Target Healthcare REIT — Key drivers in place and borrowing costs fixed

FY22 results were very much in line with the forecasts that we published following the Q422 NAV update in early August. The Q123 report subsequently released shows operational progress continuing as expected, supported by the strong fundamentals of the care home property sector. With market expectations indicating a significant further increase in interest rates beyond the current 3.0% Bank of England (BoE) Base Rate, in early October, Target capped the SONIA rate payable on an additional £50m of variable rate debt facilities at 3.0% until November 2025. The premium paid for the cap was c £2.5m, a reduction in the Q223 NAV per share of c 0.4p. All borrowings are now fixed or hedged and on a pro forma basis, we estimate a blended running interest cost of drawn borrowing of 3.3%.

Nonetheless, capital costs have spiked higher across the market, which is not yet reflected in asset prices. Unsurprisingly, while this period of uncertainty persists, the company indicates a pause in new investments. We believe this to be a sensible approach, though it will slow the growth in earnings and delay the path to full DPS cover. The impact of rising capital costs and the revised path to dividend cover are the focus of this update, along with an update on the factors that continue to mitigate inflation risks for both the company and its tenants.

Despite the building headwinds of increased inflation and interest rates, and economic and political uncertainty in the UK, tenant operators have seen their occupancy ratios continue to recover towards pre-pandemic levels, while fees have grown strongly. Target estimates that the fees of its tenants are predominantly (67%) fully or partly (through top-ups) sourced from privately funded residents and 33% from public funding. It cites external industry data that indicates an acceleration in privately sourced fees compared with publicly sourced fees. A relatively small number of underperforming assets, typically reflecting exposure to recently opened or new-build homes and growing tenants with several new homes, held FY22 rent collection to 95% and provision charges amounted to £3.2m. Q123 rent collection increased to 96% and with ongoing asset management initiatives we expect a significant improvement in FY23 as discussed below. Meanwhile, rent cover remains stable at c 1.3x.

Driven by portfolio investment and inflation-indexed rent growth (4.6% on a like-for-like basis), annualised contracted rents increased 35% to £55.5m at end-FY22 versus £41.2m at end-FY21. Yet to fully reflect annualised contracted rent growth, FY22 revenues (c 19%) and adjusted ‘cash’ earnings (c 17%) both grew strongly. A total of £223m was deployed in acquisitions, including the c £160m acquisition of a high-quality, established 18-home portfolio, well known to the investment manager. Funding for growth was provided by the upsized £125m (gross) equity raise in September 2021 and a new £100m fixed rate long-term debt facility in November 2021, fixed for a blended 13 years at an attractive 3.1%.

Although FY22 growth was strong, it was slower than Target had expected earlier in the period, with capital deployment taking longer than planned and rent collection negatively affected by a small number of tenants (see below). Target had expected to complete the portfolio acquisition in October 2021, but access restrictions because of the pandemic delayed this until December. As economic and political uncertainties climbed through H222, additional deployment of available capital was slowed. As a result of cash drag and provisions, and an increase in borrowing costs towards the end of FY22, adjusted ‘cash’ earnings per share of 5.0p was lower than in FY21 (5.5p), covering DPS by 0.72x. EPRA EPS of 6.6p (FY21: 7.2p) covering DPS 0.95x. Including like-for-like investment property gains of 4.2%, EPRA NTA per share increased 1.7% to 112.3p during FY22 and including DPS paid the EPRA NTA total return1 was 7.8% (or 8.1% assuming dividend reinvestment).

In contrast to increasing areas of the mainstream UK commercial property market, there was no sign of widening valuation yields through FY22. However, during Q123, the positive impact of continuing indexed rent growth was offset by a slight expansion in the EPRA topped up net initial yield, from 5.82% at end-FY22 to 5.84%. EPRA NTA was nonetheless broadly stable at 112.1p and the quarterly accounting total return was 1.3%.

The end-Q123 investment portfolio was valued at £914m, with annualised contracted rent of £55.6m. The 100 homes (of which four are under construction) were fully let to 33 tenants with a weighted average unexpired lease term (WAULT) of 26.9 years. Effectively, all rents are upwards only and inflation-indexed (with caps and collars). Being modern and predominantly purpose built, the portfolio benefits from strong environmental credentials, fully compliant with expected BEEAM2 2030 requirements, with 93% EPC rated A-B and 100% EPC C or better. Demonstrating the quality of the assets in its portfolio and their ability to create social value, Target highlights that 97% of its rooms have full en-suite wet-room facilities compared with a UK industry average of just 29% and that while average rents per sqm are only a little higher than average, the average sqm per resident is significantly higher, including typically generous communal facilities.

Although market developments will slow Target’s well-charted path to full dividend cover, most particularly the volatility of money markets and increasing interest rates, the key drivers remain in place, with the management of debt costs becoming increasingly important. These comprise:

Our updated forecasts are negatively affected by increased interest costs and slower capital deployment. Excluding the non-recurring interest rate hedging premium paid (c £2.5m), included in EPRA ‘net finance costs’ in Exhibit 1, the underlying income statement interest expense is lower than we had previously assumed. Our previous forecasts had assumed a 4.0% SONIA benchmark for the drawn variable rate debt plus borrowing margin, and the SONIA rate that Target will pay has now been fixed at 3.0%. Additionally, we now assume no new commitments to investment, having previously assumed £30m. While this will benefit interest expense by reducing the cost of borrowing, it will have a negative impact on our forecast cash rental income. We have also prudently assumed a slower reduction in overall rent provisioning. Our forecast for FY23 adjusted earnings, which excludes the hedging premium, is little changed (-0.5%). FY24e is reduced by 2.7%. Dividend cover is reduced slightly from 0.87x to 0.86x in FY23e and from 0.92x to 0.90x in FY24e.

The board has indicated that it sees a clear path to dividend cover exceeding 90% and feels it prudent to maintain DPS at the current level. Based on our FY24 adjusted earnings and DPS forecasts, full dividend cover requires a c £4m earnings uplift, which equates to less than two years of additional rent growth at 4% pa. If capital costs and/or acquisition yields move favourably to restore a sufficiently positive acquisition spread, and if greater certainty returns to the market, acquisitions would accelerate the achievement of full cover. We estimate that if c £45m of available debt capital were deployed at a 3% spread, the time to full dividend cover would be reduced by almost a year.

Target is primarily focused on income returns, and we would expect that maintaining a high distribution to shareholders is important to the board. It is nonetheless the case that there are some investors with a preference for fully covered dividends and we can also see some advantages that would arise from a rebasing of the dividend. An uncovered dividend requires capital resources to be diverted away from long-term growth and in the near term requires additional borrowing, which is unattractive at high borrowing rates. Moreover, whatever the level of dividends paid, there is no impact on total accounting returns. A 20% rebasing of the dividend would be sufficient to restore underlying (excluding the hedging premium) cover for FY23, create a base for future growth, and at the current share price would represent a yield of more than 6%.

Several well-planned, recent or proposed changes to the board composition will be voted on at the AGM on 6 December, including a change of chairman and two new non-executive directors. With money market conditions evolving rapidly pace, this may provide a timely opportunity for the board to assess its position.

Target’s record of consistently positive returns since it listed in January 2013, on both a quarterly and annual basis, has continued through Q123. This performance reflects the resilience of the sector and of Target’s strategy. The average annual compound return over this period has been 6.0%, of which c 80% reflects dividends paid. Including dividends reinvested, Target’s preferred measure, the average annual total return has been 7.8%.

DPS has increased each year since IPO, to 6.76p in FY22 (+0.6%) but we forecast a pause in DPS growth in current market conditions, allowing the company to build DPS cover.

Across the commercial property sector, income returns have historically shown less volatility than capital values, which have displayed material swings. Healthcare property returns have been less volatile than mainstream sectors, in many cases reflecting the non-discretionary, demographically driven nature of demand, visible long-term income streams and a shortage of adequate, sustainable supply. With government bond yields significantly higher than at the start of the year3 there is a widespread expectation that the widening of property valuation yields (decrease in values), which is already apparent across much of the UK commercial property sector, will spread. The investment manager suggests that a widening of acquisition yield towards a range of 6.00–6.25% is likely in current market conditions. While this would represent a drag on valuation growth, offsetting the positive impact of indexed rent growth, it would have the advantage of lowering acquisition prices. Our forecasts are consistent with this expectation and allow for an upwards move to 6.25% by end-FY24.

In addition to the yield widening reflected in our forecasts, we estimate that a 10bp increase/decrease in yield would decrease/increase FY23e NAV per share by c 2.6p.

Based on our forecast property valuation, and including the gap between dividends and earnings, we expect the NAV total return to be c 5% pa through FY23 and FY24, with DPS payments partly offset by a slight weakening of NAV per share.

The lagged effects of COVID-19 on a minority of Target’s tenant operators, particularly where occupancy had been slow to rebuild, were the main negative factors behind 95% rent collection in FY22. The company is well advanced in addressing the effects and in restoring rent collection towards pre COVID-19 levels, with Q123 already increasing to 96%. The three key areas of improvement, which Target says are of broadly equivalent significance, are:

It is worth reiterating from our previous research that asset management is core to Target’s strategy, greatly facilitated by its unwavering focus on asset quality. 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. The tenant recommitment to seven assets described above, and the continuing firmness of asset yields in recent months, provide tangible evidence of the appeal of modern, high-quality EPC-compliant assets to investors and operators alike.

Most homes in the portfolio are mature, stabilised and capable of sustaining high levels of occupancy under normal trading conditions. However, completed newly opened homes and forward-funded pre-let developments also provide access to modern, high-quality, ESG-compliant assets. Under normal trading conditions, newly opened homes typically require up to 36 months to build occupancy and establish a mature level of financial performance. However, the pandemic has increased pressure on home operators across the sector and lengthened the time required for new homes to reach maturity, especially for homes where private fee-paying occupancy was slower to recover. Pandemic aside, it is inevitable that some tenants, from time to time, will encounter operational or financial challenges and as an engaged landlord, Target makes available its industry knowledge and experience to provide support. In a minority of cases, the best solution for all stakeholders, including home residents, may be to seek a re-tenanting of the home and Target has a successful track record of achieving this where needed. With this in mind, our forecasts reflect a substantial improvement in rent collection through FY23 but out of prudence, in an uncertain external environment we have continued to build in a non-collection ‘cushion’ of c 2.5% of rents receivable. An improvement on this would further enhance our forecast increase in dividend cover.

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 are now the rapid acceleration in inflation and staff shortages. In this environment, increasing occupancy and strong fee growth are mitigating inflationary cost pressures as well as the withdrawal of the government’s pandemic financial support since March 2022. We note the additional factors that we believe will support operators in the current environment:

Occupancy growth and fee increases continue to support rent cover,6 which for mature homes remains at c 1.3x and no longer benefits from government pandemic financial support. When initially setting rent levels, Target aims for rents to be a sustainable c 20% of revenues. Combined with other operational costs the company believes that mature home rent cover of 1.6x remains a realistic medium-term target as illustrated below (for a typical home).

To fund portfolio growth since IPO, Target has steadily increased its capital resources, both equity and debt capital, sufficient to take advantage of opportunities in the market while avoiding excessive gearing and mitigating any drag on returns. Shorter term, variable rate debt is typically used in the asset accumulation phase (Target has mostly acquired individual properties, the late 2021 portfolio acquisition being an exception) to be ‘packaged’ for longer-term funding as appropriate.

In late November 2021 the company agreed a new £100m long-term institutional debt facility that was drawn in two tranches, with a blended 13-year maturity and 3.1% fixed cost. The financing was well timed, taking advantage of a tightening in the relevant gilt yield to 1%. As a result, end-Q123 borrowings of £223m were c 81% fixed (£150m) at a blended 3.18%, or hedged via a swap (£30m) at 0.3% plus a margin, or an attractive total interest cost of 2.48%. End-FY23 borrowings also included £43m of drawn variable rate debt, out of total variable rate debt facilities of £140m. The sharp rise in market interest rates in recent months has substantially increased the cost of variable rate borrowing. With market expectations indicating a significant further increase, in early October Target capped the SONIA rate payable on an additional £50m of variable rate debt facilities at 3.0% until November 2025. The premium paid for the cap was c £2.5m, a reduction in Q223 NAV per share of c 0.4p. On a pro forma basis, we estimate a blended running interest cost of drawn borrowing of 3.3%. At the same time, Target has exercised, with lender approval, its extension option on its £100m HSBC facility and inclusive of this the average term to maturity on its committed loan facilities was 6.9 years as at 1 November 2022.

The £150m of fixed rate debt has a weighted average maturity of more than 11 years and the swap arrangement matures in c three years along with the £70m of RBS facilities. The cap eliminates the remaining near-term interest rate risk and provides additional flexibility within Target’s overall debt strategy. This should prove advantageous if market interest rates increase to a peak in early 2013 before gently declining. Since 30 June (end-FY22), the BoE has increased the base rate three times, taking it to 3.00% from 1.25%. BoE Base Rate is closely tracked by SONIA, the reference rate for Target’s variable rate borrowing (before hedging). Money market expectations for the future development of SONIA/the base rate, reflected in the SONIA swap curve, have been volatile, indicating a peak of 4.5–6.0% by early 2023 before steadily declining towards a long-term level of 3–4%. Current rates are at the lower end of this range.

Available undrawn variable rate debt at end-Q123 was £97m, well above the end-FY22 capital commitments. At end-FY22, commitments were £38m, mostly relating to the remaining forward funding of properties under construction. We expect most of this to be paid by end-FY24. Our forecasts indicate that without further management action this will lead to a relatively modest c £20m of exposure to unhedged, variable rate debt. Until there is greater certainty about the direction of money markets and the economy, we expect the company to pause additional investment/commitments and retain a higher than normal level of liquidity. As a long-term investor this may change, as interest rates begin to decline and if acquisition pricing begins to adjust to the sharp rise in the cost of capital.

Based on the FY22 DPS, Target shares trade on a yield of 7.8%, in line with its post-IPO highs, most recently during the height of pandemic uncertainty. This has historically proven to be a very attractive entry point for investors. Similarly, at 0.78x the P/NAV is close the pandemic low point.

In Exhibit 6, 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 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.

Over one and three years, the share price performance of the group is ahead of the broad UK property market average, while dividend returns have been higher (we estimate the broad UK property market trailing yield to be currently c 5.3%). Compared with the per group average, Target’s share price performance over the same period is a little below the average, contributing to a higher than average trailing dividend yield, while P/NAV is broadly in line. There are several positive indicators for the future share price performance including a combination of the long WAULT (with no break clauses) and upward-only, triple net rents, mostly linked to RPI. These provide considerable visibility over a growing stream of contracted rental income, in turn supported by the resilience of most tenants through the pandemic, a long-term trend for operator fee growth to at least keep pace with inflation, and a proven ability to re-tenant properties where appropriate.

While the path to DPS cover has been delayed, as we note above, a rebalancing of DPS would have no impact of accounting total returns, which have been consistently positive since IPO.

Full year results for the year ended 30 June 2022 (FY22) were published on 12 October, followed by the Q123 NAV update on 2 November. Many of the key financial metrics for FY22 were available from the Q422 NAV update published in early August, and the reported results were very much in line with our published forecasts. Exhibit 5 provides a summary and reconciliation from IFRS earnings to adjusted earnings.

Focusing initially on adjusted ‘cash’ earnings, in particular we note: