Primary Health Properties — A scale platform for further growth

PHP is a UK real estate investment trust (REIT) and, following completion of the agreed merger with MedicX, has become the leading long-term investor in modern, flexible, purpose-built, primary healthcare facilities located across the UK and, more recently, in the RoI. The majority of these are leased to general practitioners (GPs), government health service organisations (the UK NHS or RoI HSE) and other associated healthcare providers, such as pharmacies and dentists. Investment is targeted at assets that can generate long-term rental income with scope for capital gains.

The company was founded by managing director, Harry Hyman, in 1995. It floated on the AIM market of the London Stock Exchange (LSE) in 1996, moved to the Main Market of the LSE two years later and converted to REIT status in 2007. PHP has a proven record of successfully investing in the sector. The agreed merger with MedicX, a UK listed closed-ended investment company and UK REIT and a similar long-term investor in primary healthcare assets in the UK and RoI, completed on 14 March 2019.

Post-merger, and including continuing acquisitions, the enlarged PHP portfolio has reached 484 assets, with a value of c £2.3bn and a contracted annual rent roll of c £125m.

Since it was founded, PHP has delivered 22 years of unbroken dividend growth and targets a further increase, 5.6p for the current (FY19) financial year, fully covered by earnings.

Primary healthcare property is a specialist sector alongside the broader mainstream commercial property subsectors (offices, retail, industrial). As well as having good growth prospects – driven by an ageing population with increasing healthcare needs – that are effectively immune to the economic cycle, the key factors that differentiate it from the broad commercial property sector are as follows:

Together, these characteristics provide primary healthcare property with a high level of income visibility and returns that have historically been much less sensitive to economic cycles than other commercial real estate subsectors.

The agreed merger between PHP and MedicX was first announced on 24 January 2019 and, following overwhelming support from the shareholders of both parties, became effective on 14 March 2019. PHP issued 0.77 new shares (c 341.0m) for each Medicx share, such that former MedicX shareholders now own a little more than 30% of the enlarged group.

At the time the merger was announced, PHP’s share price of 115.2p represented a c 14% premium to the MedicX share price and a narrower c 9% premium to its 31 December 2018 unaudited NAV per share. However, given the strong rationale for the merger, identified immediate cost synergies, and prospect for further scale benefits, the market values of both companies increased significantly during the offer period, generating further returns for both sets of shareholders. At completion of the transaction, the PHP share price was 129.2p.

There is a growing structural demand for investment in primary care health facilities in both the UK and RoI, as governments and health authorities strive to meet the challenge of ageing populations with growing healthcare needs. In both there is a general acceptance of the critical role of primary healthcare in meeting growing demands and of the advantages for healthcare services to be more integrated within the community as the NHS and HSE strive to improve levels of care and efficiency. To make this happen, the under-invested healthcare estate needs significant resources and requires modern, purpose-built, flexible premises of the type in which PHP invests.

With respect to the merger itself, the main benefits include:

The total costs of the transaction, incurred by the enlarged company, are expected to be c £24.5m comprising a one-off contractual termination payment to Octopus, the former MedicX investment adviser, of £10m (although fee rebate agreed by Nexus will see £2.5m of this cost recovered over the first five years), and c £14.5m of merger related fees and expenses incurred by the two companies. However, the merger avoids the payment of stamp duty in respect of the transfer of the MedicX assets, which we estimate would have amounted to c £40m had PHP made a similar-sized asset acquisition.

PHP is managed by the board of directors, and with no direct employees the board appoints specialist third-party advisers to assist with the day-to-day running of the group. Nexus Tradeco (Nexus) is appointed to provide property advisory and management services, including the services of the managing director and finance director, Harry Hyman and Richard Howell, as well as administrative and accounting services. It has a successful track record of creating value for PHP and its shareholders since the company was founded in 1995, including managing the successful implementation and integration of previous acquisitions including that of Prime Public Partnership (Holdings) in 2013 (54 properties with a value of £233m).

Since the completion of the merger there have been a number of changes to the PHP board aimed at maintaining an appropriate size and balance, with the complementary skills required to take the enlarged group forward. The former non-executive chair of the MedicX board, Helen Mahy, has joined the PHP board as deputy chair and senior independent NED, subject to shareholder approval at the AGM in June. Former MedicX NED Laure Duholt has also joined the PHP board, subject to shareholder approval. PHP directors Nick Wiles and Geraldine Kennel will step down from the board at the AGM.

Following these changes, the board of PHP will comprise six independent directors, Steven Owen (chair), Helen Mahy (deputy chair and senior NED), Peter Cole, Laure Duhot, Dr Stephen Kell and Ian Krieger, along with Harry Hyman (managing director) and Richard Howell (finance director).

PHP’s 2018 EPRA cost ratio of 14.3% already compares well with UK REIT sector, but management expects this to fall to c 12% in the first full year of the merger. MedicX did not publish an EPRA cost ratio, but we estimate it was c 18% for the year ended 30 September 2018 and, although it would have fallen subsequently as a result of lower management fee introduced from 1 October 2018, prior to the merger, the additional merger-related savings represent a further step-change in efficiency.

The property advisory fee payable to Nexus is based on the gross net assets of PHP’s portfolio, calculated on a sliding scale, which with incremental asset growth lowers the average fee. With effect from 1 January 2019, the fee schedule has been revised such that the marginal fee rate on assets above £2.0bn is reduced to 0.225% pa and on assets above £2.25bn to 0.20% pa, enhancing the attractiveness of further portfolio growth for investors. The fixed annual fee for administrative and accounting services increases post-merger from c £1.0m to c £1.25m, much less than the c £1.0m non-management fee administrative cost savings that are targeted from the merger. Additionally, Nexus is entitled to a performance incentive fee (PIF) that gives Nexus 11.25% of the EPRA NAV total return (change in NAV plus dividends paid) above a hurdle rate of 8%, on a cumulative basis, with annual payments subject to caps.

For the first five years after the completion of the merger, the fees paid to Nexus for the management of the formerly MedicX investment portfolio is set at a fixed 0.225% pa, reverting to the PHP fee schedule at the marginal rate. The expected saving on the fees that would have been payable by MedicX to Octopus, under the lower fee schedule that was introduced from 1 October 2018, is c £2.5m pa (before benefit from the £0.5m pa Nexus fee rebate during the first five years).

We believe management has been prudent in estimating the efficiency benefits of the merger and our forecasts look for the EPRA cost ratio to fall to 11.2% in FY20, the first full year of the merger.

Exhibit 2 shows a summary of the enlarged PHP portfolio. The long-weighted average unexpired lease term of 13.5 years with 91% of income government backed provides considerable income visibility. In our view, despite a competitive investment market, both PHP and MedicX have taken a disciplined approach in selecting investments to grow their portfolios through acquisition, targeting quality of the assets and their ability to generate growing rents and attractive returns over the long term and not just in the immediate future. It is not easy for investors to assess the quality of the assets in the portfolio, but we would suggest that larger, more modern assets and those with the flexibility to adapt and change are more likely to provide superior long-term rental growth.

PHP has continued to acquire assets during the merger period and since, adding five assets for an aggregate investment commitment of c £31m. Two of these are large additional investments in the RoI, where we see good additional growth opportunities and where yields and spreads over funding costs remain higher than in the UK (see our November update).

Low rates of inflation (in contrast to land and building cost inflation) and low open-market rent review increases in recent years have resulted in low overall levels of rent growth. However, the trend of the past three years has moved positively upwards, with an average uplift on review of 1.4% achieved by PHP in FY18.

Around 75% of UK rents are set according to three-yearly open market reviews, with the balance being RPI-linked or fixed uplift agreements. Across the market there is evidence that open-market rent reviews have failed to sufficiently capture the strong rise in land and build costs in recent years, in part the result of financial pressures and reorganisation within the NHS that has slowed decision making of commissioning the development of new primary healthcare facilities. This dearth of new developments has restricted the opportunities for increased land and building costs to be adequately reflected in the rent reviews for existing assets and threatens to restrict the flow of much-needed private investment to support modernisation of the primary healthcare estate. There is now a growing optimism that this is changing as NHS reforms bed down, plans take shape and development activity picks up.

The PHP results for the year ended 31 December 2018 (FY18) were released on 31 January 2019 shortly after the merger with MedicX was announced. These were very much in line with our expectations (Exhibit 5), showing good growth in assets, rental income and recurring earnings (basic EPRA earnings increased by c 19% to £36.8m). The increased DPS (5.40p versus 5.25p in FY17) were fully covered by EPRA earnings. Including unrealised valuation gains on the investment portfolio, EPRA NAV per share increased c 4% to 105.1p and, including DPS paid, the NAV total return for the year was 9.8%. MedicX also performed well in the year to 30 September 2018 (FY18), underlining the strategic rationale to the merger. In FY18 MedicX grew its rent roll by 10% top £44.0m and increased EPRA earnings per share by 11.4% to 3.9p. Ahead of the revised MedicX dividend policy coming into effect the DPS was uncovered, but EPRA NAV total return was a strong 14.8%.

Our revised forecasts to the end of FY21 are shown in Exhibit 6. MedicX is included in PHP earnings from the completion of the merger, making a contribution for just over nine months in FY19.

The significant enlargement of the group renders direct comparison with our previous expectations somewhat meaningless; however, our post-merger EPRA EPS expectations for FY19 are higher than previously, despite a less than full-year merger impact. Our higher FY19 DPS forecast reflects management’s target as reflected in the quarterly interim dividends paid year to date, and we expect the increased dividends paid (higher DPS and more shares in issue) to be fully covered by EPRA earnings.

They key underlying forecast assumptions we make relate to asset growth and funding:

We continue to focus on EPRA earnings and NAV as the best indicators of underlying performance. EPRA earnings strip out revaluation movements and non-recurring items from statutory IFRS earnings, and the EPRA net asset value adjusts for temporary unrealised valuation movements. FY19 IFRS earnings will also be affected by several merger-related adjustments, predominantly non-cash, which we have allowed for in our forecasts. The adjustments effectively relate to the accounting treatment of the merger as an asset acquisition, with the costs of the merger and other adjustments treated as valuation adjustments to the fair value of that asset through the income statement:

The impacts on the IFRS financial statements are summarised in the table below. The merger-related costs (c £14.5m) and acquisition premium (c £122m), an aggregate £146.4m, recognised in the IFRS income statement are excluded from EPRA earnings, along with the £2.9m amortisation of debt fair value adjustment. As always, the underlying property revaluation (£33.8m) is also excluded from EPRA. In the balance sheet, the £39.7m debt fair-value adjustment reflected in IFRS net assets is added back to EPRA net assets along with c £20.7m of other EPRA adjustments.

The enlarged group has a broadly diversified portfolio of debt facilities amounting to c £1.3bn; coming into FY19 c £0.2bn of this was undrawn. Around 97% of the facilities are fixed or hedged, with an average cost of debt of c 4.0% and an average maturity of around eight years. PHP ended FY18 with an LTV of 44.8%, and even after consolidating MedicX with its higher gearing (52.6% at 31 December 2018) the pro-forma level of 47.8% (46.9% assuming conversion of the convertible bonds) well below the c 50% that we expect the group to target over the medium term.

In terms of our modelling, we have assumed all of the portfolio growth we forecast is debt funded, taking gross debt to c £1.5bn by end-FY21, using currently undrawn debt facilities and requiring additional borrowing to be arranged. In reality we would expect PHP to increase its equity capital resources during this period, although the timing and terms of this are difficult to anticipate. As noted above, we have assumed marginal debt funding rate strikes a balance between the likely medium-term cost of funding and the lower marginal rate of debt funding available in current market conditions.

The c 4.0% average cost of debt for the enlarged group reflects the end-FY18 PHP average cost of debt of 3.90% and the c 4.26% average fixed cost of the debt assumed with MedicX. The higher cost of the MedicX debt largely reflects its long-term fixed rate nature (which can be seen clearly in Exhibit 8).

