Civitas Social Housing — Continuing positive returns in Q222

Following an article published in The Sunday Times on 12 September, short-seller ShadowFall published an open letter to the board of Civitas, which among other matters claimed that Civitas had failed to disclose a conflict of interest in certain property transactions, to the detriment of shareholders. The letter also raised concerns about the financial viability of the specialised social housing business model in general and certain Civitas registered provider lessees in particular.

From the start, the board of Civitas has strongly disputed many of the claims made in the open letter and on 11 October, in the form of a market update, issued a detailed 37-page response to the open letter and other questions raised by its shareholders. The Civitas report can be found at www.civitassocialhousing.com/media/1955/csh-market-update-11-october-2021.pdf.

It is not our aim in this report to explore the detailed contents of both the open letter and Civitas response. In a further release from the company on 15 October 2021 the board made clear that it does not intend to respond further. However, it took the opportunity to reiterate its confidence in the company and in its investment adviser and to note that the company's assets and revenues continue to perform in line with expectations. The dividend target for FY22 of 5.55p per share was also confirmed.

In this report we focus on Civitas’s financial and operational performance in relation to the broader sector concerns raised in the ShadowFall open latter. These sector issues are covered in detail in our July Outlook note. They primarily relate to shortcomings identified by the Regulator of Social Housing (RSH)1 in relation to the governance structures, operational efficiency and financial strength of some specialist registered providers. We believe it is the aim of the RSH to work with providers and other stakeholders, including landlords such as Civitas, to improve standards and safeguard the sustainability of the sector.

Civitas has consistently delivered positive total returns3F2 on both an annual and quarterly basis since its initial public offering (IPO) in November 2016. Dividends have been the main component of returns and have increased each year. Despite the pandemic, operational and financial resilience has been maintained. Rents have continued to be received in line with expectations, quarterly dividend payments have been uninterrupted, and there has been no discernible impact on portfolio valuations. This strong performance reflects the vital role of portfolio properties in the provision of an essential service; secured by long-term lease and care arrangements; providing good visibility of income with little direct correlation to the wider property market or economy; and capable of delivering stable inflation-indexed dividend growth. The impact of COVID-19 infection has been low within homes, reflecting the relatively low average age of residents (an average of 32 years), less likely to suffer from the types of underlying health conditions categorised as ‘high risk’ by the NHS, and the configuration of much of the modern housing stock, around self-contained apartments and small housing clusters, which supports infection control and management. Further insulating the approved provider lessees from the pandemic impact, the care provider generally takes responsibility for voids (unoccupied units) and pays for all of the personal healthcare equipment required by residents, for which it is reimbursed by local authorities.

From IPO in November 2016 to 30 September 2021 (end-Q222) Civitas has generated an aggregate NAV total return of 32.6% or an annual average 6.0%. Dividends paid represent two-thirds of the total return in the period.

As Civitas has grown its portfolio since IPO, dividends have run ahead of earnings and cash flow, but as scale has grown are now fully covered by earnings on a run rate basis. We forecast full cover on a reported basis in FY22, although this may be delayed until FY23 if capital is further deployed in share repurchases rather than acquisitions.

Civitas’s investment objective is to provide an attractive level of income, with the potential for capital growth, and dividends have been set in this context. It is worth noting that had lower dividends been declared, there would be no impact on the accounting total returns shown above, with an offsetting movement in NAV (and cash flow).

Lease incentives have reduced cash flow in recent years, but Civitas indicates that the lower underlying level in FY21 is more representative of the likely ongoing cost. In FY21, for accounting purposes, a £10m follow-on payment for an acquisition was treated as a lease incentive. In all other respects it was in fact a property acquisition with rental income attached. Excluding this, FY21 lease incentive payments were £1.2m and over the past three years have amounted to £11.2m. The reduction in lease incentive payments will better align cash cover and earnings cover of dividends. The payments reflect:

The Civitas portfolio provides homes to almost 4,400 vulnerable, mostly young, adults. It is well diversified, comprising 648 properties, let to 17 approved provider lessees (Windrush Housing Association became the 17th tenant earlier in FY22), working with 178 local authorities and 119 care providers (as at 30 September 2021), and is also widely spread by geography. Exhibit 3 shows the breakdown of rent roll by lessee as at 30 June 2021. Since 31 March 2021 Civitas has reassigned a number of leases, most significantly from Auckland. Reassignments are a recurring feature and generally reflect Civitas's continuing policy of driving efficiencies within the portfolio and where appropriate, seeking diversification. In so doing it enables Civitas to extend further its stated aim to work with a wider range of counterparties including established charities and community benefit societies. The most recent disclosure puts the Auckland share of rent roll at 16.9% (13 August 2021) and Falcon at 19.9% (12 November 2021).

Annualised rent roll was £50.4m at end-FY21 and will have increased since with CPI-linked rent indexation and acquisition activity. Since end-FY21, 29 properties have been acquired for an aggregate £22.0m (before costs) as Civitas begins to deploy the proceeds from the fully drawn £85m M&G seven-year fixed rate debt facility agreed in February 2021. Subsequently, in March 2021, Fitch Ratings assigned an investment grade rating to the company.3 On an IFRS basis and on a portfolio basis, the net initial yields (NIY) reflected in the end-Q222 portfolio valuation of 5.27% and 5.10% respectively have changed little over the past year.

The RSH regulates registered providers of social housing (RPs) to promote a viable, efficient, and well-governed social housing sector able to deliver homes that meet a range of needs. Civitas’s housing association lessees are regulated by the RSH but Civitas is not, although it interacts with the RSH on a regular basis. Regulation has played an important role in providing long-term stability to the social housing sector, and while individual registered providers have from time to time faced financial difficulties, there have been no material losses suffered by funders due to RP default.

Over the last few years private capital has played an increasingly important role in supporting the much-needed growth and sustainable development of the SSH sector, filling the gap created by the limited availability for all forms of social housing. The capital has been provided by a range of funds and other investors in SSH assets, which are then made available to housing associations on long leases, typically indexed to CPI inflation. Given its greater complexity and granularity, and the continuing strong demand for general needs social housing, SSH has not generally been the focus of the longer established RPs and sector growth has been led by newer specialist RPs that have been established in the past 10 years or so. RSH involvement with the smaller specialist RPs stepped up after the financial failure of First Priority Housing Association in 2018. Its leases, including those with Civitas, were reassigned on similar terms to other providers within a few weeks, with no material loss incurred by capital providers.4 The RSH subsequently reviewed the SSH sector and identified shortcomings at a number of other RPs, primarily in relation to governance structures, operational efficiency and financial strength. We believe these shortcomings are mainly a result of the rapid growth of the sector as it has strived to meet the growing need for SSH homes. The RSH has expressed a particular concern that providers reliant on lease-based models (ie entering into long-term commitments to pay rents at an increasing level indexed to inflation to support growth) should be able to present robust and prudent long-term business plans. These should include identifying the actions required to enable them to meet their lease obligations and maintain financial viability should there be a significant change in the operation of government housing benefits.

Across the sector, several RPs have been issued with regulatory notices and judgements.5 The shortcomings that the RSH has identified in some providers in part reflect the strong growth exhibited by the sector in recent years and the challenge this has presented for the development of management and governance structures, as well as capital resources, to keep pace. Solutions to many of the concerns raised by the RSH are clearly identifiable and the shortcomings are in no way existential. Civitas notes that with its support, the organisations affected by regulatory judgements and notices have shown tangible signs of improvement. Given the long-term nature of the sector, with long leases, reflecting the long time over which care is likely to be needed, satisfying the RSH’s need for long-term planning is perhaps more challenging. The first point to make clear is that we see no prospect of a significant change in government policy on housing benefits, based on the chronic and increasing excess demand for SSH and the wide acceptance that it provides improved outcomes at a lower cost than alternative provision. That said, the providers may be able to mitigate this risk by strengthening their balance sheets, including increasing accumulated capital surpluses and building up self-owned property assets. Additionally, Civitas has taken steps to address regulatory concerns about the long-term risk planning of providers by introducing caps and collars on rent indexation (typically of between 1% and 4%) and ‘force majeure’ clauses, setting out appropriate steps in the unlikely event of a formal change in government policy and funding.

More generally, Civitas welcomes this ongoing regulatory review, bringing as it does higher levels of accountability and transparency. As one of the leading private sector investors in the supported housing sector, working with some of the fastest-growing providers, 10 Civitas lessees (of a total of 17) are subject to regulatory judgements and notices, accounting for a significant percentage of rent roll6. It is important to stress that there has been no impact on rent collection nor any negative impact on the external valuations of the properties owned by Civitas as a result of these judgements and notices. We expect this to remain the case. In our view, regulatory interventions in the SSH segment of social housing are primarily aimed at identifying, assessing and making clear the risks, so that these may be adequately managed, to safeguard this financial resilience and maintain the operational standards of the sector. The social housing sector has traditionally had a low financial risk profile, in part due to the ongoing monitoring presence of the regulator and the fact that much of the rent is funded by central government through housing benefit and latterly universal credit, directed towards some of the most vulnerable in society. There may well be cases where some approved providers across the sector are unable to satisfy the RSH, which over time may lead to concentration among the providers (perhaps through mergers and other amalgamations), leading to a smaller number of stronger providers and enhancing covenant strength for landlords. As has been demonstrated, quality properties, in the right locations, adequately adapted and supporting an appropriate level of care, are attractive to alternative providers in their efforts to meet the strong and growing need for accommodation.

Since IPO in November 2016 the average discount to net asset value has been around 3% (Exhibit 5) but this includes three periods of periods of weakness. The first of these occurred from late-2018 to mid-2019, reflecting initial investor caution in response to increased regulatory intervention in the sector. As the issues became better understood, the share price began to move higher. Widespread COVID-19 fears at the beginning of the lockdown again created weakness, which also proved temporary. An appreciation of the critical role that the sector performs, the factors that mitigate the operational risks of COVID-19 and the robustness of rent payments have contributed to a quick recovery in the share price. There are significant similarities between the current share price weakness and the position in late 2018. While the short seller raised specific questions in relation to Civitas, to which the company has responded in detail, it has also revived debate about the sustainability of the lease-based provider model and this has been reflected across the sector. The recent de-rating has been sharp but less deep than the earlier bouts of weakness and the shares have begun to respond positively to the company’s active engagement with shareholders and supportive share repurchases, accretive to NAV.

In September 2021, the board recommenced share repurchases to manage the share price discount to NAV and underline its confidence in the company’s prospects and its firm belief that the issues raised by the short sellers were incorrect and misleading. Similar action was taken in the third quarter of 2019 when 85,000 shares were repurchased at an average c 85p (a discount to the 107.2p NAV per share at the time) and subsequently re-issued at an average price of c 109p.

Since 21 September 2021 Civitas has repurchased c 5.4m shares at an average c 90p, which are held in treasury. The repurchases were c 0.06p accretive to Q222 NAV per share and although repurchases have recently trailed off as the shares have begun to recover, the Q322 accretion should be greater (we estimate c 0.1p per share).

Civitas and its investment adviser Civitas Asset Management (CIM) have been active in engaging with existing and new shareholders since it published its detailed market update in October. As a result, it has gained a number of new and significant institutional shareholders, including several leading European institutions.

To provide further insight into the company's strategy and the social housing sector, Civitas plans to hold a capital markets day in the first quarter of 2022. A similar event held in May 2019 provided considerable detail on the workings of the specialised social housing market and marked the commencement of a strong re-rating in the shares. The presentation is available on the Civitas website, including an audio recording. (www.civitassocialhousing.com/media/1412/cmd-presentation-13-may-final-1.pdf).

We have made no change to our forecasts other than to factor in the share repurchases and have not at this stage assumed any impact on the quantum and timing of capital deployment. Our forecasts assume an additional £50m of capital commitment as existing capital is deployed and we will review these with the interim results in a few weeks.

Despite a strong record of low volatility and consistently positive accounting returns, based on the targeted 5.55p aggregate FY22 DPS, the prospective yield is 6.0% while the shares are trading at a 15% discount to end-Q222 NAV per share.

In Exhibit 6 we show a share price performance and valuation comparison with a group of companies that we would consider to be the closest peers to Civitas, investing in housing and healthcare properties. The table shows the dividend yield based on trailing 12-month DPS declared and on the current financial DPS targeted by each company. We also show P/NAV based on the last reported EPRA NAV/NTA. The Civitas yield is well above the peer average and P/NAV well below. Performance during the pandemic has been robust, with rents collected in full as expected and with no impact on valuations. Following the recent weakness in the share price the Civitas valuation indicates significant potential while also delivering a material social benefit.