Consistent returns and continuing growth

In this note we discuss recent financial and operational performance and our expectations for capital deployment and portfolio growth and diversification. Target completed a substantial well-received, upsized and oversubscribed £125m (gross) equity raise in September, ahead of results for the year to 30 June 2021 (FY21) on 20 October. It has since provided an update on the three months that ended 30 September 2021 (Q122). Dividends and recurring earnings have continued to increase, driven by acquisitions, development completions and inflation linked (predominantly RPI) rent reviews. The latter, along with continuing yield compression, is also generating increases in property valuations and supporting growth in net asset value. With its equity raising, Target reported a strong £230m acquisition pipeline (‘its strongest ever’) across 24 modern, purpose-built care homes, with contracted rents of £12.9m reflected in an expected weighted average net initial yield of 5.6%. This provides us with comfort that the proceeds of the equity raise and associated capital raise will be deployed fairly swiftly and the investment manager can continue to identify attractive investment opportunities despite the continuing compression of market yields. We begin this report with a review of recent financial performance.

FY21 adjusted earnings were very close to our forecast and EPRA NTA and EPRA NTA total return were both above our forecast, driven by a stronger revaluation movement in H221. Adjusted earnings increased by 12% with strong revenue growth partly offset by credit loss provisions and bad debt charges relating to the small number of struggling tenants that have responded positively to active asset as discussed below. Equity raising to fund continuing asset growth held back earnings in per-share terms but cash-dividend cover improved and we expect full cover of progressive distributions as acquisitions/commitments (past and prospective) fully contribute.

Key features of the FY21 results included:

Target’s portfolio continues to grow and at 30 September 2021 (end-Q122) was valued at £702.7m, comprising 79 properties (of which 76 operational and three pre-let forward-funded developments), let to 28 individual tenants (the largest, Ideal Carehomes, representing c 13% of the total). Two of the four assets under development at end-FY21 reached practical completion during Q122 (Rudheath, Cheshire and Droitwich Spa, Worcestershire) and one was acquired, in Holt, Norfolk, with a maximum commitment of £12.8m. Also during Q122, Target acquired a completed home in Liverpool for £5.5m (including costs).

Since end-Q22, an additional pre-let forward-funded asset has been acquired in Weymouth, Dorset for a maximum consideration of £14.3m.

The COVID-19 pandemic has had a financial impact on Target’s tenant operators, especially due to curtailed admissions and reduced occupancy, although this has recently begun to normalise. In total, 95% of FY21 rents have been collected and rent cover2 for mature homes (those that have had the same operator for a three-year period or more, therefore excluding newly developed homes not yet stabilised) was 1.5x compared with the c 1.6x that Target expects during normal trading conditions. The robustness of rent cover during a difficult trading period for tenant operators was partly attributable to the temporary government support that was put in place to support a vital service. Excluding this, Target estimates rent cover dipped to 1.2x but expects a return to 1.6x or more as trading conditions normalise. Setting rents at the right level is key to the sustainability of income and Target believes rent cover of 1.6x provides sufficient flexibility to allow for variances in occupancy and operational performance. As shown in Exhibit 4 it is consistent with rent costs at c 20% of revenues for the typical home.

Across the portfolio, COVID-19 case numbers have been very low in recent months, supported by the vaccination programme and easing of restrictions on home visits, with tenant operators reporting an increase in occupancy as admissions normalise. Having dipped by more than 10 percentage points to a little under 70% at the low point earlier in 2021, occupancy for mature homes improved by c five percentage points in Q122 and by a further c two percentage points in Q222, with strong enquiry levels from potential residents.

Most of the recent and ongoing rent arrears relate primarily to two tenants across four of the homes and, although not helped by the pandemic, reflect more fundamental performance issues. Asset management initiatives aimed at addressing these were delayed by the physical restrictions in place during the lockdowns but have recently completed. For one tenant, a new operator of two immature homes, trading performance has improved. For one of these homes, rents have been paid monthly in full since December 2020 and for the other home rent has been partially paid and Target expects the tenant to commence paying rent in full during Q4 2021. The position with the other tenant has been resolved with outstanding rents partially settled and the homes re-tenanted. The first re-tenanting occurred during FY21, providing an immediate valuation and net rental income uplift and the second has recently completed at a similar rent and short rent-free period to cover capex mitigated by a lengthened lease.

The resilience of Target’s strategy has been reflected in consistently positive accounting returns3 since IPO in January 2013, on both a quarterly and annual basis up to 30 September 2021 (end-Q122). The cumulative total return (adjusted for dividends paid but not assuming reinvestment of dividends) over the period has been 67.7% or an average annualised rate of 6.1%. Dividends have accounted for c 80% of the total. On the dividend reinvested basis reported by Target, the annualised total return to 30 June 2021 was 7.8%. Most recently, Q122 showed a return on 2.3% (2.4% assuming dividend reinvestment).

Consistent returns reflect steady and visible income growth with inflation-linked rents and long-term, triple net leases. Notwithstanding the pandemic, tenant performance has been supported by strong demographically driven demand for care home places, a shortage of quality accommodation and above-inflation fee growth. Attracted by the resilient income profile of the care home property sector, investor demand has been, and remains, strong, especially for high quality assets, leading to yield compression and capital growth. New entrants to the investment market such as Cofinimmo from Belgium and Korian REIT from France raises the prospect that valuation yields will further compress, benefiting capital growth but increasing the prices that must be paid for assets. Nevertheless, as we discuss in the next section, the investment manager continues to identify attractive acquisition opportunities and is confident of delivering further accretive portfolio growth.

Having substantially deployed the proceeds of the February 2021 £60m (gross) equity raise,4 and noting its strongest pipeline of acquisition opportunities to date, in September 2021 Target completed a further £125m (gross) equity raise, upsized5 and oversubscribed. The c 108.7m new shares issued represented a c 21% increase in shares outstanding and the issue price of 115p was at a 4.2% premium to the 30 June 2021 EPRA NTA per share of 110.4p.

The strong pipeline of investment opportunities disclosed with the issue amounted to an aggregate c £230m (including costs), across 24 modern, purpose-built care homes, with an expected weighted average net initial yield of 5.6%. If completed, this pipeline would add 1,625 new beds, increase contracted rent by £12.9m pa, slightly increase the WAULT from 28.5 years to 28.8 years, and add further diversification, including seven new tenants, all known and approved by the investment manager. More specifically the announced pipeline comprised:

Reflecting the upsizing of the equity raise and the investment manager’s ability to identify attractive investment opportunities, we forecast Target to acquire assets to a value of £285m (including costs) by the end of March 2022 (end-Q322), including the c £34m committed since end-FY21.

Including the £125m (gross) equity proceeds and associated debt funding, our assumed level of investment should allow Target to maintain a prudent level of gearing (loan to value ratio (LTV) of around 30%), well below the maximum permitted level of 35%. Historically the company has targeted a c 25% LTV, but the robust performance demonstrated through the challenging pandemic period suggests that a slightly higher gearing level is consistent with the company’s return targets and provides an offset the compression in asset yields.

With the September equity raise proceeds temporarily used to repay flexible debt, end-Q122 gross borrowing was £80m and including cash of c £73m the net LTV was just 1%. However, the required borrowing to complete the transactions that we expect is ahead of the existing aggregate £220m of facilities (Exhibit 6) but negotiations to add c £100m of long-term funding are at an advanced stage. Our forecasts assume that £300m of the increased facilities are drawn, sufficient to fund acquisitions and current and future investment commitments.

Of the total existing debt facilities, £80m are fixed rate/hedged and £140m floating rate. The weighted average term to maturity at end-FY21 was 4.8 years and the weighted average cost of drawn debt was 2.9%. All existing 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 covenants have been complied with during the past year.

In common with most companies across the sector, Target is giving an increasing focus to its environmental, social and governance (ESG) strategy. As a starting point, the social impact that its homes can generate is significant and closely aligned with ESG principles. Target invests in modern, purpose-built care homes and within its investment selection puts an unwavering focus on the quality of the physical assets. It seeks good-quality tenants capable of providing strong levels of care, sustainably, over the long term and as an engaged landlord, works with tenants to support their operations and care quality. The contribution that modern, purpose-built homes can make in supporting care quality have been highlighted by the pandemic. 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, to control the spread of infection, safely support visiting and exercise, and provide good air quality.

The board of Target is fully independent and brings a depth of relevant experience and skills to the company.

Having grown the portfolio with a focus on modern, purpose-built properties, incorporating sustainable and responsible investing principles, 100% of Target’s homes have EPC7 ratings of A-C, of which 92% are rated A-B.

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 targets 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 detailed plans in a ‘white paper’ later in the year, which 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 needs 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. State support currently cuts off where assets are 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 of applicants 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’. This appears to be positive for local authority funded fees and while 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. We believe it is very unlikely that providers of self-funded care will be willing to accept lower fees, especially for existing residents. Operators that are focused on local authority funded care appear clear beneficiaries but operators that provide a mix of self-funded and local authority care should also benefit, and this includes many of Target’s tenant operators. Across its portfolio, while 62% of underlying operator fees include some element of self-funding (44% purely self-funding and 18% a mix of self-funding and public funding),8 38% is purely publicly funded. Publicly funded fee exposure for Target’s tenants has increased slightly through the pandemic as the industry-wide increase in vacancy has been tilted towards self-funding (at end-FY20 the purely self-funded share for Target operators was 48%). We believe this mainly reflects the greater discretion that self-paying residents are likely to have over the timing of admission as well as the desire by the NHS to free up hospital beds and is likely to revert as home occupancy returns to normal. The mix of funding is reflected in average weekly fees charged by operators, with an average of £966 at 30 June 2021 compared with the market average of £790 estimated by the Laing Buisson consultancy.

Our forecasts are shown in detail in Exhibit 12 and summarised below. The September equity raise increased the number of shares outstanding by c 21% (and we estimate that this will increase FY22 average shares in issue by c 15%). We forecast the proceeds of the equity raise (and associated gearing) to be committed by the end of H122, but the full annualised impact will only be felt in FY24 as forward-funded projects complete during FY23.

This has a notable impact on FY22e earnings, although we expect dividend cover to be maintained at the FY21 level (80%) on an adjusted (‘cash’) earnings basis. For FY23 and FY24 we forecast dividends to be effectively covered on an adjusted basis and well covered on an EPRA earnings basis, with DPS growing by c 1.5% pa in FY23 and FY24.

Our estimates assume £285m of new investment from end-FY21, including the c £34m of commitments already announced, all at a 5.6% net initial yield. We assume that £230m is committed by the end of 2021 (end-Q222), and that £45m of this commitment is to forward-funded developments that we assume will reach completion by Q323 (March 2023). We assume a further £55m of commitment by March 2022 (Q322). The first full year rent contribution from all assumed investments and development completions is thus FY24. Our other forecasting assumptions include:

Target aims to provide shareholders with attractive and sustainable returns, primarily in the form of quarterly dividends. DPS has increased each year since IPO and has been the driver of consistent returns as shown in Exhibit 10 above. The current year DPS target of 6.76p (+0.6% vs FY21) represents an attractive yield of 5.7%. The shares trade at a c 6% premium to Q122 EPRA NTA per share of 111.3p, similar to the average since IPO but below the high of c 11%.

In Exhibit 11 we show a summary of the performance and valuation of a group of REITs that we consider to be Target’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 average 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. Over the same period, Target’s share price performance has been stronger than the average for the group, although its yield remains above average on both a 12-month trailing basis and based on each company’s current financial year target dividends. Target’s P/NAV is in line with the average. There are several factors that suggest a continuing positive outlook for the shares including a combination of the 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. Rent indexation also offers considerable protection against inflation at a time when inflation expectations are increasing.9 The resilience of Target’s business model during the pandemic, with no interruption to quarterly dividends, is a further positive indicator for the rating of the shares.