Target Healthcare REIT — Growth from a firm base

In this note we briefly review the modest changes to our forecasts, set out in detail in our February 2023 update, and provide the background to the dividend rebasing. We believe it is important to focus on the operational update provided by the annual report, including positive indicators for tenant performance and their ability to manage the inflationary challenge, reflected in rent cover and rent collection metrics for Target. A detailed summary of the H123 results and an update on debt financing is nonetheless provided at the end of the report.

Target is primarily focused on income returns, and maintaining a high distribution to shareholders has always been important to the board. Although on an EPRA basis DPS has been fully covered by earnings since listing (generally at 1x or above until FY22), dividend decisions have primarily been made by reference to adjusted earnings, which exclude IFRS non-cash rent smoothing adjustments,1 a significant contributor to EPRA earnings. The company has aimed for DPS to be fully covered by adjusted earnings assuming full deployment of available capital, and as it has been consistently growing its portfolio since listing it is yet to reach full cover on a reported basis.

However, the normal path to dividend cover has been slowed by rising interest rates, with a two-fold impact. While capital costs have increased, the opportunities to make accretive acquisitions have been limited by property values remaining firm due to continuing strong investor demand.2 At the same time, although 96% of drawn debt is now fixed/hedged, it is at a higher average cost,

Coming out of the pandemic, dividend cover has also been held back by a small number of tenants taking longer than hoped to rebuild privately funded resident occupancy in their homes. Tenant performance and rent collection is now improving and we estimate that in combination with inflation-linked rental growth development completions, full cover of dividends at the previous level would have achieved, but not until FY25.

It is nonetheless the case that there are some investors with a preference for fully covered dividends. Uncovered dividends also require capital resources to be diverted away from long-term growth and in the near term require additional borrowing, which is unattractive at higher borrowing rates.

For this reason, the newly constituted board3 took the decision to rebase DPS to a level that would immediately restore dividend cover and create a sustainable base for future growth. The 17% reduction in quarterly DPS to 1.9p (5.6p annualised) will apply from Q323 until indicated otherwise. Including the first two quarterly DPS of 3.38p in aggregate, this would represent FY23 aggregate DPS of 6.18p.

Although we do not publish interim forecasts, H123 was consistent with the underlying full year forecasts published in our February note and we have made no material changes other than for the dividend rebasing. We have corrected our treatment of the £2.5m cost of the new £50m nominal swap, capitalising it and amortising it within interest expense over the three-year duration. Before amortisation, this accounting adjustment has a positive impact of £2.5m on our EPRA earnings forecast but no impact on adjusted earnings, for which we had previously made an adjustment. We have also pushed back development completions but in adjusted earnings this is compensated by increased development interest.

We now expect the rebased DPS to be fully covered by adjusted earnings in H223 (1.03; 0.95x for the full FY23 year). For FY24 we have assumed that quarterly DPS begins to increase in line with the company’s intention to return to progressive fully covered DPS.

The COVID-19 pandemic presented many operational financial challenges to home operators and although it may not be over, the effects have become considerably more manageable. The key concerns for the sector in the second half of 2022 were the rapid acceleration in inflation and staff shortages. Increasing occupancy, recovering from the pandemic and strong fee growth, generally recognised as inevitable to support critical care needs, are mitigating inflationary cost pressures Meanwhile, a temporary relaxation of immigration rules for care workers is relieving some of the pressure on staffing, benefiting care while reducing the cost of agency provision.

Based on data gathered from its tenants, home occupancy for mature homes4 has increased to 84% from c 74% at the pandemic low point in April 2021. It is yet to reach the c 90% level that was typical pre-pandemic, a positive indicator for further growth in home income. In the early stages of pandemic recovery, reflecting greater average near-term flexibility over the timing of entry into a care home, those focused on privately funded residents experienced a slight lag in occupancy improvement, which now appears to be unwinding. Again, based on data collected from its tenants, the fees for 68% of residents within Target-owned homes are funded privately, wholly or through fee top-ups, ahead of the market as a whole (we estimate c 50%, with the balance of fee growth publicly sourced). Over the longer term, average weekly fee growth has more than matched inflation,5 with private growth exceeding that of publicly funded fees. At the same time, average building quality has been enhanced as older, ‘obsolete’ properties have left the market to be replaced by modern, purpose-built stock. Target expects this trend to continue, despite private fees being significantly higher than publicly funded fees, particularly for high-quality real estate that it focuses on, and good care services. While recognising the role that the publicly funded sector will inevitably play in meeting growing societal demand, including near-term initiatives to free beds from the NHS, it stresses the pressures on, and limits to, local authority funding.

Occupancy growth and fee increases are supporting an increase in mature home rent cover6 while the proportion of homes in the portfolio that have reached maturity has risen significantly.

On a rolling 12-month basis, rent cover increased to 1.4x at end-December from 1.3x at end-September.1.5x and current indications are that it continues to increase. On a spot basis, rent cover in the past two quarters (to end-December) has been 1.5x.

Target aims for rents to be a sustainable c 20% of revenues on mature homes. Combined with other operational costs the company believes that mature home rent cover of at least 1.6x remains a realistic medium-term target for a typical home.

Target has provided the following indicative data, based on a well-run home, with a high proportion of privately funded fees, which it believes is a representative illustration of the drivers of improving rent cover. It shows privately funded fees more than offsetting the negative impacts of lower occupancy and inflation, with rent cover increasing.

The acquisition of newly built homes has been an important element in growing Target’s portfolio without compromising its focus on asset quality. New homes take time to build occupancy and reach a ‘stabilised’ level of profitability, especially when targeting privately funded residents, a process that may take three years or more. As the pandemic hit, around 30% of Target’s portfolio was categorised as immature (compared with 10% now), a combination of the recently opened homes as well as a limited number of tenants who were also maturing as businesses and were not at a stage where they had built sufficient reserves to absorb a materially slower rate of occupancy growth. As a result, rent collection has subsequently been running at c 95%.

Target has worked with struggling tenants to better understand their challenges and work with them to resolve these. In some cases, it has re-tenanted properties to alternative operators or sold them. Asset management is core to Target’s strategy, and is greatly facilitated by its unwavering focus on high-quality, modern and sustainable assets, attractive to residents, operators and investors. Its investment thesis is that best-in-class properties in local areas with positive demand/supply characteristics and prevailing rental levels that are sustainable will always be attractive to existing or alternative tenants. Key portfolio metrics include:

During Q123, Target reached a settlement with the operator of seven homes (c 6% of rent roll), which was only partly meeting its rent commitments, primarily due to a slow recovery from the pandemic. With the trading environment improving, the tenant renewed its long-term commitment to the homes and settled all rent in arrears, providing an immediate improvement in rent collection and generating a recovery in rent provisioning of £1.1m. Rent collection has recently increased from another tenant that has historically been responsible for a significant proportion of rent arrears, with rent having been received in full during the first two months of 2023 (H223). Additionally, the company has completed the final stage of a re-tenanting programme, leaving its tenant with three homes whose trading performance covers current rent in full. Existing lease terms, including rent levels, have been maintained with the incoming tenant being granted a short-term rent-free period to manage the rebuild in occupancy.

Key data-points, such as the Q223 unaudited NAV, contracted rent and balance sheet highlights, had been previously disclosed and reflected in our last published note, with the H123 interim report providing the detail. In the summary below we start with adjusted earnings and reconcile to EPRA earnings and finally statutory IFRS earnings.

In particular we note:

Of Target’s £320m of debt facilities, £240m was drawn at end-H123, with an average term to maturity of 6.7 years. 96% of drawn borrowings were fixed or hedged in a way that leaves Target with no material exposure to a further rise in interest rates until 2025 and the flexibility to act as interest rates decline as is the market consensus expectation. The drawn debt included £150m of long-term fixed-rate debt and £90m of shorter-term revolving credit facilities (RCF). The cost of the RCF drawings is protected to maturity by an existing £30m nominal interest rate swap and a £50m nominal interest rate cap (at 3.0%) entered into on 1 November 2022. The premium paid for the cap was c £2.5m. The blended average cost of 3.8% pa is including amortisation of capitalised loan arrangement fees.

Allowing for all capital commitments, £62m was available when the H223 results were published, which includes the proceeds of the Northern Ireland disposal, which provides flexibility with regard to capital allocation for activities such as making strategically important new investments, portfolio improvements or other asset management initiatives.

Although healthcare property has not been immune to property yield widening (valuation decline) across the UK commercial property sector, particularly in the final quarter of 2022, it has demonstrated resilience. The average like-for-like valuation decline in Target’s portfolio in the six months to 31 December 2022 (H123) was 5.5%, which according to data from CBRE and MSCI compares favourably to the broad UK commercial market decline of c 19%. For Target, 1.8% like-for-like rental growth provided a partial offset to the negative impact of yield widening (c 40bp to an ERPRA net initial yield of 6.22%), nearly all of which in Q4 2002. Target’s very long-term leases (27-ear weighted average lease term), upwards-only, indexed linked rent uplifts (typically capped at 4% with a floor at 2%) and asset quality will all have benefited its property values in combination with positive demographic growth drivers, little related to the wider economy. Despite a pause in activity in H222 due to the level of financial uncertainty there have been signs of recovery in the opening months of 2023, and we expect care home property investors to remain attracted to good-quality property in the sector, demonstrated by Target’s sale of its four assets in Northern Ireland in March 2023. The disposal price of £22m was above both the carrying value of the assets and the June 2022 valuation, despite the general fall in property values seen during the second half of 2022 and locked in an annualised internal rate of return in excess of 10% over the period of ownership. The company says that although the homes have produced strong returns, because of staffing difficulties and a weak private pay market, as part of its asset management strategy it expects to achieve stronger returns by reallocating capital.

We do not anticipate any significant further yield widening and the additional further increase in the EPRA topped-up net initial yield (c 18bp to c 6.4%) implied in our forecasts may turn out to be conservative.

The rebased annualised rate of DPS of 5.6p represents a prospective yield of 7.4%, close to the recent peak and the level reached during the height of pandemic uncertainty. Similarly, the c 25% discount to H123 NAV of 103p (P/NAV of c 0.75x) is not far above the recent trough and close to the pandemic low point.

In Exhibit 9, we summarise the performance and valuation of a group of real estate investment trusts that we consider to be Target’s closest peers within the broad and diverse commercial property sector. The peer 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. For consistency, the data are presented on a trailing basis and the Target yield does not yet reflect the dividend rebasing. The rebased DPS prospective yield of 7.4% is slightly below the peer group average of 8.0%, while the P/NAV is similar. This prospective yield positions Target between the primary healthcare investors (Assura and PHP) and the social housing investors (Civitas and Triple Point). The primary care investors benefit from significant covenant strength (c 90% of rents paid directly or indirectly by government) but weighted average unexpired lease terms (WAULTs) and asset yields are below the peer group average and rent growth is heavily reliant on below inflation open market settlements. Like Target, the social housing investors have long WAULTs and benefit from inflation-indexed rents. Although we believe that for the social housing investors, market concerns about the strength of the tenant covenant and the sustainability of the funding model are overly pessimistic, the care home sector has already demonstrated its robustness through the pandemic challenge. With its dividend set at a sustainable level, Target has the potential to benefit from continuing growth and a re-rating.