Impact Healthcare REIT — Making hay in all weathers

The healthcare real estate sector has historically proved resilient in challenging environments, and continues to benefit from a strong demographic tailwind, largely independent of the wider economy. Within this, the care home market is large and fragmented, with a strong growth outlook. The UK population is ageing rapidly, and those aged 85 or over are the fastest growing group, forecast to increase 60% by 2036. The sector provides a substantially non-discretionary, essential service, yet the number of beds has shown no material growth over the past 10 years, with newly developed and refurbished stock offset by the withdrawal of older, obsolete homes. That said, the sector is not without challenges for operators, Impact’s tenants. Most recently, the pandemic significantly reduced occupancy levels, and this was followed by the sharp acceleration of inflation in the second half of 2022. In this context, Impact’s strong financial performance and its ability to deliver progressive, fully covered dividends is no accident but reflects the robustness of the particular strategy that it has adopted and successfully implemented. We cover the recent financial performance later in this note but first focus on its foundations, reviewing the key elements of that strategy and how it is reflected in tenant performance.

At the core of strategy has been a disciplined approach to acquisitions and careful tenant selection. The portfolio has been built by acquisition, typically of portfolios of assets, at consistently high gross yields of c 7%, providing a strong level of cash flow. Acquisition yields have been maintained despite a general tightening across the sector over the same period. However, the investment manager is keen to stress that while yield is an important factor, it is an ‘output’ from the asset selection process rather than the ‘input’ from which decisions flow. The selection process starts with an identification of suitable assets to be let to selected tenants, typically mid-sized operators, with an established track record of financial and operational performance. It is then necessary to establish whether rents can be set at a level that is sustainable to tenants, consistent with their maintaining a high level of care while providing a good level of rent cover2 and meeting Impact’s financial investment criteria. Typically, Impact has acquired assets with the following characteristics:

The following examples reflect this process:

Notable previously completed projects were at Diamond House, Leicester and Freeland House, Oxfordshire. At both, new specialist dementia care facilities were developed within the footprint of the existing homes, offering specialist care and support to existing residents of the homes who may develop dementia symptoms and providing places for 76 new residents with dementia needs.

Despite a significant reduction in occupancy through the pandemic, from a typical c 90% to a low of 79% in early 2021, tenant performance remained robust. A good level of rent cover was maintained and rents were collected in full without contract variation, as had been the case since Impact listed in 2017. In part, this robust performance through the pandemic was assisted by government grant funding for what was recognised as a critically important sector, but also significantly reflected tenant operational efficiency, Impact’s close relationship with, and monitoring, of them and, perhaps most importantly, affordable rents.

As occupancy began to rebuild, home-level profitability and rent cover both returned to ‘normal’ levels, despite the phased withdrawal of government pandemic support at the end of Q122.

As the pandemic became more manageable, the very rapid acceleration of inflation in the second half of 2022 provided a new challenge to the sector. With profitability having recovered from the pandemic, Impact’s tenants entered this inflationary environment in a generally strong financial position. Strong fee growth and a continued increase in occupancy have thus far offset staffing and other cost pressures and rent cover has remained stable (1.8x at end-FY22).

The key factors that contribute to the inflation resilience of tenants include:

Exhibit 4 shows the trend in average home-level EBITDARM margins, which remain healthy and show only a mild weakening since before the pandemic. It is worth noting the element of seasonality driven mainly by annual pay increases falling in January/April, while local authority fee increases in April have a more material impact in Q3.

During 2022, Impact’s strong track record of collecting 100% of rents due with contract variation continued. However, one of the 13 care home tenants9 failed to pay the quarter’s rent that was due in advance on 1 January 2023. The core problem relates to a small number of homes, operated by the tenant, which were acquired by Impact in the first quarter of 2020 as a turnaround project, atypical of Impact’s acquisition policy. The turnaround was significantly delayed by the pandemic that ensued and this remains the case. Impact says it remains confident in the quality of the buildings and their ability to deliver good-quality care and believes that the rents are set at a level that is affordable. The average rent per bed charged by Impact for these homes is c £4,000 pa, compared with a portfolio average that is c 50% higher and is supported by the average rent cover of 1.8x.

For Q123, Impact has received 98% of all rents due (£9.6m). Rent collection includes a £0.2m utilisation of rent deposits, offsetting half the £0.4m quarterly rent due from the under-performing tenant. Within the quarterly update we understand that the outstanding £0.2m has been provided to ensure that earnings are not overstated, while the investment manager remains in active discussions with the tenant and is hopeful of reaching a resolution by the middle of the year.

Taking account of the FY22 results and the Q123 update, we have made only modest changes to our forecasts, with slight increases in adjusted earnings, dividend cover and NAV per share.

We have not assumed any additional transaction activity although, as the portfolio acquisition in January demonstrated, despite the increased cost of capital, selective, accretive transactions remain possible (see below).

End-Q123 debt drawn was £187.3m and the gross LTV was 28.3% (end FY22: £142.3m and 23.9%). LTV is a little above the company’s medium-term target of 25% but well below the 35% maximum specified by its gearing policy. Impact’s policy is to have at least 75% of the cost of drawn debt fixed or hedged and, including additional hedging undertaken during the period, the proportion was 80% at end Q123, with a blended cost of 4.3%. A £25m interest rate swap at 1%10 will mature in June and we expect Impact to take further measures to increase the hedging rate, from an adjusted c 67%, in line with policy.

Allowing for the January transaction and all other capital commitments, at the end of FY22 Impact had available liquidity of c £63m. However, given the continuing volatility in debt markets, we expect the company to remain cautious and highly selective in pursuing acquisitions. Funding of the January transaction was innovative, combining attractively priced new equity with new borrowing at a hedged cost. We estimate an immediate positive earnings impact and for this contribution to increase with RPI-linked rental growth (capped at 4.0%). Of the £56m consideration, £44.8m (or 80%) was in cash, funded by newly drawn debt, with the balance in new shares issued to the vendors and priced at 116.62p per share, the Q322 NAV, a significant premium to the current price. The debt drawn has been hedged through a new £50m interest rate cap at a cost of £1.5m, which caps SONIA at 3.0% for two years.

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. Likewise, Impact’s portfolio has demonstrated resilience, confirmed by the Q123 update.

For FY22, the valuation loss was £9.9m, with the positive impact of rent uplifts (£22.1m) more than offset by the negative impact of yield widening (£32.0m). The EPRA-topped up net initial yields increased from 6.71% to 6.98%. In Q422 alone, there was a negative net valuation movement of £21.6m with a 6.98% yield increasing from 6.68%.

Q123 showed significant stabilisation, with EPRA-topped up net initial yield showing no material change (6.99%) and c £9.1m in positive revaluation movements, driven by like-for-like rent growth.

With inflation remaining stubbornly high and debt markets remaining volatile, it may be too early to call a turning point in valuations, but we expect the resilience of sector valuations to continue. Our valuation forecast is increased slightly but continues to reflect yield widening for the year of c 10bp.

For FY23, Impact is targeting a DPS of 6.77p (+3.5%), fully covered by adjusted ‘cash’ earnings. This represents an attractive yield of 7.0%. Meanwhile the shares trade at c 0.9x Q323 EPRA NTA (NAV) per share of 112.6p. The discount to NAV appears to anticipate some modest further weakening of property valuations, although this was not evident during Q123.

Leaving aside the pandemic period, Impact’s share price has not fully kept pace with dividend growth and its dividend yield has trended upwards. It is at the upper end of its historical range (excluding the peak of pandemic uncertainty) and above the average c 5.7% since listing. While rising interest rates will have contributed to a widening dividend yield, we would argue that the maturing of the care home investment sector and Impact’s robust performance through the pandemic are both positive offsetting factors.

Exhibit 9 shows a summary of the performance and valuation of a group of real estate investment trusts (REITs) that we consider to be Impact’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. For consistency, NAV and DPS data are presented on a trailing basis11 and do not reflect Impact’s increased FY23 DPS target.

Impact’s shares have outperformed the peer group and tracked the broader UK property sector over the past year and have substantially outperformed the peer group over three years, and have tracked the broad UK property sector. As a result, Impact’s trailing yield is now below the average of the peer group but remains above that of the primary healthcare REITs. Although the latter have the benefit of government-backed rents (c 90% paid directly by government or indirectly through GPs), they have significant exposure to open market rent reviews. Although these are accelerating, we do not expect rent growth to reach 4% in the near term (the average level at which Impact’s indexed rents are capped).

We have referred to Q123 financial performance throughout this note, which built on the strong FY22 underlying income performance and benefited from the stabilisation of the portfolio valuation yield, in contrast to the c 40bp widening in Q422. In Exhibit 10, we present the results on an adjusted earnings basis with a reconciliation to EPRA earnings and IFRS earnings.

In particular we note: