggregate DPS each year since IPO. The current year target of 6.54p (+2.0%) represents an attractive yield of 5.2%. The shares trade at a c 11% premium to the end-Q122 NAV per share.

Exhibit 15 shows a summary of the performance and valuation of a group of 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 trailing yield and P/NAV are both above the average of a wide range. Its shares are supported by considerable visibility over a growing stream of contracted rental income, a combination of the long WAULT and upwards-only, triple net rents, mostly linked to RPI. In combination with the resilience of tenants this offers considerable protection against inflation

Demand for residential care is driven by demographic and health trends rather than being directly linked to economic conditions. Although the pandemic negatively affected industry wide care home occupancy by reducing the short-term demand for care home places and slowing the pace at which available rooms can be safely occupied, this has begun to rebuild. The longer-term structural trends suggest that the need for elderly residential care will continue to increase for a great many years.

Impact Healthcare REIT is closely overseen by a non-executive board of directors and is externally managed, under a management contract, by IHP. IHP was established in 2016 by its principals, Mahesh Patel and Andrew Cowley, who collectively bring considerable experience of investment and operation in the UK care home market and wider alternative asset markets. David Yaldron joined IHP as finance director in June 2017. Biographies of these key members of the IHP team can be seen at the back of this report. Mahesh Patel owns 10m shares in the company (c 3.1%), primarily through Maal Limited, and other members of the IHP team own c 0.4%, which closely aligns the interests of the investment manager with those of the company and its shareholders. The broader IHP team includes a further six property and finance professionals, dedicated to the management of Impact.

The independent non-executive chairman of the board is Rupert Barclay, managing partner of Cairneagle Associates LLP. He is a chartered accountant with almost 30 years’ experience as a strategy consultant specialising in strategic decision support for companies and private equity firms and has extensive non-executive board experience. The other non-executive directors of the company bring broad experience in the real estate sector, and specifically healthcare real estate, finance and capital markets, social housing, and corporate stewardship and governance. Full details of the board can be found on the company’s website.

We see the key sensitivities as relating to the following: