Impact Healthcare REIT — Visibly growing income and capital

Finding well-performing tenants, providing good levels of care, in suitable buildings let at affordable rents is the core of Impact’s strategy of generating attractive and sustainable returns, mainly in the form of quarterly dividends. The company’s external specialist investment manager brings considerable experience of the UK care home market. It has been of particular benefit in the sourcing of acquisitions and the selection of an increasingly diversified tenant base, of established mid-sized operators, with whom Impact can partner and grow over the long term. Asset growth has been achieved mainly through off-market acquisition of small portfolios, comprising operational homes with established trading histories, and with attractive and sustainable initial acquisition yields, consistently around 7%. The assets mainly comprise a majority core of good-quality, upper-middle-market homes alongside value-add assets that offer tenant-driven asset management opportunities with potential for low-risk enhancement of returns beyond that available from a pure ‘buy and hold’ strategy. A continuation of successful operator performance combined with long, upwards-only, inflation-linked leases promises a high-quality, sustainable and growing income stream to support dividends. Care homes have a vital role to play in an integrated care system, capable of efficiently meeting the current and growing needs of the elderly and relieving strains on the hospital system. Impact believes the homes it targets, which are positioned in its preferred upper-middle-market segment broadly serving both the local authority and private markets and providing good quality care at affordable cost, will remain key to meeting this challenge.

We identify the key elements of the investment case as:

The only material change to our last published forecasts is a reduction in our forecast debt costs, particularly in FY25, driven by moderation in market interest rate expectations in the interim. Otherwise, we expect rental growth, a combination of rent reviews and asset management projects at completion, with a targeted yield on investment of at least 8%, to drive earnings growth. We expect continuing earnings growth through FY26 despite the maturity of currently hedged floating rate debt in late 2025. Market interest rate expectations indicate a relatively modest impact on overall borrowing when this debt is refinanced at or before maturity.

Our NAV/NTA forecasts assume a positive impact on property valuations, with the valuation yield stable.

In the table below, we show earnings on the company’s adjusted basis, to provide a clearer indication of cash earnings to support dividend growth, and on an EPRA earnings basis. Both exclude valuation movements but, unlike EPRA earnings, adjusted earnings also exclude non-cash IFRS rent-smoothing adjustments, loan arrangement fee amortisation and include the interest received on interest rate caps.

Driven mainly by dividends paid, the average annual NTA/accounting total return since listing has been 7.1%. Dividends have increased each year and have accounted for 70% of total return over this period. The total return has been positive in each year, including through the COVID-19 pandemic and in FY22 when interest rates began to increase and the UK commercial property market experienced widespread declines in property values. The FY23 NTA total return of 10.5% was the highest since listing and the unaudited Q124 return was 3.2%, including a benefit from the significant number of rent reviews in the period.

Strong care sector fundamentals and non-cyclical, long-term, inflation-protected income prospects have mitigated the impact that rising bond yields and economic uncertainty have had on property valuations across the broad UK commercial property sector. Also, in contrast to that wider sector, investment demand for good-quality care home properties has remained robust.

The EPRA topped-up net initial yield (‘the valuation yield’) of Impact’s portfolio at the end of FY21 was 6.7% and although it rose in late 2022 (to 7.0%), directionally in line with the broader UK commercial property sector, the widening was significantly less, and valuations were more robust. Yields have tightened very slightly over the past years and the end-Q124 yield was 6.9%.

Long-term relationships

Given the nature of the care sector, Impact seeks long-term relationships with carefully selected tenant operators with whom it can grow. It invests alongside them in suitable properties that they can operate efficiently and provide a good quality of care. It looks for operators that it believes are most likely to provide good care, while running a sustainable and profitable business, with experience of home improvement and ambitions to grow. The investment manager’s sector experience and industry/operator relationships are highly beneficial in assessing potential operators.

Throughout the challenges of the pandemic and subsequent spike in inflation, the performance of Impact’s tenants has been well-tested and has generally remained robust.

In part, the robust performance of tenants through the COVID-19 pandemic was assisted by government grant funding for what was recognised as a critically important sector, but also significantly reflected tenant operational efficiency, Impact’s close relationship with and monitoring of them and, perhaps most importantly, affordable rents. A combination of the continuing post-pandemic recovery in home occupancy, strong fee growth, and easing staff shortages (with less need for expensive agency staff) have all contributed to a more sustained improvement in tenant profitability. Capped rent increases have also protected tenants against the pressures of elevated inflation, just as they are designed to do. Similarly, over previous periods of low inflation, the floors on rent increases (typically c 2%) have worked to the company’s advantage.

Occupancy has recovered strongly since a COVID-19 pandemic low point of 79%, back towards a more normal 90%. The average home-level occupancy achieved by Impact’s tenants was 88.3% in Q124, very slightly up from end-FY23, with some further upside remaining. The level of increase has levelled out in recent months and in this respect, we note indications across the sector that some operators are increasingly focused on ensuring that fees for new residents are appropriate to the level of required care, as opposed to simply prioritising occupancy. Average weekly fees increased by c 13% on average during FY23, consistent with the sector track record of successfully increasing fees ahead of inflation.

Despite the sector challenges, rent cover6 has remained consistently strong and within the historical range. Average rent cover over the 12 months to end-Q124 was 2.0x, similar to the FY23 average, although it reflected the usual seasonal cycle.7

Impact has a very strong track record of rent collection, fully collecting rents, with no contract variations, from listing until end-FY22. It was only at the end of FY22 that one tenant (of 14), Silverline, got into financial difficulties and requested a six-month rent holiday from 1 January 2023.

The background to the problems with Silverline were covered in detail in our June 2023 update. The strength of rent cover across the wider portfolio provides a strong indication that the problems encountered by Silverline stemmed from its inability to respond effectively to industry challenges and were not indicative of wider stresses among Impact’s other 13 tenants.

Silverline operated seven Impact homes, three in Bradford, with identified turnaround opportunities, and four homes in or around Glasgow, with annualised contracted rents of £1.6m. Following a detailed internal and independent assessment, Impact was satisfied that the assets operated by Silverline were capable of providing an attractive and sustainable return with good levels of care, subject to enhanced stewardship. Extensive discussions were held with a number of alternative care providers, but the company concluded that a consensual transfer of the Silverline operations to Melrose Holdings (MHL), a newly created affiliate of an existing related party, Minster Care Group, would provide the best outcome for all stakeholders. MHL was able to immediately take on operational responsibility for the homes, supported, under a service agreement, by Minster. Minster has significant experience operating mid-market homes in both England and Scotland and a track record in turnarounds.

Since transferring the operations of the homes, their underlying performance has improved, albeit at a faster pace in the assets located close to Glasgow than in Bradford, providing support to Impact’s assessment of the quality of the of the homes. The performance improvement enabled Impact to begin discussions with potential long-term, third-party operators for the homes and all three of the Bradford homes have now been transferred to a new tenant, We Care Group on long leases.8 We Care is an experienced operator with over 30 homes located throughout the North of England and it has significant experience with turnaround homes, including in the Bradford submarket. The transfer agreement includes a rent-free period and a lease incentive of £1.5m, of which £0.25m is additional cash for We Care to invest directly in the homes. These incentives are structured to enable We Care to complete the refurbishment of the homes and absorb the working capital funding provided by Impact during the turnaround phase into the long-term lease returns of the properties. Impact expects cash rent payments to resume in the first quarter of 2025, although we expect an immediate contribution to ‘smoothed’ IFRS rental income.

The four remaining homes, located in Scotland, that were transferred from Silverline continue to be operated by MHL. The investment manager is making progress with its negotiations to transfer these four homes to a new operator on long-term leases.

Setting affordable rents at the outset has been key to maintaining rent cover on a long-term basis, including through challenging market conditions.

We estimate that across Impact’s portfolio the average value per bed is c £90,000 and the average rent per bed is c £6,500. The build-cost per bed for a modern, high-quality, purpose-built home is likely to be as much as twice this, albeit with a superior specification, including energy efficiency, to the benefit of operators, staff and residents. The point is not that one property is better than the other but that higher capital costs require higher rents and higher resident fees, which to a large extent defines the scale and scope of the market they are able to address.

In the example provided by Impact below, it compares the actual data from a selected home within its portfolio (home A), with mostly local authority funded (82%), with the data, supplied by a developer, of a ‘typical’ new build home (home B) with fees mostly privately funded. Reflecting the resident/funding mix, weekly fees for home A are significantly lower for home B, although its cost structure is not materially different. Staffing ratios in particular are relatively similar across the sector, and differences predominantly reflect acuity. Home A earnings before amortisation, rent, and management overhead (EBITDARM) is much lower at home A but so too is rent. Rent cover is correspondingly 2.6x compared with 1.6x at home B. No capital costs are provided in this illustration but we estimate that applying a yield of 6% to home B rents suggests a value per bed of c £236k while a yield of 7% applied to home A indicates a value of £77k per bed.

Careport, the operator of home A and eight other Impact homes, is a good example of a successful operator with predominantly publicly funded residents (an average 74% across all of its homes in 2023). It has sought to differentiate itself as a leading provider of higher acuity dementia care in each in which it operates, generating high levels of occupancy (an average 96% across all its homes in 2023) and a good level of profitability (average 26% EBITDARM margin since 2020), enabling to invest back into its homes and operating systems to improve care and generate efficiencies.

Impact considers asset management to be one of the most attractive strategies available to it for deploying capital, enhancing returns beyond a pure ‘buy and hold’ strategy. The total spend since listing has been £32m but we expect this to accelerate and make an increasing contribution to Impact’s growth while enhancing asset quality.

Asset management projects are designed to enhance tenant revenues, increase rents and improve capital values. Projects are undertaken in partnership with tenants, who 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. Meanwhile the risks are typically low compared with new development. The additional rent to paid to Impact is set at level that generates a yield on investment of at least 8%.

Asset management projects vary considerably in scope and scale. Notable previously completed projects include Diamond House, Leicester, and Freeland House, Oxfordshire, where new specialist dementia care facilities were developed within the footprint of the existing homes. At Fairview House and the adjacent Fairview Court, a new ‘link block’ was constructed to bring the two buildings together and a comprehensive upgrade to Fairview House is close to completion. The refurbishment will bring it up to the same high standard as Fairview Court, adding ensuites to bedrooms, improving the residents’ day spaces and increasing energy efficiency, so the new combined building will have an EPC rating of A.

Fairview provides an interesting example of the attractive returns that asset management can generate. The homes were originally acquired for £4.9m, with the £0.4m of annual rent reflecting a gross initial yield of 7.3%. The developments represent a further investment of £3.5m, bringing the total invested to £8.4m. Including rent increases since acquisition and rentalisation of the capex at 8.6%, contracted rent has increased to c £0.7m, a yield of more than 8% on investment, well above the portfolio average. In combination with the enhanced quality of the asset, this indicates strong potential for further valuation uplift following completion of the works.

During 2023, Impact approved new asset management projects with a combined investment value of £11.7m, of which £2.2m was invested during the year. There is a further pipeline of 24 potential projects at various stages, with an aggregate funding value of up to £31m. This may be funded over the next two to three years, which Impact says it will support if it enhances the quality of care and environment and is accretive to shareholder returns. Our forecasts assume c £30m of investment by the end of FY26.

At end-Q124, £188m had been drawn from total available borrowing facilities of £250m, with a weighted average maturity of six years. The EPRA net loan to value ratio (LTV) was 27.6%, a little above the company’s medium-term target of 25%, but well below the 35% maximum specified by its gearing policy. The balance sheet is liquid and flexible, with liquidity headroom of c £60m, including undrawn debt of £62m and cash of £10m, less capital commitments.

Borrowings comprise £75m of senior secured private placement loan notes at a blended fixed rate 2.97%, maturing in 2035, and shorter-term bank debt of £110m with variable interest costs which are mostly hedged. The average cost of drawn debt was 4.6% at end-Q124 (with the SONIA benchmark rate at c 5.25%) and, with the fixed/hedged ratio at 93%, debt costs are well protected from interest rate increases until early 2025.

The first debt maturity, in April 2026, is the £75m HSBC revolving credit facility (RCF), and the interest rate caps used to hedge interest rate risk expire during 2025. A £50m nominal value cap on SONIA at 3% expires in January 2025 and a £50m cap on SONIA at 4% expires in August 2025. Market interest rate expectations remain volatile but anticipate a decline in the SONIA rate from c 5% currently to c 4% by the end of 2025. This indicates a relatively modest increase in borrowing costs as the hedges mature but as our FY26 forecasts indicate, we estimate that a good level of dividend cover would remain. Regardless, we expect further financing activity before hedge expiry with the company seeking opportunities to maintain its financial flexibility, increase average debt maturity and enhance interest cost visibility.

The positive social impact the company makes is, we think, self-evident. Impact also has robust and transparent governance structures. In 2023 the investment manager became a signatory to the UN Principles of Responsible Investment and has embedded those principles in its risk management and investment decision-making processes. Focusing on environmental matters, Impact is targeting net carbon zero by 2045 with the intermediate goals of reducing emissions by 15% (from the 2022 base) by 2025 and 50% by 2030. The intermediate goals seek to encourage progress while balancing the affordability and operational practicality of the required investment and actions. Impact also aims to ensure all homes are EPC9 rated C or better by 2026 and EPC B or better by 2030, with an intermediate target of at least 50% B rated by 2025.

During FY23, the portfolio average EPC ratings made good progress, with the proportion of properties rated EPC B or better increasing to 57% from 53% in the previous year, already ahead of the 2025 intermediate target. EPC C properties and above now represent 93% of the total, up from 88% in FY22. The measures taken to improve ratings include more efficient LED lighting, improvements to the building fabric and upgraded heating systems, of which there are more opportunities.

Despite the EPC progress, carbon intensity and total emissions increased (to 54kg10 from 50kg) which Impact believes was significantly driven by increased resident occupancy within its homes. The 2025 intermediate emissions reduction target (-15%) is now more of a stretch, but Impact nonetheless expects to make progress as efficiency measures are progressively implemented through asset management projects.

This year’s dividend target of 6.95p (+2.7%) represents an attractive yield of 8.5%, while the shares continue to trade at a 27% discount to Q124 EPRA NTA per share of 116.9p.

Exhibit 11 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.

Impact’s trailing dividend yield and P/NAV are in line with the peer group average. Over three years, Impact’s share price has significantly outperformed the peer group.

Impact’s portfolio was valued at £661m at end-Q124, comprising 138 properties providing residential and nursing care, let to 13 different tenants with two co-located medical facilities leased to the NHS. The number of care home tenants is now 14, including We Care.

All the care homes are let on long-term triple net leases (the tenant is responsible for all maintenance expenditure and insurance costs), with upwards-only rent reviews that are indexed to inflation.11 Impact’s standard leases include covenants in respect of minimum rent cover, minimum maintenance expenditure and standards of care, with an initial term of 25 years, with tenant options to extend for an additional 10 years. Since 2020, all new leases include ‘green’ clauses to assist the company in working with tenants to achieve its ESG objectives.

The portfolio is diversified but at its core, a significant majority of the properties are good-quality, well designed, upper-middle-market care homes, in good condition and viable for the term of the existing leases at the very minimum. Most of the balance of the portfolio is classified as value add, with the potential, working in partnership with tenants to physically enhance and reposition the properties within their local markets.

The portfolio continued to grow during FY23, including the innovatively financed and accretive acquisition of a portfolio of six homes for £56m, on a gross initial yield of 7.0% in January 2023. The consideration comprised a blend of cash (80%) and new equity issued to the vendor at the prevailing NAV and a material premium to the share price. We have not assumed acquisitions in our forecasts although if interest rates decline in line with market expectations, accretive opportunities may emerge. Currently, we view asset management investment as offering more attractive returns.

One non-core home was sold in FY23 for £1.25m, in line with the prevailing book value. Further sales are likely as accretive capital recycling opportunities emerge but, again, are not assumed in our forecasts.

The tenant base has steadily diversified since launch, with the addition of new tenants, diluting the position of the original tenants, Minster and Croftwood, both parts of the Minster Care Group.12 We expect this process to continue, although the focus is on carefully selecting suitable tenant partners with whom to grow, not in simply broadening the list of counterparties.

Impact Healthcare REIT is closely overseen by a non-executive board of directors and is externally managed by IHP. IHP was established in 2016 by its principals, Mahesh Patel and Andrew Cowley, who bring considerable experience of investment and operation in the UK care home market and wider alternative asset markets. David Yaldron joined IHP as finance director in June 2017. Biographies of these key members of the IHP team can be seen at the back of this report. Mahesh Patel owns 10m shares in the company (c 3.1%), primarily through Maal, and other members of the IHP team own c 0.4%, which closely aligns the interests of the investment manager with those of the company and its shareholders. The broader IHP team includes further property and finance professionals, dedicated to the management of Impact.

Investment adviser fees are payable at 1.0% a year on average net assets of up to £500m and at 0.7% a year on average net assets of more than £500m. There is no performance fee.

The board, currently comprising five independent non-executive members, has been chaired by Simon Laffin since 1 April 2023. He has more than 30 years of board experience across a number of sectors, including previously serving as the chairman of Assura, Flybe Group and Hozelock Group, and he is author of ‘Behind Closed Doors. The Boardroom: How to Get In, Get On and Make a Difference’. More broadly, the board brings to Impact, complementary skills and experience across the real estate sector, and specifically healthcare real estate, finance and capital markets, social housing, and corporate stewardship and governance. Full details of the board can be found on Impact’s website.

Mahesh Patel is an investor in and director of Minster Care Group (MCG). Two of Impact’s tenants, Minster Care and Croftwood, which together provided the initial seed portfolio at IPO, are both part of MCG. Melrose is an affiliate of MCG. Each of these is treated as a related party and a detailed agreement exists to manage any potential conflicts of interest between these and the investment manager, overseen by the board. The company provides comprehensive and transparent disclosure of all relevant transactions.

FY23 results were published 25 March. During the period, annualised contracted rent roll increased 13% to £48.8m from £43.1m as a result of rent renewals (at an average 4.1% uplift), the six-home portfolio acquisition and asset management activity. A further increase to £50.1m at the end of Q124 included the impact of rent reviews settled during the quarter and the progression of Impact’s pipeline of asset management projects. Asset management projects are included in contracted rents when once legally agreed and in passing rent when completed. Passing rent, which drives cash rental income, was £45.6m with the main adjustments to contracted rents being the temporary lease variation in respect of the Melrose managed assets (c £1.6m), the Norwich pre-let development (c £0.7m), contracted asset management projects (c £0.5m) and rental uplifts in respect of performance-based deferred payments (c £0.4m).

For FY23, we note in particular:

We see the key current and potential sensitivities as relating to the following: