MedicX Fund — Update 15 December 2016

MedicX’s portfolio of modern, purpose-built primary healthcare assets is let on long leases at effectively zero vacancy with the large majority of rents underpinned by the UK and Irish governments, providing a strong tenant covenant. This secure and growing income stream helps support a high dividend yield as well as historically more stable capital value than some other commercial property sub-sectors. Management continues to increase dividend cover from EPRA earnings (which exclude valuation increases) as well as growing the portfolio by investing in large, modern facilities suited to the changing and increasing demands placed on the primary care sector in the UK and ROI. Debt funding is raised at fixed rates and for durations matching the assets’ leases, locking in a spread between property yields and costs of debt. As rents rise (rent reviews are effectively upwards only in the UK) and economies of scale (such as the declining rate of marginal advisory fees) take effect, we expect dividend cover to continue to grow. The fund has a strong pipeline of investment opportunities, broad access to debt funding and has seen high demand for shares from its block listing programme at prices well above EPRA NAV per share.

MedicX’s prospective dividend yield of c 6.8% is the highest among its immediate peers and is over 8% of EPRA NAV per share. Although covered 1.2x by net attributable profit, the exclusion of revaluation gains reduces this to 63.8% in 2016 (ahead of our forecast of 61.5%). Nonetheless, the nature of its income streams gives confidence that the board will maintain a progressive dividend policy and makes the underlying assets attractive, particularly at a time of considerable uncertainty. In line with other listed property investors specialising in long leases, MedicX trades at a premium to EPRA NAV, showing the highest premium as well as paying the highest yield.

Maintaining its disciplined approach to acquisitions, the fund committed less investment in FY16 than we had forecast, therefore increasing rental income less than expected, but also incurring less financing cost. Adjusted EPS was ahead of our forecasts and yield tightening led to revaluation gains, which increased EPRA NAV above our estimates too. These points and changes to our forecasts are dealt with in more detail on page 6. We expect investment to pick up in FY17 as the UK and ROI pipelines complete and as government policies to enhance primary care infrastructure in both countries take effect. This should drive earnings, NAV and dividend cover growth.

MedicX’s portfolio has a low-risk profile and relatively predictable income. 90% of rents in the UK are government backed, as are c 75% in the ROI. Key sensitivities include:

FY16 adjusted EPS and EPRA NAV per share were ahead of our estimates at 3.8p and 73.2p respectively (we had forecast 3.6p and 71.9p). The EPRA EPS figure was lower at 3.4p as a result of the performance fee earned by the adviser by virtue of the total shareholder return exceeding 10% per annum since 2009. We have moderately increased our EPS and NAV estimates for FY17 and introduced a FY18 forecast (see page 6). The main points from the results are below:

MedicX Fund is a leading investor in modern, purpose-built primary care assets with long leases in the UK and the ROI. Its tenants are mainly GPs, the NHS or the HSE, other healthcare providers such as dentists or physiotherapists and associated businesses such as pharmacies. Leases are typically for 25 years with three-yearly upwards-only rent reviews (in the UK) or five-yearly reviews (in the ROI). Funding comes from a combination of equity and debt, the latter being fixed-term and closely matched to the unexpired lease lengths of the portfolio, locking in the spread between the property yield and the debt cost.

The fund’s objective is to achieve rising rental income and capital growth, which it seeks to achieve by investing in high-quality assets with long, secure income streams. Assets must be purpose-built and therefore fit for purpose beyond their existing lease term, and may have potential for enhancement. New investments come from a variety of sources:

Other criteria for investment include that in any financial year at least 80% of rental income will come from the NHS, the HSE and Irish GPs; no more than 20% of assets by value will be in the ROI; and borrowings shall not exceed 75% of the adjusted total assets excluding goodwill. In practice the board does not expect assets in ROI to exceed 15% of the portfolio and targets LTV of 50% with a self-imposed limit of 65% (it was 50.8% at 30 September).

The adviser, Octopus Healthcare, takes a disciplined approach to acquisitions, preferring to adhere to investment criteria focusing on healthcare facilities that are or can become dominant in their catchment areas. It uses a proprietary database and analysis of GP practices, associated services and local demography to identify sites and works with prospective tenants and developers to optimise their design.

Primary healthcare is a subsector of commercial property characterised by long leases, strong tenant covenants, no speculative development and little volatility in rents and capital values. Here we give a brief overview of the UK and ROI primary healthcare sectors and their corresponding property markets.

