MedicX Fund — Positioning for continuing growth

H118 saw continued growth, with rental income benefiting from portfolio acquisitions, completions of properties under development and rent increases. Costs were well controlled, substantially reflecting the freeze on management fees until the property portfolio reaches £782m (end-H118: £719.7m). The positive developments in the results, briefly reviewed below, are somewhat overshadowed by news of the new dividend policy, under which MedicX will transition to a lower, fully covered dividend from FY19 (FY18 dividend per share target of 6.04p unchanged). NAV total return is unaffected by the move, which rebalances prospective shareholder returns more towards NAV growth and enhancing internal resources to fund further accretive asset growth. MedicX has a near-term acquisition pipeline of c £174m.

The highlights of the H118 results were:

The value of the investment portfolio increased by 5.8% to £719.7m as at 31 March 2018, with net capital investment of £21.2m in addition to the £18.3m revaluation gain. The lot size profile of the portfolio (57% of properties valued at £5m or more) and the age profile (26% of properties less than five years and 59% less than 10 years) are positive indicators for the quality of the assets, dominated by modern purpose-built facilities with the potential to adapt to changing healthcare needs over many years. The weighted average lease term of 14.0 years provides strong visibility of income, and in the UK leases are effectively subject to upwards-only rent reviews at the option of the landlord. Income security is also high, with minimal vacancy, and c 90% of rents effectively government backed, while most of the rest (c 9%) is attributable to co-located secure pharmacy operations. Settled rent reviews generated an average uplift of 1.5% in H118, an acceleration from c 1.0% in FY17. RPI-linked/fixed rental uplifts (32% of rents) are still the driving force, while open-market rent reviews continue to lag the rise in land and building cost inflation but, positively, there is a general expectation across the industry that this will soon change. For the new buildings needed by health authorities to attract the required investment, rental levels will need to increase, providing evidence for a knock-on impact for existing assets.

Since MedicX Fund was launched in August 2006 it has progressively grown dividends (Exhibit 2), distributing c £156m over the period. Dividend payments have regularly exceeded recurring income earnings per share, but have broadly tracked NAV total returns in recent years, with steadily increasing property valuations supporting NAV per share growth. In the nine years since the financial crisis, from end-FY08 to end-FY17, the cumulative annual total return (change in EPRA NAV per share plus dividends paid, not adjusted for scrip) was 83.1% or a compound 7.0% pa. 90% of this total return represented dividends paid, with NAV per share growth (after dividends paid) making up the balance.

The rise in property valuations has outstripped rental growth in recent years such that yields have tightened significantly, particularly since 2014 (Exhibit 4). The flip side of improving valuations is that the cash returns to be earned on new investments (existing investments are unaffected) has fallen. Helpfully, the average cost of debt funding has also reduced, maintaining a positive spread on new investment, such that portfolio growth remains attractive, especially with management fees frozen until the portfolio reaches £782m and rental growth showing signs of acceleration.

However, although dividend cover has been on an increasing trend (Exhibit 5), the step change in property yields means that closing the gap has become increasingly difficult, despite dividend growth having been moderated. Additionally, the share price de-rating relative to NAV increases the number of shares that need to be issued to maintain a prudent level of gearing while growing the portfolio, which unchanged would put further pressure on dividend distributions relative to EPS and cash flow.

MedicX has maintained its DPS guidance for the current (FY18) financial year at 6.04p per share, but intends to pay a fully covered DPS from FY19, targeting a payout ratio of c 95% of EPRA earnings.

The illustrated potential quarterly dividend per share payments for FY19, shown in Exhibit 6, represent the distributions that would be supported by the results for the six months to 31 March 2018, allowing for a 95% payout ratio (105% dividend cover). It is important to note:

The investment manager has identified short-term investment opportunities of more than £174m in the UK and Republic of Ireland, including a £64m off-market corporate acquisition opportunity, One Medical, which MedicX hopes to complete by 8 June, and a further £60m in solicitors’ hands. The latter comprises £41m in the UK and £19m in the Republic of Ireland, a mixture of standing and forward funding opportunities (mainly with the eight “framework” developers with which MedicX works). A further £50m of the short-term pipeline represents active opportunities, across the UK and Republic of Ireland, at the stage of legal due diligence.

The One Medical portfolio of 12 operational and fully let primary care centres is significant in size, representing c 9% of the existing portfolio value. MedicX believes it to be a good strategic fit, comprising larger and locally important premises, four of which are less than four years old, with a portfolio weighted average unexpired lease term (WAULT) of 14.3 years. The portfolio rent roll is c £3.0m pa, which represents 7.4% of the existing total.

Including costs of £1.6m, the planned acquisition includes a cash consideration of c £29m and the assumption of existing debt with a fair value of c £37m, plus a small amount of working capital. To part-fund the acquisition, and subject to market conditions, MedicX intends to issue 42.88m shares at close to EPRA NAV, and it is possible that the vendor of One Medical may participate, becoming a MedicX shareholder. Our forecasts now assume completion of this acquisition, and the intended share issue at 80p (around H118 EPRA NAV). Should it not be possible to issue shares within the targeted price range, we would expect MedicX to proceed with the acquisition, funding the cash consideration from debt.

We have adjusted our financial forecasts to take account of the updated acquisition pipeline, equity funding guidance and revised dividend policy. We continue to look for continued accretive asset growth and scale economies, while the equity funding reduces our forecast LTV but slightly dilutes EPRA EPS. Our forecast total returns are rebalanced between dividend distributions and NAV growth.

The main drivers of our revised estimates are:

Drawn debt amounted to c £380m at 31 March 2018, almost all long term and fixed rate, and diversified across a range of lenders. The weighted average unexpired term was 12.1 years at the same date, closely matching the 14.0 years remaining unexpired lease term of the portfolio, with an average cost of 4.27%. Adjusting for cash, net debt was £361m with a loan to value ratio (LTV) of 49.5%, unchanged from end-FY17.

A number of UK REITs have taken the opportunity provided by favourable funding conditions to refinance relatively high-cost, long-term debt and MedicX is similarly in discussions with its lenders. The main opportunity relates to the four debt facilities with Aviva, as highlighted in Exhibit 8 below, and discussions are underway about a restructuring.

The main objective for MedicX from refinancing the Aviva facility would be to release from charge properties that are surplus to the LTV covenant and enhance cash flow by reducing debt amortisation. MedicX estimates that it may be possible to release £70.1m, providing it with greater flexibility in its overall debt portfolio. In current market conditions, additional borrowing to support portfolio growth would likely attract interest at closer to 3%, reducing the blended cost of borrowing.

As some other companies have done, MedicX could decide to further reduce the average cost of borrowing by repaying relatively expensive long-term debt, triggering a break cost. The interest saving would lift recurring earnings and dividend-paying capacity, but EPRA NAV would reduce as a result of the break payment. We would consider any restructuring as broadly neutral to valuation, with the positive impact on recurring earnings offsetting the impact on EPRA NAV per share.

The impact of marking to market the long-term, fixed-rate debt was £42.4m at 31 March 2018 (a similar figure to end-FY17), and is reflected in the alternative published NAV format, EPRA NNNAV, which includes debt at its fair value rather than its nominal value. EPRA NNNAV per share was 69.4p at end-H118 compared with EPRA NAV of 79.6p, and EPRA NNNAV would be unaffected by triggering break payments as it already reflects the likely cost of these. We focus on EPRA NAV as debt will either be held to maturity and repaid at nominal value, or refinanced at advantageous terms. A substantial part of the total debt mark-to-market adjustment will relate to the Aviva debt, which accounts for c 60% of drawn debt, with a longer than average blended duration (c 15 years) and at an above average blended cost (c 4.7%). On this basis, the Aviva debt may account for some 75% of the total mark to market adjustment.

In addition to the Aviva discussions, MedicX is also negotiating with Bank of Ireland to amend the euro-denominated facility that funds and hedges its assets in the Republic of Ireland, putting in place a development facility while seeking to lower the overall cost. An extension of the £20m revolving credit facility with RBS, not currently drawn, is also being documented, doubling the commitment by bringing in a club lender to provide a flexible source of attractively priced tactical funding to facilitate the timely closure of acquisitions.

High dividend distributions and a progressive dividend policy has been a key attraction of MedicX shares in recent years, with cash flow supported by a secure, long-term income and a growing asset base. Although dividend distributions have regularly exceeded income earnings (ie earnings adjusted primarily for property valuation movements) over the period, this has been more than made up for by capital earnings. As noted above, in the nine years since the financial crisis, from end-FY08 to end-FY17, the cumulative annual total return (change in EPRA NAV per share plus dividends paid, not adjusted for scrip) was 83.1% or a compound 7.0% pa. 90% of this total return represented dividends paid, with NAV per share growth (after dividends paid) making up the balance.

As discussed above, the decision to rebalance the dividend policy does not negatively affect NAV total return (and should even enhance it), but will reduce the returns earned through dividend distributions while enhancing NAV growth. Our forecasts imply a total return on EPRA NAV of 11.9% in FY18 and 8.5% in FY19. Within this, we assume some continuing revaluation gains in H218 and FY19, driven by our estimate of the impact of rent growth, but we do not seek to anticipate valuation changes resulting from further movements (up or down) in market yields. As noted above, the external valuation of the UK assets in the MedicX portfolio reflects a net initial yield (NIY) of 4.99%. This compares with a 4.91% NIY reflected in the Primary Health Properties (PHP) valuation at 31 December 2017, and 4.80% reflected in the Assura valuation as at 31 March 2018. We estimate that a 0.25% reduction in NIY, from 4.99% to 4.74%, reflected in the MedicX portfolio, would add c 8.9p per share to EPRA NAV (79.6p at end-H118). Although it seems unlikely in current market conditions, a 0.25% increase in NIY would reduce EPRA NAV per share by c 8.0p.

The listed investors in primary care properties have experienced a de-rating relative to EPRA NAV in recent months (Exhibit 10), at least in part reflecting a shift in broader property sector valuations in response to rising longer-term interest rates. Unlike the broader property sector, they are not exposed (certainly not directly) to uncertainties about economic cyclicality, while the prospects for further growth through investment and an acceleration in rent growth are positive.

The reaction to its decision to rebase the dividend has taken MedicX to a slight discount to EPRA NAV, some 10 percentage points or so below its close peers. This puts it on a current year dividend yield of 7.7%. Looking through to the revised dividend policy, the prospective FY18 DPS of 6.04p would be 3.81p at a 95% payout ratio, a level that would give a dividend yield of 4.9%, slightly ahead of peers.

For the primary healthcare subsector as a whole, the strength of tenant covenants (mainly growing, government-funded rent income, from long-term leases) invites a comparison of recurring income yields of 4.5-5.0% with 10-year UK government gilt yields at c 1.4%.