Triple Point Social Housing REIT — Financial and operational progress

Time to reassess the investment case

With rent collection and dividend cover rebuilding as the issues with Parasol and My Space move closer to a resolution, we expect investors to give greater focus to the underlying investment case and continuing low valuation of the shares. In particular, we would highlight:

SOHO operates in a structurally supported sector, providing a high level of social benefit.

SSH provides homes for some of the most vulnerable in society, in need of high levels of care and support, often spanning decades, and requiring accommodation that is suitably adapted to the residents.

There is a chronic shortage of all forms of social housing, including SSH, and it is widely expected that the demand will continue to increase, driven by greater penetration of the existing population in need and the further growth of that population, primarily driven by improved post-natal care and increased life expectancy.

Private capital has a crucial role to play in meeting the need for more, better-quality SSH homes.

For investors, SOHO provides a high level of inflation linkage and protection against higher interest rates.

The rent costs for residents in SSH are directly supported by government through housing benefit awards which have historically tracked inflation closely. SOHO’s leases are all linked to the lower of inflation or housing benefit policy.

All borrowing is fixed rate at a low average cost of 2.74% with a weighted average maturity of c 10 years.

In August 2023, Fitch Ratings reaffirmed the group’s existing investment-grade, long-term Issuer Default Rating of ‘A-’ with a stable outlook and a senior secured rating of ‘A’ for the group’s existing loan notes.

Active regulation of the sector will support sustainable long-term returns.

The social housing sector has traditionally had a low financial risk profile, in part due to the ongoing monitoring presence of the Regulator of Social Housing (RSH) and the fact that much of the rent is funded by central government through housing benefit.

Regulatory engagement is promoting greater accountability and transparency across the sector and higher financial governance standards, which we believe is to be welcomed and will enhance the resilience and sustainability of the sector.

SOHO expects some consolidation among approved providers (APs)2 over the next two years, which should create larger and stronger counterparties for SOHO.

A strong board and well-resourced manager.

Since it listed in 2017, SOHO has been managed by Triple Point Investment Management, part of the Triple Point Group that manages more than £2bn of private, institutional and public capital through specialist teams in the areas of real estate, debt, infrastructure and venture capital, and has been investing in the social housing sector for more than five years. The investment manager has a well-resourced and experienced team focused on monitoring the performance of portfolio properties, lessees and care providers.

The company is overseen by an experienced board with a wide range of relevant experience, complementary to the strategy, in the areas of social housing and care, closed-end companies, construction, legal, audit and taxation.

Details of FY23 financial performance

In the table below we lead with EPRA earnings and show a reconciliation to the company’s adjusted ‘cash’ earnings, an approximate guide to the cash generated to support dividends, and then the statutory IFRA results. In summary we highlight:

Annualised contracted rent roll increased to £41.0m versus £39.0m at end-FY22, including the impact of rental growth and asset sales.

Rental income increased by 6%, driven by inflation-linked uplifts, voluntarily capped by SOHO at 7%.

The expected credit loss increased to £4.6m with a full-year impact of the arrears generated by Parasol and My Space, along with a £1.0m impact from unpaid rent in FY22.

Administrative expenses reduced slightly while investment management fees, linked to net assets, increased 12%. The 4% increase in expenses was less than the growth in revenue, generating a reduction in the EPRA cost ratio to 20.6% (FY22: 21.1%).

The cost of the company’s long-term, fixed-rate debt was unchanged in the year but the overall finance charge was reduced by the elimination of fees related to the cancellation of the unused revolving credit facility in FY22.

EPRA earnings increased 1% to £19.5m and, reflecting the repurchase of shares, EPRA EPS by 3%.

Adjusted ‘cash’ earnings adds back loan fee amortisation and also now excludes the increase in lease incentive debtor position (see below).

Adjusted earnings of £18.3m or EPS of 4.61p covered DPS of 5.46p by 0.85x.

IFRS earnings includes the movement in property fair values and, in FY22, non-recurring finance costs.

EPRA NTA per share increased by 4% to 113.8p and, including DPS paid, the accounting total return was 9.3%.

Gross LTV of 37.0% was slightly reduced by the increase in property values.

Exhibit 1: Summary of FY23 financial performance

Source: SOHO data, Edison Investment Research

Focus on closing the share price discount

Closing the wide share price discount to NAV has been a focus for the board over the past year.

In July 2023, SOHO completed a £5m share repurchase programme, acquiring and cancelling 9.3m shares at an accretive average discount of 53% to the prevailing EPRA NTA, enhancing EPRA NTA per share by 1.31p.

In August 2023, the company sold a portfolio of four diverse properties for £7.6m, just 3.6% below the 30 June 2023 book value. The sale provided supportive evidence of the robustness of published valuations and NAV, and also demonstrated continued investor demand for SSH properties.

Although the end-FY23 cash balance was £30m, c £11m was restricted or allocated, and c £8m was held for working capital purposes. The available cash of c £11m limits any potential further capital return to shareholders to around £5m, assuming a matching pay-down of debt to avoid an increase in leverage.3 The board has decided that any larger return of capital would be dependent on significant additional liquidity being delivered through property sales, and in current market conditions this is not being actively considered.

Growth opportunities compete for capital

While capital return to shareholders offers immediate accretion, there is an immediate and growing shortage of SSH, and this suggests a positive outlook for continuing profitable investment over the medium term. The government estimates that demand for SSH will increase by more than 100,000 units by 2030, nearly double the existing number of available homes. Despite pressures on local authority budgets, SOHO has seen no impact on their ability to meet their statutory obligations to fund the accommodation and care of the vulnerable. The general election to be held later in the year in unlikely to have an material impact on the expected development of the sector given strong cross-party support for SSH.

Meanwhile, the development budgets of RPs are being squeezed by higher interest rates, increased costs and the need to invest in environmental and other enhancements to their existing housing stock. Recent research indicates that RPs plan to cut their own investment budgets by 9% in 2024 and by 15% over the next 10 years, with a knock-on impact on the number of new homes that they are able to deliver. This has increased the need for private capital to support the delivery of the needed new homes, for which SOHO is well placed. This is demonstrated by its recent relationship with Golden Lane, one of the leading RPs in the SSH sector with strong regulatory credentials (a regulatory compliance rating of G1 V2).4

SOHO is working on a medium-term pipeline of projects in partnership with Golden Lane. Initially, SOHO has allocated £2.8m to the acquisition of a forward funding project, which it expects to commence in May, for the development of 12 adapted flats for people with learning disabilities in Chorley and which will be leased to Golden Lane.

Forward funding projects bring new, specially adapted supply to the sector and SOHO has completed 33 forward funding projects since launch, although the last was completed in March 2021, and these are typically low risk, being pre-let with fixed construction costs. We would expect the initial yield on investment to be c 6% (portfolio EPRA net initial yield of 5.6%), well ahead of the 2.74% cost of debt, fixed for around 10 years, while subsequent rent indexation would generate an increasing return on cost. Strategically, Golden Lane is an excellent partner with which to grow.

Most tenants performing as expected and progress with Parasol and My Space

APs and care provider partners have generally been able to manage inflationary cost pressures, primarily dependent on the majority of SOHO’s diverse range of 27 APs, and have performed steadily over the past year, successfully navigating the twin challenges of inflation and labour shortages well. The only material rent arrears in the year were attributable to My Space and Parasol and the annual report includes useful information about these and each of the other top 10 lessees.

The SSH sector continues to evolve positively, in large part driven by the active engagement of the RSH, promoting greater accountability, transparency and enhanced governance. Most of SOHO’s lessees are RPs for which the RSH has oversight. Across the sector, most RPs have responded constructively to issues raised by the RSH5 and as landlord, SOHO is doing what it can to support them, including the introduction of its new lease clause (see below).

Parasol Homes (with 38 properties and 9.7% of rents) and My Space (34 properties and 8.1% of rents) have been paying rents only partially due during the year but SOHO continues to make progress with resolving the issues and this is reflected in increasing levels of rent collection.

A creditor agreement was put in place with Parasol in August 2023, effective from 1 July 2023, which set a minimum level for monthly rent payments for the period until full rent again became due. Having consistently met the terms of the initial agreement, SOHO recently agreed to extend it for a further six months while a longer-term agreement is finalised, which would see rents paid increase over time. SOHO is working with its new leadership team towards agreeing an equitable long-term agreement. If this is not possible, it has agreed terms with an alternative AP to which the properties leased to Paraosol may be moved.

My Space has been in the process of significantly strengthening its leadership, including a new CEO and CFO as well as several new board appointments which, while a positive development, has slowed the process of finalising a creditor agreement. Operational improvement has seen the level of rent collection increase and SOHO expects this to continue in FY24. Meanwhile, a creditor agreement, now expected to complete during Q2, will determine the long-term level of rent that SOHO expects to collect. Reflecting the progress that is being made at My Space, most of the properties that SOHO has leased to it are expected to remain in place, which the company believes is the best way to improve and sustain their rental income. A small number will be moved to an alternative provider, positioned to better manage them.

Operational progress

Lease clause should help providers address regulatory issues

Following a period of consultation with stakeholders, including the RSH, in June SOHO began the roll-out of its new lease clause. The aim is to enable RPs to address some of the general risks raised by the RSH in relation to long leases. The clause increases risk sharing between SOHO and its RPs, providing them with protection against certain risks that are beyond their control. This may be a change to government funding policy or local government commissioning where the income that RPs are able to generate from a property is reduced. In some such circumstances, and subject to a materiality threshold, the clause allows for the RP to agree a new rent level that reflects the revised circumstances. Should the new rent level not be acceptable to the company, it has the ability to re-assign or terminate the lease.

Additionally, the new clause provides for contractual rent increases to be linked to the lower of UK CPI (or RPI where applicable), or the maximum rent increase allowed under prevailing central housing policy to the extent that it applies to SSH. To date, leases have included annual upward-only rent increases linked to inflation. The new clause would not have had an impact on FY23 rent increases as SSH was not included in the temporary cap on social housing rent payments, no longer applicable in 2024. Based on historical experience, there has been a close correlation between government housing policy and CPI, and we believe that it is unlikely to have any practical impact on medium-term rent growth.

The clause has already been agreed with SOHO’s lessees and to date it has been included in 28% of its leases and it hopes it will be fully rolled out to existing leases in the near future.

The external portfolio valuers have indicated that there is unlikely to be any negative impact on SOHO’s portfolio and lenders have agreed to the inclusion of the clause in SOHO’s leases.

Eco-retrofit pilot launched

In July 2023, SOHO launched the pilot phase of its ‘eco-retrofit’ project, which will see SOHO investing to upgrade the energy efficiency of certain of its properties and preserving their long-term value. All socially rented properties are required to have an EPC6 rating of C or above by 2030 and 71% of SOHO’s properties already meet this hurdle compared with the 43% social housing sector average. The pilot is aimed at building the knowledge and experience of undertaking the necessary works efficiently and with minimal disruption to vulnerable residents. It includes 11 (of c 500 properties in the portfolio) that were EPC D or E rated and all works have thus far been completed on time and within budget. The pilot is expected to complete before the end of 2024 and will provide a basis for the broader roll-out of the retrofit programme. SOHO hopes to provide an update on the cost and timing of the project with the interim results. The costs to date of the pilot project have been expensed within ‘property costs’ which, in aggregate, including other items, increased to £579k in FY23 from £404k in FY22.

Forecasts: Rental growth to drive earnings

FY23 EPRA earnings in line with our forecasts

FY23 EPRA earnings were in line with our forecasts, as were SOHO’s adjusted earnings before considering the change in methodology which, unlike EPRA earnings, conservatively now excludes changes in the lease incentive debtor. Compared with the previous definition, this reduced FY23 adjusted earnings by £1.5m and the restated FY22 result was £0.6m lower than previously published.

The main difference between the FY23 results and our forecasts was the robustness of year-end property valuations, reflected in a higher NAV than we had expected.

We continue to forecast strong growth in FY24 earnings, albeit at a slower pace than previously due to slightly slower progress with Parasol/My Space than previously assumed, and expect further progress in FY25. FY24 earnings should benefit from increased rents, higher rent collection and lower provisioning, partly offset at the adjusted level by changes in the lease incentive debtor. We expect this to support a c 4% increase in DPS (to 5.7p), fully covered.

Further lease incentives with Parasol and My Space?

Given the ongoing negotiations with Parasol and My Space, relatively few details have been provided with respect to creditor agreements or the terms of the expected longer-term arrangements. We have attributed roughly half of the £1.5m net increase in the lease incentive debtor balance during FY23 to Parasol It represents a deferral of contracted rents that would otherwise be due and we expect this to be amortised over the remaining lease term.7 We anticipate that the extension for a further six months of the Parasol creditor agreement and the agreement with My Space that SOHO expects to conclude soon to include lease incentives. There is also potential for a reduction in ongoing contracted rents on properties involved, irrespective of whether the leases are maintained or where they are re-assigned. Our forecast adjustments should be seen as illustrative as we claim no visibility and include an additional £2.3m of lease incentives in FY24 and £1.3m in FY25. We also allow for some recurring lease incentives which ordinarily arise and which represented the balance of the addition to the lease incentive debtor in FY23. As previously, we have built in a c £0.6m pa reduction in the annualised rents attached to the assets (aggregate annualised contracted rent roll at end-FY23 of £7.3m).

Rental growth and property valuation gains

All rents are annually indexed to the lower of inflation8 or, under the terms of the new lease clause, government housing benefit policy. For FY24, 65% of lease uplifts are linked to the September 2023 CPI annual rate of increase of 6.7%. Other rent reviews occur across the year, and we have assumed an average 3% uplift on these. For FY25, we assume a 2% increase across the portfolio.

For FY24, we forecast growth in EPRA earnings of £4.9m, or 25%, to £24.4, driven substantially by a £3.6m reduction in credit loss provisioning along with rental growth and fixed debt costs. We expect £4.1m or 22% growth in adjusted earnings, including a deduction for lease incentives granted, fully covering an increased DPS of 5.7p (+4%). SOHO has not provided guidance for the current year, but it does seek to sustainably grow dividends over time on a fully covered basis. If lease incentives are higher than we forecast, this will reduce our estimate of dividend-paying capacity.

We expect NAV to increase, with the positive impact of rental growth continuing to more than offset some assumed further upward drift in valuation yields (to c 6% by end-FY25 versus 5.7% at end-FY23).

Our forecasts show an increasing EPRA cost ratio in FY25, which results from our assumption of increased eco-retrofit expenses. Pending the findings of the pilot programme, the company is yet to provide guidance on its expectations for the investment required and whether this may be expensed or capitalised.

Exhibit 2: Forecast summary

Source: SOHO 2023 data, Edison Investment research forecasts

The FY23 NAV/accounting total return of 9.3% was the highest in any year since the initial public offering (IPO) in 2017, primarily reflecting the positive impact of indexed rent growth on property values as well as income, despite the drag of lower rent collection. The total return implied by our forecasts is around 8% for the next two years. Total returns in the period since IPO have been consistently positive, amounting to 47.7% or an average 6.3% pa. Dividends paid represent two-thirds of the total.

Exhibit 3: NAV total return has been constituently positive since IPO

Source: SOHO data, Edison Investment Research. Note: *Annualised return from August 2017.

The valuation remains low in contrast to consistently positive financial returns

SOHO shares have increased markedly from a low of c 42p a year ago but the valuation remains undemanding relative to its consistent, low-volatility financial performance, and to our selected peer group. On a trailing basis, the FY23e DPS of 5.46p represents a yield of c 9%, while the shares are trading at a more than 40% discount to end-FY23 NAV.

Material discount to peer group

Compared with a selected group of companies that we would consider to be the closest peers to SOHO, investing in housing and healthcare properties, SOHO shares offer a noticeably higher yield than the average and trade at a significantly lower P/NAV ratio, despite SOHO’s track record of positive financial and operational performance and delivery of material social benefit.

Exhibit 4: Peer valuation and performance comparison

Source: Company data, LSEG. Note: Prices at 17 March 2024. *Based on last reported EPRA NAV. **Based on trailing 12-month DPS declared.

In our last published note we showed how, based on a range of financial metrics, the SOHO shares are trading at a c 30% discount to the valuation that was reflected in the acquisition of Civitas by Hong Kong-based property developer CK Asset Holdings9 in June 202310 for 80p in cash. Although not directly comparable to SOHO, we believe this to be a strong indicator of the value of the company.

Exhibit 5: Financial summary

Source: SOHO historical data, Edison Investment Research forecasts