Target Healthcare REIT — DPS growth from a sustainable base

FY23 results were in line with the indications reported with the Q423 report published in August and covered in our update note and progress has continued in Q124. This report begins with a detailed commentary on our expectations for further earnings and dividend growth and attractive total returns. For those less familiar with the company, later in this report we discuss Target’s strategy and portfolio and its investment focus on high-quality, modern, purpose-built properties. Of particular note:

We start the report by reviewing our updated forecasts.

With many of the key financial data previously disclosed in the unaudited Q423 update and reflected in our previous note, the FY23 financial performance provided no surprises. The changes to our FY24 adjusted earnings forecasts are modest and primarily related to an increased assumption for loan arrangement fee amortisation and debt facility non-utilisation fees. Our dividend forecast is in line with the company’s target, slightly below our previous assumption, and is 1.05x covered (1.33x on an EPRA basis). We have also introduced a new FY25 forecast, with earnings growth driven by rent reviews and development completions. We forecast further growth in FY25 DPS of a little over 2%, with cover increasing to 1.09x.

Rental growth is the key to our forecasts, offsetting higher financing costs and expenses in FY24 to maintain earnings, and driving earnings growth in FY25.

Like-for-like rental growth should continue to benefit from annual, inflation-indexed rent reviews2, mostly collared and capped at 2% and 4% respectively.3 Annual fixed uplifts apply to 1% of rental income. Rent reviews added 3.8% pa to contractual rental income in both FY23 and FY22 and we forecast a similar rate of increase in FY24 and FY25. Independent forecasts provided to the UK treasury4 indicate that annual RPI inflation is unlikely to fall below 4% before the end of 2024 and the average rate of annualised inflation through the 12 months to 30 June 2025 (FY25) should remain above 4%. We expect this to add somewhat more than £2m pa to annualised contracted rents in each of FY25 and FY25.

We forecast that the completion of forward-funded development projects (there are currently five under construction) will add an additional £4.0m to annual contracted rental income by end-FY25, well ahead of our estimate of the interest earned by Target in respect of the average funding extended for the construction costs during the build period.

Our forecasts for annualised contracted rent roll are shown in Exhibit 2 and, on a weighted basis, these are reflected in our rental income forecasts for FY24 and FY25. The contribution of the FY25 rent roll growth will not be fully reflected in the income statement until FY26.

We have estimated the rent roll contribution from development completions based on an assumed initial yield of 6% on the development cost including land, although actual yields are likely to differ from project to project according to factors such as the property specification and locality, as well as market pricing at the time of commitment. The assumed yield is similar to the current portfolio EPRA topped-up net initial yield of 6.22%.

Our forecasts for expenses are very much driven by investment management fees, lined directly to average net asset value. Other expenses increase with inflation. Credit loss provisions at a rate of 1% of rents are included in our forecasts, in line with current rent collection and acknowledging that a minority of tenants will inevitably encounter challenges from time to time.

With underlying earnings substantially distributed, our NAV forecasts are driven by our property valuation assumptions.

Strong care sector fundamentals and non-cyclical, long-term, inflation-protected income prospects have mitigated the impact of rising bond yields and economic uncertainty on property values. In contrast to the broader sector, investment demand for good-quality care home properties, especially modern, purpose-built properties with strong environmental credentials, has remained robust. In the year to June 2023, Target’s property values fell 4.1% on a like-for-like basis compared with c 19% across the broad UK property sector. The FY23 valuation movement reflected c 40bp (0.4%) of yield widening (£73m valuation reduction), partly offset by rental growth (£36m valuation increase).5 All of the net decline came in H1, with rental growth yield stabilisation in H2 reflected in 1.5% like-for-like valuation growth. Despite continued volatility in the bond market, the portfolio yield was unchanged in Q124, with rental growth driving a 0.8% like-for-like portfolio gain. Nonetheless, our forecasts imply only a modest (c 15bp or 0.15%) widening over the forecast period. Each 10bp (0.1%) increase in this implied yield is equivalent to a 2.3p reduction in forecast NAV per share, with a broadly equivalent increase in NAV from a lower yield.

The operator sector, in general, is benefiting from increased occupancy, recovering from the pandemic, and strong fee growth, while a temporary relaxation of immigration rules for care workers is relieving some of the pressure on staffing, supporting the provision of care and reducing the cost of agency provision. In combination this has provided an effective offset to inflationary cost pressures.

Based on data gathered from its tenants, underlying resident occupancy in Target’s mature homes6 remains on a slow but consistently upward trajectory, to 85% at end-FY23 and 86% in Q124. During the pandemic, occupancy reached a low of c 74% in April 2021 and there is further room for growth until it reaches the c 90% level that was typical before the pandemic. Target says that many operators have been focused on admitting new residents at fee levels appropriate to the care package required, as opposed to prioritising occupancy in itself.

Privately funded weekly fees have continued to outstrip inflation, as has been the case over the past 25 years, and data collected from the company’s tenants show 13% growth in average weekly fees charged to residents in the year to June 2023. Target says that in this inflationary environment, increased fees have generally been recognised as inevitable to support critical care needs. Over the longer term, average weekly fee growth has more than matched inflation The company has observed that recent local authority fee awards have been mixed and that there are pockets of poor fee awards where authorities lack the ability or willingness to match inflationary cost pressures. 68% of residents within Target-owned homes are funded privately, wholly or through fee top-ups, ahead of the market as a whole (we estimate c 50%, with the balance of fee growth publicly sourced).

From its tenant data, Target estimates that staff costs have increased c 6% in FY23, with wage growth mitigated by lower use of expensive agency staff. Not surprisingly, staffing is the largest single cost item for the sector, typically accounting for c 60% of revenues. Energy costs and other operational expenses, an aggregate 16% of costs within Target’s homes, remained stable. With rent increases typically capped at c 4%, it is easy to understand why rent cover7 is improving so strongly.

Rent cover for mature homes,8 now 90% of the total, has continued to increase and was 1.75x in the June 2023 quarter compared with 1.47x in the prior year period. On a rolling 12-month basis, yet to fully reflect the continuing improvement, rent cover to end-June 2023 was 1.6x (12 months to June 2022: 1.3x).

On a quarterly (or spot basis) basis, cover is now above its pre-pandemic level, when resident occupancy was higher, and is also above the 1.6x that Target has previously indicated to be a realistic medium-term target for a typical home. Nonetheless, with room for resident occupancy to increase further, there seems every prospect of rent cover continuing to build.

Asset management initiatives and improved trading conditions have restored rent collection to in excess of 99% as of Q124, slightly above the end-FY23 level, having previously dipped to around 90% during FY22, with a small number of tenants slow to recover from the pandemic. Average rent collection throughout FY23 was 97%.

During Q123, Target reached a settlement with the operator of seven homes (c 6% of rent roll), which was only partly meeting its rent commitments. With the trading environment improving, the tenant renewed its long-term commitment to the homes and settled all rent in arrears, providing an immediate improvement in rent collection and generating a recovery in rent provisioning of £1.1m. As a result of this settlement alone, the run-rate of rent collection increased immediately to c 95% and in 2023 rents have been received in full.

Further progress on rent cover was achieved with the re-tenanting of one of the four Target homes it operated was completed in Q323 with the effect of alleviating cash flow pressures and allowing it to return to a fully rent-paying position on its three remaining homes. Existing lease terms, including rent levels, were maintained with the incoming tenant being granted a short-term rent-free period to manage the rebuild in occupancy.

While the improvement in trading conditions has benefited tenants across the portfolio, one tenant in particular, the operator of two Target homes, responsible for a significant proportion of the rent arrears, moved to full payment of rents in 2023 on the back of improved rent cover. To further support the tenant’s plans for its business and grow the returns on its assets, Target is investing £2.5m in one of the homes, creating an additional 18 rooms, soon to complete. During Q124, £1.7m of the costs were incurred and 10 of the rooms were completed. A portion of these will be immediately sub-let for three years by the operator to a local charitable organisation, at which point it is anticipated that the tenant will be able to take back the space for its own operation. Target’s rental income on the property will increase at a net initial yield consistent with the current property valuation and rent cover for the tenant is expected to improve. Post-completion, the tenant (including the sub-let) will represent 4.6% of the portfolio’s contracted rent. Previously provided for historical rent arrears will be partly written off, while rent deposits covering both properties operated by this tenant have been established to further strengthen the surety of rent receipts.

The acquisition of newly built homes has been an important element in building a high-quality portfolio and continues to be so (there are currently five properties under development). However, new homes take time to build occupancy and reach a ‘stabilised’ level of profitability, especially when targeting privately funded residents, a process that may take three years or more. As the pandemic hit, around 30% of Target’s portfolio was categorised as immature (compared with 10% now). The immature homes are a combination of the recently opened homes as well as a limited number of tenants which were also maturing as businesses and were not at a stage where they had built sufficient reserves to absorb a materially slower rate of occupancy growth.

Target’s ability to re-tenant properties, and in some cases sell them, is key to maintaining occupancy and income and this has been greatly facilitated by a focus on high-quality, modern and ESG-compliant assets that are attractive to residents, operators and investors. Its investment thesis is that best-in-class properties in local areas with positive demand/supply characteristics and prevailing rental levels that are sustainable will always be attractive to existing or alternative tenants.

Of Target’s £320m of debt facilities, £243m was drawn at end-Q124 (end-FY23: £230.0m), with an average term to maturity of 6.0 years. The drawn borrowing comprised £150m of long-term fixed rate debt at a low average cost of 3.2%, with a first maturity in 2032, and £93m of shorter-term debt. The shorter-term debt is floating rate but the interest costs on £80m of this have been capped at least until November 2025. In aggregate, 95% of the Q124 drawn debt was fixed/hedged at an all-in rate, including the amortisation of loan arrangement costs, of 3.91% (end-FY23: 3.70%).

The £77m of undrawn borrowing would, if fully drawn, be at a variable cost, including amortisation of loan arrangement fees, of 2.46% plus SONIA (or an interest cost before fees of 2.21%).

Allowing for capital commitments of c £35m, primarily in respect of funding for the five development assets, the company had available capital of £42m at end-Q124. Including the utilisation of cash balances, our forecasts assume an additional £25m of debt drawing, taking outstanding borrowings to £268m. Based on the hedging arrangements currently in place, this limits exposure to any further increase in interest rates before November 2025 to £38m of c 15% of projected borrowings. Meanwhile, the company has the flexibility to react to any decline in interest rates during this period.

Market interest rate expectations remain volatile but, at the time of this report, do not indicate any further increase in the Bank of England base rate, closely tracked by the SONIA market rate, and currently 5.25% with a decline to c 4% by November 2025. This indicates an increase in borrowing costs, of shorter-term floating rate borrowings no later than the maturity in November 2025, corresponding with the expiry of the hedges. However, based on current market interest rates, we estimate that a good level of dividend cover would remain.

Assuming the shorter-term borrowing were to be refinanced at a SONIA rate of 4.0% plus a lending margin of 2.5% (6.5% in aggregate), the impact would be to increase the overall blended all-in cost of borrowing to 4.9%, or an annualised £13.0m. This represents an increase of c £2.5m9 compared with our existing forecast for the 12 months to 30 June 2025 (FY25). If applied to that FY25 forecast on an annualised basis, dividend cover would be c 1.02x, before the further contracted rent growth in FY26.

Allowing for cash, the end-Q124 loan to value ratio was 25.0% (end-FY23: 24.7%). On a pro forma basis, adjusting for outstanding capital commitments, the Q124 LTV was c 28%.

Each loan facility is secured against a discrete pool of assets with specific loan covenants. These include maximum loan to value ratios of at 40–50% and minimum interest cover ratios of 200–225%. Target is well within these requirements and at end-FY23 had unencumbered assets with a value of c £107m.

Target is primarily focused on income returns, and progressively increased DPS in the period from listing to H123. The re-basing in mid-FY23 (from a quarterly rate of 1.690p to 1.400p) was in recognition of the change in market conditions, to a level from which it could continue to grow on a sustainable basis. The increase in the Q124 DPS to 1.42p (+2%), which the company intends to maintain throughout FY24, suggests this is the case. We forecast aggregate FY24 DPS of 5.71p, 1.05x covered by adjusted earnings, with further 2.2% growth in FY25, 1.09x covered. This would leave Target in a strong position to maintain dividend progression through FY26 despite the maturity of interest rate hedging.

Historically, the company has aimed for DPS to be fully covered by adjusted earnings, assuming full deployment of available capital. Adjusted earnings provide a better indication of dividend capacity than EPRA earnings, which include significant non-cash IFRS rent smoothing adjustments.10 However, with consistent growth in both the capital base and the portfolio, the earnings reported in any period have historically always been in a process of catch-up to the fully invested potential, with dividends less than fully covered. However, the sharp rise in interest rates, well in excess of the widening in acquisition yields, has significantly removed the opportunity for accretive acquisitions, delaying the expected path to full dividend cover. Uncovered dividends also require additional borrowing, which is unattractive at higher borrowing rates. It was against this background that the board decided it was appropriate to rebase dividends, despite the improvement in tenant performance and rent collection.

Looking beyond our forecast period, we expect the company to align dividends more closely with immediate earnings.

Since listing in March 2013, up to end-Q124, the aggregate NAV/accounting total return (not including reinvestment of dividends paid)11 is 75% or an average 5.4% pa. Dividends paid have accounted for 90% of returns. Capital returns have mostly been positive until H123 (June to December 2022) when property values declined in common with the broad commercial property sector. With its property values beginning to recover in H223, the total return of 4.5% substantially offset the H123 negative return of 5.2%, Overall, FY23 total return was overall negative (1.2%), the only year since listing. This positive trend continued in Q124, with a total return of 2.4%.

The table below provides a summary of FY23 financial performance, starting with adjusted earnings before reconciling these to both EPRA earnings and the statutory reported IFRS earnings.

In respect of adjusted earnings, in particular we highlight:

The targeted FY24 DPS of 5.712p represents a prospective yield of 7.1%, while the shares continue to trade at a discount to NAV of more than 20% despite property values recently increasing.

In Exhibit 13, we summarise the performance and valuation of a group of real estate investment trusts that we consider to be Target’s closest peers in the broad and diverse commercial property sector. The peer group is invested in the primary healthcare, supported housing and care home sectors, all targeting stable, long-term income growth derived from long lease exposures. For consistency, the data are presented on a trailing basis.

Target’s yield is below the average, although this is slightly inflated by Triple Point Social Housing’s (SOHO) high yield. Target’s P/NAV is broadly in line with the group, excluding SOHO.

The demand for care home spaces in the UK is expected to grow strongly. The number of people aged 85 or over is forecast to almost double over the next 25 years,12 with increasingly complex care needs. The numbers living with dementia are forecast to grow from an expected 1.0 million in 2024 to 1.6 million by 2040. The sector provides a substantially non-discretionary, essential service largely independent of the wider economy.

The number of care and nursing beds available has shown no material growth over the past 10 years, with newly developed and refurbished stock offset by the withdrawal of older, obsolete homes. Significant investment in the care home estate is required to meet existing and future needs and satisfy the expectations of residents and their families, as well as regulatory demands for better quality care.

Healthcare real estate has historically provided attractive risk-adjusted returns compared with the broader commercial real estate sector. Target’s portfolio has also continued to outperform the MSCI UK Annual Healthcare Property Index. In the year to December 2022, Target’s portfolio delivered a total return of 2.5% versus 1.7% for the index. Since Target was launched, its portfolio has returned 10.2% pa versus 6.9% for the index (and over five years, 8.6% versus 8.1

At the core of its strategy, Target has an unwavering focus on high-quality, modern and sustainable assets, attractive to residents, operators and investors. Its investment thesis is that best-in-class properties in local areas with positive demand/supply characteristics and prevailing rental levels that are sustainable will always be attractive to existing or alternative tenants.

Key portfolio metrics include:

At end-Q124, including the Weston-super-Mare development acquired in the period, Target’s portfolio comprised 98 homes, of which 93 were operational and five were development properties under construction. It was externally valued at £890.3m with annualised contracted rents of £57.1m, reflected in an EPRA topped-up net initial yield of 6.22%. Allowing for short-term lease incentives, annualised passing rent was £55.6m and the EPRA net initial yield was 6.05%. Contracted rents on the development properties are not included in these figures until completion. The WAULT was 26.3 years.

The homes are well diversified by geography and by tenant. Of the 32 tenants, the 10 largest account for 63% of contracted rent, with the largest individual tenant 16%. Of the 22 remaining tenants, each account for less than 3.3%.

Completed forward-funded developments and the five that were under construction account for 21 of the portfolio assets. They provide access to attractive new homes that satisfy Target’s strict investment criteria that may be otherwise unavailable. They also bring much needed new capacity to the market. Target is itself not a developer and we believe that forward-funding developments is relatively low risk. Target acquires land plots, with planning consent, from developers and funds the construction, on fixed-price contracts, of pre-let homes. During the construction phase, Target accrues interest on the funding that has been extended and this is reflected as a deduction in the acquisition price. The interest is included in adjusted earnings.

During FY23, five properties were sold for an aggregate £25.8m after costs, all at above book value, realising a gain of £0.5m, and reducing annualised contracted rents by £2.1m. One of the properties had been acquired as part of the 18-home portfolio acquisition in December 2021 (H122), which added £9.3m to contracted rents at that time. Target says this property was below the average standard of the portfolio as a whole. Target also exited the Northern Irish market, where it says that the fee and resident funding dynamic is less favourable. The four homes sold in Northern Ireland represented c 2.5% of the overall portfolio value at the time (or c £22m).

The proceeds can be recycled into the new (and existing) developments on a gradual basis as construction proceeds over the next year or so. At the start of FY23, there were four homes under development of which one reached practical completion13 during the year. An additional home was acquired during FY23 and a further one in Q124.

The other three developments that are under construction are:

At end-FY23, there was £31.1m of capital committed to the completion of forward funding projects. Including the commitment to Weston-super-Mare and subsequent development funding we estimate this was little changed at end-Q124.

Target also invested £6.1m in FY23 in portfolio improvements, converting 128 beds into full wet rooms at four homes, increasing the proportion of portfolio beds to 98% from 96%, and commenced work on the addition of 18 rooms to another, discussed above. Ten of these homes were completed in Q124. A further £3.7m had been committed towards increasing the proportion of beds with wet rooms to 100%, with 15 upgrades completed in Q124. A portion of capital has also been allocated to direct carbon reduction initiatives, most notably the installation of photovoltaic panels, in partnership with tenants.

These organic investment projects are reflected in uplifts to contracted rents, reflecting net initial yields in line with market levels. This added 0.3% to the 1.0% increase in Q124 contracted rents, including rentalisation of the £1.7m cost of the 10-room addition to one home and £0.5m of wet room installation at another.

There have been several recent changes to Target’s independent non-executive board as part of its now completed succession planning. Alison Fyfe became chair in December 2022, having joined the board in May 2020 on the retirement of Malcolm Naish, who had held the position since the company listed in 2013. Ms Fyfe is an experienced property professional with 35 years’ experience in surveying, banking and property finance. She also has board experience, having acted as a director of a number of companies in the property and debt finance sector. The other directors of the company bring broad financial, commercial, property, fund management and healthcare experience. They are Dr Amanda Thompsell (appointed in February 2022), Richard Cotton (senior independent director, appointed in November 2022), Michael Brodtman (appointed in January 2023) and Vince Niblett (chair of the audit committee, appointed in August 2021).

Full details of board members can be found on the company’s website.

Target Fund Managers (the investment manager) is a family-owned sector specialist manager investing exclusively in the elderly healthcare property sector. It is led by Kenneth MacKenzie, its chief executive, supported by a growing team of professionals, the core of which, including original co-founders John Flannelly and Andrew Brown, has worked closely together since 2010, providing continuity as well experience. This experience spans 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 involved in the management of Target Healthcare REIT on page 17.

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. With end-FY23 net assets of £655m, the marginal investment management fee is 0.95%.

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: