Target Healthcare REIT — Income progress mitigates pressure on valuation

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.

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

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.

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.

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.

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.

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.

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.

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.