Target Healthcare REIT — Portfolio performing well and growing

Target Healthcare REIT’s recent Q4 NAV update showed a further increase in EPRA NAV per share in the three months to 30 June 2018 (the final quarter of the 2018 fiscal year) to 105.7p (Q318: 105p). Net gains on investment property valuation added c 1.2p, while the per share movement in the revenue reserve after performance fees (income earnings of EPRA earnings) remains below dividends per share, reflecting the more than one-third increase in share count that resulted from February’s £94m (before costs) capital raise, the proceeds of which are in the process of being deployed. Taking the quarterly change in EPRA NAV per share together with dividends per share paid of 1.6125p, we calculate a NAV total return of 2.2%. On the same basis, we estimate a c 10% NAV total return for the year, including DPS paid during the year, of 6.4p.

Target continues to make progress in deploying its available capital and has now committed c £73.0m to the acquisition of completed and let care homes and to funding the development, and acquisition at completion, of new care homes (see below). The total portfolio value at end FY18 reached £385.5m (market value, before IFRS adjustment for fixed/guaranteed minimum rent reviews), comprising 55 assets, of which 51 were operational and delivering an annualised rent roll of £26.0m (end FY17: £20.3m). The portfolio valuation reflects a net initial yield of 6.44% (end FY17: 6.75%) and revaluation gains continued through Q418 with a like-for-like gain of 2.0%. Rental growth is also continuing, with 13 rent reviews completed during the quarter providing an average uplift of 3.25% pa and resulting in a 0.8% quarterly increase in the like-for-like rent roll. The WAULT was 28.5 years at the end of Q418.

With an end-Q218 cash balance of £41.4m and undrawn debt facilities of £64.0m (drawn debt £66.0m), Target has substantial resources to meet its existing investment commitments (predominantly forward-funding development commitments and some asset management spending) and to complete additional acquisitions from a continuing strong pipeline of opportunities (see below).

While longer-term funding for adult social care continues to be debated publicly and the problems facing the wider industry inevitably receive much media attention, what is often overlooked is the ability of well-managed operators, with efficiently run homes, in locations with a good demand-supply balance to effectively and sustainably meet this need.

Investor interest in such homes remains strong and is continuing to drive a tightening in valuation yields, especially for purpose-built homes in prime locations, focused on self-funded residents. While this is positive for NAV, the yield tightening also highlights the strong competition for quality assets in the market. In this environment, selective investment in modern, purpose-built homes that are most likely to be future proof and to effectively and profitably meet care needs over many years is essential; we believe Target remains focused on building such a portfolio. Target has always put a strong emphasis on selecting the right assets matched with the right tenant, and its growing portfolio is increasingly diversified by tenant (now more than 20), by geography and by resident payment profile, with a relatively high proportion of those who are self-funded. Forward-funding agreements provide access to assets and operators that may otherwise be unavailable. Target itself is not a developer and funds the development of the homes, with agreement to acquire them at completion, on a pre-let basis. As long as the location and operator of the home is carefully selected, the additional risk compared with the acquisition of operational homes should be minimal.

During Q418, Target invested £37.0m (including costs) in the acquisition of two luxury care homes in Cirencester and Camberley. Both assets, totalling 137 bedrooms, are let to subsidiaries of Aura Care Living, which becomes Target’s 21st tenant, on 30-year full repairing and occupational leases with RPI-linked rent increases subject to a cap and collar.

The Q418 investment follows the £21.9m (including costs) that was committed to acquiring and forward funding the development of three new care homes in Q318. These were a 70-bed home at Earl Shilton, Leicestershire, for a total cost of c £6.3m, let on a 35-year RPI-linked lease subject to cap and collar to Care Concern (an existing tenant of the group); and two new care homes, with an aggregate 138 beds, located near Shrewsbury, Shropshire and in Preston, Lancashire, for a combined cost of £15.6m, to be let on more than 30-year duration leases to Rotherwood Healthcare and L&M Healthcare respectively (both new tenants to the group) on RPI-linked leases with caps and collars.

Most recently, since the end of Q418 Target has committed a further £13.9m (including costs) to two additional assets. One of the assets is a 43-bed care home in Doncaster, South Yorkshire operated by an existing tenant of the group, Orchard Care Homes. The full repairing and insuring lease has 24 years remaining and is subject to annual RPI-linked rent increases subject to caps and collars. The other asset is a development site for an 80-bed care home in Burscough, Lancashire. The development will be carried out in partnership with Athena Healthcare, and in addition to acquiring the site, Target will forward fund the development under a capped development contract. On completion, expected in late 2019, the home will be let to Athena on a 35-year lease with RPI-linked rent increases subject to a cap and collar.

Target says it has £52.0m of investment opportunities at an advanced stage of due diligence, and that the majority of these are expected to complete over the next few months. This would leave the proceeds of the February capital increase fully deployed such that the group would once again begin to draw on its debt facilities. In Q318 £15m of revolving debt was temporarily repaid. In addition to these immediate opportunities, a significant value of earlier stage pipeline opportunities is also being assessed by the investment manager.

The broader pipeline is constantly evolving as new opportunities arise and are then subjected to robust consideration with respect to building quality, the ethos and operational capabilities of the operator, rental prospects, and the likelihood of meeting the group’s investment criteria. Although investment yields have tightened, Target continues to identify assets it believes will both meet its near-term objective of generating sufficient income earnings to cover dividend payments when fully invested, as well as generating sustainable value creation over the longer term.

Once existing capital resources have been deployed, we would expect Target to consider increasing its capital resources further, both equity and debt. The February 2018 shareholder meeting approved a one-year placing programme, allowing for up to a maximum 150m shares to be issued including the 87m initial share issue completed at the time, at the discretion of the company, as and when it identifies suitable acquisition opportunities.

From the Q418 NAV report we have a good guide to many of the key financial figures in respect of the FY18 year, for which we expect Target to report in detail in a few weeks. FY18 EPRA NAV appears slightly above of last published forecast, benefiting from higher revaluation gains than we had allowed for, and DPS is in line with expectations for the year. The quarterly NAV reports also provide an indication of the contribution of income returns (EPRA earnings) to NAV growth for the year, and suggest H218 EPRA EPS of c 2.2p, or c 2.4p before investment manager performance fees. This suggests full-year EPRA EPS of c 5.2p, lower than the c 5.6p that we had previously forecast, which we attribute to the timing of acquisitions. The significant amount of funds deployed in the period was actually lower than we had allowed for, based on the published acquisition pipeline that was in place at the time of the capital raise. We expect this to be made up in the coming months and our revised forecasts for FY19 and FY20, detailed below, reflect no material change in aggregate to our investment assumptions over the forecast period to end-FY20. We do factor in a slight reduction in the assumed yield on those investments, reflecting continuing strong investor interest in the asset class, reflected in a market-wide increase in asset prices/reduction in valuation yields. Our FY20 EPRA EPS forecast continues to reflect what we believe to be a fully invested position and, while it is reduced by 1.1%, it remains sufficient to cover the DPS, which we have assumed to grow at c 2% pa.

The key forecasting assumptions that we make relate to assets growth and funding:

Within the broad commercial property universe, Target is differentiated by its focus on care home assets, which appear primed to benefit from the ongoing demographic shifts, and the very long nature of leases arrangements in the sub-sector. Target’s WAULT of 28.5 years at 30 June 2018 is one of the longest of all REITs and, combined with upwards-only rent reviews, mostly capped-and-collared RPI linked, there is considerable visibility to future contracted rental income in real terms.

In Exhibit 4 we show the key valuation and performance metrics for Target and a group of peers that also benefits from lease exposure to both care homes and primary healthcare property. Like care homes, primary healthcare property is also a beneficiary of demographic trends. Compared with care homes, primary healthcare WAULT tends to be lower (closer to 15 years) but has the advantage of substantial government backing for lease payments, either directly or indirectly through GP rent reimbursement. As a whole, the group has de-rated slightly over the past 12 months, with historical P/NAVs reducing slightly and prospective dividend yields increasing slightly. Target’s share price is c 10% below its 12-month high (of 123p in August 2017) and its P/NAV is down from a peak of c 1.20x. One possible trigger for the group de-rating is the increase in long-term interest rate expectations in late 2017/early 2018 (the generic 10-year UK gilt yield was close to 1.7% in February 2018), with the subsequent retracement to c 1.3% triggering a relatively modest correction. Other factors may include equity issuance (including significant cash calls from Assura and PHP as well as Target) and the continuing increase in the valuation of (and cost to acquire) both care home and primary healthcare assets.

Target’s prospective yield of 5.7% is above the group median and its historical P/NAV is in line with the average. Impact Healthcare, another investor in care homes, has a slightly lower P/NAV compared with Target, and a slightly higher prospective yield, but its market capitalisation is somewhat lower and it still has a relatively concentrated tenant base. As noted above, our forecasts for Target include further dividend growth and the potential for full dividend cover in the year to June 2020.