Target Healthcare REIT — Consistent positive returns with social impact

Target Healthcare REIT (Target) is a closed-ended property investment company that is a real estate investment trust (REIT) for the purposes of UK taxation. It is externally managed by Target Fund Managers, a sector specialist investment manager with an experienced team. The group’s shares are traded on the Main Market of the London Stock Exchange with a premium listing. The investment objective is to provide investors with attractive quarterly dividend income through investment in a diversified portfolio (by tenant, asset, geography and source of fees) of high-quality, mostly purpose-built, well-equipped residential and nursing care homes providing full en-suite wetroom facilities and generous indoor and outdoor public and private spaces. The demand for care home places is ultimately driven by a growing population of elderly, with increasingly complex care needs, and is relatively insensitive to wider economic conditions; meanwhile there is an under-supply of quality care home beds. The homes that Target invests in are let to a diversified group of 27 selected operators on long (average weighted average unexpired lease term (WAULT) 28.6 years), on fully insuring and repairing leases with predominantly upwards-only inflation indexed rents (generally capped and collared). This provides a high level of visibility to future contractual income, while risk-adjusted returns for the sector (income and capital) have historically compared favourably with most other commercial property sectors.

The company and investment manager have a strong belief in the positive social impact that its homes can generate, and is giving increasing focus to its environmental, social and governance (ESG) strategy. It starts from a position where its business strategy is closely aligned with ESG principles and a full suite of relevant key performance indicators will be introduced during the current year. Target is an engaged landlord and puts a strong emphasis on the tenant quality and the levels of care provided, recognising this as a crucial element in delivering sustainable long-term returns. The benefits that modern, high-quality homes bring to residents, operators and staff have been highlighted by the pandemic, while such buildings generally benefit from good EPC ratings.

Target has delivered consistent profitable growth since IPO in 2013 and has increased aggregate quarterly DPS each year. Despite the pandemic this trend has continued through the past year, with the company targeting an increased aggregate DPS of 6.72p for the year that will end on 30 June 2021 (FY21), a yield of 5.8%. Driven by inflation-linked rent increases and strong investor interest in the relatively non-cyclical care home real estate sector, capital values and net asset value (NAV) have also increased. From IPO in March 2013 to the end of December 2020 (Q221), the company delivered an EPRA NAV total return (EPRA NAV growth plus dividends paid but not reinvested) of 59.2%, or an average annualised rate of 6.0%. With dividends reinvested the company estimates a cumulative return of 77.5% or 7.7% pa.

Target’s strategy is based on the recognition that as the average age of the UK population continues to increases, along with the care needs of older people, there is a clear requirement for investment that will increase the size and quality of the UK care home estate.

Although the COVID-19 pandemic is having a near-term impact on care home admissions and occupancy, demographic trends clearly suggest that the need for elderly residential care will continue to increase for a great many years. Those aged 85 or over are the fastest growing part of the UK population and the predominant users of residential care. The Office for National Statistics forecasts that this group will more than double by mid-2046 to 3.2 million. The number of people living with dementia is expected to grow at an even faster pace. The research consultancy LaingBuisson has forecast that an additional 93,000 beds may be needed over the next 10 years, an increase of more than 20% on the current number.

The number of UK nursing and care home beds has actually fallen over the past 20 years, to less than 500,000 currently, primarily driven by the withdrawal of local authorities from care home operation and by obsolete homes leaving the market. Even since 2013, with the bulk of the local authority withdrawal complete, the number of new beds being built has only just matched the number withdrawing. The number of new homes has continued to decline as smaller, often converted and obsolete homes withdraw to be replaced by modern, larger homes.

Despite recent new building and the continued withdrawal of obsolete stock, there are still many older, often converted properties that may be unsuitable for upgrading and increasingly struggle to meet the standard needed to support the delivery of safe, effective and high-quality care increasingly demanded by residents and their families, care professionals and regulators such as the Care Quality Commission. Such properties may increasingly be seen as unfit for purpose or economically unviable and while modern, purpose-built homes do not guarantee good levels of care, they confer clear advantages to operators and residents alike. Among a range of indicators that guide Target’s investment decisions is full en-suite wetroom provision, the appeal of which to residents is obvious and the operational advantages have been highlighted by the pandemic (see below). Data sourced from LaingBuisson suggests that across the UK sector, rooms with full en-suite wetroom facilities represent a minority (only around one-fifth) of the care home stock, with the vast majority of en-suite facilities representing WC and handwash basins only. Target will only invest in homes with full en-suite wet room facilities in place (more than 95% of portfolio beds) or, on occasion, where there is an agreement with the tenant that a satisfactory upgrade will be undertaken, and 85% of the homes in its portfolio at the end of FY20 had been built in the previous 10 years.

Taking account of the net new rooms that will be required in coming years and the need to replace or upgrade a significant share of the existing stock, the sector investment requirement is very significant. With care provision largely in the hands of the private sector, private capital providers such as Target have a vital role to play in meeting this need and shaping the development of future provision, offering the potential for stable, long-term returns to investors while providing a positive social and community impact.

Target seeks to provide investors with stable and sustainable dividend income and to achieve this it invests in modern, purpose-built care homes, putting a strict focus on the quality of the physical assets and their location, and seeks good-quality tenants capable of providing strong levels of care, sustainably, over the long term. The COVID-19 pandemic has put this strategy to the test and the evidence thus far shows a generally resilient operational and financial performance by tenant operators, with robust levels of rent collection maintained, and quarterly dividends uninterrupted and continuing to increase. While many of the factors supporting the resilience of tenant operators are sector-wide, we would also highlight the contribution that Target’s modern, purpose-built homes make in supporting its own tenant base. 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. A recent virtual property tour explored this in detail, with many testimonials from tenant operators, and may be viewed on the company’s website at www.targethealthcarereit.co.uk/investor-relations/reports-and-presentations/financial-reporting.

While there remains much uncertainty about the future course of events with respect to the pandemic, with the vaccine roll-out in care homes at an advanced stage (all residents in Target homes were offered the first dose by the end of January and most have now received the second dose), and the easing of the lockdown continuing (with an expectation that it will end in June), it seems an appropriate time to review the impact and immediate prospects. In particular we note that:

The asset manager’s strict focus on the quality of each asset largely rules out the acquisition of multi-asset portfolios (which will usually present assets of mixed quality) such that the growth in Target’s portfolio has been very granular, asset by asset. In spite of this, as at 31 March 2021(end-Q321) Target’s portfolio had grown to a value of £650.8m, comprising 76 properties, of which 73 were operational and three were pre-let sites being developed under forward-funding agreements, let to 27 different tenants. With an annualised contracted passing rent of £40.3m, the portfolio valuation reflected an EPRA net initial yield (and EPRA topped-up net initial yield, which is now the same as lease incentives have unwound) of 5.94%. The WAULT of 28.6 years remains one of the highest in the property sector, the product of 30- to 35-year leases at inception and the low average age of the assets. All leases are fully repairing and insuring, with one exception upwards-only, with the majority Retail Price Index (RPI)-linked, subject to caps and collars, although some have fixed annual uplifts. The long WAULT and inflation-linked leases provide considerable visibility of long-term income growth.

Exhibit 4 shows the split of tenants at 31 December 2020 (end-H121), with the seven largest tenants representing just over 50% of contracted rents (the largest, Ideal Carehomes, 13.2%).

Across the portfolio, Target estimates that approximately 63% of the income of the operator tenants includes at least some element of private fees, and that in turn purely private fees represent c 47% and mixed private/public fees (‘top-ups’) c 16%. Fees received from purely public sources (local authorities and the NHS) represent approximately 37%. As may be expected from the quality of the assets, the private fee element is above the industry average (c 50:50 private/public) and this is reflected in higher than industry average fees per resident received by the operator tenants; in the quarter ended 30 September 2020, Target estimates £964 per week per resident compared with £790 for all UK care homes (sourced from LaingBuisson). As well as being higher than local authority fee rates, private fees have grown faster, and in real inflation adjusted terms in recent years. The pandemic has highlighted the symbiotic relationship between the care and health sectors and may accelerate long-awaited reforms to the funding of care. However, there are no immediate proposals or timetable, and while reform could enhance local authority funding resources the form that it might take remains unclear.

Investment activity paused for a while as the effects of the first wave the pandemic were assessed but recommenced in July 2020 and is poised to accelerate as Target deploys its recently increased capital resources. July saw the £15m (including costs) acquisition of a new-build care home in Bicester, Oxfordshire, and two pre-let development sites were also acquired during H121 subject to forward funding agreements with a combined commitment of £21.4m. Also during H121, practical completion was reached on the £10m forward-funded development (Burscough, Lancashire) and construction work continued on the £9.7m development at Rudheath in Cheshire.

As previously indicated by the company, during Q321, one care home, representing c 1% of portfolio value, was sold, at a premium to book value as well as cost value, under a pre-existing agreement with the tenant.

With its equity raise in March, Target provided details of a significant pipeline of identified further investment opportunities, and substantially all capital available for investment, including the proceeds of the equity issue, have been allocated to board-approved acquisitions under non-binding heads of terms.

The March pipeline comprised four ‘imminent acquisition assets’ at an advanced stage of due diligence and negotiation, with an aggregate investment value of £46.7m, and a further pipeline of 16 assets (referred to as the ‘pipeline assets’) for which negotiations had commenced, representing an aggregate potential further investment of £177m (including costs). The investment manager has also begun early due diligence on additional assets that had been identified as meeting the company’s strict investment criteria.

The imminent acquisition assets comprised one forward funding scheme and three modern care homes, which the company said it hoped to be able to acquire by 30 June 2021 (end FY21) subject to satisfactory completion of due diligence, adding three new tenants to the group in the process.

The pipeline assets comprised 10 modern care homes, five forward funding schemes and a forward commitment (a commitment to acquire at completion but without providing development funding) that would add a further five tenants to the group if all completed.

Our updated forecasts assume acquisition of the £46.7m imminent acquisition assets and an additional £50m (before costs) in acquisitions by December 2021 (end-Q222).

Most of the recent and ongoing rent arrears relate primarily to two tenants across four of the homes. The pandemic has aggravated the performance issues at these homes, and has slowed Target’s efforts to address these, although the relative immaturity of two of the homes is also a factor. Most homes in the portfolio are mature with stabilised, high levels of occupancy under normal trading conditions. However, with its focus on asset quality, Target often invests in completed newly opened homes and commits to acquire pre-let developments at completion, often forward funding the development phase. Newly opened homes typically require up to 36 months to establish occupancy levels and reach mature levels of financial performance, and with its extensive industry experience the investment manager is well placed to support tenants through what can sometimes be a challenging phase and provide ongoing support.

At the two immature homes, both operated by one tenant, the performance improvement that was underway was punctuated by COVID-19, although occupancy and trading are again improving towards the levels anticipated by the investment decision. The other two homes are mature homes that were acquired at yields that reflected Target’s assessment of the increased level of risk posed by the performance of the large national operator. Although delayed by COVID-19, one of the homes has now been re-tenanted to an existing tenant (a family-owned operator), with the combination of a longer lease length and slightly reduced annual rent better positioning the home for the future and generating an immediate net valuation uplift. A lease transfer payment from the outgoing tenant will fund capex on the home and cover rent incentives granted to the incoming tenant. We expect similar action on the second home. This changing of tenants when required is part of the investment manager’s role as an engaged landlord. The recent actions on these two home mirrors the successful FY20 re-tenanting of six assets (c 8% of rent roll) leased to Orchard Homes, which also preserved shareholder value and continuity of resident care and demonstrated the resilience of good-quality assets and their appeal to a range of tenant operators.

Target Healthcare REIT is overseen by an independent board of directors and is externally managed, under a management contract, by Target Fund Managers. Target Fund Managers was founded in 2010 by Kenneth MacKenzie, its chief executive. It is a sector specialist manager investing exclusively in the elderly healthcare property sector. The growing investment team (28 individuals as of February 2021) brings together strong experience in all aspects of the healthcare property sector including operating, owning, investing in, developing and building healthcare businesses and healthcare property assets. We provide biographies of the key members of the investment team on page 16.

The investment management fee schedule has a tiered fee structure with reducing rates at higher NAV levels, allowing shareholders to benefit from the increasing economies of scale that a larger portfolio provides. The marginal investment management fee will reduce from 1.05% to 0.95% as average NAV increases above £500m (end-Q321: c £558m). There is no performance fee.

The independent non-executive chairman of the board since IPO in 2013 is Malcolm Naish, a chartered surveyor with more than 40 years’ experience of working in the real estate industry. Before becoming chairman of Target, Mr Naish was head of property at Scottish Widows Investment Partnership until 2012. The other independent directors of the company bring broad experience in the real estate, healthcare, and fund management and administration sectors. They are Professor June Andrews OBE (appointed 2013), a former trade union leader, NHS manager and senior civil servant and world-renowned dementia expert; Gordon Coull (appointed 2013), a former partner at Ernst & Young LLP specialising in investment trusts and property; Thomas Hutchison III (appointed 2013), who has more than 40 years of experience focused in the lodging, hospitality, real estate development, seniors’ housing and financial services industries; and Alison Fyfe (appointed May 2020), a highly experienced property professional with 35 years of experience in surveying, banking and property finance.

Target has delivered consistent profitable growth since IPO in 2013 and has increased aggregate quarterly DPS each year. Despite the pandemic this trend has continued through the past year (Exhibit 7), with income returns being supported by acquisitions and development completions as well as inflation-indexed rental uplifts, despite provisions being taken against rent receivables from a small number of tenants/homes. Capital returns have also benefited from rent uplifts as well as further tightening in market valuation yields with investors continuing to be attracted by the non-cyclical nature of returns, and this was the main factor driving the acceleration in Q321 quarterly EPRA NAV total return to 2.4% (dividends added back but not reinvested).

Exhibit 8 shows the more detailed H121 financial data, which more clearly highlights recent trends in financial performance. In our comments below we particularly focus on adjusted earnings, a measure that includes company-specific adjustments and is aimed at presenting a clearer picture of recurring cash earnings as a basis for dividend distributions. In addition to the usual EPRA adjustments to IFRS earnings (for property valuation movements and other non-recurring items), the adjusted earnings measure excludes non-cash IFRS rent smoothing and includes development interest earned on development forward funding extended. The IFRS smoothing primarily relates to the straight-line recognition under IFRS of fixed and guaranteed minimum rent uplifts over the life of the leases. Licence fee income accrues during the construction phase of forward funded development schemes and is ‘settled’ at completion by a reduction in the amount paid to the developer. This typically results in a valuation uplift (to market value), which is excluded from EPRA earnings and so otherwise not recognised.

We note the following key features of the recent adjusted earnings performance:

As well IFRS smoothing adjustments (including in income but excluded from net valuation movements to avoid inflating NAV) and excluding interest earned in respect of forward funding, H121 IFRS earnings of £15.8m include:

Our revised forecasts, shown in detail in the financial summary in Exhibit 16 at the back of this note, are updated to include the H121 asset management and investment activity detailed above (the acquired home at Bicester, the Chesterfield and Droitwich Spa developments, the home disposal and re-tenanting) and the H121 results, the March 2021 £60m (gross) equity raise and further acquisitions. Our assumed acquisitions are sufficient to deploy the proceeds from the equity raise, with associated debt, while being consistent with the company’s c 25% loan to value (LTV) target.

Our assumptions include:

A summary of our key forecasts is shown in Exhibit 10, including FY22 and FY23 for the first time. FY21 is adjusted for several of the factors listed above. The increase in forecast rental income includes a positive impact from acquisitions as well as a c £2.0m increase in our forecast for non-cash IFRS rent smoothing adjustments, excluded from adjusted ‘cash’ earnings. FY21e adjusted earnings also now includes c £3,0m (the H1 charge plus H2 estimate) in rent receivable impairment, while adjusted EPS includes a slight increase in the average number of shares in the year resulting from the March 2021 equity raise. FY21e DPS is increased in line with quarterly payments and the annual target. With acquisitions and development completions continuing to lift revenues in FY22 and FY23 we expect continuing growth in DPS (c 1.2% pa in each year), substantially covered by adjusted ‘cash’ earnings in FY22 and fully covered in FY23.

To fund portfolio growth since IPO, Target has steadily increased its capital resources, both equity and debt capital, sufficient to take advantage of opportunities in the market while avoiding excessive gearing and mitigating any drag on returns. The company targets moderate gearing with a medium-term target of around 25% (borrowings to gross assets) with a maximum permitted level of 35%. The £60m (gross) upsized equity issue in March 2021 (c 54.0m new shares at 111p) forms part of a placing programme, approved by shareholders, under which up 150m new shares may be issued at the discretion of the board at any point up until 11 February 2022. The 150m shares includes the March issue, with c 96.0m shares still available under the programme and may be issued on a non-pre-emptive basis at a premium to EPRA net tangible assets (NTA), sufficient to cover the cost of issue. The placing programme should allow the company to tailor future equity issuance to its acquisition pipeline, providing flexibility and minimising any drag on returns. We estimate that at the current share price, the additional shares that may be issued would provide funding for c £140m of additional investment commitment, over and above the investment we assume in our forecasts, on a geared basis (25% LTV).

During H121 available debt facilities were increased from £180m to £220m, comprising £80m of fully drawn fixed-rate term loan facilities and £140m of more flexible variable-rate revolving credit facilities (RCF). The increase in facilities and extension of the term was completed with a minimal increase in the ongoing interest costs and lengthened the group weighted average term to expiry to more than five years with a weighted average cost, including amortisation of loan arrangement fees and swap costs, of c 2.8%. During Q321 Target used the proceeds of the equity raise to temporarily reduce borrowings by £48m to £114m. Allowing for cash balances of £26.6m, net debt was £87.4m and the net loan to value ratio was a low 13.4%.

Of the total debt facilities, £80m are fixed rate/hedged and £140m floating rate. All 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.

Annualised DPS has increased in each year since Target’s IPO in 2013, paid quarterly and uninterrupted by the pandemic. The current quarterly run-rate of DPS (1.68p) leaves the company on target for aggregate annual DPS of 6.72p in the current (FY21) financial year, representing a prospective yield of 5.7% and taking annual compound growth in DPS since 2014 to 1.63%. Based on the end-Q321 EPRA NAV per share of 109.1p, the P/NAV is 1.09x, broadly in line with the average since IPO of c 1.08x and below the peak of 1.19x. The only period of notable relative weakness in the P/NAV was at the start of the COVID-19 pandemic when uncertainty was high for care home operators and for the wider equity market.

Exhibit 14 shows the NAV total return history since IPO. The cumulative total return (adjusted for dividends paid but not assuming reinvestment of dividends) from IPO in March 2013 to 31 December 2020 (end-H121) was 59.2% or an average annualised rate of 6.0%. Dividends accounted for c 80% of the total. On the dividend reinvested basis reported by Target, the cumulative return is 77.5%, an annualised 7.7%. Our forecasts imply an annual average return of 7.0% pa in the FY21–23 period, increasing in FY23 in the absence of assumed acquisitions and acquisition-related costs.

In Exhibit 15 we show a comparison of Target with its nearest competitors. The Target dividend yield is well above the peer group average and its P/NAV is broadly in line. Within the peer group, the impact on valuation of investor perceptions of the strength of tenant covenant is apparent. The primary healthcare investors (Assura and PHP) trade with below average dividends yields, resulting in above average P/NAV ratings, and in our view this is partly a reflection that most of their rents are funded by government, either directly or indirectly through GP rent reimbursement. Against the background of strong demographically driven fundamentals, a successful test of the strength of tenant covenant during the exceptional challenge of the pandemic suggests good potential for Target’s yield differential to narrow versus the peer group average.

The visibility of Target’s contractual income and dividend paying capacity is provided by long leases and RPI-linked rent increases. We see the key sensitivities as relating to the following: