Target Healthcare REIT — Income progress mitigates pressure on valuation

Target Healthcare REIT (LSE: THRL)

Last close As at 20/04/2024

GBP0.77

1.00 (1.32%)

Market capitalisation

GBP475m

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Research: Real Estate

Target Healthcare REIT — Income progress mitigates pressure on valuation

For Q223, Target Healthcare REIT declared a second quarterly DPS of 1.69p, supported by inflation-linked rental growth and improving rent collection, which are in turn protected by fixed costs on 96% of borrowings. Yield widening across the broad property sector affected the portfolio’s property valuations, although the effect was significantly mitigated by the quality of Target’s portfolio and long-term, indexed leases.

Martyn King

Written by

Martyn King

Director, Financials

Elderly care image

Real Estate

Target Healthcare REIT

Income progress mitigates pressure on valuation

Q223 NAV report

Real estate

15 February 2023

Price

80.7p

Market cap

£500m

Net debt (£m) at 31 December 2022

218.2

Net LTV at 31 December 2022

25.1%

Shares in issue

620.2m

Free float

100%

Code

THRL

Primary exchange

LSE

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

(4.3)

(5.0)

(25.7)

Rel (local)

(5.5)

(11.0)

(28.0)

52-week high/low

119.2p

76.1p

Business description

Target Healthcare REIT invests in modern, purpose-built residential care homes in the UK let on long leases to high-quality care providers. It selects assets according to local demographics and intends to pay increasing dividends underpinned by structural growth in demand for care.

Next events

Q223 DPS paid

24 February 2023

H123 results

Expected March 2023

Analyst

Martyn King

+44 (0)20 3077 5700

Target Healthcare REIT is a research client of Edison Investment Research Limited

For Q223, Target Healthcare REIT declared a second quarterly DPS of 1.69p, supported by inflation-linked rental growth and improving rent collection, which are in turn protected by fixed costs on 96% of borrowings. Yield widening across the broad property sector affected the portfolio’s property valuations, although the effect was significantly mitigated by the quality of Target’s portfolio and long-term, indexed leases.

Year end

Rental income (£m)

Adjusted net
earnings* (£m)

Adjusted
EPS* (p)

NAV**/
share (p)

DPS
(p)

P/NAV (x)

Yield
(%)

06/21

50.0

26.0

5.5

110.4

6.72

0.73

8.3

06/22

63.9

30.2

5.0

112.3

6.76

0.72

8.4

06/23e

68.1

36.3

5.8

102.7

6.76

0.79

8.4

06/24e

73.1

37.7

6.1

105.6

6.76

0.76

8.4

Note: *Adjusted earnings exclude revaluation movements, non-cash income arising from the accounting treatment of lease incentives and guaranteed rent review uplifts and acquisition costs and include development interest under forward-fund agreements. **NAV is net tangible assets (NTA) throughout this report.

Indexed rent growth and improved rent collection

Including a 2.6% increase in Q223, the rent roll rose by £1.7m in H123 to £57.2m (end-FY22: £55.5m), primarily due to rent indexation and the completion of a development asset, partly offset by a non-core disposal. H123 rent collection increased to 96% (FY22: 94%) and should improve further, with meaningful progress achieved with two tenants post the period end. Rent indexation, improved rent collection and development completions are the key drivers to increased dividend cover, while £35m is available for investment. The Q223 like-for-like valuation decline for completed properties was 5.0% vs 12.8% for the broad market according to MSCI data, while the impact on NAV was softened by moderate gearing (25.1% at the period end). Q223 NAV per share decreased to 103.0p (Q123:112.1p) and the accounting total return was a negative 6.6%, resulting in a negative total return of 5.3% in H123. Our forecasts for recurring income and dividend cover (0.86x in FY23 and 0.9x in FY24 vs 0.72x in FY22) are unchanged but we reduce our FY23e NAV per share by 7%.

Sustainably meeting a long-term need

A growing elderly population and the need to improve the existing estate point to continuing demand for modern, high-quality, ESG-compliant residential facilities. With its unwavering focus on asset quality, these are the homes in which Target invests. Not only are they appealing to residents (two-thirds private pay), but they support operators in providing better, more efficient and more effective care. When let at sustainable rent levels in well-located areas, with strong supply/demand characteristics, they will always be attractive to existing or alternative tenants and are key to providing sustainable, long-duration, inflation-linked income.

Long-term, indexed leases support valuation

The annualised rate of H123 DPS (6.76p) reflects a prospective yield of 8.4% and the discount to FY23e NAV is c 20%. DPS cover should gradually build but even if DPS were rebased, there would be no impact on total return.

Further details on the NAV and trading update

The quarterly report does not provide an update on tenant performance or rent cover and we expect this to be included in the interim results. We expect the trend in improving tenant occupancy to be maintained, perhaps with seasonal fluctuations, and for fee growth to provide a strong offset to inflationary cost pressures.

Amidst uncertain financial markets in H123, while rent indexation has driven income growth the focus of activity has been on asset management and rent cover. 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, primarily due to a slow recovery from the pandemic. 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 (we estimate c £1m). Active portfolio management has resulted in meaningful progress with two further underperforming tenants after the period end. The re-tenanting of a home with the first tenant is imminent, with an improved trading performance increasing rent collection from the other.

Target’s unwavering focus on high quality, modern and sustainable assets is key to its ability to re-tenant properties when the need arises. 93% of the portfolio is EPC1 rated A or B and is compliant with the minimum energy efficiency standards anticipated to apply from 2030.

1 Energy performance certificate.

There were no acquisitions during H123, although in Q123 Target paid £2.8m in performance payments, and the funding of development assets continued. There were four homes under development at the start of H123, but the home at Weymouth in Dorset reached practical completion during Q223. It has been let on a 35-year lease, with upwards-only indexed rent reviews, to a new tenant to the group, and we estimate it added c £0.8m to the end-Q223 rent roll.2

2 These are contractual commitments that are triggered by the achievement of agreed rent cover thresholds. The payments receive additional rents (are ‘rentalised’) in line with the acquisition net initial yield. The purpose is to support homes during a period of stabilisation.

Dividend returns remained positive in Q223, but capital returns were negative

Dividend returns remained positive during Q223, taking the year-to-date return to 3.0%. This was more than offset by the 8.3% negative capital return year to date, nearly all in Q223, primarily reflecting valuation yield widening but also an element of uncovered dividends. As a result of the yield widening, this was Target’s first negative quarterly return since listing in March 2013. This is perhaps of little surprise in one of the worst quarters for market-wide capital values in 30 years.

Exhibit 1: Quarterly NAV total return

Q123

Q223

H123

Pence per share unless stated otherwise

September 2022

December 2022

Opening NAV

112.3

112.1

112.3

Closing NAV

112.1

103.0

103.0

DPS paid

1.69

1.69

3.38

Dividend return

1.5%

1.5%

3.0%

Capital return

-0.2%

-8.1%

-8.3%

NAV total return

1.3%

-6.6%

-5.3%

Source: Target Healthcare REIT data, Edison Investment Research

Target is primarily focused on income/dividend return and this has been consistently positive since listing, contributing more than 90% of the average total return of 5.3% pa.

Exhibit 2: Consistent long-term return

Pence per share unless stated otherwise

FY14*

FY15

FY16

FY17

FY18

FY19

FY20

FY21

FY22

H123

FY14–H123

Opening NAV

98.0**

94.7

97.9

100.6

101.9

105.7

107.5

108.1

110.4

112.3

98.0

Closing NAV

94.7

97.9

100.6

101.9

105.7

107.5

108.1

110.4

112.3

103.0

103.0

DPS paid

6.5

6.1

6.2

6.3

6.4

6.5

6.7

6.7

6.8

3.4

61.5

Dividend return

6.6%

6.4%

6.3%

6.2%

6.3%

6.2%

6.2%

6.2%

6.1%

3.0%

62.7%

Capital return

-3.3%

3.3%

2.7%

1.3%

3.8%

1.6%

0.6%

2.2%

1.7%

-8.3%

5.1%

NAV total return

3.3%

9.7%

9.0%

7.5%

10.1%

7.8%

6.8%

8.4%

7.8%

-5.3%

67.8%

Average total return pa

5.3%

Source: Target Healthcare REIT, Edison Investment Research. Note: *22 January 2013 to 30 June 2014. **Adjusted for IPO costs.

Dividend return and cover

With the sustained growth in Target’s portfolio, necessitating the raising and subsequent deployment of additional capital, dividends have typically reflected ‘fully invested’ income levels. The impact of higher borrowing costs, weaker rent collection and delayed acquisitions, reduced FY22 rent cover to 72%. With the FY22 results the board indicated that as it could see a clear path to dividend cover exceeding 90%, it felt it was prudent to maintain DPS at the current level. It is nonetheless the case that there are some investors with a preference for fully covered dividends and we can also see some advantages that would arise from a rebasing of the dividend. An uncovered dividend requires capital resources to be diverted away from long-term growth, and in the near term requires additional borrowing, which is unattractive at high borrowing rates. Moreover, whatever the level of dividends paid, there is no impact on total accounting returns. A 20% rebasing of the dividend would be sufficient to restore underlying (excluding the hedging premium) cover for FY23 and create a base for future growth. At the current share price, it would represent a yield of more than 6%.

Several well-planned changes to the board were approved by the AGM in December, including a change of chairman and two new non-executive directors. With money market conditions evolving rapidly, this may provide a timely opportunity for the board to assess its position and provide additional guidance on its policy with the interim results.

Forecasts and valuation

We have made no changes to our recurring income forecasts, which we published in our November update, but market-wide yield widening across all sectors of the UK property market has been greater than we expected, and we have revised down our NAV forecasts from 110.8p to 102.7p for FY23 and from 110.1p to 105.6p for FY24. It is worth noting that while Target has c £35m of capital available for investment (net of all commitments), we have not assumed this in our forecasts. However, Target is a long-term investor and as financial markets seem more stable than in autumn 2022 it may seek to deploy the available capital, particularly if interest rates show signs of peaking or if acquisition pricing begins to adjust to the sharp rise in the cost of capital.

The relatively small further decline in NAV per share (H123: 103.0p) assumes, and we stress that it is an assumption, a significantly smaller decline in property values in H223. We expect the higher level of asset yields compared with the wider property sector, and long, indexed leases (27 years weighted average unexpired lease term) to mitigate the impact of further market-wide yield expansion.

The EPRA topped-up net initial yield on Target’s portfolio increased to 6.22% in Q223 versus 5.84% at end-Q123, the highest level since September 2019. The 5.0% like-for-like decline in the valuation of completed properties in Q223 comprised a negative 6.2% resulting from the yield movement, offset in part by a 1.2% benefit from income growth. Assuming no change in its property valuations, rent growth would be reflected in an increasing yield on Target’s portfolio. In fact, our forecasts imply a further increase in the EPRA topped-up net initial yield of c 18bp to c 6.4%.

After listing in 2013 Target’s portfolio EPRA topped-up net initial yield steadily declined from c 7.3% to a recent low of c 5.8%. However, until the middle of 2021, the yield spread over the 10-year risk free gilt yield had remained stubbornly wide, at more than 5%. The failure of the yield spread to narrow during this period is surprising given the deepening of the investment market for care home property, strongly positive demographic support, the quality and sustainability of Target’s assets, and a robust tenant performance in the face of pandemic challenges. Compared with other types of healthcare properties, care home property yields have remained at a considerable premium (Primary Health Properties reported a 30 June 2022 net initial yield of 4.6%).

The rise in risk free yields since mid-2021, from less than 1% to c 3.4% currently, has reduced the yield spread to c 2.8%. However, we do not think this is an indicator that the net initial yield on target’s portfolio will increase significantly further. This is based on the factors listed above, the fact that monetary policy had contributed to gilt yields remaining unusually low for several years, the consensus expectation that inflationary pressures will continue to ease, and the fact that unlike the gilt coupon, Target’s income will continue to increase.

Exhibit 3: Trend in EPRA topped-up net initial yield, inflation and 10-year gilt yield

Source: Target Healthcare REIT data, Bank of England

The valuation appears to be discounting significant stress on both income and capital values

The annualised rate of DPS of 6.76p represents a prospective yield of 8.4%, in line with Target’s post-IPO highs, most recently during the height of pandemic uncertainty. This has historically proven to be a very attractive entry point for investors. Similarly, at c 0.8x the P/NAV is close to the pandemic low point.

Exhibit 4: Price/NAV dividend yield history

Source: Refinitiv price data. Note: Trailing basis using company NAV and annual DPS data.

In Exhibit 5, we summarise the performance and valuation of a group of real estate investment trusts that we consider to be Target’s closest peers within 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.

Exhibit 5: Peer valuation and performance summary

WAULT* (years)

Price (p)

Market cap. (£m)

P/NAV** (x)

Yield*** (%)

Share price performance

1 month

3 months

1 year

3 years

Assura

12

53

1575

0.88

5.7

-6%

-8%

-16%

-34%

Civitas Social Housing

22

62

374

0.56

9.2

1%

-5%

-34%

-36%

Impact Healthcare

20

101

419

0.91

6.5

-4%

-4%

-12%

-7%

Primary Health Properties

12

111

1477

0.95

5.8

-5%

-6%

-18%

-32%

Residential Secure Income

N/A

77

143

0.82

6.7

-9%

-12%

-28%

-23%

Triple Point Social Housing

26

54

219

0.49

9.9

-10%

-20%

-42%

-44%

Average

18

0.77

7.3

-5%

-9%

-25%

-29%

Target Healthcare

27

81

501

0.78

8.4

-5%

-6%

-26%

-34%

UK property sector index

1,438

3%

1%

-24%

-26%

UK equity market index

4,346

2%

7%

1%

3%

Source: Company data, Refinitiv pricing at 10 February 2023. Note: *Weighted average unexpired lease term. **Based on last reported NAV/NTA. ***Based on trailing 12-month DPS declared.

The average trailing yield of the peer group has risen in recent months, driven mainly by share price weakness, and is reflective of the broader property sector. Target’s trailing dividend yield remains well above the peer group average, while its P/NAV is in line with the average.

Exhibit 6: Financial summary

Year to 30 June (£m)

2020

2021

2022

2023e

2024e

INCOME STATEMENT

Rent revenue

36.0

41.2

48.8

57.1

61.7

Movement in lease incentive/fixed rent review adjustment

8.2

8.7

10.2

11.0

11.4

Other income

0.0

0.1

4.8

0.0

0.0

Total revenue

44.3

50.0

63.9

68.1

73.1

Gains/(losses) on revaluation

1.7

9.4

5.5

(61.3)

11.1

Realised gains/(losses) on disposal

0.6

1.3

0.0

0.0

0.0

Management fee

(5.3)

(5.8)

(7.3)

(7.674)

(7.597)

Credit loss allowance & bad debts

(2.1)

(2.7)

(3.2)

(1.2)

(1.5)

Other expenses

(2.2)

(2.6)

(3.2)

(3.3)

(3.4)

Operating profit

37.0

49.6

55.7

(5.4)

71.6

Net finance cost

(5.4)

(5.7)

(6.6)

(12.2)

(11.5)

Profit before taxation

31.6

43.9

49.1

(17.6)

60.2

Tax

0.0

0.0

(0.0)

0.0

0.0

IFRS net result

31.6

43.9

49.1

(17.6)

60.2

Adjust for:

Gains/(losses) on revaluation

(0.2)

(9.5)

(5.6)

61.3

(11.1)

Other EPRA adjustments

(1.0)

(0.3)

(3.9)

0.0

0.0

EPRA earnings

30.5

34.0

39.7

43.7

49.1

Adjust for fixed/guaranteed rent reviews

(8.2)

(8.7)

(10.2)

(11.0)

(11.4)

Adjust for development interest under forward fund agreements

1.0

0.6

0.8

1.0

0.1

Adjust for interest cap premium

0.0

0.0

0.0

2.5

0.0

Group adjusted earnings

23.2

26.0

30.2

36.3

37.7

Average number of shares in issue (m)

440.3

475.4

599.1

620.2

620.2

IFRS EPS (p)

7.18

9.23

8.20

(2.84)

9.70

EPRA EPS (p)

6.9

7.2

6.6

7.1

7.9

Adjusted EPS (p)

5.3

5.5

5.0

5.8

6.1

Dividend per share (declared)

6.68

6.72

6.76

6.76

6.76

Dividend cover (EPRA earnings)

1.00

1.05

0.95

1.04

1.17

Dividend cover (Adjusted earnings)

0.76

0.80

0.72

0.86

0.90

BALANCE SHEET

Investment properties

570.1

631.2

857.7

816.7

841.9

Other non-current assets

46.0

54.8

65.9

77.0

88.4

Non-current assets

616.1

686.0

923.6

893.7

930.3

Cash and equivalents

36.4

21.1

34.5

20.8

23.1

Other current assets

11.2

11.3

5.5

6.9

7.4

Current assets

47.6

32.4

40.0

27.8

30.5

Bank loan

(150.1)

(127.9)

(231.4)

(250.8)

(270.2)

Other non-current liabilities

(6.4)

(6.8)

(7.1)

(7.1)

(7.1)

Non-current liabilities

(156.5)

(134.7)

(238.5)

(257.9)

(277.3)

Trade and other payables

(13.1)

(18.5)

(26.4)

(24.3)

(26.0)

Current Liabilities

(13.1)

(18.5)

(26.4)

(24.3)

(26.0)

Net assets

494.1

565.2

698.8

639.2

657.5

Adjust for derivative financial liability

0.2

(0.3)

(2.3)

(2.3)

(2.3)

EPRA net assets

494.3

564.9

696.5

637.0

655.2

Period end shares (m)

457.5

511.5

620.2

620.2

620.2

IFRS NAV per ordinary share (p)

108.0

110.5

112.7

103.1

106.0

EPRA NTA per share (p)

108.1

110.4

112.3

102.7

105.6

EPRA NTA total return

6.8%

8.4%

7.8%

-2.5%

9.4%

CASH FLOW

Cash flow from operations

25.6

29.2

35.6

41.4

50.4

Net interest paid

(4.1)

(4.2)

(5.2)

(12.8)

(12.1)

Tax paid

(0.1)

(0.0)

(0.0)

0.0

0.0

Net cash flow from operating activities

21.5

25.0

30.4

28.6

38.3

Purchase of investment properties

(117.5)

(51.4)

(207.0)

(20.3)

(14.1)

Disposal of investment properties

14.1

7.8

4.4

0.0

0.0

Net cash flow from investing activities

(103.4)

(43.6)

(202.6)

(20.3)

(14.1)

Issue of ordinary share capital (net of expenses)

78.2

58.3

122.5

0.0

0.0

(Repayment)/drawdown of loans

44.0

(22.0)

104.8

20.0

20.0

Dividends paid

(29.2)

(31.5)

(39.8)

(41.9)

(41.9)

Other

(1.6)

(1.5)

(1.8)

(0.0)

(0.0)

Net cash flow from financing activities

91.4

3.3

185.6

(21.9)

(21.9)

Net change in cash and equivalents

9.5

(15.3)

13.4

(13.6)

2.3

Opening cash and equivalents

26.9

36.4

21.1

34.5

20.8

Closing cash and equivalents

36.4

21.1

34.5

20.8

23.1

Balance sheet debt

(150.1)

(127.9)

(231.4)

(250.8)

(270.2)

Unamortised loan arrangement costs

(1.9)

(2.1)

(3.4)

(4.0)

(4.6)

Net cash/(debt)

(115.6)

(108.9)

(200.3)

(233.9)

(251.7)

Gross LTV

24.9%

19.2%

25.8%

28.9%

29.9%

Net LTV

18.9%

16.1%

22.0%

26.5%

27.4%

Source: Target Healthcare REIT historical data, Edison Investment Research forecasts

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This Communication is being distributed in the United Kingdom and is directed only at (i) persons having professional experience in matters relating to investments, i.e. investment professionals within the meaning of Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005, as amended (the "FPO") (ii) high net-worth companies, unincorporated associations or other bodies within the meaning of Article 49 of the FPO and (iii) persons to whom it is otherwise lawful to distribute it. The investment or investment activity to which this document relates is available only to such persons. It is not intended that this document be distributed or passed on, directly or indirectly, to any other class of persons and in any event and under no circumstances should persons of any other description rely on or act upon the contents of this document.

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Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

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United Kingdom

This document is prepared and provided by Edison for information purposes only and should not be construed as an offer or solicitation for investment in any securities mentioned or in the topic of this document. A marketing communication under FCA Rules, this document has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

This Communication is being distributed in the United Kingdom and is directed only at (i) persons having professional experience in matters relating to investments, i.e. investment professionals within the meaning of Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005, as amended (the "FPO") (ii) high net-worth companies, unincorporated associations or other bodies within the meaning of Article 49 of the FPO and (iii) persons to whom it is otherwise lawful to distribute it. The investment or investment activity to which this document relates is available only to such persons. It is not intended that this document be distributed or passed on, directly or indirectly, to any other class of persons and in any event and under no circumstances should persons of any other description rely on or act upon the contents of this document.

This Communication is being supplied to you solely for your information and may not be reproduced by, further distributed to or published in whole or in part by, any other person.

United States

Edison relies upon the "publishers' exclusion" from the definition of investment adviser under Section 202(a)(11) of the Investment Advisers Act of 1940 and corresponding state securities laws. This report is a bona fide publication of general and regular circulation offering impersonal investment-related advice, not tailored to a specific investment portfolio or the needs of current and/or prospective subscribers. As such, Edison does not offer or provide personal advice and the research provided is for informational purposes only. No mention of a particular security in this report constitutes a recommendation to buy, sell or hold that or any security, or that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person.

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

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Deutsche Beteiligungs — Robust exit activity in Q123

Deutsche Beteiligungs (DBAG) posted a 7% increase in NAV per share in Q123 (ending 31 December 2022), supported by a €23.9m positive effect related to the higher earnings of portfolio companies, mostly due to the shift from 2022 to 2023 budgeted earnings in their carrying values. This was further strengthened by €36.5m valuation tailwinds from higher multiples amid the rally in public equities in the last quarter of 2022, as well as the recognition of agreed disposal prices (most notably for BTV Multimedia). DBAG’s shares trade at a 6% discount to NAV, while historically they have traded at a premium (6% on average in the last five years), reflecting the value of the fund services business.

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