The average cost of both the PHP and MedicX debt and derivatives is above current market values, reflected in the published mark-to-market impacts. Other than at maturity, we do not expect PHP to take any significant action to refinance the existing debt as this would trigger settlement of the mark-to-market liability and would be effectively net present value neutral despite lowering recurring interest costs. However, new borrowing should immediately benefit from the increased scale of the group and for existing borrowing we see good potential for the enlarged group to benefit from improved borrowing terms:

In Exhibit 9 we show the sensitivity of our FY20 (first full year of the merger) EPRA earnings estimates to a range of fairly small changes in the average cost of debt. We estimate that every 10bp reduction in average interest costs enhances forecast EPRA earnings by almost 2%.

Given strong primary healthcare property investment fundamentals and an environment of continuing low interest rates, the security and length of PHP’s lease portfolio with good prospects for continuing growth continues to be are attractive to investors. Historical returns on primary healthcare assets have been higher than other sectors of the UK commercial property market, with a lower level of volatility. This has been a function of more resilient income, with no material voids and rents continuing to grow through downturns and more muted yield shifts.

Our forecast FY19 dividend of 5.60p represents a 4.5% dividend yield on the current share price, with growth potential, and is covered by forecast cash earnings off a secure, long-term income stream. With c 91% of the rent roll funded directly or indirectly by the NHS in the UK or HSE in Ireland, it is tempting to draw comparison with the generic yield on 10-year gilts at little more than 1.0%. This secure and growing dividend return on PHP shares provides support for a continuing valuation premium to EPRA NAV.

Between the end of 2013 and the end of 2018, PHP generated an EPRA NAV total return of 74.6% or a compound 11.8% pa. Dividends paid have accounted for around a half of the return, with capital values benefiting from yield tightening and modest rental growth.

With indications of open market rental growth picking up and the scope for further yield tightening less clear, we would expect the balance of future returns to shift towards income. At some point we are likely to enter a market environment in which valuation yields stop tightening and may even increase again, although the latter is only likely in the context of a broad property market yield shift. This would have no impact on the rental income from existing assets and would increase the cash yield available on acquisitions. In our near-term estimates, by assuming capital value growth in line with 2.0% assumed rent growth over the next two years, our forecast EPRA NAV total returns to end-FY21 are a compound average 8.0% pa, of which income returns represent around two-thirds of the total.

In Exhibit 11 we show the key valuation and performance metrics for PHP, a group of peers with similarly long lease exposure to a range of asset types with differing covenant strengths, the broad UK property sector and the FTSE All-Share Index. For comparative purposes, the data are on a trailing basis, using the last published EPRA NAVs and trailing 12-month dividends declared. Within the peer group, primary healthcare assets are differentiated by the strength of the tenant covenant (91% NHS/HSE). The mix of lease rental terms that provides significant exposure to a pick-up in open market rents compared with significant index-linked rents amongst peers. Given the multi-year lag in open market rents and signs of acceleration, this may well prove advantageous.

PHP’s share price performance over the past 12 months has been consistently strong, ahead of peers, the broad property sector and the FTSE All-Share Index. As a result, its trailing dividend yield of 4.2% is a little below the average for the peer group and broad property sector and FTSE All-Share Index but given the stage of the property cycle (the recovery from the last major down-cycle began in 2009), this difference may be explained by the visible growth prospects for primary healthcare income in general, and the expected merger benefits still to come through at PHP. Our forecasts include an average 3.6% DPS growth between end-FY18 and end-FY21, with DPS fully covered by earnings.

We view PHP as relatively low operational risk as a long-term investor in a specialist sector of the commercial property market characterised by long leases, predominantly government backed, with minimal vacancy and (in the UK) upwards-only lease adjustments supported by predominantly fixed-cost debt. We do not believe the merger with MedicX presents a material integration risk given the complementarity of the businesses, the security of income and the predictability of management fee expenses, and the continuity of management. There are nevertheless a range of factors that could affect the business, especially over the longer term, including structural changes in the markets in which the group operates, changes to government health and fiscal policies, general economic and monetary conditions and operational performance. In particular we note: