Funded for growth opportunities

Target has for some time made clear that its intention is to grow its portfolio further, with a view to capturing the positive spread between rental income and funding costs as well as operational efficiencies, but also to continue to diversify the portfolio both by the number of assets and tenants. When the company announced its FY17 results in October 2017, it stated that the investment manager was performing due diligence on a range of further acquisition opportunities that it believed would meet its investment criteria and in aggregate had a value in excess of the capital that was available.

It invested c £34m (including costs) during the quarter ended 31 December, including three significant care home acquisitions, but that was only a part of the opportunity that had been identified. That took end-2017 debt to £81m (from its £90m of debt facilities at the time), and effectively represented full or near full deployment, in a total of 18 care home acquisitions, of the £84m proceeds from the equity raise that took place April 2016.

The first stage of increasing the capital resources available to Target was to negotiate a new £40m revolving credit facility, with an initial three-year term and an option for two one-year extensions. However, gross gearing, or borrowing as a percentage of gross assets (overwhelmingly represented by the investment portfolio), is limited to 35% at the time of drawdown. In practice, a lower level of c 20% is targeted by the board over the medium term, while exceeding this occasionally to fund the growth of the portfolio also limited cash drag. The second stage of the capital raising process was therefore to increase equity capital resources. At the beginning of February Target announced an initial placing, open offer and offer for subscription at 108p (a premium to the end-December 2017 EPRA NAV per share of 104.4p), subsequently raising gross proceeds of £94m through the issue of 87.0m new shares in the initial issues. Shareholders also gave approval for a one-year placing programme, allowing for further issuance, up to a maximum 150m shares including the initial issues, at the discretion of the company, as and when it identifies suitable acquisition opportunities.

With the prospectus to accompany the share issue, Target stated that it had identified a pipeline of investment opportunities comprising:

Target’s intention is to optimise the deployment of the £94m net proceeds from the initial issue, and its debt facilities in the acquisition of the imminent and pipeline assets. Depending on the timing of investments, some of the revolving debt may be repaid for a time and should the acquisition of these assets not complete, Target intends to direct its available resources towards the acquisition of further properties that have been identified by the investment manager. This includes a portfolio of care homes with an estimated acquisition value of £62m (including costs).

While longer-term funding for adult social care continues to be debated publicly, and the problems facing the wider industry inevitably receive much media attention, what is often overlooked is the ability of well-managed operators, with efficiently run homes, in locations with a good demand-supply balance to effectively and sustainably meet this need.

Investor interest in such homes remains strong and is continuing to drive a tightening in valuation yields, especially for purpose-built homes, in prime locations, focused on self-funded residents. The average net initial yield on Target’s portfolio tightened further in the quarter to end-2017, to 6.58% versus 6.69% in September. While this is positive for NAV, the yield tightening also highlights the strong competition for quality assets in the market.

In this environment, selective investment, in homes that are most likely to effectively and profitably meet care needs over many years is essential and we believe that Target remains focused on building just such a portfolio. Target has always put a strong emphasis on the careful selection of operators and growing share of forward funded assets in the investment pipeline gives access to modern, purpose-built homes. Target is not a developer and forward funding agreements allow it to acquire pre-let care homes at completion, meanwhile funding the development cost. So long as the location and operator of the home is carefully selected, the additional risk compared with the acquisition of operational homes should be minimal.

We have updated our forecasts to include the equity issue, the increase in total debt facilities and a revised assessment of how the increased funds are likely to be deployed. In short, given the scale of potential opportunities to which management refers, we assume the increased resources to be fully invested by the end of FY19. However, the FY19 investment will not fully contribute to earnings in that year, so we have extended our forecast period out to FY20 to illustrate the likely benefit. The FY20 forecast assumes no new investment and is perhaps best seen as an illustration of the potential earnings, dividend paying capacity and dividend cover that the new level of capital resources (equity and debt), fully invested, is capable of generating.

Our revised forecasts assume:

Faster than previously assumed investment increases our revenue forecasts for FY18 and FY19. The negative impact on EPRA EPS in FY18 from the increased number of shares is minimal, aided by Target having a strong pipeline of opportunities to quickly deploy the funds raised, as well as the ability to reduce the revolving debt usage in the near term to manage cash drag. The impact on FY19 is positive as a result of higher revenues and the effect of operational gearing. EPRA NAV is little changed, with the benefit to NAV per share from share issuance at a c 3.4% premium to the December 2017 EPRA NAV per share of 104.4, effectively off-setting share issuance costs and the additional property acquisition costs that we have assumed as a result of increased investment.

Our forecasts indicate that EPRA earnings per share will be 87% of DPS in the current year, a slower increase on the 77% reported in FY17. This increases to 93% in FY19, with full cover og 103% achieved in FY20. The FY20 cover may be regarded as indicating the potential for full dividend cover on a fully invested basis. In reality, this may be deferred if Target continues to identify suitable further investment opportunities and raises additional capital (equity and debt) to fund these.

Within the broad commercial property universe, Target is differentiated by its focus on care home assets, which appear primed to benefit from the ongoing demographic shifts, and the very long nature of leases arrangements in the sub-sector. Target’s weighted average unexpired lease term (WAULT) of 28.9 years at 31 December 2017 is one of the longest of all REITs, and combined with upwards-only rent reviews, mostly capped-and-collared RPI-linked, there is considerable visibility to future contracted rental income in real terms.

In Exhibit 2 we show a summary of the valuations and share price performances for a small group of companies that similarly target long leases. The closest comparators are perhaps Assura, MedicX and Primary Health Properties, all investors in modern primary healthcare facilities, primarily used by GPs. The average WAULT is a little lower at c 15 years, but the tenant covenant is strengthened by having NHS backing, directly or indirectly. In broad terms, the group shown in Exhibit 2 has outperformed the FTSE All Share Index over the past 12 months, and also offer a higher yield, supporting valuations above NAV.

Target’s share price is c 10% off its 12-month high (of 123p in August 2017) and its P/NAV is down from a peak of c 1.20x. We suspect that increased expectations for interest increases and the recent equity issue are the main contributing factors. Its prospective yield is well above the average for the group, and second only to MedicX, and its P/NAV is very slightly below the average. As noted above, our forecasts include further dividend growth and the potential for full dividend cover in the year to June 2020.