Impact Healthcare REIT — Resilient growth staretgy

Although many of the key headline numbers in respect of FY20 have been previously released, publication of the detailed FY20 results provides an opportunity to assess the strong progress made during the year, and the resilience of the group’s strategy, against the challenging backdrop of the pandemic.

Impact received 100% of its contracted rent for 2020, with no changes to lease terms or payment schedules, and this has continued into the current year. This strong performance can primarily be attributed to:

With no material change in the underlying demographic drivers of care home need/demand, care home managers report a high level of tenant enquiries. Meanwhile, the fast roll-out of the vaccination programme within care homes and the gradual easing of visiting restrictions are positive steps for the home operators in rebuilding occupancy. Residents at all of the group’s homes had been offered their first dose of a COVID-19 vaccine by mid-February 2021, and by 25 March, 80% had received a second dose. Impact is cautiously optimistic about the speed with which the operators will be able to rebuild their occupancy, but notes that the pandemic is not yet over and remains unpredictable. At one of its homes (at Holmesley, operated by Welford) a severe and as yet unexplained COVID-19 outbreak occurred in late February/early March despite what appear to be effective infection-control measures being in place, and following initial vaccinations. Welford is a strong tenant with a good level of overall rent cover and Impact does not expect the problems at this one home to have affect rent recovery.

Exhibit 3 provides a summary of the FY20 financial performance. Accretive acquisition-led asset growth drove the strong increase in earnings and cash flow, enhanced by scale efficiencies, to support increasing dividends and dividend cover. We note the following key highlights:

In this section we provide a brief updated overview of Impact’s portfolio, which continued to grow and diversify (by asset, location and tenant) during FY20. The annualised contracted rent roll of £30.9m at end-FY20 has since increased to £31.7m, including the acquisition of Mavern House for £5.1m (before costs) at an acquisition yield of 7.6%, and rent reviews. Included in rent roll is one forward funded new development at Hartlepool that is expected to complete by mid-year 2021 (we estimated rent of c £0.5m).

The total number of tenants has now selectively increased to 12 (from two at IPO) and while this increasing diversity is welcome, management continually stresses that the target is not simply to add more tenants, but to add selected quality tenants with which to partner over the long term. The portfolio is well diversified geographically, although the investment manager highlights opportunities to grow in the Midlands area.

Of the 108 properties owned at end-FY20, 106 are care/nursing homes let 11 tenants on leases of 20–25 years, with no break clauses. Rents are subject to annual upward-only reviews linked to RPI, with floors and caps of 1% and 5% or 2% and 4%. The remaining two homes are healthcare facilities leased to the NHS (the 12th tenant of the group).

Portfolio growth has been achieved primarily through portfolio acquisitions, often less competitive and off-market, at attractive yields, consistently in the range of 7.5% before costs. Portfolio acquisitions have been a source of asset management opportunities, a core part of Impact’s strategy.

Impact considers asset management to be one of the most attractive strategies available to it for the deployment of capital and for enhancing returns beyond a pure ‘buy and hold’ strategy. Unlike ‘physical’ asset management in the mainstream commercial property sector, which often involves the landlord taking advantage of or agreeing a void period in which to reposition the property with the aim of increasing its attractiveness, income potential and valuation when subsequently re-let, for Impact it is led by the tenants, identifying and agreeing with Impact projects that can create value for both parties. Tenants benefit from the potential to enhance or extend facilities, broaden their appeal to residents, and increase earnings. Impact benefits from higher rents and improved rental cover, with the potential for capital appreciation. We consider the risks to be low compared with speculative or greenfield development.

Most assets within Impact’s portfolio are defined as ‘core assets’ (68% by value). These are good quality buildings, requiring little or no investment, with a stable trading performance underpinning a sustainable level of rent cover, and an expected useful life that is greater than the duration of the leases. A further c 30% (by value) of the portfolio are defined as ‘value-add assets’. These present opportunities to deploy additional capital to enhance the asset and its performance in a way that creates value for both the tenant and Impact. Typical candidates may be smaller homes and/or those with a low level of en-suite bathrooms or other elements of functional obsolescence. Larger homes may benefit from investment that would enable them to offer a new service such as dementia care or other facilities that may increase their appeal to the private fee-payer market. During FY20 Impact completed two significant projects, at Diamond House, Leicester, and Freeland House, Oxfordshire, both involving the development of new specialist dementia care facilities at the existing homes. Non-core assets represented less than 2% of the portfolio value at end-FY20. They are most likely to have been acquired as part of larger portfolio acquisitions and may have a limited lifespan because of a high degree of functional obsolescence or they may be geographically isolated and are likely to have a higher alternative use value. During FY20, one of these was sold for £0.9m, a 24% premium to the carried value.

