Target Healthcare REIT — Driven by demographics

Target Healthcare REIT invests in modern, purpose-built residential care homes across the UK and is externally managed by Target Fund Managers, a sector specialist investment manager with an experienced team. Target aims to provide investors with attractive quarterly dividend income through a portfolio that is diversified by tenant, geography and the payment profile of the end-user care home residents. Target’s approach to care home investment is characterised by a focus on the quality of the physical asset and location, alongside a comprehensive assessment of tenant capabilities, both before and after investment. From IPO in March 2013 to the end of March 2020 (Q320), the company delivered an EPRA NAV total return (EPRA NAV growth plus dividends paid but not reinvested) of 54.0%, or an average annualised rate of 6.2%. Dividends have accounted for c 80% of this total return. During FY20 to date Target has declared three quarterly dividends of 1.67p (an aggregate 5.01p), an increase of 1.5% on the prior year. Medium-term gearing is targeted at c 25%.

Care home investment is characterised by long lease lengths (30–35 years) at inception, with annual rent uplifts (RPI-linked or fixed) providing a high degree of visibility to long-term contracted rental income. The demand for care home places is being driven by the ongoing demographic shift to an ageing population with more complex care needs rather than the economic cycle. However, despite a growing population of elderly the number of care homes is lower today than it was in the late 1990s and much of the existing stock (older, inadequate or poorly converted premises) falls below best standards. There is an undersupply of modern, well-designed and equipped homes with generous communal spaces, and Target’s focus on only such assets differentiates it in the quoted sector. 85% of the homes within the Target portfolio have been built since 2008 and all of the rooms are single occupancy. Substantially all (96%) have full en-suite wet room facilities (with plans in place to upgrade those that did not).

At 31 March 2020 (Q320) the external valuation of Target’s portfolio was £613.4m, comprising 73 homes (71 operational and two pre-let sites in development under forward funding agreements), let to 27 different tenants. The EPRA topped-up net initial yield (NIY) was 6.05%, based on annualised contractual rent on expiry of relatively short-duration lease incentives of £38.9m and the EPRA net initial yield was 5.69% based on current passing rent of £36.6m. The weighted average unexpired lease term (WAULT) was 29.2 years, with leases mostly linked to RPI and a small number with fixed rent uplifts.

We do not expect the COVID-19 pandemic to have a material impact on the fundamental investment case although it brings near-term challenges to tenant care home operators. Over the medium term, by highlighting the critical role that sector plays, including its support for the NHS, the pandemic may even help to crystallise long-debated reform of the care funding model and thereby help to unlock much needed investment. For that reason, in this report we focus on Target’s strategy and the longer-term investment case but begin with an update on the near-term impacts of the COVID-19 pandemic.

The current pandemic presents a significant near-term challenge to the care home sector and potentially for some of Target’s tenants, as they strive to maintain the best quality of care and protect the safety and wellbeing of their residents and staff. Staffing is a key challenge for care operators in normal times and maintaining adequate staff levels during the COVID-19 outbreak is a key concern. Staff members that show signs of infection are required to remain at home in self-isolation for two weeks while residents who are put into isolation, either through infection or upon newly entering a home, will require additional staff resources. More positively there have been indications of increasing job applications across the sector as a result of displacement from other sectors but whilst this will ease recruitment pressures it will not eliminate near-term staffing and staff-cost pressures. In addition to staff pressures there has been widespread reporting of the shortage and high cost of personal protective equipment (PPE) facing many operators. While the NHS is striving to utilise all available care home capacity for suitable elderly patients who would otherwise be forced to remain in hospital beds the operators must balance their efforts to assist with their duty to provide effective care to existing residents. Where infection and/or death does occur there is likely to be a temporary downward pressure on available beds.

Target’s regular close engagement with, and support for, its 27 operator tenants has been stepped up during the pandemic. All the operators routinely have business continuity procedures and infection control protocols in place, and these were implemented well ahead of the COVID-19 guidelines for the general public using existing PPE stocks. Confirmed or suspected cases of COVID-19 are currently affecting residents occupying less than 5% of the beds in Target’s portfolio, although the company expects this to increase as the pandemic progresses. Staff absences amongst Target’s operators have increased but are currently manageable.

Target received its March quarter rental payments in line with its typical collection pattern, although recognising the uncertainties being faced it has agreed for a limited number of tenants to stage their rental payments (in advance) through the upcoming quarter. The company says that it expects demand for the beds provided by tenant operators to remain strong, supporting cash flows despite short-term increases in staff and other costs.

More fundamentally, Target highlights that modern, purpose-built homes with larger than average bedroom size and full en-suite wet-room facilities will assist operators in the effective control of infections and implementation of isolation procedures.

As discussed in detail on page 13, at 31 March 2020 (end-Q320) the group had drawn £142m out of total borrowing facilities of £180m, comprising £80m of fixed-term debt (fully drawn) and £100m of variable rate revolving credit facilities (£62m drawn). In addition to the £38m of borrowing headroom the group has c £30m of current cash balances. Net loan to value at end-Q320 was 18.1%. Investment commitments, primarily relating to the two forward-funded (pre-let) development assets, was £12m.

Clearly this is a fast-moving situation and the full impacts remain difficult to assess. As a starting point, Target says that aggregate rent cover in respect of the mature homes in its portfolio (that is, homes that have had the same operator for a three-year period or longer and by definition excludes newly developed homes) was 1.6x at the end of December 2019. Our dividend forecasts are driven by our expectations for adjusted earnings which in turn assume that contracted rents are received in full. Our analysis on page 14 suggests that Target would be able to maintain a good level of quarterly distributions, albeit at a lower level, even with fairly significant deferral of rental income. We do not expect Target’s recent agreements with a limited number of tenants for staged payments in advance over the coming quarters to have any material impact on cash flow and dividend paying capacity. However, should any of Target’s tenant operators be more seriously affected by the pandemic, there is a risk of a more significant cash flow impact with implications for near-term dividend payments. In the extreme case of tenant failure there would potentially be an impact on reported earnings as well as cash flow as a result of bad debts and potential delays in re-tenanting with associated costs.

It is too early to anticipate what impact the pandemic may have on property valuations across the broad property sector and for the care home sub-sector. There was no apparent impact in property valuations in Q320 with a 0.6% like-for-like increase in the portfolio value driven by RPI-linked rental growth. In part reflecting changes in the asset mix, the portfolio net initial yield was marginally lower at 6.05% compared with 6.07% at end-Q220. However, the external valuation was subject to the material uncertainty clause that has become an industry standard, with a dearth of transactions to provide evidence of market values.

While the COVID-19 pandemic may have a short-term impact, demographic trends suggest that the need for elderly residential care will continue to increase for a great many years. Existing estimates by the Office of National Statistics (ONS) indicate that the number of people in the UK aged 85 or older will double by 2041, from c 1.6 million to c 3.2 million, and the COVID-19 pandemic is unlikely to change this basic direction of travel. Currently, around 15% of those aged over 85 require specialist care that can only be adequately provided in a hospital or care home. Meanwhile, the number of residential and nursing home beds in the UK has in recent years failed to keep pace with this growing need and has declined from a peak of 563,000 in 1996 to 466,000 in 2018, as obsolete homes have withdrawn from the market, often driven by the requirement for higher care standards. Much of the new care home development is focused on geographical areas with supportive demographics and which can support a high share of self-funded residents such as the South-East and South-West.

As local authorities have substantially withdrawn from the operation of residential care homes it will largely fall to the private sector, both for profit and not-for-profit, to meet this growing need. However, while the private sector is the dominant provider of care, accounting for c 90% of all beds, local authorities remain a significant provider of funding for care home residents, accounting for c 50% of the total, either in full or with some top-up from residents and their families. Given the pressures on local authority funding and increasing demand, there is a widespread recognition of the need to find a long-term funding solution for social care in the UK if the challenges and opportunities presented by an ageing population are to be met. Longer-term funding for adult social care continues to be debated publicly, along with closer co-operation between health and social care. A government Green Paper exploring the options was originally due in 2017 but has been delayed several times and there is no indication that it will be produced in short order. The prime minister had promised a new set of social care proposals this year and while this too may be delayed, the current pandemic can only highlight further the critical role that the care industry plays in providing for the care to vulnerable elderly people and relieving pressures on the hospital system.

Across the industry, this combination of growing demand, shrinking supply and the shift from local authority to private sector provision continues to generate sustained, above-inflation growth in revenues and average weekly fees for the operators. LaingBuisson estimate that over the past 20 years average weekly fees to private sector operators have increased at an average c 3.7% pa (compared with average increases in RPI of 2.8%) with £16.5bn being spent on care of the elderly in care homes in 2019. Factors contributing to this rise in fees include rising staff and property costs, increasingly complex medical and care needs (including rising levels of dementia), higher standards of care required by the regulator, and growth in the private pay market driven by customer choice and the shrinking pool of those eligible for public funding.

However, despite real-term fee growth over the past five to six years, industry profitability margins have trended lower and performance is mixed across the sector. Given the pressures on local authority funding and their significant pricing power, in general there is a clear differential between the fees that they pay compared with the fees paid by self-funded residents. In many cases, the local authority fees paid are insufficient and are effectively cross-subsidised by higher-paying self-funding residents. Whilst a balance of resident funding is desirable, operators that rely heavily on local authority-funded residents may struggle more to cope with industry-wide pressures from staff costs, staff shortages and regulatory pressures to improve standards of care. This is more so if the homes that they operate are older, often converted and poorly configured. Conversely, homes at the very high end of the market and fully reliant on privately funded residents may in certain economic circumstances struggle to maintain the above average fee growth of recent years. For all operators, post Brexit immigration proposals introduced by the government in January 2020 appear to have the potential to increase staff shortages, while the April 2020 6.2% increase in the National Living Wage, the largest ever annual increase, will add to staff costs, typically around 60% of care home operating costs.

The problems facing the wider industry inevitably receive much media attention and what is often overlooked is the ability of well-managed operators, with efficiently run homes, in locations with a good demand-supply balance to meet this need effectively and sustainably.

In recent years there has been increasing competition for assets, with a range of investors attracted to the typically long lease lengths and upwards-only rent reviews. This is especially true for modern, purpose-built assets that benefit from a supportive supply-demand imbalance and it remained so up until the spread of COVID-19. In common with the wider property sector, the pandemic has to a large extent brought a near-term freeze in transaction volumes and it remains too early to assess the longer-term impact on the care home investment market

Across the market, yields vary according to a range of factors including asset quality. The valuations of modern, high-quality assets typically reflect lower yields, recognising the expectation that these assets are best placed to generate sustainable, long-term income with a lesser requirement for capital expenditure and a lesser risk of obsolescence.

At the very highest end of the market (‘super-prime’), yields in the range of 4% have been typical, representing a capital value of c £350k per bed. At the low end of the market yields have been closer to 9% with capital values of perhaps £40k per bed. Target operates in the mid-upper range of the market. We estimate an average capital value per bed at end-H120 of c £120k.

Target’s approach to investment in the sector reflects a desire to provide stable and sustainable, long-duration rental income with which to support the dividend policy. To this end, it puts a very strong focus on the quality of the physical asset and its location, alongside an in-depth assessment of the operational capabilities and financial performance of the tenant, both before and after investment. Target believes that modern, purpose-built homes with flexible layouts and high-quality residential facilities, including single-occupancy bedrooms complete with en-suite wet rooms, are more likely to provide sustainable, long-duration rental income. Not only do such homes provide an attractive environment for residents, they also support tenants in the provision of better and more effective care. Target only invests in these ‘future-proof’ homes and avoids homes that may require material asset management, especially older adapted properties, and homes with small bedrooms and poor en-suite facilities, lack of public and private space and narrow corridors with stairs.

Across the UK sector, 75% of homes currently registered were built prior to 2000, many being conversions of existing properties during the period of expansion from the mid-1980s to the mid-1990s. Data sourced from LaingBuisson suggests that rooms with full en-suite wet room facilities represent a minority (only around one-fifth) of the care home stock, with the vast majority of en-suite facilities representing WC and hand wash basins only. In contrast, 85% of the homes in the Target portfolio at the end of FY19 had been built in the previous 10 years and 96.3% of the rooms had full en-suite wet room facilities (with plans in place to upgrade those that did not).

The quality of rental income depends not only on lease length and how rent levels are reviewed, but also on the sustainable performance of the tenants. Prospective tenants’ operational ability, care ethos and finances are scrutinised before acquisitions are made and Target maintains an ongoing dialogue with its tenants after investing that goes well beyond the classic landlord role. When necessary, assets are subject to more focused management, which usually involves supporting the tenant towards improved performance and may occasionally lead to the company promoting a change in the operator of the asset. During FY19, Target was engaged with the outgoing operator and carefully selected new operator in the re-tenanting of an existing home.

Across the portfolio, Target estimates that approximately two-thirds of the income of the operator tenants includes at least some element of private fees, and that in turn purely private fees represent approximately two-thirds of this and mixed private/public fees (‘top-ups’) the balance. Fees received from purely public sources (local authorities and the NHS) represent approximately one-third of operator income. This mix is reflected in higher than average fees per resident received by the operator tenants; in the quarter ended 30 June 2019, Target estimates £858 per week per resident compared with £718 for all UK care homes.

When invested, Target is an engaged landlord and invests considerable resource in its ongoing property management role. The purpose of this is to add value to the rental covenant and help ensure that this endures over the long period of the lease. Target maintains an ongoing dialogue with its tenants, receives and reviews management accounts for each home on a regular basis, and each home is visited at least every six months. During the current pandemic the established reporting channels for key operating and financial metrics remain in place but physical home inspections have been replaced by remote monitoring.

As part of Target’s own engagement and monitoring process, it also considers the results of the assessments carried out by the industry regulators (in the case of England, the Care Quality Commission or CQC with similar rating systems operated in Wales and Scotland). Care is needed in interpreting this data as while providing useful insights into operator performance the inspection timetable can often lead to delays in ratings adjusting to material changes, such as a new operator, new standards of practice, or a change in the home manager.

As at 31 March 2019 (end-Q320), Target’s portfolio was valued at £613.4m, comprising 73 properties, of which 71 were operational and two were pre-let sites being developed under forward-funding agreements, let to 27 different tenants. With an annualised contracted passing rent of £38.9m (£36.6m of annualised cash passing rent after adjusting for short-term lease incentives) the portfolio valuation reflected an EPRA topped-up net initial yield of 6.05%. The WAULT of 29.2 years remained very high, the product of 30- to 35-year leases at inception and the low average age of the portfolio. All leases are fully repairing and insuring, and upwards-only, with the majority RPI-linked, subject to caps and collars, although some have fixed annual uplifts. The long WAULT and inflation-linked leases provide considerable visibility of long-term income growth.

Target has continued to diversify its tenant base, the majority of which are mid-sized care home operators managing more than five homes. As a result of this growth and diversification, the share of rent roll attributable to Target’s largest tenant, Ideal Care Homes, has reduced to c 12%. The reduction in the number of tenants from 28 at end-FY19 to 27 currently reflects the re-tenanting of six homes operated by Orchard Care Homes to two existing tenant operators (see below).

The company says that the majority of the portfolio continues to perform well, which is reflected in the fact that, of the 55 assets owned at the beginning of FY19, all but four increased in value during the year with two remaining the same and two reducing. Target quotes rent cover for the mature homes (that is, homes that have had the same operator for a three-year period or more and by definition excludes newly developed homes). Newly constructed homes typically require 18–36 months to build occupancy and rent cover. At 31 December 2020 (end-H120), rent cover for mature homes was 1.6x, a similar level to the FY17-19 average (end-FY19: 1.7x).

During the first nine months of FY20, the portfolio valuation increased to £613.4m from £500.9m at end-FY19. Target has completed acquisitions totalling a commitment of c £110m (including transaction costs) and has completed two pre-let developments. As a result, the proceeds of Target’s last equity fund-raising in September 2019, when it raised £80m (gross) in an oversubscribed issue of 72.4m shares, have been quickly deployed. The company has also drawn on available debt facilities of which more remains available. The (FY20) year-to-date investment comprises:

Specific acquisition yields have not been disclosed, but Target has indicated that these are consistent with previous similar transactions.

As a result of Target’s active management of the portfolio, including continuous monitoring of the performance of each asset at both a tenant and property level, in July 2019 (Q120) two homes were sold. The homes were relatively small (amounting to less than 3% of portfolio value) and the company says that while both were acquired as long-term investments, the initial investment case had changed and the opportunity for disposal at more than 5% above the carried value would optimise the portfolio performance and free resources for reinvestment.

As the severity of the pandemic emerged, towards the end of Q320 Target prudently postponed the completion of the acquisition of two homes. The position remains under review and there is an ongoing dialogue with the vendors. Additionally, the company continues to analyse and perform due diligence on a number of near-term investment opportunities and a wider pipeline of opportunities at a less advanced stage, but the timing of any further acquisitions will be considered carefully against both the market outlook and the group’s available funds.

In addition to long lease terms, successfully chosen assets contribute significantly to income security. This is best demonstrated when tenants inevitably run into problems. As part of its ongoing asset management, during FY19 Target re-tenanted one of its homes to remove an underperforming tenant. The process was completed with no interruption to residents and resulted in an increase in property value.

In September 2019, Target was informed by Orchard Care Homes that as part of its own business restructuring it intended to exit the six homes it leased from the group. By February 2020, these had been split into two regional sub-portfolios and successfully re-tenanted to two of Target’s existing operators. Burlington Care now operates the three homes that were located in Yorkshire and Sandstone Care operates the three homes located in the North West. Target continued to receive the contracted rental income throughout the re-tenanting process and, while new rental incentives have been offered in relation to some of the properties, these are offset by Orchard's rent deposits that will be retained by the group. On an aggregate basis there has been no material change in the contracted rental income the group will receive from these properties once the rental incentives expire and the valuation at end-Q320 resulted in a small uplift across the homes.

Target Healthcare REIT is overseen by an independent board of directors and is externally managed, under a management contract, by Target Fund Managers. Target Fund Managers was founded in 2010 by Kenneth MacKenzie, its chief executive, and is a sector specialist manager investing exclusively in the elderly healthcare property sector. The investment team has experience in all aspects of the healthcare property sector including operating, owning, investing in, developing and building healthcare businesses and healthcare property assets. We provide biographies of the key members of the investment team on page 17.

Target Fund Managers manages three investment funds with aggregate assets under management of c £700m, of which Target Healthcare REIT represents the largest share. The other funds are the Kames Target Healthcare Property Unit Trust, with a similar investment remit to Target Healthcare REIT, but whose investment period is now over, and a specialist fund providing flexible, bespoke funding solutions to finance a wide range of transactions in the elderly healthcare sector.

A revised investment management fee schedule, in place from 1 July 2018, abolished performance fees and introduced a tiered base fee structure with reducing rates at higher NAV levels, allowing shareholders to benefit from the increasing economies of scale that a larger portfolio provides. The marginal investment management fee will reduce from 1.05% to 0.95% as average NAV increases above £500m (end-Q320: £494.2m). A continuing improvement in underlying cost ratios in FY19, reflecting the growing scale of the business, is obscured by the impact of change in management fee arrangements on the reported ratios. As reported, the total expense ratio (TER) and the adjusted EPRA cost ratio increased to 1.52% (FY18: 1.48%) and 22.4% (FY18: 20.8%). However, had the FY18 cost ratio not been adjusted for now discontinued performance fees, the FY18 TER would have been 1.66% and the EPRA cost ratio 23.3%.

The board recently agreed an amendment to the notice period provision for the investment management agreement. The first date that notice may be served is one year from the date of the change and the minimum notice period was extended from one to two years. This amounts to an effective initial term of three years, providing welcome continuity and certainty to the arrangement during this more challenging period.

The independent non-executive chairman of the board is Malcolm Naish, a chartered surveyor with more than 40 years’ experience of working in the real estate industry. Before becoming chairman of Target in 2013, Mr Naish was director of real estate at Scottish Widows Investment Partnership (SWIP) until 2012. At SWIP, he had responsibility for a portfolio of commercial property assets spanning the UK, continental Europe and North America, and for SWIP’s real estate investment management business. In addition to Target, Mr Naish is a director of GCP Student Living and Ground Rents Income Fund. The other independent directors of the company bring broad experience in the real estate, healthcare, and the fund management and administration sectors. They are Professor June Andrews OBE, a former trade union leader, NHS manager and senior civil servant and world-renowned dementia expert, Gordon Coull, a former partner at Ernst & Young LLP specialising in investment trusts and property, and Thomas Hutchison III, who has more than 40 years of experience focused in the lodging, hospitality, real estate development, seniors’ housing and financial services industries.

A shareholder EGM in July 2019 approved changes to the group’s corporate structure, establishing a new England-incorporated parent company (Target Healthcare REIT) at the head of the group. The main driver for moving the group’s ultimate parent company to a UK domicile from Jersey was to align the group with its existing UK tax jurisdiction, maintain and enhance its important relationships with UK local authorities and health services, and help reduce administrative costs and regulatory complexities. Importantly, there was no change to the way the group is run, its investment strategy or its dividend policy. Following the change in corporate structure, Hilary Jones and Craig Stewart retired from the board, but the board expects to nominate one new director during 2020 as part of its succession planning.

The company has an indefinite life, but shareholders are invited to vote on continuation at five-yearly intervals. The last vote was held in November 2017 and the next vote is expected in 2022.

Results for the period-ending 31 December 2019 (H120) showed the effects of continuing strong portfolio growth. Compared with H119, rental revenues increased by 28%, benefiting from acquisitions, development completions and RPI-linked rental uplifts. Adjusted earnings increased 21% to £11.5m with adjusted EPS at 2.72p. DPS increased 1.5% to 3.34p although dividend cover (75%) was held back during deployment of the £80m equity issuance in the period. EPRA NAV per share increased by 0.6% to 108.1p driven primarily by revaluation gains and NAV total return (adding back but not reinvesting DPS paid) was 3.7%.

During Q320 rental income continued to benefit from index-linked increases and acquisitions. The average uplift on completed rent reviews was 2.6%, generating like for like growth in contracted rents of 0.4% during the quarter, the main driver of 0.6% like for like growth in the property valuation. EPRA NAV per share reduced very slightly during the quarter, to 108.0p, as a result of one-off debt refinancing costs (see below), equivalent to 0.3p per share. Including dividends paid, EPRA NAV total return was 1.5%, taking the aggregate return for the first nine months of 2020 to 5.1%. An unchanged Q320 interim dividend of 1.67p per share was declared for payment on 29 May 2020 to shareholders on the register at 11 May 2020.

Our forecasts have been updated for the recent developments detailed above, including all the announced transactions and equity raising. We have not assumed any further investment commitments in the light of the current market uncertainties, although the company has available funding and continues to review potential acquisitions from an active pipeline of opportunities. We would expect acquisitions to have a positive impact on our forecasts. Our key forecasting assumptions include:

Target ended Q320 with a robust balance sheet position, strengthened by the September 2019 oversubscribed £80m equity issue, and conservative leverage.

Including the new £50m term loan facility with ReAssure agreed in early January 2020 and the repayment of an existing £40m term loan with First Commercial Bank (FCB), Target now has £180m of committed banking facilities comprising £80m of term loan facilities and £100m of more flexible revolving credit facilities. At the end of Q320 Target had drawn £142m of its debt facilities, leaving £38m undrawn. End-Q320 cash was £31.1m and outstanding commitments amounted to £12m, primarily in respect of the two development assets. The end-Q320 loan to value ratio was 23.1% gross and 18.1% net of cash. As at 21 April 2020 the cash balance was £29m.

The new facility with ReAssure is for a term of 12 years at a fixed cost of 3.28% pa and after repayment of the FCB loan (due in August 2022 with a cost including hedging of 3.08%) provided £10m of additional debt funding capacity, while extending the duration of the debt facilities. In March Target exercised its option, with the consent of HSBC, to extend the term of this facility by one year to January 2022. With the refinancing, the interest rate swap used to hedge the FCB facility was closed out leaving swaps covering £30m of the otherwise floating rate RBS facilities in place. The above financing activity lengthened the weighted average expiry of Target’s debt from less than 2 years to 4.5 years at end-Q320 with an average cost of drawn debt, inclusive of arrangement fee amortisation, of 2.99%. Our forecasts assume no need for further debt drawing during the forecast period with net LTV ending FY21 at 18.3%.

Our revised estimates are shown in Exhibit 9. Compared with our previous forecasts, net rental income is higher, reflecting the equity raising and further investment since our last estimates were published. Adjusted net earnings are also higher, primarily for the same reason, but adjusted EPS based on the increased number of shares in issue is lower. The reduction in forecast adjusted EPS compared with our last published forecast primarily reflects:

We now assume an unchanged DPS reflecting the reduction in forecast adjusted earnings and current market uncertainty, but expect FY21 DPS to be substantially (94%) covered by adjusted earnings.

Our dividend forecasts are driven by our expectations for adjusted earnings that in turn assume contracted rents are received in full and our analysis suggests Target would be able to maintain a good level of quarterly distributions, albeit at a lower level, even with fairly significant deferral of rental income. At present, we do not expect Target’s agreements with a limited number of tenants for staged payments in advance over the coming quarters to have any material impact on cash flow and dividend paying capacity. However, should any of Target’s tenant operators be more seriously affected by the pandemic, there is a risk of a more significant cash flow impact with implications for near-term dividend payments. In the extreme case of tenant failure, there would potentially be an impact on reported earnings as well as cash flow as a result of bad debts and potential delays in re-tenanting with associated costs.

In Exhibit 10 we illustrate the potential near-term sensitivity of DPS and DPS cover from rent deferral. For simplicity, we have assumed any rents deferred to be a deduction from forecast income and adjusted EPRA earnings, although in most cases this is likely to be a cash flow impact (the timing of collections, in most cases temporary) rather than an income impact (the amount of rent to be collected over time). We have modelled the sensitivity based on our FY21 forecasts, which include a full contribution from recent acquisitions. A 10% reduction in our forecast FY21 rental income reduces dividend cover from the forecast 94% to 81%. From an alternative perspective, if targeting 100% dividend cover, the implied FY21 DPS would be 6.29p rather than our forecast 6.68p, or 5.38p with a 10% reduction in rental income.

Depending on the nature and expected duration of any shortfall in near-term income Target may decide to use existing financial resources to support distributions.

Annualised DPS has increased in each year since IPO in 2013 and, based on the Q320 DPS of 1.67p, the annualised rate of DPS is 6.68p, representing a prospective yield of 6.2%. The P/NAV is 1.0x.

Exhibit 11 shows the NAV total return history since IPO. The cumulative total return (adjusted for dividends paid but not assuming reinvestment of dividends) from IPO in March 2013 to the end of Q320 was 54.0% or an average annualised rate of 6.2%. Dividends accounted for c 80% of the total. In the absence of acquisition costs, our FY21 forecasts imply a return of 8.9% with RPI-linked rent uplifts contributing to earnings and capital growth (with an assumed unchanged yield) and supported by modest gearing. The key risks to this forecast return are a negative near-term impact on earnings (not simply on the timing of rent receipts) from COVID-19 or a widening of market valuation yields.

Within the broad commercial property universe, Target is part of a group of companies that is differentiated by its focus on stable long-term income growth derived from long-lease exposures across a range of property types, including healthcare property, social housing, ‘big box’ distribution centres, supermarkets and leisure assets. Care home property investment yields are higher than for other healthcare assets and the leases at inception are longer.

Although all the companies listed in Exhibit 12 (above) are focused on generating long-term income and have WAULTs that are above the average of the broad property sector, there are considerable differences between the different asset classes in which they invest, lease terms and the tenant covenants that support the long-term contractual income. These differences are reflected in valuation and performance differences (Exhibit 13). Target’s very long WAULT and predominantly RPI-linked rent growth provides investors with considerable visibility over a growing stream of contracted rental income and offers considerable protection against inflation. Compared with the peer group average, Target shares trade with a similar P/NAV but have a noticeably higher yield.

Among the companies shown in Exhibit 13, over the past 12 months the strongest share price performance has been delivered by the primary care asset investors (Assura and PHP) and, in our view, the strength of tenant covenant has contributed significantly to this (the vast majority of rents are backed directly or indirectly by government). Compared with care homes, the average lease length is shorter, and although upwards-only, a significant share of the leases are subject to open-market review rather than being indexed to inflation. For the social housing investors (Civitas, Triple Point), rental income is also funded by government via local authorities, although payment is made to the housing association tenants who then pay the investor landlords. Lease terms for the other companies are predominantly index-linked, with tenant exposures being mostly corporate, across a range of sectors – industrial, supermarkets and care home operators where a significant differentiating factor is the strength of the corporate lease covenant.

The visibility of Target’s contractual income and dividend paying capacity is provided by long leases and RPI-linked rent increases. We see the key sensitivities as relating to the following: