Target Healthcare REIT — Vaccine roll-out adds further confidence

Target seeks to provide investors with stable and sustainable dividend income and to achieve this it invests in modern, purpose-built care homes, putting a strict focus on the quality of the physical assets and their location, and seeks good-quality tenants capable of providing strong levels of care, sustainably, over the long term. The COVID-19 (C-19) pandemic has put this strategy to the test and the evidence thus far shows a generally resilient operational and financial performance by tenant operators, with robust levels of rent collection maintained, and quarterly dividends uninterrupted and continuing to increase. In this note we briefly review C-19 related recent developments before providing a more detailed review of Target’s strategy, portfolio, financial performance and valuation.

On 20 January 2021 Target held a virtual property tour and updated on progress with C-19 vaccinations within the care homes it is invested in. The presentation may be viewed on the company’s website at www.targethealthcarereit.co.uk/investor-relations/reports-and-presentations/financial-reporting. The event was particularly timely given the recent rapid roll-out of the care home vaccination programme, a significant positive development for the sector, while widespread testing across homes now provides a detailed picture of the extent of C-19 infection, and it is now possible to look back and assess the performance of tenant care home operators in managing the operational and financial challenges that the pandemic represents. The presentation provided a positive assessment of its tenants’ performance with managing the pandemic and the contribution that Target’s modern, purpose-built homes make in supporting them. Modern home configuration and design, including en-suite wet room facilities and generous communal space, make it possible to comfortably isolate individual floors, parts of floors or even individual rooms, in order to control the spread of infection, safely support visiting and exercise, and provide good air quality.

Data reported to Target by tenants, during bi-weekly calls, shows that while the incidence of C-19 within portfolio homes has followed the broader wave pattern observed within the wider community, the number of affected homes and the number of cases remain below the levels seen in the first wave of the pandemic. The most recent data as at 1 February 2021, updating on the presentation data, showed a further recent decline in confirmed C-19 cases to 2.1% of beds across 11 of the 73 operational homes in the portfolio, down from the April 2020 peak when suspected or confirmed cases represented 3.2% of beds across 32 homes. There is increased confidence in the current figures, which are derived from mass testing. Most of the operators have been cautious about admitting residents and were quick to implement lockdown procedures. The data indicate that by successfully minimising infection cases, the spread of infection through homes was well-controlled, and that the measures taken have been increasingly effective.

‘Rent cover’ is a key metric used by Target in monitoring and assessing the ability of individual homes and operators to sustainably support the rents that it expects from its portfolio. The ratio tracks operational cash earnings at the home level (before rent) with the agreed rent. Across the entire portfolio the average rent cover for mature homes has remained at c 1.6x throughout the past year despite the operational pressures, including reduced occupancy, faced by operator tenants. Mature homes are defined as those that have had the same operator for a three-year period or more and therefore excludes newly developed homes. Newly constructed homes typically require 18–36 months to build occupancy and rent cover.

From Target’s perspective, homes are fully let to the operators. For the operators, although the reduction in average occupancy within the homes, from a ‘normal’ c 90% across the portfolio ahead of the pandemic to less than 85%, is a clear negative for financial performance and rent cover, this has been offset by fee growth, non-essential cost containment, and government support measures for sector. The 85% occupancy shown in Exhibit 2 is taken from the September 2020 quarterly management data and based on subsequent regular interactions with the care homes the investment manager anticipates a further near-term decline during the final quarter of the year. Annual local authority fee increases (c one-third of residents within the portfolio are fully funded by local authorities or the NHS) came through promptly (and Target describes them as ‘fair’) while fees for privately funded residents have continued to outstrip inflation. Counterintuitively, operators are generally reporting lower staff costs (typically c 60% of all operating costs) where the prime driver appears to be the exceptional effort of full-time staff during the pandemic that has intentionally mitigated the need for high-cost agency staff from outside the homes. Certain non-essential expenditures (eg day-trips/outing for residents) have been curtailed.

As at 1 February, vaccinations had been made available to all to residents and staff in all of the group-owned care homes, with substantial uptake across each group. In addition to the immediate benefit to residents, staff and their families, the vaccination programme should be a key step in the process to rebuild occupancy. The demand for residential care is primarily driven by need and while those in need and their families may have the flexibility to defer admission, this may not be possible over the longer term. Home managers have been reporting a good level of enquiries and when combined with an easing in visitor restrictions, the vaccine roll-out should support an increase in admissions, although Target’s investment manager, perhaps cautiously, suggested that it may be late in the year before occupancy within the homes returns to normal.

Rent collection has continued to be robust in recent quarters, demonstrating the overall stable and secure nature of the portfolio's cashflows. As at 1 February 2021, 92% of the rent due and payable in respect of the quarter had been collected, with the collection pattern remaining consistent with recent quarters.

While the portfolio overall is continuing to perform resiliently, there are obviously variations across 73 operational homes (76 including developments) that are let to 27 different tenants. The majority of recent and ongoing rent arrears relate primarily to two tenants across four of the homes. Two of these homes are relatively new, immature homes, operated by one of the tenants. Performance improvement was punctuated by C-19 but occupancy and trading are again improving towards the levels anticipated by the investment decision. The other two homes are mature homes that were acquired at yields that reflected the increased level of risk posed by the operator performance and, although delayed by C-19, Target is making progress to replace the operator. Changing tenants when required is part of the investment manager’s role as an engaged landlord and the successful FY20 re-tenanting of six assets (c 8% of rent roll) leased to Orchard Homes, preserving shareholder value and continuity of resident care, demonstrates the resilience of good-quality assets that will appeal to a range of tenant operators. The FY20 results included £2.1m in provisions for doubtful rental income and although the H121 results have not yet been published, our analysis of the quarterly updates suggests a similar level of provisioning (see page 6).

As at 31 December 2020 (end-Q221), Target’s portfolio was valued at £647.7m, comprising 76 properties, of which 73 were operational and three were pre-let sites being developed under forward-funding agreements, let to 27 different tenants. With an annualised contracted passing rent of £40.6m (£39.4m of annualised cash passing rent after adjusting for short-term lease incentives), the portfolio valuation reflected an EPRA topped-up net initial yield of 5.97%. The weighted average unexpired lease term (WAULT) of 28.7 years remained very high, the product of 30- to 35-year leases at inception and the low average age of the portfolio. All leases are fully repairing and insuring, and upwards-only, with the majority RPI-linked, subject to caps and collars, although some have fixed annual uplifts. The long WAULT and inflation-linked leases provide considerable visibility of long-term income growth.

Investment activity paused for a while as the effects if the first wave the pandemic were assessed, but recommenced in July 2020 with the £15.0m (including costs) acquisition of a new-build care home in Bicester, Oxfordshire. The high-quality, 66-bed, purpose-built asset is let to Ideal Carehomes, the group's largest tenant, on a 35-year, fully repairing and insuring, occupational lease that includes annual, upwards-only RPI-linked increases, subject to a cap and collar.

Two pre-let development sites have also been acquired subject to forward funding agreements:

Both are pre-let to existing tenants of the group on 35-year, fully repairing and insuring, occupational leases that include annual, upwards-only RPI-linked increases, subject to caps and collars.

Also during H121, practical completion was reached on the £10m forward-funded development of an 80-bed care home in Burscough, Lancashire, let to Athena Healthcare, an existing tenant, on a 35-year lease with RPI-linked increases, subject to a cap and collar. Construction work continues on the c £10m forward-funded development at Rudheath in Cheshire, pre-let to L&M Healthcare, an existing tenant.

The investment market for high-quality, modern, fit-for-purpose assets that meet Target’s strict investment criteria remains very competitive. Strong investor appetite continues, with the best properties and sites attracting offers and transacting at pre-C-19 pandemic pricing. The investment manager is analysing and undertaking diligence on a number of potential acquisitions, with a combination of imminent, near-term and earlier-stage opportunities, but says that commitments to future acquisitions will continue to be considered carefully, taking into account both the market outlook and available capital. We discuss the recently increased, current debt funding headroom in the financial section below.

Exhibit 4 summarises Target’s consistent growth in balance sheet, earnings and dividends since IPO. Despite the first impacts from COVID-19, this growth continued in the year to 30 June 2020 (FY20), with further progress in H121 (see quarterly commentary below).

During FY20 the equity base was increased by the £80m (gross) equity raise in September 2019 (Q120) with the proceeds directed towards further strong growth in the portfolio, although investment paused during the first wave of the pandemic. A total of £117m was invested in the acquisition of 12 care homes/sites. Rental income increased by c 29%, EPRA earnings by c 25% and adjusted earnings by c 15%. As noted above, rent collection both in FY20 and during H121 has remained robust but earnings were affected by £2.2m (FY19: £0.3m) of provisions taken against rent receivables. Despite this, DPS was well covered by EPRA earnings although on an adjusted earnings basis, Target’s preferred measure of ‘cash earnings’, it reduced to 76% compared with 82% in FY19. Adjusted earnings exclude the non-cash IFRS rent smoothing adjustments that are included within EPRA earnings and includes licence fee income earned on forward funding advances in respect of development properties that remain under construction.

Like-for-like rent growth was 1.5% during the year and was a key driver of the 2.8% increase in like-for-like property valuations, along with continuing yield compression. EPRA net asset value (NAV) per share increased to 108.1p from 107.5p and including dividends paid, NAV total return (change in NAV plus dividends paid but not reinvested) was 6.8%.

Although Target is yet to report detailed financial results for H121, the unaudited quarterly reporting shows continuing growth in NAV, recurring earnings and dividends in the period. EPRA NAV has increased slightly from £494.3m at end-FY20 (the small difference from shareholders’ equity in Exhibit 4 relates to the EPRA add-back of swap liabilities) or 108.1p to £494.8m/108.2p. The aggregate quarterly movement in the revenue reserve during H121 is c £11.9m, an increase on both H120 and H220. The movement in the revenue reserve is broadly equivalent to adjusted earnings, except that adjusted earnings also includes licence fees earned on forward-funding extended in respect of development assets under construction. EPRA earnings includes the IFRS rent smoothing adjustments that are yet to be reported.

Based on our analysis of rent roll, disclosure on rent collection and management’s commentary in respect of tenant performance, we assume that the H121 movement in the revenue reserve includes further provisions in respect of rent receivables, which we estimate at c £2m. The reported movement in H121 revenue reserve represents just under 80% of dividends paid in the period but adjusted for our estimate of H121 rent provisions would increase to more than 90%. Although the provisions are a near-term drag, recent commentary from the investment manager suggests that progress is being made with resolving the operational issues at the small number of homes that are the main contributors. The positive movement in H121 NAV is driven by continuing rent indexation and a further slight tightening in valuation yields driven by continuing strong investment interest in good-quality care home assets. Including DPS paid the H121 NAV total return was 3.2%. The quarterly run rate of dividends was again increased for the current year to 1.68p or an annualised 6.72p (FY20: 6.68p).

We will update our forecasts with the interim results, which last year were published in March. Our last published forecasts, shown in detail in the financial summary in Exhibit 12 at the back of this note (and explained in our last published note), are yet to reflect the H121 investment activity detailed above (the acquired home at Bicester and the Chesterfield and Droitwich Spa developments) and have not been updated to reflect the H121 performance implied in the quarterly reports. Compared with our last published forecasts, H121 investments increase annualised rental income on a fully developed basis, while rent provisioning will act as a drag on income. By way of illustration, if one were to apply the current portfolio EPRA topped-up net initial yield of c 6% to the c £36m of disclosed H121 investment commitment, this would represent additional annualised rental income of more than £2m. This is broadly equivalent to our estimate of H121 rent provisioning. More provisions are possible in H221, although the vaccine roll-out represents a positive indicator for future tenant financial performance, and Target’s rent collection, across the portfolio.

To fund portfolio growth since IPO, Target has steadily increased its capital resources, both equity and debt capital, sufficient to take advantage of opportunities in the market while avoiding excessive gearing and mitigating any drag on returns. The company targets moderate gearing with a medium-term target of around 25% (borrowings to gross assets) with a maximum permitted level of 35%.

The last equity fund-raising was in September 2019 (Q120) when £80m (gross) was raised in an oversubscribed issue of 72.4m shares. The equity proceeds were quickly deployed but there remained considerable scope to re-gear the balance sheet with additional debt funding. The COVID-19 pandemic then slowed investment activity, leaving the balance sheet conservatively liquid and modestly geared. Recent investment activity has put additional capital to work and although the end-H121 gross loan to value ratio (LTV) of 25.0% is little different to end-FY20 (24.6%), the deployment of cash resources has seen the net LTV increase from 18.7% to 22.2% over the same period. As further debt is drawn to complete the existing forward funding commitments, we expect gross LTV to increase to c 25%. Additional debt facilities are in place to support further acquisition-led portfolio growth, but we would expect Target to seek additional equity funding in the medium term.

During H121, drawn debt has increased from £152m to £162m and available debt facilities increased from £180m to £220m. The committed debt facilities comprise £80m of fully drawn fixed-rate term loan facilities and £140m of more flexible variable rate revolving credit facilities (£82m drawn at end-Q221), diversified across three lenders. The extension both in the quantum and tenor of the group's borrowings during Q221 was completed with a minimal increase in the ongoing interest costs in return for a significant lengthening of the weighted average term to expiry to 5.3 years (Q121: 4.0 years). The weighted average cost of drawn debt, including amortisation of loan arrangement fees, was 2.81% at end-Q221 versus 2.72% at end-Q121.

The changes to the HSBC and RBS facilities also address the required transition, by the end of 2021, away from Libor based loan rates towards the new Sterling Overnight Index Average (SONIA) benchmark. An existing hedge on the £30m term loan element of the RBS facility was closed out and replaced with a new SONIA-based interest rate swap, aligned with the new term loan. The one-off costs of the refinance reduced Q221 NAV growth by 0.2%. Post the refinancing, £80m of the debt facilities are fixed rate/hedged and £140m floating rate. All loans are secured against investment properties owned by the group with maximum LTV requirements of 50–60% and interest cover ratios of a minimum 300%. All of the covenants have been complied with during the past year.

Annualised DPS has increased in each year since IPO in 2013. The current quarterly run rate of DPS (1.68p) leaves the company on target for aggregate annual DPS of 6.72p in the current (FY21) financial year, representing a prospective yield of 5.8% and taking annual compound growth in DPS since 2014 to 1.63%. Based on the end-Q221 EPRA NAV per share of 108.2p, the P/NAV is 1.07x, broadly in line with the average since IPO of c 1.08x and below the peak of 1.19x. The only period of notable relative weakness in the P/NAV was at the start of the C-19 pandemic, although this has now retraced as tenant operators have generally shown themselves to have been both operationally and financially resilient in the face of the challenges that they have faced.

Exhibit 10 shows the consistently positive NAV total return history since IPO. The cumulative total return (adjusted for dividends paid but not assuming reinvestment of dividends) from IPO in March 2013 to 31 December 2020 (end-Q221) was 59.2% or an average annualised rate of 6.0%. Dividends accounted for c 80% of the total.

In Exhibit 11 we show a comparison of Target with its nearest competitors. With investors attracted by secure, long-term yield, the group has performed relatively well over the past 12 months, outperforming the FTSE All Share Index and the broader UK property index. Long-term income, especially indexed to inflation, is attractive to investors provided the tenants are secure. The impact of tenant covenant strength can be seen in the valuations of the primary healthcare investors (Assura and PHP), which trade with below average dividends yields, resulting in above-average P/NAV ratings. In our view this is substantially a reflection that rents are c 90% funded by government, either directly or indirectly through GP rent reimbursement.

The Target dividend yield is well above the peer group average and its P/NAV broadly in line. The care home sector in which it invests should benefit from long-term, demographic-driven demand for care home places and a requirement for private capital investment to meet this need. In the near term, while care home operators have inevitably been challenged by the C-19 pandemic, the overall resilient operational and financial performance to date of Target’s tenant operators is highly reassuring, with rent collection to support dividends remaining robust. Looking forward, the rapid roll-out of the C-19 vaccination programme should provide significant support to operators as they seek to rebuild levels of occupancy. A successful test of the strength of tenant covenants during the exceptional challenge of the pandemic suggests good potential for Target’s yield differential to narrow versus the peer group average.