Primary Health Properties — Rental growth further accelerates

A detailed description of PHP’s strategy and the positive fundaments of the market in which it operates can be found in our March 2022 Outlook. In this update we focus on what we think are the key messages from the interim report. These are PHP’s continued opportunities for acquisition growth, despite the rise in funding costs, the acceleration in organic rental growth, and its significant protection from rising interest rates. A summary of the interim results can be found towards the end of this note, along with our forecast updates and valuation analysis.

Driven by strong fundamentals, the investment market for modern, purpose-built primary healthcare properties continued to be competitive through H122, maintaining upward pressure on asset prices. This was reflected in PHP’s net initial yield, which tightened to 4.57% at end-H122 versus 4.64% at end-FY21. At the same time, with interest rates increasing, funding costs have increased. This is true for PHP as although the cost of its existing debt is 95% fixed rate or hedged, the marginal cost of borrowing has risen. In this environment, PHP was highly selective in respect of acquisitions during H122 and has since taken advantage of strong pricing to dispose of a portfolio of 13 properties at 13% above the FY21 valuation. The properties were smaller facilities (average lot size £2.1m) that were well below both PHP’s average lot size (£5.5m) and its targeted lot size, as reflected in recent investments and the investment pipeline. Modern, purpose-built facilities, capable of sustainably providing a wide range of facilities, are invariably of larger scale.

As previously announced, during H122 and subsequently PHP acquired:

PHP also continued to make good progress with the start of construction of the first net zero carbon (NZC) development at Croft Primary Care Centre, West Sussex, with a development value of £6.8m; it achieved practical completion of the forward funded development at Enniscorthy, County Wexford, Ireland, with a development value of c £11m; and expects soon to complete its remaining forward funded development at Arklow, County Wickford, Ireland, with a development value of c £15m. A total of 22 asset management projects were completed or are currently on-site, requiring investment of £14.9m, and will generate £0.3m of additional rental income. Just as importantly, these projects will extend the weighted average unexpired lease term (WAULT) on the properties to an average 20 years and improve their ESG performance.

Although the interest rate outlook has caused PHP to reconsider some potential investments in recent months, the pipeline of opportunities remains strong, totalling c £187m in the UK and c £98m (€114m) in Ireland. Of this, c £123m and c £43m respectively is already in legal due diligence, a significant proportion of which is likely to complete. Approximately 42% of the acquisition pipeline represents opportunities in Ireland, PHP’s preferred area of investment due to higher net initial yields and larger lot sizes. It is already the largest primary healthcare investor in Ireland with a portfolio of 20 assets, valued at £228m, reflecting a large average lot size of c £11m. Similarly, direct and forward funded development opportunities represent c 64% of the acquisition total. With relatively fewer investors able to invest in development assets, competition for standing assets is greater.

PHP fully anticipates that its selective approach to investment, and the assets identified within its pipeline of opportunities, will continue to generate accretive growth as illustrated in Exhibits 2 and 3 below.

It is nonetheless the case that the positive spread over funding costs has narrowed in recent months,1 and an increased focus on development assets will have the effect of deferring cash rental income until completion. This makes the continued acceleration in rent uplifts an increasingly important driver of rental income while also supporting PHP’s selective and patient approach to acquisitions. That patience may well pay off. Yield tightening has been a mixed blessing for a growing business like PHP; it generates capital growth but increases the cost of acquiring assets and inorganically growing income. With bond yields on a rising trend, PHP anticipates that the long downward trend in sector valuation yields is likely to flatten and may even increase slightly. It nevertheless expects positive revaluation movements as rent growth is capitalised.

Rental growth has continued to accelerate, in part benefiting directly and indirectly from inflation, and as PHP is now internally managed, the resulting increase in rental income drops straight to the bottom line. The direct benefit from inflation relates to the 25% of income that is indexed (to RPI and CPI in Ireland) with recent increases progressively feeding into rent reviews. Another 6% of rents provide fixed uplifts at c 3.0% pa. However, the key opportunity to organically grow rental income lies in open market rent reviews, 69% of the total,2,3 which continue to pick up after relatively muted growth in recent years. For open market reviews, land prices and building cost inflation are important inputs into the rent review process for existing assets. New developments create rent benchmarks that in turn provide evidence in the rent setting process for existing assets. If rents for development assets do not keep pace with the cost of development, then the new supply of environmentally efficient, modern, purpose-built assets required by the NHS will be squeezed.

Rent reviews in the UK are typically on a three-year revolving basis and effectively upward only, at the option of the landlord.4 During H122, 192 UK rent reviews were concluded and documented, with a combined value of £24.4m, resulting in an uplift of £1.5m in annualised rents, or 6.1%, representing an average uplift of 3.0% pa. This compares with 1.7% in FY21 and is the highest rate since 2011.

Exhibit 6 provides a breakdown of the H122 concluded rent reviews. Average uplifts of 5.9% pa were achieved on RPI-linked reviews and 2.7% pa on fixed uplifts. A total of 104 open market reviews were settled (H121: 132) at an average of 1.4% pa uplift (H121: 1.0%) including 24 reviews concluded with no uplift (H121: 42). In addition, a further 278 open market rent reviews were agreed in principle, which will add another £1.6m to the contracted rent roll when concluded and represent an uplift of 1.3% pa.

In many cases PHP holds off from settling open market reviews, awaiting the market evidence that will provide support for rent increases. At end-H122 there were 633 open reviews that remain outstanding and under negotiation, with the large number reflecting the requirement for all reviews to be agreed with the district valuer. These represent £85.4m of passing rent, £2.3m lower than the estimated rental value (ERV), a significant upside potential.

PHP has £1,553.3m of debt facilities of which £1,285m was drawn at end-H122. The cash balance was £29.7m, with net debt at £1,255.3m, an LTV of 43.1%. Allowing for capital commitments and including the post-period purchase and portfolio sale investment headroom was £290.6m.

On a pro forma basis, 95% of drawn debt was fixed rate or hedged (compared with the c 92% reported position shown in Exhibit 7) for around eight years, providing significant protection against rising interest rates. The floating rate share of total debt facilities (drawn and undrawn) was 24.1% at end-FY22, at the bottom end of PHP’s 20% to 40% target for floating rate debt exposure.

The end-H122 average cost of borrowing was 3.0%, slightly up from 2.9% at end-FY21, the result of a higher balance of floating rate borrowing. Our forecasts for portfolio acquisition/investment indicate that most of the existing debt facilities will be drawn by end-FY24, increasing exposure to debt that is unhedged. In the near term, the governor of the Bank of England has signalled the potential for taking stronger action to bring down inflation, interpreted by many as a 0.5% increase in the base rate, to 1.75% in August. Meanwhile, financial markets appear to be pricing in an increase to c 3.0% by around the end of the year, before easing. We have sought to reflect this market expectation in our forecasts.

A hallmark of PHP’s performance in recent years has been the lack of surprise. Compared with our expectations this was the case in H122, other than a further tightening of valuation yields and a larger increase in NAV.

From the results we highlight:

Our adjusted earnings forecast for the current year is effectively unchanged (other than for small rounding differences) and likewise DPS. Our EPRA NTA forecast rises with the strong H122 performance.

For FY23 and FY24 our DPS forecasts are slightly reduced in line with adjusted earnings, reflecting a combination of faster rental growth, rental income deferred by an increased focus on development investment, and higher administrative and finance expenses. We have assumed lower capital growth, allowing for the positive impact of rental growth to be partly offset by modest yield widening, reducing our expected rate of growth of EPRA NTA per share.

Our forecasts continue to reflect c £120m pa in investment commitments (the cash flow shown in the financial statements differs, reflecting the timing of development spending) at a blended average c 4.5% and organic rent growth of £3.5–4.0m pa. The implied EPRA cost ratio in our forecast is between 10% and 11% and the blended average cost of borrowing increases from 3.0% in H122 to around 3.2% in FY24.

Historical returns on primary healthcare assets have been higher than other sectors of the UK commercial property market, with a lower level of volatility. This has been a function of the strong fundamental backing for healthcare property, in turn generating secure and more resilient income, and less pronounced yield shifts through the property cycle.

PHP is well into its 26th year of unbroken dividend growth and is on track towards its targeted FY22 aggregate DPS of 6.5p (up 4.8% on FY21), a yield of 4.4% at the current share price. We forecast continuing growth in fully covered DPS (Exhibit 10).

DPS paid represents c 52% of the cumulative NAV total return generated since end-FY16. Capital returns have contributed the balance, including the impact of asset management, rental growth and yield tightening. Since end-2016, the aggregate NAV total return has been 67.3% or an average 9.8% pa. We forecast income returns to represent a greater share of total returns in the coming years.

The security and visibility of income returns is the key driver of PHP’s valuation, in turn providing the support for a continuing valuation premium to NAV. PHP’s share price has not kept pace with strong DPS growth over the past three years (5.1% pa to end-FY22e) such that the P/NAV has compressed. We expect DPS to grow at c 3.6% over FY22–24, and total return by an average 7.8% pa, which, given the security of cash flow and quality of its portfolio, we believe is attractive.

In Exhibit 13, we show the key valuation and performance metrics for PHP and a group of its closest peers, including Assura (another investor in primary healthcare assets), care home investors (Impact and Target) and social housing investors (Civitas, Secure Residential Income and Triple Point).

Over three years, PHP’s price performance is the strongest performer in the group, well ahead of the peer average, the broader UK property sector and the UK equity market.