Primary Health Properties — Continuing dividend growth

PHP’s H124 adjusted earnings1 increased by £0.4m or 0.9% to £46.3m compared with H123 (£45.9m). The increase in the period reflects the improving organic rental growth from rent reviews and asset management projects in both FY23 and H124, along with an increased contribution from PHP Axis2 (the Irish property management business acquired in January 2023) and slightly lower administrative costs.3 These were partly offset by increased interest costs on the small proportion of borrowings exposed to interest risk fluctuations. H124 DPS of 3.5p (+3.0%) was fully covered by adjusted EPS.

Adjusted net tangible assets (NTA) per share was 3.0p, or 2.9%, lower than at end-FY23 reflecting a property revaluation deficit of £40.0m. This comprised the negative impact of yield widening (£73m), partly offset by gains arising from rental growth and asset management (£33m). The endperiod EPRA net initial yield was 5.18% (end-FY23: 5.05%), with a reversionary yield of 5.5% (endFY23: 5.4%). PHP believes that yield expansion is close to an end and that values should start to stabilise in the remainder of 2024 and 2025, with continuing rental growth offsetting any further widening of yields. It notes the dearth of recent market transactions, leaving valuers significantly reliant on sentiment to arrive at fair values, and believes that further significant reductions in primary care values are likely to be limited, with the stronger rental growth outlook and the expectation of interest rate reductions providing support.

The balance sheet remains strong and liquid, with the cost of 96% of drawn debt fixed or hedged, and more than £300m of undrawn headroom.

There is no change to our forecasts for growth in FY24 and FY25 adjusted earnings and fully covered DPS. We expect further growth in fully covered DPS in FY26, forecast for the first time. The growth in operating profit is driven by increased rental income, primarily organic but also benefiting from development completions, with further improvement in the already low EPRA cost ratio. PHP expects to save £1m pa from FY25 as a result of staff reductions.

Our forecasts allow for some additional moderate property yield widening (to c 5.35% vs 5.18% at end-H124), more than offset rental growth in FY25 and FY26, with valuation gains generating growth in NAV and a modest reduction in the loan to value ratio (LTV).

Organic rental growth is driving earnings growth and we expect this to continue as market rents accelerate. Annualised rent roll increased by £1.8m in H124, to £152.6m, including £1.6m from rent reviews and £0.2m from asset management projects. Acquisitions (see below) added £0.5m but this was offset by FX translation movements in respect of the Irish portfolio and lease surrenders and voids. Occupancy of 99.2% was temporarily affected by the insolvency of LloydsPharmacy at three units in the UK (co-located with primary health facilities) and the surrender of two pharmacy leases in Ireland, where the space is to be re-let to the HSE as part of an asset management initiative.

The annualised rent increases secured on completed reviews have picked up very significantly over the past three years. The continued acceleration of open market rent reviews in H124 is highly encouraging even though the overall achieved increase of 3.2% was lower than the 4.0% average annual uplift in 2023, as the impact of inflation linked uplifts waned.

Open market reviews apply to 68% of rent roll and are key to sustaining organic rental growth. After many years of very modest uplifts, high levels of land and building cost inflation, particularly in the past couple of years, are increasingly being recognised but there is much further to go. Open market rents are typically reviewed every three years, but it can take much longer for these to settle. At end-H124, rent reviews on £87m of rents were outstanding. Around half the outstanding reviews are in the process of being settled, with the potential to lift rents by £2.1m or 4.8% versus the existing level. The balance of outstanding reviews will be actioned when there is further comparative evidence available to support the expected level of market rent. All awards need to be agreed with the district valuer and the evidence to support uplifts comes from the completion of historical rent reviews and the rents set on delivery of new properties into the sector. NHS initiatives to modernise the primary care estate will result in previously agreed rental values having to be renegotiated to make a number of these projects viable in the current economic environment.

The balance of UK rents are linked to UK inflation (27%) or have fixed uplifts (5%). Irish rents (c 9% of the total) are linked to Irish CPI and are reviewed every five years.

The improving rental growth outlook is reflected in the independent valuers’ assessment of estimated rental values (ERV) of the portfolio, which increased by 1.7% in H124. The portfolio reversionary yield is 5.5% compared with the EPRA net initial yield of 5.23%.

PHP adopted a cautious approach to investment activity as acquisition yields tightened, this continued as interest rates climbed, and remains the case until the economic and interest rate environment become clearer. During H124, it ‘opportunistically’ acquired a completed health centre at Basingstoke for a total consideration of £4.5m and commenced work on its second development scheme at South Kilburn, London. The scheme was made viable by a capital contribution from the commissioning Integrated Care Board and local authority, each contributing £0.5m to the overall development cost. By reducing PHP’s share of the cost, this equates to a 26% uplift in the rent originally set by the district valuer.

More generally, PHP continues to pause direct development activity and estimates that to compensate for much higher costs, to make new development economically viable and bring forward schemes that are much needed by the NHS, agreed rents need to be 20–30% higher.

Ireland remains PHP’s preferred area of future investment activity, with similar market dynamics to the UK from a lower cost of capital and higher property yields. Over the medium term, the company targets an increase in the Irish share of the portfolio from the current 9% to c 15%. However, PHP’s most immediate pipeline of external investment opportunities in legal due diligence continues to be focused predominantly on existing portfolio asset management projects. These create value by increasing rents and extending lease lengths. There are currently 23 projects in legal due diligence with an aggregate investment requirement of c £15.3m, expected to generate an additional £0.7m pa of rental income and extending the weighted average unexpired lease term on those premises back to an average of 19 years.

The UK commitment to NHS reform and investment has been reiterated by the new government, particularly a continuation of the shift of services out of hospitals and into the community. It recognises the need for a reform of primary healthcare and seeks to provide enhanced patient access to services and earlier diagnosis of progressive health conditions, but this will be challenging to achieve and will require significant investment. Driven by an increasing and ageing population, there is constantly growing demand for healthcare services, while existing facilities face capacity constraints. The extent of the NHS backlog also remains a significant concern, with the number of patients waiting for treatment reaching record highs and hospitals struggling to meet objectives. All these factors make more urgent the need for improved and increased primary healthcare infrastructure, with approximately one-third of the UK’s current primary care estate in need of modernisation or replacement.

PHP is very well placed to help meet the need for investment but, for it to be economically viable, rents must increase materially.

PHP has a strong balance sheet. Debt facilities are well spread by lending source and maturity, with an average maturity of more than six years. Of the drawn debt, 96% is fixed rate or hedged, with an average rate of 3.3%. Allowing for capital commitments, it has more than £300m of undrawn headroom.

The LTV ratio increased marginally to 48.0% during H124, due to the property valuation movements, but it sits comfortably within the company’s target range of 40–50%. Although this is above the LTV range for more mainstream listed UK commercial property investors, it needs to be seen in the context of the exceptional strength of the tenant covenant, the essential nature of the assets and long leases with upwards-only4 rent reviews. Net debt/EBITDA is more than 9x. It would take a more than 30% decline in portfolio value, or an implied 8.0% net initial yield, to challenge covenant headroom. Rightly in our view, PHP has reiterated its comfort with its balance sheet structure and, for the avoidance of doubt, confirmed that it has no plans to reduce borrowing by raising equity.

Terms have been agreed to extend and increase existing revolving credit facilities that mature in 2025. Once completed, the new facilities will provide sufficient headroom to repay both the £150m convertible bond and £70m variable rate bonds that mature in 2025.

Stable and growing dividends are central to PHP’s business model and the investment case. PHP is already in its 28th year of unbroken DPS growth and the company comments that this is set to continue as the new UK government commits to increased investment in primary and community care.

For the current (FY24) year, PHP targets annual DPS of 6.9p, in four equal payments, three of which have already been paid or declared. We forecast dividends of 7.0p in FY25 and 7.1p in FY26.

Over 10 years to H124, PHP has generated an average accounting total return/ EPRA NTA total return5 of 8.0% pa. Dividends paid have accounted for two-thirds of the total.