Primary Health Properties — Continuing strong DPS growth well supported

FY21 was characterised by selective new investment in a competitive market, organic growth from rent reviews and asset management, development completions, and the generation of significant operational and financial savings from internalising the management structure and refinancing high-cost legacy debt. PHP’s FY21 EPRA cost ratio of 9.3% is the lowest in the UK REIT sector and, with a competitive funding position (2.9% average cost of debt, all fixed or hedged, with a marginal funding cost of 1.8%), this maintains a positive spread versus property yields (FY21 portfolio net initial yield of 4.64%) and allows most of the growth in rental income to fall to the bottom line. We forecast a continuation of growth based on the following:

Firmly embedded in its investment policy are PHP’s environmental targets and it has now published its Net Zero Carbon (NZC) Framework, which sets out the five key steps it is taking towards achieving NZC by 2030 for all its operational, development and asset management activities and to help occupiers achieve NZC by 2040.

On 5 January 2021, PHP completed the internalisation of the group’s management structure, with strong shareholder approval (99.95% of votes cast at the extraordinary general meeting in favour), resulting in annualised savings of approximately £4.0m (0.3p per share) compared with the position if the business were still externally managed. The savings represent 25% of the FY20 EPRA cost base and the FY21 EPRA cost ratio fell further to 9.3% (FY20: 11.9%), the lowest in the UK REIT sector by some margin.

Internalisation secured the services of a well-regarded and experienced management team, along with a fully operational platform, including systems, know-how and proprietary knowledge, and allows shareholders to benefit fully from the expected future growth of the portfolio. The acquisition also included the Nexus primary care development business, which has already begun to allow PHP to undertake direct development in addition to its traditional forward funding activity, on a fixed-cost, pre-let basis to add high-quality assets that support its ESG commitments. By utilising its own substantial balance sheet, direct development activity will allow PHP to capture attractive development margins not available on forward funding schemes.

In October 2021, PHP arranged a new £200m 15-year debt facility with Aviva Investors at a fixed rate of 2.52%, using the proceeds to repay legacy facilities, also with Aviva, amounting to £177m, with a blended fixed rate of 5.0% and remaining term of a little under six years. At the same time, PHP renewed its £100m revolving credit facility with NatWest for a further three-year term, with extension options. Both facilities incorporate sustainability KPIs which, if met, will reduce loan margins. Before these potential additional savings, the new arrangements reduce PHP’s current average cost of debt from 3.4% to 2.9% (with a marginal cost of debt of 1.8%). The annualised interest expense saving is c £5.0m with a positive impact on weighted average debt maturity. One-off early termination costs were £24.6m. PHP still has £386m of legacy loans, acquired with the merger of MedicX in 2019, at a blended fixed rate of 4.2% and a weighted average maturity of 9.7 years. Excluding these facilities, the average cost of debt is 2.3% and the company continues to look at further opportunities to reduce the average cost of debt and deliver further finance cost-saving synergies. We have not allowed for this in our forecasts

PHP’s pipeline of external investment opportunities has increased to £377m (H121: £216m), comprising standing assets, direct and forward-funded development opportunities, across the UK and Ireland, of which £152m is in legal due diligence (£72m in the UK and £80m in Ireland). Additionally, it has a strong pipeline of more than 100 identified asset management projects with an aggregate value of £67m (FY20: £46m), providing opportunities to improve the quality of assets, organically increase rental income, extend (re-gear) leases and enhance capital values.

The external investment pipeline includes 11 standing assets with an expected acquisition value of £105m (£87m in the UK and £18m in Ireland. However, most of the external opportunity comprises direct and forwarded-funded developments. PHP and its recently acquired direct development team have many years of experience in successfully delivering development projects and we see little incremental risk. All developments are pre-let and prices are fixed with contractors. Contractors are liable for penalties in the case of delays of more than six months for reasons that are within their control.

The direct development programme, all in the UK, now consists of 21 assets with an expected gross development value (GDV) of £163m, an increase from £80m in January 2021 when Nexus Developments was acquired. Two projects that will commence imminently, in Lincoln and West Sussex, have an expected combined GDV of £10.8m, reflecting a blended valuation yield of c 4.6% and an attractive c 11% development profit for PHP on the cost of development reported as a capital gain. A further five projects with a GDV of £42m are at a significantly advanced stage, which will be progressed during this year together with a wider medium-term pipeline at various stages of progress across 14 projects with a GDV of £110m.

During FY21, four existing forward-funded development projects, all in the UK, completed on time and on budget with a net development cost of £20.1m. Two forward-funded developments remain on site, both in Ireland, and both are expected to reach practical completion in Q122 with a combined net development cost of £25.7m (c £9.0m of which remained to be invested at end-FY21). The advanced pipeline of future potential projects includes nine projects in Ireland (GDV of £89m) and three in the UK (GDV of £20m).

Asset management projects such as property extensions and refurbishments provide an opportunity to enhance the quality of the portfolio, including its environmental credentials, avoid obsolescence and support the tenants in improving their healthcare delivery. These generate additional rents for PHP but, just as importantly, support lease extensions that extend the weighted average unexpired lease term (WAULT) and visibility of income, enhancing capital values. During FY21, 30 asset management projects were completed and a further nine are on site. These will increase rental income by a further £0.4m pa for an aggregate investment of c £15.0m. More than 100 additional projects have been identified (of which 24 are board approved) with an estimated investment requirement of c £67m over the next three years. PHP expects these projects to add an additional c £1.3m to rental income and extend the average WAULT on those assets back to an average c 20 years.

Rent reviews in the UK are typically on a three-year revolving basis and effectively upward only, at the option of the landlord. Irish rents (c 8% of the total) are linked to CPI and, in theory, may decrease as well as increase, although this seems a remote prospect.1 Rental growth continued in FY21, adding £2.0m pa to contracted rent roll (FY20: £1.7m) or 4.0% (FY20: 4.3%). This equates to an average 1.7% pa uplift on completed rent reviews, slightly lower than in FY20 (1.8%), but we see good prospects for this to accelerate. Of total rents, 25% are indexed to RPI and recently increased inflation will progressively feed into rent reviews. Another 6% of rents provide fixed uplifts at c 2.7% pa. However, the key opportunity lies in open market rent reviews, 69% of the total, which have shown relatively muted growth in recent years, in contrast to land and building cost inflation, an important input into the rent review process for existing assets. As the NHS long-term healthcare planning takes shape, development activity has begun to increase creating rent benchmarks that provide evidence for upward rent reviews for existing assets. Rents on newly developed assets must be set at levels that justify the investment that is needed to support modernisation of the primary healthcare estate and PHP anticipates that this will increasingly be reflected in market rent levels across the estate. In many cases, it has held off from settling open market reviews, awaiting the market evidence that will provide support. There are 635 open reviews that remain outstanding and under negotiation, with the large number reflecting the requirement for all reviews to be agreed with the district valuer.2 These represent £84.9m of passing rent, £2.1m lower than the estimated rental value (ERV), a significant upside potential.

During FY21, 375 UK rent reviews were concluded and documented, with a combined value of £49.5m. Average uplifts of 2.8% and 2.7% were achieved on index-linked (25% of the total) and fixed uplift (6% of the total) reviews. For open market reviews (69% of the total), an average of 1.5% pa (FY20: 1.3% pa) was achieved on 159 positive reviews. Including 74 reviews concluded with no uplift, the average increase was 1.1% pa. In addition, a further 236 open market rent reviews were agreed in principle, which will add £1.7m to the contracted rent roll when concluded, representing an uplift of 1.6% pa.

At 31 December 2021 (end-FY21), the portfolio consisted of 521 assets, externally valued at £2.80bn, and with a contracted rent roll of £140.7m, reflecting a net initial yield of 4.64% (FY20: 4.81%). During the year, nine assets were acquired for an aggregate £86.6m (mostly in H2) and one asset was sold for £2.3m (generating a net gain of £0.3m). The £5.5m (or 4.1%) increase in contracted rent roll during the period included acquisitions of £4.1m, like-for-like rental growth of £2.0m, and asset management projects £0.5m, partly offset by FX translation in respect of the Irish assets.

With 90% of contracted rental income paid directly or indirectly by the UK and Irish governments, and the balance primarily by co-located pharmacies, covenant strength is exceptionally strong and, given the nature of the assets, vacancy is minimal.

Only 6% of the annualised rent roll expires in the next three years and 13% in the next five years. Terms have been agreed to renew leases or for asset management projects in respect of almost 70% of this rent.

The continued increase in average lot size reflects investment in larger, purpose-built, multi-disciplinary medical centre hubs as well as capital value growth. In this respect, increasing lot size may be viewed as a proxy for enhanced portfolio quality.

There are now 20 properties in Ireland with an aggregate valuation of £213m (FY20: £198m), making PHP the largest primary healthcare investor in the country. Including the c £9.0m cost to complete the two forward funding assets, the fully developed valuation of £222.1m represents just under 8% of the portfolio total. The end-FY21 Irish rent roll was €14.6m, 75% let directly to the Health Service Executive (the Irish equivalent of the NHS) or government agencies, with a long WAULT of 21 years. Reflecting a focus on primary healthcare hubs, the average lot size of the Irish assets is around double the £5.4m portfolio average. Yields remain higher in Ireland, although the premium has narrowed, with the valuation of PHP’s Irish assets reflecting a net initial yield of 5.1%. As is reflected in the investment pipeline statistics, PHP plans further growth in its Irish assets to a portfolio value of c €500m, around 15% of the current portfolio value.

Exhibit 6 provides a summary of the FY21 financial performance, starting with adjusted EPRA earnings with a reconciliation to EPRA earnings and the IFRS result.

We note the following key points from the results:

FY21 results were in line with our forecasts and our FY22 expectations are little changed overall. Our FY22 net rental income is increased slightly (in line with end-FY21 rent roll), but is offset by slightly higher costs, while NAV per share increases in line with FY21.

We have introduced FY23 and FY24 forecasts, which anticipate further growth in earnings and DPS driven by portfolio growth and like-for-like rent growth. The latter drives NAV growth, assuming no change in property valuation yields. Our forecasts are explained below and shown in detail in Exhibit 13 at the back of this report.

The key underlying assumptions driving our FY22–24 forecasts include:

With a progressive dividend policy that sees recurring earnings effectively fully distributed, portfolio growth is funded by a balance of new equity and debt, locking in a positive spread between investment yields and funding costs. and generating operational and financial economies of scale.

PHP last issued equity for cash in July 2020, raising £140m (£136.9m net of issue expenses) to provide funding for the continuing strong pipeline of investment opportunities, while maintaining LTV within its target gearing range of between 40% and 50%. During FY21, c 11.5m shares were issued for part consideration of the Nexus acquisition (management internalisation), c 0.6m shares for the part consideration of one property acquisition3 and 5.2m shares in lieu of cash dividends.

The target LTV range is higher than is typical across the mainstream commercial property sector, recognising the visibility and security of cash flows, reflected in an FY21 interest cover ratio of 3.2x (FY20: 2.9x). The end-FY21 LTV of 42.9% is at the lower end of the target range, providing ample room to deploy available debt capital resources to fund the investment pipeline, with a low marginal cost of debt of 1.8%. Assuming conversion of outstanding convertible bonds, the LTV would fall to 37.5%.4 Undrawn debt headroom after all capital commitments5 was £321m on a pro forma basis at end-FY21, allowing for subsequently arranged debt facilities.

Since the end of FY21, PHP has issued a new €75m secured private placement loan note to MetLife for a 12-year term at a fixed rate of 1.64%, with an option to increase to €150m over the next three years at the lenders discretion. The proceeds will be used to finance the continuing investment in Ireland. Also post year-end, an existing revolving credit facility with Santander (£50m) has been renewed for an initial three years with options to extend by a further year at both the first and second anniversaries. Including the post-year end financing, PHP’s debt portfolio stands at £1.55bn, 90% secured and 10% unsecured (the outstanding convertible bonds), broadly diversified across a range of lenders with a weighted average term to maturity of 7.3 years (8.2 years for just the drawn debt facilities). The average cost of the debt facilities of 2.7% (FY20: 3.1%) is below the average cost of drawn debt of 2.9% (FY20: 3.5%) due to low cost (1.8% undrawn marginal funding).

Interest rate risk is well managed, with 100% either fixed rate or hedged for an average maturity of 7.3 years. Unfettered assets of £88.4m at end-FY20 provide significant flexibility in the utilisation of the debt facilities.

Historical returns on primary healthcare assets have been higher than other sectors of the UK commercial property market, with a lower level of volatility. This has been a function of strong healthcare fundamentals, secure and more resilient income and less pronounced yield shifts through the property cycle.

PHP is in its 26th year of unbroken dividend growth, having already declared a Q122 DPS of 1.625p, 4.8% ahead of the FY21 quarterly rate. The annualised rate of 6.5p represents a prospective 4.8% dividend yield and we expect further growth in fully covered DPS (Exhibit 9).

DPS paid represents 52% of the cumulative NAV total return generated over the past five years, with capital returns contributing the balance, including the impact of asset management, rental growth and yield tightening. In the five years to end-FY21, the aggregate NAV total return was 59.3% or a compound annual average return of 9.8%. With valuation yields for primary healthcare having tightened over a number of years, we would expect income returns to represent a greater share of total returns in the coming years.

The valuation of the PHP shares is very much driven by the security and predictability of its income. In turn, this provides support for a continuing valuation premium to EPRA NAV. However, as DPS has grown strongly, the yield has increased and the P/NAV ratio has compressed from a peak of c 1.5x in 2020 to c 1.1x currently, below the five-year average (c 1.27x) and the 10-year average (c 1.21x). Given that we expect DPS to grow slightly more than 4% on average over FY22–24, the current valuation appears attractive.

In Exhibit 12, we show the key valuation and performance metrics for PHP and a group of its closest peers, including Assura, another investor in primary healthcare assets, care home investors (Impact and Target) and social housing investors (Civitas, Secure Residential Income and Triple Point).

Over three years, PHP’s price performance is well ahead of the peer group average (in fact it is the strongest performer in the group), the broader UK property sector and the UK equity market. However, during the past 12 months, the share price performance for the whole peer group has been below that of the broad UK property sector and UK share index. During this period, share price performance has been led by the recovery of those companies that suffered most during the pandemic, as well as those focused on the industrial sector6 and, as inflation has increased, many of those companies with predominantly long, index-linked leases. Some of the latter appear in the Exhibit 12 peer group but there are many in other subsectors that do not.7

PHP shares trade at a lower yield than the peer group average, which in our view reflects the strength of the tenant covenant and the strength of free cash flow, supported by a low cost ratio.

PHP’s social benefit is clear. Private capital has a key role in the modernisation of primary health infrastructure and service provision in both the UK and Ireland, resulting in better patient experiences with a positive impact on health and wellbeing. The company has a strong commitment to acting responsibly with integrity and transparency and is overseen by an experience board of directors. Recent focus has been focused on enhancing performance. The goal of NZC by 2030 for all PHP’s operational, development and asset management activities is embedded in its investment process. All developments completed during the year achieved BREEAM8 ratings of Excellent or Very Good, while all asset management projects completed met EPC9 ratings of B or better. PHP’s first two direct investment schemes (discussed below) are both designed to be NZC. PHP indicates that the additional development and capex costs related to environmental enhancement will not have a material impact on returns and financial performance.

The goal of helping occupiers achieve NZC by 2040 is ahead of that set by the NHS for becoming the world’s first NZC national health system by 2045 and 10 years ahead of the 2050 target set by the UK and Irish governments.

The board of directors currently has seven members (normally six),10 consisting of five (normally four) independent non-executive directors and two executive directors. The two executive directors are Harry Hyman, chief executive of PHP (having served on the board prior to managements internalisation as managing director of Nexus), and Richard Howell, chief financial officer (who previously served in the role of finance director of Nexus). Mr Hyman was the founder of PHP in 1996 and with the management internalisation he confirmed his continuing commitment to the group for at least five years from the MedicX merger in March 2019. The independent non-executive directors are Steven Owen (chair), Laure Duhot, Ivonne Cantu, Ian Krieger and, until April 2022, Peter Cole. Biographies of the key members of the leadership team can be found at the back of this report, with further details available on the company website.

In our view, PHP has low operational risk in the context of the UK property sector. This reflects its position as a long-term investor in a specialist sector of the commercial property market characterised by long leases, predominantly government backed, with minimal vacancy and (in the UK) upward-only lease adjustments supported by long-term fixed or hedged debt. Occupational demand in the primary healthcare sector is driven by demographics (ageing, growing and sicker populations) and the need to upgrade the existing primary care estate rather than general economic conditions. There are nevertheless a range of factors that could affect the business, especially over the longer term, including structural changes in the markets in which the group operates, changes to government health and fiscal policies, funding conditions and operational performance. In terms of our forecasts we note: