Target Healthcare REIT — Care home specialist

Target is a specialist investor in UK residential care properties. Since listing in March 2013 it has raised £223m which has been invested in a portfolio of 41 assets across the UK. The portfolio was valued at £253m at 31 December 2016. Target’s main focus when assessing assets is on the suitability of each property and the operator’s standard of care; the operator’s financial strength is a secondary, although important, consideration. The manager seeks to invest in areas with good demographics for the care home business, a shortage of modern, high-quality care homes and the availability of well-motivated and experienced senior staff. Assets are let on very long leases to generate predictable and rising income underpinned by demographic trends supporting demand for residential care. Target only invests in modern, high-quality assets and visits its care homes regularly to check the quality of care. The tenant list leans towards the high-end of the sector, where self-funded residents provide the majority of income and operators tend to be more profitable. Rents underpin a 72%-covered dividend of 6.18p per share (c 5.7% yield) which the board aims to have fully covered when the REIT is fully invested (occurring in FY18 on our estimates). With c £26m of cash at 31 December 2016 and a long-term LTV target of c 20%, vs 8.3% at present, Target has around £60m of funds to deploy without further equity funding.

The current c 11% premium to NAV is less than the average of 18% for other property companies with long leases. Looking at EPRA earnings yield on EPRA NAV, Target appears to be valued below peers, and the same is true on a comparison of dividend yields, possibly because the dividend is not yet fully covered. However, as Target becomes fully invested and dividend cover reaches 100%, which we expect in FY19, the P/EPRA NAV ratio could move closer to the group average. For now, it appears to be a relatively inexpensive and low risk opportunity for investors to access long term, secure streams of income.

Target’s leases are subject to upwards-only rent reviews, mostly capped-and-collared RPI-linked, but with some on fixed uplifts. The advisory fee is 0.9% of NAV and other costs are fairly stable, including effectively fixed debt, making the company’s earnings relatively predictable apart from a total return-based performance fee. The board has a progressive dividend policy and targets full cover when the company is fully invested. We therefore forecast earnings to rise faster than the dividend, with full cover achieved in FY18. We have not included any investment beyond existing cash and available debt to a level of 20% LTV, leaving potential for upside to our earnings forecast.

With such long leases on index-linked, capped-and-collared or fixed uplifts, low gearing and hedged debt, Target’s earnings should follow a broadly stable path. Tenant risk is mitigated by frequent visits to each home, the manager’s close relationship with operators, deep understanding of the sector, and operational abilities of the 15 underlying tenants (16 when the latest acquisition closes). Due to the nature of the assets, even if a tenant were to run into difficulty it is likely that each home would be attractive to a competing operator on similar terms. In the near term, yield movements could affect NAV (likely to the upside) although in the long term NAV will be affected more by rental growth than yield fluctuations. We have assumed that Target will be fully invested using existing debt up to 20% LTV and cash by the end of FY18 (30 June 2018). If the manager is able to invest more quickly, we would expect full dividend cover to be achieved sooner and should the board decide to increase funding further using debt or equity, we would also expect higher earnings.

Target is a UK-listed specialist investor in residential care homes. It aims to provide long-term, stable and sustainable income via rising dividends based on secure income streams. These come from a high-quality portfolio of 41 care homes across the UK, let to 15 operators on leases averaging 29.4 years and valued at £253.1m (31 December 2016). The majority of leases are RPI-linked and subject to upwards-only annual reviews, although some have fixed annual uplifts. Prospective tenants’ operational ability, care ethos and finances are scrutinised before acquisitions are made and discipline is exercised in acquiring only assets offering attractive yields at sustainable rental levels (7% net initial yield has been the benchmark to date). This has helped Target to build a portfolio generating passing rent of £18.2m at 31 December 2016 at a 6.7% initial yield without sacrificing lease length. The weighted average unexpired lease term has remained over 28 years at all times and in H117 it rose to over 29.

The quality of rental income depends not only on lease length and how rents are reviewed, but on the tenants’ performance. This performance stems from the commercial success of the individual homes, which in turn depends on the provision of high-quality care to a local population where demand will be sustained. To that end, Target maintains close relations with all its tenants and while it does not inspect homes in the way that the regulator can (not having access to care plans etc), it is able to check that the fixtures and fittings are being maintained, that the general standard of care is good and that the homes are well-run. When assessing a potential new acquisition the manager’s criteria include:

Target Advisers looks at several hundred homes a year and the healthcare partner, Andrew Brown, has extensive experience in the sector, having developed and run one of the largest retirement communities in Europe with his family (see below for further details). The manager estimates that it invests in less than 10% of the opportunities it is offered, and in many cases the decision not to invest is made for operational rather than financial or property-related reasons. This aspect of Target’s investment process differentiates it from other investors in the sector and is central to the long-term security of its income streams.

Target is also financially conservative. The current LTV of 8.3% is one of the lowest in the sector and management targets a level of 20% once fully invested. The company has raised £222.5m of equity in its IPO and subsequent issues and has £50m of debt facilities, of which £21m has been drawn and had cash of £26.7m at 31 December. Allowing for the increase in LTV and dividend payments, the company has c £60m of funds to invest. We explain the company’s finances in more detail in the financials section, but would list the low LTV limit among Target’s differences from peers with similarly long rental income streams.

Target Healthcare REIT is externally managed by Target Advisers, which was founded in 2010 by Kenneth MacKenzie, who remains the managing partner. Target Advisers also acts as investment manager to Kames Target Healthcare Property Unit Trust which also invested in homes specialising in needs-based care, but whose investment period is now over. The investment management agreement can be terminated by either party on 12 months’ notice provided that notice does not expire before 30 September 2019. In case of the manager’s breach of contract, negligence, wilful default, fraud or insolvency, or if there is a change of key managers which the Target’s board has not approved, the board may terminate the contract immediately.

Mr McKenzie led the acquisition of Independent Living Services in 2005, which was then Scotland’s largest provider of domiciliary care. He expanded the business and eventually sold it to a private equity buyer. He had previously been involved in the acquisition of a large UK independent living business by a US care home operator, the experience and contacts from which led him to found the Kames Target Healthcare Property Unit Trust.

Target Advisers’ investment partner, John Flannelly, has extensive experience managing real estate investments for an HBOS subsidiary and therefore as a board member of investee companies, including the parent of Caring Homes Group, a large UK elderly care company.

The healthcare partner is Andrew Brown, who grew up in the care home his parents managed in Scotland and subsequently established Auchlochan Trust, a major charitable retirement community with around 350 beds and 100 retirement properties. His experience and understanding of the operation of care homes and communities is essential to the investment process. Mr Brown’s team views over 100 homes a year and visits each of Target Healthcare REIT’s properties regularly. He is in contact with each home’s manager at least once every two months. Brief biographies of the directors of Target Healthcare REIT are on page 12.

The manager is remunerated through a management fee of 0.9% of Target’s net assets, plus a performance fee of 10% of the group’s portfolio total return outperformance of the IPD UK Annual Healthcare Property Index1. Performance fee periods are calendar years and performance fees paid are subject to clawback if cumulative performance is below the index. The maximum amount of fees payable to the investment manager is 1.25% of average net assets over the year.

Target’s portfolio was originally concentrated in Scotland and northern England, but is now diverse in terms of its tenant base and geographic spread (Exhibits 1 and 2). The charts below do not include the recently announced acquisition of two homes in Dorset let to the Care Concern Group on 35 year leases, but we have adjusted the reported figures for the addition of 70 beds. The value and the rental income of the latest additions to the portfolio have not been made public, but we have made the assumption in our modelling that they are let on similar terms to the portfolio average and do not exceed our total investment assumptions. All leases are fully repairing and insuring and have upwards-only rent reviews, either on fixed increases or RPI-linked. Two leases also have variable rental agreements whereby Target receives the fixed base rate of rent plus a figure which varies according to how well the home performs. The tenants are mostly mid-sized care home operators managing more than five homes and Target does not own all the homes managed by any one operator (although all of Ideal Carehomes’ homes are owned by either Target Healthcare REIT or Kames Target Healthcare).

The 43 care homes have 2,867 rooms (including the latest acquisitions), all with en suite lavatory facilities and the vast majority with wet rooms. Each home also has additional facilities such as a hairdressing salon, cinema, library or spa. The homes almost all less than ten years old with most built in 2010 or later. The high quality and youth of the individual assets underpin the portfolio’s longevity and therefore its ability to produce steady income streams for decades without major capital expenditure. All leases are fully repairing and insuring and operators are responsible for the majority of fixtures and fittings. Target’s visits to the homes provide an opportunity to ensure that these are in good condition and that fixtures are replaced before they wear out, preserving the fabric of the asset and assessing the quality of care being provided by the tenant. Where structural changes are required (extensions for instance), Target will invest further capital in its portfolio.

The portfolio had a rent roll of £18.2m at 31 December, a 17.6% increase on June 2016. We expect portfolio value and rent to continue to grow at a similar rate for the next year as the £60m of existing funds are invested. At 31 December Target was committed to acquire a purpose-built care home in Essex for £9.2m including costs and one in Nottinghamshire for £5.6m. Both are modern and purpose-built and are expected to complete when the properties have been fitted out to the company’s standards, due to be in March and April respectively. Aside from these, Target has a pipeline of single and multi-asset opportunities across the country.

As noted above, Target has been able to increase the weighted average unexpired lease term (WAULT) of the portfolio with additions in H117 and it remains high at over 29 years (as of December 2016). The portfolio valuation yield has fallen slightly over time but is still high, at 6.7% and the net initial yield on acquisitions is around the 7% blended initial yield modelled when Target was launched. Although there is competition for assets yielding secure long-term income, we believe Target’s network and expertise mean it is well-placed to continue to invest at similarly attractive yields, maintaining the portfolio’s ability to underpin a progressive dividend which we expect to be covered by EPRA earnings when the company is fully invested.

Healthcare property is a subsector of commercial real estate characterised by long leases, effectively no vacancy, a strong state presence in the occupier mix and growing demand for modern facilities. All of these characteristics reflect the fact that healthcare is an essential social service whose demand is driven by an ageing and increasing population.

The Office for National Statistics (ONS) expects the UK population to increase from 64.6m in 2014 to 74.3m in 2039, a rise of 15%. This will be accompanied by a shift in the national age profile as the large cohort of people born in the 1960s outlives its predecessors and outnumbers younger people: the population over the age of 60 is expected to increase by 58% from 20.1m in 2014 to 31.8m in 2039. The older part of the population tends to have greater healthcare needs and constitutes the majority of those in residential care homes.

This demographic trend is common to most developed countries and is already affecting healthcare in the UK at every level, from primary care (GPs) to hospitals and residential care. The government has responded and is planning for future demand by reforming the healthcare sector. How increased need from a larger elderly population translates into an increase in provision of residential care is unclear and will depend on personal and policy decisions: choices between domiciliary and residential care, funding structures, how elderly people with medical conditions are treated and in what setting, be it clinical or domestic.

While these factors remain imponderable, it does seem clear that additional care home places will be in demand over the next several decades, and that a recent decline in residential care beds (c 12% since 2010) has not been completely offset by an increase in nursing home beds, which bodes well for investors in property in the sector.

The decline in bed numbers despite a growing elderly population implies that more people are being cared for in their own homes by family or by professional service providers (the number of domiciliary care companies in England has grown by 47% since 2010) or that some people are not getting enough care. The decline has been due in part to many smaller operators exiting the market, facing pressures on several fronts. In the following section we will examine the current structure of the residential care market and the issues it faces.

LaingBuisson estimated in a 2015 report that 433,000 older or disabled people were in care homes, which had a capacity of 487,000 (89% occupancy, which is generally considered a healthy level by operators). In England the Care Quality Commission (CQC) currently monitors 14,520 residential homes run by 7,225 operators, whereas residential care was historically dominated by the state. According to a study by the University of Manchester, local authority homes accounted for over 90% of beds as late as the 1980s; now 90% of the available beds are in non-state homes. The fragmentation of the market is considerable, with a very long tail of single-home businesses accounting for three-quarters of operators and over a third of homes.

The 2015 LaingBuisson report estimated that 37% of residents were directly state-funded and a further 12% received local authority top-ups, while the NHS funded 10%. This market was worth £15.9bn, which largely went to for-profit providers, with significant charitable and state minorities.

The issues facing operators fall into three main areas: costs, fees and regulation. The provision of care is capital intensive, requires a large and well-motivated workforce, is closely monitored by the regulator and the wider public (with severe consequences for poor care) and has a dominant buyer in the form of local authorities. We examine these factors below.

Central government austerity measures have restricted the funding available to local authorities for care provision, who, as purchasers of almost 60% of the market, have considerable pricing power. Although there are large regional variations in costs and fees, local authorities usually pay less per capita than privately-funded residents, meaning that the latter group subsidises the care of the former. Age UK estimates that local authorities pay between £421 and £624 per week and self-funders pay from £603 to £827. Over half the residents cared for by several of the biggest operators are state-funded (Barchester being the exception, which targets the high-end private market).

The National Living Wage is set to rise from £7.20 an hour to £9.00 by 2020 and increased from the old minimum wage of £6.70 in April 2016. More highly qualified and paid staff understandably demanded similar raises and it is estimated that staff costs have increased by c 10% across the industry since the introduction of the living wage. Staff costs currently comprise c 50-55% of the cost of running a care home, and with wage increases that proportion is likely to rise by 2020, squeezing earnings unless price increases can be implemented. For that reason, investors in the sector prefer wealthier areas with more self-funding residents.

The establishment of the CQC has also had an effect on the market. The CQC inspects homes regularly and marks each one in five areas of performance: how safe, effective, caring, responsive and well-led they are. An overall rating of “inadequate” or “requires improvement” discourages people from joining, and homes can be barred from accepting new residents until issues have been dealt with. The new rigour the CQC has brought to regulating the care market is welcomed by operators, but inspections can be time-consuming for home managers and poorly-run homes may suffer losses of business if they score badly. Larger operators have proportionally fewer homes that score badly in CQC inspections. Of the 312 homes that the CQC has rated “inadequate”, 46% were single-home operations, although those operators accounted for only 38% of all care homes. Two-home operators were also relatively overrepresented in the “inadequate” category.

While the smaller operators who account for c 80% of beds have been most affected by rising costs, price pressure and increased regulatory zeal, the larger operators have not been immune. Southern Cross, once the largest operator by far, failed in 2011 as a result of its debt and rent burden after the financial crisis. Some existing major operators are troubled; Four Seasons Group is reported to be struggling to keep up debt payments, and Bupa Care Homes is for sale. However Barchester, Care UK and HC-One, the third to fifth largest operators, appear to be performing better. Of these, Barchester targets the high-end market while the others have around 70% local authority-funded residents (above average) and therefore more exposure to government austerity.

Although pressures on operators are important, residential care homes present a potential source of sustainable, predictable long-term rental income from financially stable tenants. For this reason there has been considerable interest in the sector. Assets in wealthier and more densely populated parts of the country, especially the south-east, have been popular with institutional and overseas investors because they have high numbers of privately funded residents. The attraction of these assets has been emphasised by low bond yields in recent years, and as a result, yields on high-quality modern care homes with privately funded residents in south-east England have come under pressure. For a specialist investor with close relationships with operators, there are opportunities in the rest of the country as well. Target is currently the one of only two UK-listed specialist investors in the sub-sector but other landlords include operators themselves, pension funds, foreign investors including sovereign wealth funds and, notably, private equity companies. The latter have been criticised in the past for buying operators that owned their own homes, selling and leasing back the properties and over-gearing balance sheets. Private equity remains a presence in the market as an owner of operators (Four Seasons is owned by Terra Firma) and as a landlord.

As noted earlier, Target’s finances are relatively simple. The only slightly unusual part of its reporting is the rent-smoothing effect that arises from an IFRS requirement: where rent increases over the life of a lease are known, the company is required to report the average rental income over the life of the lease as revenue each year. In the first half of the lease this means that a figure higher than the actual rent received is reported. An adjustment for this is made when calculating EPRA earnings. The additional reported rent is accrued as a liability and netted off the valuation gains on the investment portfolio. In the second half of the life of each lease, actual rental income is higher than reported income and the accrued liability unwinds. This treatment means that the portfolio value is neither inflated nor deflated, and EPRA earnings represent an accurate picture of the company’s rental profits.

Target reports rental income (as described above), the gain from rent review adjustments and gains on portfolio value as income, and provides EPRA earnings figures too. We assume that the revaluation gains of 2% of the opening portfolio value are made each year, roughly in line with inflation and implicitly allowing for rent increases in line with inflation to increase the portfolio value proportionately without any valuation yield changes. Without exact details of all the leases, we cannot forecast the rent smoothing effect exactly, and assume that movements in the year due to fixed increases are the same each year (which we believe to be conservative, because they should diminish each year unless new fixed-increase rents are added). We net this figure (£2.7m in H117, and the same each half year in our forecasts) off the revaluation gains. We assume that rents represent a constant yield on portfolio value, which has been 7.16% over the last two halves. Rents therefore increase in line with portfolio growth as new assets are added and as revaluation gains are made. We assume costs continue at c 7% of rental income, plus a management fee of 0.9% of average forecast net assets each year. We have also allowed £0.8m per annum for a performance fee. The company’s interest rates on current borrowings of £21m are fixed to September 2021 with two swaps: one paying 0.85% and receiving three-month Libor until June 2019 and the second paying 0.70% and receiving the same. Non-utilisation fees are 1% per annum and we have assumed that any further drawings are 75% hedged on the same terms as existing debt.

On these assumptions, we forecast EPRA earnings per share rising significantly, from 4.6p in FY16 to 4.8p in the current year and 6.3p and 6.6p in FY18 and FY19 respectively as Target becomes fully invested and LTV increases towards 20%. This will cause dividend cover to rise to 100% in FY18 and 104% in FY19.

Target was in a net cash position on 31 December and borrowings have already been described. The £50m loan incurs interest at 1.5% over three-month Libor (currently fixed with swaps). We have assumed that in the next three halves Target can secure additional debt and draws £39m, buying £60m of assets, including the £14.8m already committed to. This will take the company to 20% gross LTV by the end of H118 on our estimates. The aforementioned rent smoothing adjustments will affect revaluation gains, meaning that on our assumptions, which include no yield compression and, we believe, conservative ERV increases, these will be relatively small. With the dividend not being fully covered by earnings, we therefore forecast slower increases in EPRA NAV per share during the forecast period from 100.6p in June 2016 to 100.7p in June 2017 with acceleration thereafter once the dividend is covered to 102.3p in June 2018 and 105.2p in June 2019.

We have compared Target to other UK-listed investors in healthcare property and Tritax Big Box REIT, which shares the long lease profile and high occupancy rate of those companies. All the comparators have mainly index-linked rent reviews with some fixed uplifts. We have not included LXi REIT yet, because it only listed on 27 February 2017, but will do in future.

The table below shows statistics relating to each company’s ability to generate income in the long term (rental yields, costs of debt and lease length) and how it currently distributes that income (dividend yield on NAV and dividend cover). Despite having the longest WAULT, biggest spread between the cost of debt and portfolio yield and comparing well on other metrics, Target is at the bottom of the group in terms of its premium to NAV. This may be a result of the level of dividend cover, but we would argue that a rating closer in line with the peers would be justified.

The table also shows the correlation between P/EPRA NAV and each factor. The closest positive relationship is with EPRA EPS yield on NAV, which is equivalent to the companies’ free cash flow yield and indicates their ability to pay a dividend covered by EPRA earnings. Among property companies investing in more mainstream office, industrial and retail properties, the strongest correlation is with the spread between portfolio yields and the cost of debt. Most UK REITs currently trade at a discount to EPRA NAV. This implies that the market is confident in the ability of long-lease specialists to generate earnings, values their lease lengths (hence the premiums to NAV) and compares them with each other on an earnings basis.

This is illustrated in Exhibit 14, which shows EPRA earnings yield on EPRA NAV against the share price premium to EPRA NAV per share for the peer group. The companies generating a higher earnings yield trade at higher premiums. We would argue that Target’s security of income would justify a rating closer in line with the peer group.

Target’s ability to pay its growing dividend depends on the security of its long-term leases. The possibility of a tenant failing to pay is mitigated by the rigour of the investment process and Target’s ongoing oversight of all its homes and operators, and the diversity of the tenant base reduces risk. Were any operator or home to fail, the focus on investing in homes situated in areas with supporting demography should make the home attractive to another operator. Dividend cover should rise as more funds are deployed and we forecast full cover in FY18. If the company can invest faster, this is likely to be achieved sooner.

Target’s funding position is conservative and we expect the company will not have difficulty securing further debt. We have not forecast any equity capital increases, but in order to keep LTV under 20% and continue to grow the portfolio, these will be necessary in future. At the current share price a capital increase would be NAV accretive, but this would depend on the market at the time, with a rising interest rate environment potentially crimping the premium to NAV.

In the long term, the UK’s ageing population will need more care. This is likely to necessitate more residential care beds, which have been declining in number in recent years as smaller operators exit the market and older facilities cease to meet the required standards. This should to lead to increased demand for modern, purpose-built homes of the sort Target invests in. While competition for these may increase, there are likely to be more opportunities for an experienced and well-regarded landlord and investor such as Target, and we expect the sensitivity to be to the upside as the market grows. If interest rates were to rise, there might be less institutional competition for assets as non-specialists looked to other asset classes for secure long-term income.