Target Healthcare REIT — Q322 quarterly return of 2.5%

The 2.5% Q322 NAV1 total return2 takes the FY22 year to date total to 5.8%, despite significant property acquisition costs incurred in Q222. We estimate that adjusting for this, the year-to-date total return would be 7.0%. Consistently positive returns since IPO in January 2013, on both a quarterly and annual basis, reflect the resilience of the sector and of Target’s strategy. The average annual compound return over this period has been 6.1%, of which c 80% reflects dividends paid. A Q322 DPS of 1.69p per share was declared for payment on 27 May 2022 and total DPS declared year to date is 5.07p, with the company well on track to meet its 6.76p (+0.6%) FY22 target.

Target’s unwavering focus on asset quality is core to its strategy for generating sustainable financial returns and social impact. 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 quality and appeal of Target’s assets contributes significantly to income security. This is best demonstrated by Target’s ability to successfully re-tenant properties where the need arises, although re-tenanting is also driven by opportunities to optimise the portfolio. The successful re-tenanting of a minority of Target’s assets and the continued modest tightening of valuation yields also provides tangible evidence of the continuing strong investment demand for care homes as an asset class and for high-quality assets.

Across the sector, despite recent new building and the continued withdrawal of obsolete stock, there are still many older, often converted properties. Many of these may be unsuitable for upgrading and may increasingly be seen as unfit for purpose or economically unviable. While modern, purpose-built homes with flexible layouts and high-quality residential facilities do not guarantee good levels of care, in combination with careful tenant selection they confer clear advantages to operators and residents alike. Among a range of indicators that guide Target’s investment decisions is full ensuite wet room provision, the appeal of which to residents is obvious and the operational advantages have been highlighted by the pandemic through enhanced infection control capabilities. Data sourced by Target from LaingBuisson suggest that across the UK sector, rooms with full ensuite wet room facilities represent a minority (c 28%) of the care home stock, with the vast majority of ensuite facilities representing WC and handwash basins only. Target will only invest in homes with full ensuite wet room facilities in place (more than 95% of portfolio beds) or, on occasion, where there is an agreement with the tenant that a satisfactory upgrade will be undertaken. Most homes in its portfolio were built within the previous 10 years.

Where performance problems arise with a tenant, as an engaged landlord, the investment manager leverages its extensive industry experience to work collaboratively with its partners to support and deliver the best long-term solution. In some cases, the optimal solution is to re-tenant the assets to a stronger operator and, as Target’s portfolio has increased in size and diversity, there have been several examples of this being successfully achieved, with no negative impacts on home residents or Target’s financial returns.

Most homes in the portfolio are mature with stabilised, high levels of occupancy under normal trading conditions. However, with its focus on asset quality, Target also invests in completed newly opened homes and commits to acquire pre-let developments at completion, often forward funding the development phase. Under normal trading conditions, newly opened homes typically require up to 36 months to establish occupancy levels and reach mature levels of financial performance. However, the pandemic has increased pressures on home operators across the sector and has lengthened the time required for new homes to reach maturity, especially for homes where private fee-paying occupancy has been slower to recover.

During Q322, in an example of portfolio optimisation, Target completed the re-tenanting of four homes that it had initiated, moving from a large national operator to an established regional operator, more focused on the local market, in line with strategy. Although the homes were performing satisfactorily, with a substantial remaining lease term, Target was able to negotiate a surrender premium from the outgoing tenant to cover short-term lease incentives for the incoming tenant and lease change impacts on valuation.4 Target says it benefits from a positive financial effect, following agreed capex to each of the homes.

Currently, Target is in the process of undertaking comprehensive asset management initiatives involving two tenants whose resilience in managing multiple new homes has been stretched following restrictions during the most recent COVID-19 Omicron wave. As part of this process, we expect the company to actively pursue the re-tenanting of at least some of the assets operated by these tenants.

The quarterly and year to date NAV movement reflects a positive revaluation movement net of acquisition costs, with dividends paid exceeding the movement in revenue reserves.

The end-Q322 portfolio value was £886.8m, an increase of £16.3m or 1.9% in the period. Acquisitions added 0.8% and like-for-like uplifts, generated by index-linked rental uplifts and modest yield compression, added 1.1%. At the end of the period, the portfolio comprised 99 assets let to 33 different tenants. As previously announced, an operational home in greater Manchester was acquired for £7.2m, let to Harbour Healthcare, a new tenant to the group. Subsequently, Target has committed to the forward funding of a development asset in Dartford, Kent, its 100th asset.

Contractual rent increased by £0.7m or 1.2% during the quarter, including a like-for-like increase of 0.8% from settled index-linked rent reviews. Target has a long WAULT of more than 27 years which, combined with upward-only annual RPI-linked (96% of income) and fixed (4%) contractual rent uplifts, provides significant income visibility and protection against inflation. Uplifts are typically capped at c 4% (with a floor of c 2%) and although this means that while Retail Price Index (RPI) inflation is above 4%, rental growth will lag in real terms, it contributes towards rents remaining affordable for tenant operators and enhances the security of Target’s income.

While contractual rent continued to increase in Q322, passing rent declined slightly to £49.7m (Q222: £51.1m) as a result of short-term lease incentives provided as part of the re-tenanting of four homes in the period (see below).

We expect the current dip in rent collection, to 92% in Q322 versus 96% in Q222, to be short-lived with no material impact on Target’s expected progression to full dividend cover on an adjusted (‘cash’) earnings basis,5 discussed in detail in our April update. We now assume that rent collection remains at 92% until end-June 2022 (end-FY22) and that uncollected rents for Q322 and Q422 are provided for in full (8% of passing rents). This takes the FY22 provisioning rate to 6.6% (c £3.3m) compared with 2.9% (c £1.4m) previously. We expect a sharp decline from FY23 as asset management actions take effect, continuing to expect a return to a background level, prudently assumed at 2.5% of rents receivable. Target’s expected path to full dividend cover includes the impact of continuing capital deployment, a full contribution from previous acquisitions, development completions, rent reviews and economies of scale. Including the April commitment to fund the development of a new home in Kent, Target says that it now has c £67m of capital available for further deployment, allowing for existing commitments, fully allocated to board-approved deals in due diligence. Including the deployment of this available capital and completion of the assets that are under development (including the Kent commitment), we estimate that the Q322 annualised contractual rent of £54.1m will increase to c £64m. We forecast FY24 dividend cover of 99%, based on continuing growth in dividends. We had previously forecast 100% but have increased our interest cost assumption in line with current market rates.

H122 dividend cover was 85% on an EPRA earnings basis and 65% on an adjusted earnings basis. Excluding the £0.8m of non-recurring income in Q3, the net £8.2m of adjusted earnings compares with £10.5m of dividends, suggesting 78% cover. Like H122, including undisclosed adjustments, EPRA dividend cover will have been higher.

Also discussed in our April 2022 update, Target’s long WAULT of more than 27 years, combined with upward-only annual RPI-linked (96% of income) and fixed (4%) contractual rent uplifts, provides significant income visibility and protection against inflation. Rent uplifts are typically capped at c 4% with a floor of c 2% and, although rent growth will lag in real terms while RPI inflation is above 4%, this contributes towards rents remaining affordable for tenant operators and enhances the security of Target’s income. Across the sector the growth in average fees charged has tracked or exceeded inflation over the past c 20 years and we expect improving home occupancy to further assist tenant operators in meeting the inflationary challenge and providing an offset to the gradual withdrawal of government financial support that was put in place at the peak of the pandemic.

The new £100m fixed-rate funding facility that was agreed in November 2021 significantly increased Target’s protection against the prospect of further interest rate increases. Total debt facilities amounted to £320m, of which c £223m had been drawn at end-Q322. Including interest rate swaps, £180m of the drawn borrowings had been fixed at an all-in rate of 3.22% (including amortisation of arrangement costs) at least until November 2025 and mostly (£150m) until January 2032. On the drawn element of floating rate borrowing, priced at a margin over the SONIA benchmark rate, we have increased our debt cost assumption in line with the recent rise in market interest rates.

Our forecasts are updated for the increase in FY22 rent provisioning and, to a lesser extent, for the increase in the cost of floating rate debt due to higher market interest rates. FY22e adjusted earnings and adjusted EPS are both reduced by 10% to £29.9m and 5.0p respectively. Our FY23 and FY24 forecasts are unaffected by the increase in FY22 provisioning, which we expect to be short-lived, with adjusted earnings and adjusted EPS c 0.7% lower as a result of the increased borrowing cost assumption.

The current year DPS target of 6.76p (up 0.6% versus FY21) represents an attractive yield of 5.8%, while the shares trade at a small c 3% premium to Q322 NAV per share of 111.8p. This compares with an average premium since IPO of 7% and a high of c 11%.

In Exhibit 7, we show a summary of the performance and valuation of a group of REITs 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.

Target’s share price yield is clearly above the group average, while its P/NAV is in line with the average. There are several factors that suggest a continuing positive outlook for the shares including a combination of the 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, supported by the resilience of tenants through the pandemic and their long track record of being able to pass through inflationary cost pressures to fee increases.