Target Healthcare REIT — Positive momentum continued in Q3

Organic rental growth is driving increased earnings, fully covered dividend growth and property valuation gains, reflected in an uplift in NAV per share. For now, Target is focused on optimising its existing portfolio and we have not assumed any acquisitions in our forecasts. If interest rates begin to decline as is expected, opportunities for accretive capital deployment may begin to emerge. Allowing for existing investment commitments, £41m of free capital was available at end-Q324.

With the H124 financial performance in line with the previously released quarterly data, and our forecasts, Q324 continued the positive trends. There is no material change to our last published forecast for FY24 and FY25 and we expect further progress in FY26.

The past five quarters have now seen a positive development in property valuations, reflecting rental uplifts as property yields have stabilised, generating capital growth alongside consistently positive dividend returns.

Q324 NAV per share increased 2.2% to 109p and including DPS paid, the NAV total return was 3.6%, taking the total return in the first nine months of FY24 to 8.3%.

In Q324, contractual rental income increased by £2.2m, or 3.7%, to £60.1m. The increase reflected annual, inflation-indexed rent reviews,1 mostly collared and capped at 2% and 4% respectively,2 and an additional £1.7m from the completion of two pre-let development properties at Dartford in Kent and Holt in Norfolk. During the current year, organic revenue growth (including interest earned on the funding extended to developments during the construction phase) is offsetting increased net finance costs. With borrowing costs now fixed on 89% of drawn debt, we expect organic revenue growth to drive earnings and dividend uplifts over the next two years. Revenues will benefit from the completion of three further development properties, currently under construction, which will add £2.3m to contracted rents.

The dividend rebasing in mid-FY23 successfully established a level from which DPS could sustainably grow on a fully covered basis. We expect this to continue. Commencing in Q124, the quarterly rate of DPS was increased from 1.40p (the rebased level during H223) to 1.42p, although the total DPS for FY24, targeted by the company to be 5.712p, will be lower than the 6.180p declared for the whole of FY23. We forecast 2.2% growth in FY25 DPS and a further 2.0% in FY26, covered 1.07x and 1.05x by adjusted earnings, respectively. On an EPRA basis, dividend cover is much higher (1.32x in H124) due to the inclusion of non-cash IFRS rent smoothing adjustments.

Of Target’s £320m of debt facilities, £259m was drawn at end-Q324, with an average term to maturity of 5.5 years. The drawn borrowing comprised £150m of long-term fixed-rate debt at a low average cost of 3.2%, with a first maturity in 2032, and £109m of shorter-term debt. The shorter-term debt is floating rate, but the interest costs on £80m of this have been capped at least until November 2025, and the blended interest cost is 4.4%. In aggregate, 89% of the Q324 drawn debt was fixed/hedged at an all-in rate, including the amortisation of loan arrangement costs, of 4.14%, with an average 5.5 years’ maturity. The £61m of undrawn borrowing would, if fully drawn, be at a variable interest cost of 2.22% plus SONIA. Allowing for undrawn debt, cash resources and £21m of investment commitments in respect of development funding, Target had £41m of available capital at end-Q324.

Market interest rate expectations remain volatile, but currently anticipate a decline in the SONIA rate from c 5% currently to c 4% by November 2025. This indicates an increase in borrowing costs of shorter-term floating rate borrowings no later than the maturity in November 2025, corresponding with the expiry of the hedges. However, based on current market interest rates, we estimate that a good level of dividend cover would remain.

Our forecasts assume a refinancing with effect from July 2025 (the start of FY26), ahead of the November 2025 maturity, and we assume a debt margin of 2.5% over SONIA (forecast at 4.0% in FY26), or 6.5% in aggregate. On this basis, the increased DPS remains well-covered at 1.05x.

Strong care sector fundamentals and non-cyclical, long-term, inflation-protected income prospects have mitigated the impact that rising bond yields and economic uncertainty have had on property valuations across the broad UK commercial property sector. Also, in contrast to that wider sector, investment demand for good-quality care home properties, especially modern, purpose-built properties with strong environmental credentials, has remained robust.

As a result, while the EPRA topped-up net initial yield (‘the valuation yield’) of Target’s portfolio rose in late 2022, directionally in line with the broader UK commercial property sector, the widening was significantly less, and valuations were more robust.

Over the past year, the yield on Target’s portfolio has stabilised, with a small tightening in Q324 to 6.19%. For the broad UK commercial property sector, yields have continued to widen. Driven by rental uplifts, during the first nine months of FY24, Target’s property valuation gains amount to c £4.4m compared with a loss of c £8.0m in the equivalent period of FY23. Our forecasts assume no change in yield, with rental growth continuing to generate valuation gains, supporting NAV growth. Our forecasts may prove to be conservative, given strong care home property sector fundamentals, the quality of Target’s assets and the market expectation of interest rate reductions. Target expects the valuation premium attached to better-quality care home real estate to increase further.

Healthcare property is relatively defensive and characterised by lower volatility of returns compared with the broader commercial property sector, and Target’s portfolio has performed strongly versus the MSCI UK Annual Healthcare Property Index. In 2023 it was ranked first out of the 37 constituents, with an ungeared total property return of 9.7% versus 4.2% for the index. Target’s annualised total return since launch is 10.1% pa and over the more challenging past five years it is 8.0% pa (index: 5.9%).

At the core of its strategy, Target has an unwavering focus on high-quality, modern and sustainable assets, attractive to residents, operators and investors. Its investment thesis is that best-in-class properties in local areas with positive demand/supply characteristics and prevailing rental levels that are sustainable will always be attractive to existing or alternative tenants.

Key portfolio metrics include:

The operator sector, in general, continues to benefit from the post-pandemic recovery in home occupancy, strong fee growth and an easing in staffing pressures. In combination this has provided an offset to inflationary cost pressures.

Based on the latest available data3 gathered from its tenants, underlying resident occupancy in Target’s mature homes4 remains on a slow but consistently upward trajectory, to around 87% currently. For the whole portfolio, end-December occupancy was 85%, prior to the two development completions in Q3. During the pandemic, occupancy reached a low of c 74% in April 2021 and there is further room for growth until it reaches the c 90% level that was typical before the pandemic. Target says that many operators have more recently been focused on admitting new residents at fee levels appropriate to the care package required, as opposed to prioritising occupancy in itself.

Average weekly resident fees have continued to outstrip inflation and Target notes that fees for privately funded residents (two-thirds of the total across its tenants) have exceeded inflation over the past 25 years.

In addition to higher occupancy and strong fee growth, the caps on rent increases have also protected tenants against the pressures of elevated inflation, just as they are designed to do. Similarly, over previous periods of low inflation, the floors on rent increases (typically c 2%) have worked to the company’s advantage.

Rent cover5 for mature homes, now c 90%6 of the total, has continued to increase and was 1.90x in the December 2023 quarter compared with 1.5x in the prior year period. On a rolling 12-month basis, yet to fully reflect the continuing improvement, rent cover to end-December 2023 was 1.8x (12 months to December 2022: 1.4x).

On a quarterly (or spot) basis, rent cover is now above its pre-pandemic level, when resident occupancy was higher, and is also above the 1.6x that Target has previously indicated to be a realistic medium-term target for a typical home. Nonetheless, with room for resident occupancy to increase further, there seems every prospect of rent cover continuing to build.

Asset management initiatives and improved trading conditions restored rent collection to around 99% by end-FY23 (an average 97% for the year) and it has continued to be robust during the current year. During FY22, collection had dipped to around 95%, with a small number of tenants slow to recover from the pandemic.

In our forecasts we allow for 1% pa non-collection of rent, recognising that within a large portfolio of almost 100 homes spread across 32, mostly mid-sized, tenants, it is not unreasonable to expect some of these to face challenges from time to time.

The targeted FY24 DPS of 5.712p represents a prospective yield of 7.0%, while the shares continue to trade at a discount of c 25% to Q324 NAV. Asset yields are above the property sector average, valuations appear well-supported, there is no material requirement for repair and maintenance capex, gearing is moderate and there is no ‘re-financing cliff’.

In Exhibit 11, we summarise the performance and valuation of a group of real estate investment trusts that we consider to be Target’s closest peers in 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. For consistency, the data are presented on a trailing basis.

The H124 financial results were published on 12 March 2024. The earnings performance was robust, with increased rental income offsetting the impact of higher average borrowing costs in the period, mostly now fixed or hedged until November 2025. EPRA earnings and adjusted EPRA earnings were both at similar levels to H123 and H223. Property valuation gains versus losses in H123 generated a swing in IFRS earnings to a profit of £30.8m versus an H123 loss of £34.2m. NAV per share increased 2.1% in the six-month period to 106.7p, and including dividends paid the NAV total return was 4.8%. Borrowings increased modestly as debt was drawn to fund capex, but the net loan to value ratio of 25.8% remained conservative.