In both countries primary care, or general practice, is the foundation of national medical care with GPs being the first point of contact most people have with the health system. As the populations of the UK and ROI age and live longer with more conditions requiring treatment, the burden on those systems is increasing; a trend that is set to continue for decades. The Office for National Statistics forecasts that the UK population will grow 15% from 64.6 million in 2014 to 74.3 million in 2039. At the same time the population over 65 years old is expected rise from 11.4 million to 18.0 million (24.3% of the total population), an increase of 58%. In Ireland the Central Statistics Office has forecast total population growth of 13.4% from 4.6 million to 5.2 million between 2011 and 2031 and for the proportion of over 65s to rise from 11.6% to 19.1%. Not only will larger populations require more care, but the requirement for locally-delivered services such as traditional GP appointments as well as other non-acute ones will too. Both the NHS and the HSE have responded with strategies to deliver more services outside hospitals in local hubs. In the larger and more complex UK healthcare environment, a wider variety of care models will be used, but governments in both countries have recognised the requirement for modern, purpose-built facilities to accommodate services which are fit for purpose. There is broad political commitment to more effective healthcare, and the fund’s investment policy is in line with national efforts to modernise and make primary care facilities more efficient and sustainable.

Most GP practices remain independent partnerships, although in some cities larger commercial groupings, known as super practices, have emerged. Smaller practices’ premises were often converted residential buildings. As more services are being delivered in a primary care setting, converted houses are becoming less and less suitable: a 2014 survey by the British Medical Association (BMA) found that 70% of GPs described their premises as too small to deliver enhanced or additional services; 52% said they had seen no investment or refurbishment for 10 years and a majority said their premises were unsuitable for the delivery of training and education. The NHS does incentivise GPs to enhance their premises by offering payments for additional services they provide and funds for refurbishment or redevelopment. The NHS also reimburses rent and rates for practices providing General Medical Services. The strength of the UK property market in recent years means that as older GPs retire, it is more expensive for their successors to buy the practice premises, and converted houses are not attractive as premises in which to run the practice. As a result, there is a growing requirement for modern, purpose-built premises to accommodate single or multiple practices, as well as other service providers such as dentists and pharmacists. With medical service providers being reimbursed by the NHS for rent, the tenant covenant is effectively with the UK government. Non-NHS-reimbursed rents are typically from associated businesses such as pharmacies which are by default well-situated to trade successfully.

The trend towards more healthcare services being delivered in a primary care setting is backed by NHS England’s strategy for healthcare as a whole and general practice in particular: in 2013 the NHS trusts were replaced with clinical commissioning groups (CCGs), led by GPs, with responsibility for delivery of primary care in their regions. CCGs have greater control of NHS budgets and are able to spend any savings they make in one field in others of their choosing. Also in 2013 NHS Property Services was created to manage, maintain and improve the NHS estate, increasing the focus on making it fit for purpose. In 2014 NHS England published its Five-Year Forward View (NHS Review). This confirmed that “the foundation of NHS care will remain list-based primary care” and described plans to deliver more services in that context. It also announced the setting aside of £1bn over five years for enhancing primary care infrastructure. The plans have since been set out in greater detail in the General Practice Forward View (April 2016) and in individual CCGs’ sustainability and transformation plans (STPs). The publication of STPs is an important milestone because it brings closer the implementation of policies which have been discussed for several years. This is expected to have two effects:

The HSE launched a new strategy in 2012, which aims eventually to provide a single-tier primary care service that is free and universal. To date only those under six (with a plan to increase to twelve) and over 70 years old are guaranteed free access, although the aim remains to make this available to all by 2019 (c 464,000 GP visitors’ cards have been issued so far and they remain means tested). Currently, the majority of GP services are paid for directly by the patient (or their insurer) and the GPs’ costs are not reimbursed by any government agency. This has previously inhibited private investment in primary care.

The new strategy has established a number of state-funded primary care teams responsible for specific geographical areas and made up of a range of service providers including (but not limited to) community and public health nursing, home helps, mental health services, social workers and dental care. They are not currently all co-located, but where this would improve efficiency it is planned that they will be. To that end the Department of Health is planning the construction of c 90 new primary care centres (PCCs). In each the HSE is, or will be, the anchor tenant with around 75% of the building on a 25-year lease with five-yearly index-linked reviews. The remaining space will be let to GPs, pharmacies and other care providers. At the start of 2016 the HSE had sought expressions of interest for 73 PCCs in addition to the 90 already operating, and expected 15 to be completed in 2016. Irish PCCs tend to be larger than most assets in MedicX’s UK portfolio because the HSE requires at least 800sqm per primary care team, before space for GPs and other tenants, and plans to have more than one primary care team per PCC in most cases. As a result, the average PCC is expected to be around 2,300sqm. We note that the tenant mix means the rental covenant will not be as strong as in the UK, where the NHS underpins 90% of rents, but it will still provide secure income streams.

Since the publication of FY16 results, which were ahead of our expectations of EPS and EPRA NAV per share, we have raised our FY17 forecasts slightly and also introduced them for FY18.

Management’s ability to increase earnings by investing in new assets with a good yield spread above the cost of financing is key to raising dividend cover. In the past, proceeds from major equity issues have taken time to deploy, increasing the quantum of distributions but acting as a cash drag until they have been spent. In September 2016 MedicX established a block listing of c 24m shares which has enabled the fund to manage demand for shares as well as providing a source of funds for investment without creating a cash drag. This and a strong pipeline place MedicX well for further asset growth, which we forecast will increase earnings and dividend cover over the next two years. After lower investment than expected in 2016 we have reduced our assumption for committed investments for 2017 from £80m to £75m and introduced a 2018 forecast assuming that £95m of funds are invested that year. An overview of our new forecasts is in Exhibit 1 below.

Although revenues were below forecasts as a result of lower investment, finance costs were reduced too and careful control of administrative costs meant that adjusted EPS (excluding the performance fee earned) was above our forecast, as was dividend cover and NAV per share. We forecast that marginal administrative costs will continue to fall as the incremental advisory fees diminish and the fund’s existing debt is at fixed rates. In the current environment we do not forecast any increase in the cost of debt. We have reduced our assumptions of yields on new commitments from 7% on Irish assets to 6.75% reflecting yield compression trends described by the fund and kept our UK assumption at 5%, below the current portfolio valuation yield of 5.25%. Importantly, we have not reduced our future valuation yield assumption and therefore have not forecast valuation increases other than those driven by rental growth. If we assume a valuation yield compression of five basis points, to 5.2%, our FY17 and FY18 NAV per share estimates rise by 1p each. We therefore expect that the fund will continue to be able to lock in the spread between debt costs and property yields.

Modest future rental growth is assumed at 1.5% in FY17 and FY18. This is above the level seen in FY16 (1.2%) but below 2015 (1.8%) and the 10-year average of c 2%. We note that rental growth by market review may accelerate following a rise in inflation. The latter effect would be magnified if the portfolio continues to have a growing proportion of rents linked to RPI. We also note that the fund is challenging the rent increases suggested by district valuers in some cases in South East England. In that region especially, management states that recent build costs and rental prices in the wider real estate market have risen in the order of 30% in the last three years, whereas rent increases suggested by district valuers for primary care properties are considerably less than that implied by the level of growth. Although a detailed review process is required, if MedicX Fund succeeds, not only would we expect to see rental increases on existing assets but we would expect a rise in new developments as well.

MedicX continues to have access to debt finance, with the possibility of extending an existing facility by £10m with lender consent at a margin of 2% over Libor, allowing the fund to react quickly if attractive opportunities arise. Adjusted gearing, as noted earlier, remains close to the target 50% and well within the limit of 65%. We do not forecast any equity issue, but do note that the company has treasury shares and a block listing capacity totalling 21.3m shares. Given the current premium to EPRA NAV at which the shares trade, these are an immediately NAV-accretive potential source of funds for acquisitions. 10.9m block listing shares have been issued in recent weeks at an average price of c 88p, or a 19% premium to 30 September EPRA NAV, increasing balance sheet strength. In FY 2016 a total of £18.96m (net) was raised through the sale of shares out of Treasury and a small amount of block listing prior to the year end.

At 30 September MedicX’s portfolio comprised 152 properties, with 146 operational and fully let and six were under development, these were valued at £612m after construction costs to complete the development assets and net of purchaser’s costs of 6.1%. The portfolio had passing rent of £35.2m at 30 September, for a net initial yield of 5.25%; we note that the Irish development assets have been acquired at yields over 7%. Since the period end the company has contracted to forward-fund another primary healthcare centre in Wales. Three of the six development assets are in the Republic of Ireland. The portfolio is geographically diverse (Exhibit 3) and the largest asset comprises only 2.9% of the portfolio value (down from 3.1% at 30 September 2015). The top 10 assets account for 18.2%, down from 19.6%. The averaged unexpired lease length is 15.5 years.

Apart from the lease length, yield and method of rent review, significant characteristics of MedicX’s healthcare property assets are their future longevity, average size and tenant mix. We examine these in more detail below.

The weighted average unexpired lease term (WAULT) across the fund’s portfolio is 15.5 years and combined with the strength of the tenant covenants, provides a secure and predictable income stream comparable to that of a bond. New leases are typically for 20 or 25 years and the majority of rents change by market review although a significant minority (24.5% at 30 September 2016, up from 22.6% a year earlier) are linked to RPI or CPI, including all rents in the ROI. In the UK, rent reviews are triggered by the landlord and can typically be as often as every three years. As a result they are effectively upwards only. Rents in the ROI are reviewed every five years and may fall as well as rise. A smaller number of rents rise on fixed increments throughout the lease term. Exhibit 5 shows the rental portfolio divided by method of rent review. In recent years, rents reviewed by open market comparison have risen less than those assessed using other methods, partly as a result of the slower rate of approvals for new developments, as discussed above. It is possible that an acceleration of primary care construction will help increase rental uplifts.

In the UK, valuation yields have reduced steadily in recent years (Exhibit 7), driven by demand for income-generating assets from institutional and private investors alike. While this has driven asset values up, it could potentially have made new acquisitions at attractive yields harder to find. MedicX’s investment adviser has exercised discipline in only selecting modern, high-quality assets available at net initial yields around 5% in the UK and one of the attractions of the Irish market is that yields there are in excess of 7%. As a result, the adviser has been able to continue to find assets to buy at cash yields above the portfolio average (6.02% in FY16). In combination with the fixed cost of debt (including a drop in the cost in 2012), the spread between the average cost of debt and the cash yield on acquisitions has remained relatively wide, currently at 1.6%.

More modern and larger premises are able to accommodate a broader range of services, allowing GPs and other tenants to offer a wider range of care, in line with the future healthcare policies of the UK and ROI. Such assets are therefore in greater demand, command higher rents and will have longer useful lives than older (particularly converted residential) surgeries. Larger premises are particularly suited to the trend in the UK of co-locating more than one GP practice as well as other services. The adviser’s proprietary database and analysis of population and medical service distribution in the UK allows the identification of sites which are best placed to optimise the catchment area for particular services; to identify where certain services might find greater demand; and to help design better premises to meet healthcare demands in a particular area. In the UK as a whole, Savills estimated in 2015 that 50% of the primary healthcare estate was over 30 years old and as noted earlier, most GPs surveyed by the BMA in 2014 said their premises were inadequate. MedicX Fund’s high-quality portfolio has an average age of eight years, average value of £4m and an average size of 1,410sqm.

The fund has a board of four non-executive directors: John Hearle, Steve Le Page and Shelagh Mason, and a non-executive chairman, David Staples, whose biographies are on page 13. It has been indicated that, after 10 years’ service, Mrs Mason will step down in this financial year once a suitable successor has been identified.

The investment adviser, Octopus Healthcare Adviser, was an original part of MedicX Group (now Octopus Healthcare) and has extensive experience in this specialist area of commercial property. The Octopus group also includes an in-house development arm and invests in other areas of healthcare property including secondary and retirement care. The investment adviser is remunerated according to the formulae below, which when implemented effectively froze the investment advisory fee until the portfolio reaches £782m. The formulae cover four types of fees:

Total fees payable to the adviser in FY16 amounted to £6.362m, including £3.852m of advisory fees, £889k for property management and £68k arising on the acquisition of a new subsidiary. Octopus Healthcare Adviser owns c 2.15m shares of the fund.

As noted above, the key sensitivity is that the fund is able to invest in new assets at favourable yields, which is reflected in its decision to expand its ambit to include the ROI. The investment adviser exercises discipline in selecting new assets, not growing the portfolio for the sake of scale alone. Investor demand for yield-producing assets has helped reduce valuation yields in the UK in recent years, but the adviser has consistently been able to find new investments at cash yields over 5.8% and there is scope for acceleration of rent increases. Other sensitivities include:

MedicX’s key attraction is its access to sources of secure, long-term income that underpins its dividend payments. The company, barring unforeseen circumstances, expects to pay dividends of 6.0p per share in FY17, 1% above FY16, a yield of 6.8% on the current share price. We expect this to be 64.4% covered by EPRA earnings, the highest level since 2009. Portfolio growth would allow cover to continue to grow, and the use of block listing above NAV to finance acquisitions may allow acceleration of dividend cover growth. The prospective dividend yield is the highest among the peer group of property companies specialising in long-let assets, despite the considerable (c 20%) premium to NAV at which the shares trade. In fact, MedicX has recently had the highest dividend yield on EPRA NAV of the group as well as the highest premium to NAV, implying investor appetite for yield even when this is in part paid from capital. Notably, the three primary care property companies with mainly government-funded income trade on higher premiums than the other three, indicating that the market may place more importance on the tenant covenant than the unexpired lease term of the portfolio, or dividend cover. We note that the shares trade at a discount to the investment adviser’s DCF valuation as explained below.

EPRA NAV per share of 73.8p at 30 September as calculated by the company’s valuers, JLL, means the shares currently trade at a c 20% premium. The investment adviser also carries out a discounted cash flow valuation of the assets annually using assumptions that are consistent each year: discount rates of 7% for completed and occupied assets, and 8% for developments (a weighted average of 7.06%); an average 2.5% annual increase in rents and residual values based on 1% capital growth from current value to lease expiry. This gives an NAV of 96.6p per share for 2016. The adviser reports that for DCF NAV to match the 30 September share price of 88.75p, it would have to assume separately either a 7.9% discount rate, a 1.1% increase in rents per year or 0.1% capital growth.