Impact Healthcare REIT — Strong H1 progress and positive reforms

Impact’s performance during the pandemic has provided good evidence of the resilience of the group’s strategy and of its tenants. Impact has continued to receive 100% of its contracted rent without changes to lease terms or payment schedules, made possible by an affordable level of rents and strong underlying tenant rent cover.1 Average rent cover across all of Impact’s portfolio is now back at the pre-pandemic level of just under 1.9x, which we believe represents a good performance by industry standards.

Tenant rent cover dipped in the early stages of the pandemic as a slowdown in new admissions and an increase in deaths reduced operator occupancy by c 10%, mirroring the industry trend. As occupancy first began to stabilise and has more recently begun to increase again, rent cover has rebuilt, further benefiting from continuing strong fee growth. Average weekly fees in Q221 were c 8% above Q220. The vaccination programme and opening of care homes to visitors has seen pent up demand translate into a normalisation of new admissions while deaths have recently been running below ‘normal’, in combination leading to an occupancy increase. By mid-August, average occupancy had increased to c 83%% from the mid-April low point of c 79% and continues to improve steadily by c 0.2–0.3% per week, which if continued should see occupancy restored to normal levels (c 90%) within six months.

Impact has built its portfolio through acquisitions at an attractive average yield of c 7.4%, but management puts a great emphasis on setting rents at a sustainable level, affordable to the operator tenants, while meeting the company’s investment targets and leaving room for Retail Price Index (RPI) linked rental growth. In this process, management sees property acquisition yields as an ‘output’ of its strategy rather than the ‘input’ driving asset selection. Care homes are primarily considered for acquisition based on actual historical performance rather than future potential. The risks as well as future opportunities are considered, but Impact avoids paying for future performance upfront unless there is a clear and identifiable path to improved performance (for example, through asset management), and in such cases will seek deferred payments, linked to achieved performance targets, in return for increased rents. Having established the ‘correct’ level of rent for the home (typically within the range of 11–15% of operator revenues) this is used as the basis for negotiating an acquisition price that will in turn meet Impact’s investment return targets, a process that does not differentiate between the underlying funding sources (private pay or local authority) of the home residents.

Impact has continued to grow its portfolio, with existing and with new selected tenants to the group, adding further diversification. It acquired four homes late in FY20, three of which are leased to Electus Healthcare, a new tenant for the group, and one to Welford Healthcare (its seventh home leased from Impact). In April 2021 Impact exchanged contracts for two further properties, both let to a new tenant for the group, Carlton Hall. One of these properties is a high-quality care home near Lowestoft, let on a 30-year lease, and the other is a pre-let forward funding arrangement for a new care home in Norwich, pre-let for 35 years. The initial consideration for the two properties is an aggregate £20.8m reflecting net initial yields of 6.3% and 7.1% respectively. The portfolio is now comprised of 111 healthcare properties let to 13 tenants. Of the total, 109 are care homes (107 operational and two under development) and two are healthcare facilities leased to the NHS.

Growth has been achieved while maintaining a moderate level of gearing and has delivered a steady decline in the EPRA cost ratio. The end-H121 gross loan to value (LTV) ratio of 13.7% remained well below the medium-term target of 25% (maximum 35%) ahead of deployment of the April 2021 equity raise proceeds. The EPRA cost ratio reduced to 15.5% in H121, and we expect this trend to continue. The H121 total expense ratio (TER) was 1.50%.

Impact seeks opportunities to further grow the portfolio alongside both existing and new tenants, adding further asset and tenant diversification, and generating economies of scale. As it grows, it is also adding much needed new capacity to the market through forward funding the development of new pre-let homes,2 expanding capacity and the range of services within the footprint of existing homes3, and supporting the development of successful operators within the growing mid-market segment of the care home market. Alongside the recently contracted forward funding of a home in Norwich, pre-let to Carlton Hall, Impact will jointly develop with the operator retirement bungalows within the grounds. This is Impact’s first entry into ‘extra care’.4

Impact has a large and active pipeline of potential acquisition opportunities and significant funding headroom to meet these. Total funding headroom at 20 July 2021 was £101.1m, comprising £22.5m in cash (slightly increased from £17.7m at end-H121) and undrawn debt of £78.6m. The proceeds of the April 2021 £35m equity raise have initially been used to repay debt. After allowing for investment commitments (acquisitions yet to complete, capex, forward funding and deferred payments), the available uncommitted headroom was £70.9m and management estimates that fully deploying available debt would take the LTV ratio to 26%, well within the company’s leverage limits. Within the larger pipeline of opportunities there are several identified assets where Impact is in exclusive discussions with vendors. There can be no certainty that these will complete and for all to complete would exceed the currently available resources (Exhibit 7). As discussed below, we have assumed £60m of acquisitions in our forecasts.

Attracted by the resilient inflation-linked rents available in the care sector, investor demand remains strong and Impact notes new entrants to the sector such as Cofinimmo from Belgium and Korian REIT from France, as well as a more active approach from Octopus in the UK. This raises the prospect that valuation yields will tighten further, benefiting net asset value (NAV) growth but increasing the prices that must be paid for assets. Nevertheless, management is confident that it will be able to continue its accretive growth.

The fundamental drivers of the care home sector remain strongly positive, primarily driven by demographics (an ageing population with increasingly complex care needs) with little correlation to the wider economy. In recent years, capacity has failed to keep pace with this growing need and in many cases homes that are more reliant on local authority funding have been starved of the resources to maintain adequate staffing and levels of care. The recently announced reforms to health and adult social care aim to address this and, in management’s view, have the potential to be transformational. The government announced plans for a cumulative £36bn in new investment in health and social care over the next three years, funded by a 1.25% ring-fenced increase in the national insurance levy. It is the government’s intention to improve the integration of the NHS and social care system to both improve outcomes and generate efficiencies (for example, freeing up hospital beds by increasing access to appropriate alternative care. Most of this new funding will go to the NHS, but £5.4bn pa of additional social care funding, including residential care for the elderly, will be available from 2022–25. The government will set out a detailed plan in a ‘white paper’ later in the year that is expected to make clear exactly how the new proposals will operate. Depending on the detail, as well as providing additional resources to fund more and better services, the reforms have the potential to provide greater certainty to care home operators in their long-term planning, an essential element in making sure that future need are met.

Under the government’s proposals, more people will become eligible for state support for social care, including elderly care, and from October 2023 nobody will pay more than £86,000 for adult social care in their lifetime. Those with assets of less than £20,000 will have their care costs fully met by the state and those with assets of between £20,000 and £100,000 will receive some means-tested state support, compared with the current support cut-off on assets of more than £23,250.

Combined with the growing, demographically-driven need for elderly care, the reduced funding burden on individuals is likely to increase the number of requests that local authorities receive for long-term care. In 2019/20, of the 1.9m requests to local authorities (of which 1.4m were from elderly people), only 839,000 received the care support requested, primarily reflecting limited resources available. The fees paid by local authorities to providers are currently too low and are reset annually, making it difficult for the providers to plan and recruit or retain staff. Because of low fees, local authority-funded recipients of residential care are subsidised by privately funded residents and the government is keen to address this and ensure that local authorities pay a ‘fair rate’. While this appears to be positive for fees, the government is also proposing that self-funders will be able to ask their local authority to arrange their care for them so that they may find better value care. It remains to be seen how this will work in practice, although it seems unlikely that providers will be willing to accept lower fees, especially for existing residents.

Impact very much welcomes the reforms, while making it clear that it awaits further details on how the additional resources will be allocated and how the proposals will work in practice. For providers, the potential benefits are clear and for the elderly, the funding burden has eased, most clearly for the less well off. It may therefore be the case that care homes more heavily dependent on local authority and NHS-funded residents have the most to gain. Local authority fee exposure (both wholly funded or part local authority funded with private top-ups) for Impact’s tenants has increased through the pandemic, but not at the cost of fee growth, as shown in Exhibit 2. Behind this shift in the breakdown of fee sources is the greater discretion that privately funded residents typically have in respect of the timing of admission. A continuation in the recovery of home occupancy should see the private pay share increase. For those with a specific medical need, the NHS already provides c 9% of the funding for Impact’s tenants. For these residents, both the care needs and fees are typically much higher than local authority fees.

The H121 results showed strong year-on-year growth driven by acquisitions and inflation linked (predominantly RPI) rent growth. With an end-H121 contracted rent roll of £33.8m there is further growth embedded in the portfolio (as recent acquisitions/commitments fully complete) before the further portfolio growth that we expect, off a strong and liquid balance sheet. The increased dividend is now fully covered on an adjusted ‘cash’ basis (and well covered on an EPRA basis) and we expect both dividends and cover to increase further.

Key features of the interim results included:

We have made no material changes to our forecasts, explained in detail in our July Outlook, and summarised below.

The company adjusted earnings measure excludes non-cash IFRS rent smoothing adjustments (relating to fixed rent increases and lease incentives) and amortisation of loan arrangement fees. Adjusted earnings approximate to cash earnings and a more conservative indicator of dividend paying capacity than EPRA earnings. We forecast 109% cover of dividend by adjusted earnings in FY21 (135% cover on an EPRA earnings basis), increasing to 119% (144% on an EPRA basis) in FY22. Increasing dividend cover demonstrates the strong cash flow emerging from the growing portfolio. Under the company’s progressive dividend formula, linked to rental growth, the 2.5% DPS growth that the company targets (and we expect) for FY21 looks back to rent indexation achieved in FY20. The increase in cover that we forecast indicates there may be scope for future dividend growth beyond the level suggested by this formula, although we have not forecast this.

Our forecasts are based on an additional £60m of capital deployment by the end of Q122 (March 2022) and 3% RPI-linked rent uplifts in FY22. We assume a 7.25% yield on consideration for the assumed capital commitment, which makes some allowance for the continuing strong investor interest in care home properties, although this may prove to be conservative; management hopes to achieve yields consistent with the c 7.5% historical trend. We estimate the assumed acquisitions represent an effectively full deployment of the recently increased debt facilities (see below) and is consistent with the medium-term target gross LTV of 25%.

We expect property revaluation movements will continue to be driven by rental growth and asset management initiatives in combination with ‘buying well’, contributing to NAV growth.

The current year DPS target of 6.41p (+1.9% vs FY20) represents an attractive yield of 5.7%. The shares trade at a c 2% premium to H121 NAV per share, similar to the average premium since IPO and below the high of c 11%.

Impact aims to provide shareholders with attractive and sustainable returns, primarily in the form of quarterly dividends. DPS has increased each year since IPO, with a clear and progressive dividend policy, targeting growth in line with the inflation-linked rental uplifts received in the preceding financial year. Dividends paid have driven the consistently positive quarterly total returns since IPO in 2017, with aggregate NAV total return (adjusted for dividends paid, but not reinvested) from IPO to end-H121 of 38.1%, a compound annual return of 7.8%. We believe this is attractive in the low interest rate environment that has persisted since IPO, even though slightly below the company’s medium-term return target of 9% pa. Increasing inflation is positive for rental growth.

In Exhibit 13 we show 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.

In terms of share price performance, the peer group has trailed the overall UK property sector and FTSE All-Share Index over the past year as less defensive, more cyclical areas of the market have rebounded from last year’s lows. Over the same period, Impact’s share price performance has been stronger than the average for the group, although its yield remains above average and its P/NAV below average. There are several factors that suggest a continuing positive outlook for the shares including a combination of the long weighted average unexpired lease term (WAULT) with no break clauses and upwards-only, triple net rents, mostly linked to RPI, which provides considerable visibility over a growing stream of contracted rental income. It also offers considerable protection against inflation at a time when inflation expectations are increasing. The robust tenant performance reported by Impact during the pandemic thus far, with no interruption in rent collections, is a further positive indicator for covenant strength.