So far in FY21 Impact has acquired one home (Mavern House) for £5.1m (before costs), completing in January. In our forecasts we include Mavern House and assume an additional £25m in acquisitions by the end of H121, at a 7.5% yield on consideration. We believe this yield assumption is consistent with the historical trend (shown in Exhibit 7). Our acquisition assumption is consistent with the strong pipeline of investment opportunities identified by the company and reiterated with the results, and strikes a balance between the company’s aim of further deploying available capital while maintaining a good level of liquidity. We estimate an end-FY21 gross LTV ratio of c 24%, well below the company’s 35% upper limit, with net LTV at c 22%.

We have assumed rent indexation at 1.5% pa in FY21 (was 2.0%) and 2.0% in FY22, with rents continuing to be received in full without deferral or waiver.

We expect revaluation movements will continue to be driven by rental growth and asset management initiatives in combination with ‘buying well’. We allow for existing asset valuations to increase in line with our rental growth assumption, for an uplift on asset management investment and for the yields on acquired assets to migrate towards the portfolio average over time. In FY21 this is partly offset by our estimate of acquisition costs written off.

Exhibit 9 shows a summary of our key forecasts, which in underlying terms are little changed. We have slightly reduced our forecast for the non-cash IFRS rent smoothing adjustment (in respect of the straight-line recognition of fixed rent increases over the long contractual lease period) to rental income, affecting EPRA earnings but not adjusted ‘cash’ earnings. We forecast aggregate FY21 DPS in line with the company’s 6.41p target with further growth of 2% to 6.54p in FY22, in line with our rent indexation assumption. Forecast earnings continue to benefit from accretive acquisitions, with EPRA dividend cover increasing further and full cover on an adjusted earnings basis from FY21.

Based on the current equity capital base, our forecasts imply cash dividend cover of 1.10x in FY21 and 1.16x in FY22. Increasing dividend cover demonstrates the strong cash flow emerging from the growing portfolio. The coverage ratio is relatively high compared with the REIT distribution requirement (minimum 90%/1.11x pay-out of tax-exempt property rental income within 12 months of the accounting period end) and reflects the increasing level of deployment of current capital implied by our portfolio growth assumptions (see below).

Impact entered the COVID-19 pandemic with low gearing, good liquidity, material borrowing headroom on existing agreed debt facilities and no debt maturities before 2023. It currently has £125m of committed banking facilities comprising a £25m term loan facility and £100m of more flexible revolving credit facilities (RCF). At the end of FY20, £76.4m of the debt facilities had been drawn reflected in the reported gross LTV of 17.8% (including cash of £8.0m the net LTV was 16.2%). Thus far in FY21 Impact has drawn down an additional £20m to fund acquisitions and other capital commitments and our forecasts assume that £40m in total is drawn during the year. Including both the additional debt and our assumed acquisitions, we expect a gross LTV of just over 24% at end-FY21. With an internal upper limit to gross LTV of 35%, scope would remain for further accretive growth funded by increased debt facilities. Impact says that it is continuing to explore new alternative sources of debt finance to support the continued growth of the business while maintaining conservative leverage levels. With this in mind, and given the scale of the market opportunity, we would expect the company to also seek additional equity funding at some stage in the future.

We estimate the average maturity of the debt facilities at a little under 2.5 years with an average cost of c 2.4% (based on three-month Libor at 0.1%). To mitigate the interest rate risk of the variable rate borrowing, Impact has hedged £25.0m, until June 2023, with an interest rate cap that protects against a rise in Libor above 1%.

Impact has a clear and progressive dividend policy under which it seeks to grow its dividend in line with inflation-linked rental uplifts, and has increased annual aggregate DPS each year since IPO. The increased dividend target of 6.41p (+1.9%) for FY21 represents an attractive yield of 5.6%, while the shares trade at a small c 4% premium to FY20 EPRA net tangible asset value (NTA).

Dividends are a key component of the wider total return target of 9% pa, alongside the potential for capital growth (driven by inflation-linked rental growth and asset management opportunities) enhanced by moderate gearing. Since IPO in March 2017 to the end of FY20, the cumulative total return (adjusted for dividends paid but not assuming reinvestment of dividends) was 33.8%, or an average annualised rate of 7.9%. Dividends accounted for around two-thirds of the total return. We estimate that adjusting for acquisition costs incurred in growing the portfolio since IPO and subsequently written off, approaching c £10m or more than 3p per share, the cumulative total return would increase with the average annualised return being 8.6%.

Exhibit 13 shows a summary of the performance and valuation of a group of 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. The table is based on trailing DPS declared and so does not reflect the increase in Impact’s FY21 DPS target.

In terms of share price performance, the peer group has outperformed the overall UK property sector and the FTSE All-Share Index over the past year. We attribute this to the long-term leases, in many cases indexed to inflation, typical of the group as well as strong tenant covenants, reflecting the essential role that the assets play in supporting the care and health sectors. Impact shares have performed slightly ahead the average, particularly over the past three months, capturing the period of vaccine roll-out across the care home sector. Despite this, the care home investors, Impact and Target, continue to have the highest yields in the peer group.

In our view, the potential for a re-rating of Impact shares is strong, based on: