Impact Healthcare REIT — Interest hedging provides dividend visibility

Impact’s strategy for sustainable growth in the structurally supported care home sector, with a disciplined approach to acquisitions and careful tenant selection at its core, is discussed in detail in our May update note.

Having successfully collected 100% of rent, without lease variation, in the period since listing in March 2017, through the pandemic, and up until end-FY22, Impact’s problems with one of its 13 care home tenants1 was a disappointment, but we forecast that the swift re-tenanting and implementation of a turnaround plan (discussed in our June note) will restore rental income, on a sustainable footing, by the end of 2024.

Across the portfolio, underlying tenant occupancy had increased to 89% by late July 2023, a further increase on end-FY22 (86.6%) and well up from the COVID-19 low of 79% in January 2021. There remains some further headroom to the pre-COVID-19 ‘norm’ of a low 90% level. Average weekly fee growth in the year to end-H123 was an underlying 15%, up from 13% in the year to end-FY22. Combined with a significant reduction in the need for expensive agency staff (down to 9% of staff costs vs 14% at end-FY22), average rent cover2 of 1.8x continues to be high and stable, in line with historical experience.

We provide an overview of the H123 performance below. During the period, the annualised contracted rent roll increased by 11.6% to £48.1m (end-FY22: £43.1m), including the acquisition of a six-home portfolio, one non-core disposal and indexed rental growth. The number of homes closed the period at 140 from 135 at the start of the period, and the 90 annual rent reviews completed were at an average 4.0% increase, contributing £1.1m of the increase in annualised rental income,

The end-H123 portfolio valuation was £638m, up by £69m or 12.2% over six months. The main driver was the portfolio acquisition (£57.1m including costs) but with valuation yields stabilising (topped up EPRA net initial yield of 6.95% at end-H123 versus 6.98% at end-FY22 and 6.69% a year earlier), like-for-like rental growth of 2.4% drove a £12.6m increase in valuation.

In the following table we provide details of the interim financial performance and a reconciliation from adjusted ‘cash’ earnings to both EPRA earnings and statutory IFRS earnings.

Looking first at the adjusted earnings result:

The H123 total return continues a strong track record of positive NAV/accounting total returns since listing in March 2017, with an average of 7.1% pa. Even in 2022, when the broad UK commercial property sector was negatively affected by rising yields and falling values, the relative robustness of care home valuations and continuing strong cash flow enabled the company to report a dividend-driven total return of 3.8%. Since listing, progressive dividends have generated 70% of returns.

As the portfolio increased in scale and diversification after listing, since 2019, dividend growth has been directly linked to the previous year’s inflation-indexed uplift in rents received. Dividends have been fully covered by EPRA earnings in each year since listing and, as cash rents have continued to increase, have been well covered on an adjusted ‘cash’ basis. We expect Impact to continue to target progressive dividends and despite the increased cost of borrowing we forecast a fully covered dividend in both this year and next, albeit with cash cover slightly lower than in previous years. With interest costs on 92% of drawn debt3 now fixed or hedged, the primary risk to our forecasts has been removed.

Although the interest rate hedges are of relatively short duration (£50m matures at end-2024 and £50m in August 2025), we note that:

With the fixed/hedged ratio at 92%, debt costs are now well protected from interest rate increases for the next two years. The ratio had dropped briefly at the end of H123, to 66% from 80%, due to the expected expiry of a £25m interest rate swap at 1%,4 but the company had made clear its progress with various options to increase it again.

The new £50m interest rate cap limits the SONIA rate paid5 to 4.0% for a two-year period, expiring on 15 August 2025. Including the £1.75m paid to acquire the cap, which will be amortised over its maturity, the total rate paid by Impact is effectively limited to 5.76%, before lending margin. This provides almost complete visibility over the cost of existing borrowings through the peak of more than 6% reflected in current money market pricing, although this has increased recently and remains volatile.

The blended average interest cost of fixed/hedged and floating rate drawn debt at end-H123 was 4.85% with the three-month compounded SONIA rate at 4.9%. The SONIA rate has subsequently increased by c 50 percentage points to c 5.4% and including the additional hedging, the average running interest cost of drawn6 debt to 4.66%. At current drawn debt levels an increase of 50bp in the SONIA rate would increase this by just 4bp.

End-H123 debt drawn was £190.7m and the gross loan to value ratio (LTV) was 28.5% (end FY22: £142.3m and 23.9%). LTV is a little above the company’s medium-term target of 25%, but well below the 35% maximum specified by its gearing policy.

Borrowing facilities amount to £250m, with a weighted average maturity of 6.8 years at end-H123, of which £59.2m was undrawn. Allowing for cash (£22m), capital commitments of £22.6m7and payment of the Q2 dividend, available liquidity was c £52m. While management continues to identify numerous attractive investment opportunities, describing current conditions as ‘a buyers’ market’ amid the continuing volatility in debt markets, we expect the company to remain cautious and highly selective.

Our forecasts for adjusted ‘cash’ earnings are little changed with fully covered growth in dividends maintained. With little sensitivity to future interest rate rises, much of the past increases is absorbed by increases to our revenue forecasts and reductions to administrative costs. H123 cash rental income was above our expectations, prompting us to reappraise our assumptions for passing rent relative to contracted rents.8 We have also included the additional £9.8m of asset management projects that Impact has committed to, forecasting monetisation at 8% on completion, in line with the company’s financial targets. Growth in administrative expenses was slower than we had anticipated in H123, and we expect this to continue.

We forecast the current year DPS target of 6.77p (+3.5%) to be met and to be 105% covered (H123: 109%). We forecast DPS growth of 2.8% to 6.96p (104% covered) in FY24 and growth of 2.0% to 7.10p (105% covered) in FY25.

For FY23, Impact is targeting a DPS of 6.77p (+3.5%), fully covered by adjusted ‘cash’ earnings. This represents an attractive yield of 8.0%. Meanwhile the shares trade at a c 25% discount to H123 EPRA NTA (NAV) per share of 113.6p. The market appears to be anticipating that further increases in interest rates will lead to wider property valuations, despite recent stabilisation.

Exhibit 8 shows a summary of the performance and valuation of a group of real estate investment trusts (REITs) that we consider to be Impact’s closest peers within the broad and diverse commercial property sector. The 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, NAV and DPS data are presented on a trailing basis9 and do not reflect Impact’s increased FY23 DPS target.

Impact’s shares have performed broadly in line with the peer group over one year, but have substantially outperformed over three years. Despite this outperformance, continuing dividend growth leaves the shares on a similar yield to the group average.