Primary Health Properties — Update 22 February 2016

Full-year results were strong and very slightly ahead of our forecasts on an underlying EPRA basis. Statutory IFRS earnings were noticeably ahead of our forecasts due to stronger revaluation gains on the back of a further second-half compression in valuation yields that we had explicitly not assumed. The numbers per share quoted in the results release and below reflect the four-for-one sub-division undertaken in November 2015. One of the key features of the full-year results is the return to full dividend cover in H2. The second-half underlying earnings covered dividends 107% (98% for the year versus 84% for 2014), slightly better than our forecast due to the earnings beat. The other significant development is the news that PHP has made its first steps to invest in the primary care market in Ireland (see page 4). We have made relatively small changes to our numbers (EPRA 2016e EPS 5.2p vs 5.4) with lower rental income than previously, following cautious asset growth, partly offset by lower financial expense.

Of the eight new healthcare properties added to the portfolio during the year, representing an aggregate commitment of £44m, seven were in H1 and one in H2. The H2 property added was a forward-funding commitment to a new health centre in Swindon at a cost of £10.4m; it is expected to be completed in February 2017 and will be let to NHS Property Services on a 20-year lease. Full-year commitments were a little behind our full-year estimate of £55m.

Including asset management initiatives and a £39.8m net revaluation gain during the year, the total completed and committed portfolio grew to just over £1.1bn as shown in Exhibit 2

The compression in valuation yields is reflective of the strength of investor demand in the attractive, secure yields provided by primary healthcare property. New supply remains limited although the medium- to longer-term growth outlook remains very strong (see below). In this environment, PHP’s management says it has remained highly disciplined and selective in its acquisitions, seeking properties with the potential to meet longer-term healthcare needs and add value, not simply near-term yield. NHS development commissioning is expected to show a pick up over the next 12 to 18 months. Additionally, like certain peers, PHP has decided to make a limited commitment to the Irish market, where healthcare property demand is being driven by similar economic and demographic drivers to the UK market, but where debt adjusted yields are materially (c 150-200bp) higher. In the UK, PHP has a pipeline of £28m of transactions agreed and in solicitors’ hands with a further £70m of transactions under offer and progressing. In the Republic of Ireland there are €14m of transactions agreed and in solicitors’ hands, with €40m under offer.

Ireland has similar demographic trends to the United Kingdom in several respects: the population is expected to continue to grow while living longer and living with medical conditions requiring treatment for longer. To prepare for the future needs of the population (and as part of a post-financial crisis stimulus package) the Irish government has embarked on a major restructuring of the health system. One of the main objectives has been to establish a single-tier system where primary care will become freely and universally available.

As part of this process, the Department of Health strategy seeks to deliver a number of new primary care centres (PCCs); nine were delivered in 2015 and 28 are planned for 2016 and the first half of 2017. When the targets were published at the end of 2014, there were around 30 centres under construction with a further 50 planned. The planned facilities are relatively large (1,500 to 5,000sqm) and host care and affiliated providers.

Unlike in the UK, Irish GP rents and rates are not reimbursed by the government. This has inhibited private investment in healthcare facilities. The new strategy put the Health Service Executive (HSE, or the Irish equivalent of the NHS) in the position of anchor tenant in the planned new facilities, accounting for 60-75% of the tenanted space on 25-year leases. The HSE will provide a range of services including community and public health nursing teams, home helps, mental health services, social workers, dental care and other services such as speech therapy. It is planned that the remaining space will be tenanted by GPs and pharmacies or other private tenants.

While the tenant covenant will not be as strong as in the UK (91% of rents received from government directly or indirectly, and 8% from co-located pharmacies), the above tenant mix should provide a good quality income stream. We see the main differences as 1) HSE rents are subject to five-year rent reviews but may in theory go down as well as up, subject to a minimum base of the initial rent (the UK is effectively upwards only); and 2) unlike the UK with effectively full occupancy, there may be more variability in non-HSE occupancy. We do not feel that foreign exchange movements between sterling and the euro pose a material threat as much of the risk can be mitigated by matching euro assets with euro borrowings.

PHP management indicates that Irish assets may come to represent c 10% of the portfolio over time. This seems reasonable as the market is much smaller than the UK. PHP expects to structure its investments in a way that remittances to the UK as well as Irish profits will be free from tax.

For the core, and much larger UK market, we believe the medium- to long-term growth outlook for PHP remains strong in a market driven by an ageing population with growing healthcare needs, an underinvested primary healthcare estate and a general acceptance of the need for more integrated primary care services in the community.

The NHS’s Five Year Forward View has been endorsed by government. An additional £10bn pa in funding for the NHS has been committed and £6bn of this has been brought forward to 2016-17. In addition to increased funding, the NHS will need to deliver significant operational efficiencies, estimated at £22bn pa and as part of the plan to achieve this, the NHS plans significant changes to the way it operates. Additional and more integrated services are to be delivered within the primary care sector, in the community, with extended opening hours to improve access. The anticipated changes in healthcare delivery require modern, purpose-built, flexible premises (of the type in which PHP invests), in contrast to a significant proportion of the existing estate that is comprised of ageing, converted, residential properties.

Clinical Commissioning Groups (CCGs) are putting their strategies in place for their primary care estates, aimed at ensuring the healthcare infrastructure is fit for purpose and able to support changing health care needs. As these are completed in the coming months it anticipated that the pace of commissioning of needed new developments will finally start to increase.

50% of primary care premises are more than 30 years old and many of these are converted residential premises (source: Savilles/EC Harris). In a recent survey by the BMA, 70% of GPs stated their premises are too small to be able to deliver enhanced and additional services, 52% said their premises had seen no investment or refurbishment in the past 10 years, and the majority said that their premises are too small to be able to deliver training and education.

Even allowing for ongoing consolidation of smaller GP practices into larger groups, the implied future demand for investment in modern, purpose-built premises is very significant. However, if the NHS commitment is restricted to rent reimbursement, this would be a much more manageable
5-6% of the capital investment required.

The return to a fully covered dividend in H215 marks the achievement of a longstanding goal for management. The high distribution ratio of the REIT and the growing dividend are supported by long-term cash flows underpinned by long leases to the UK government, via the NHS, being the underlying tenant of 90% of the UK portfolio. We expect PHP to pay out 5.125p per share in dividends in 2016, a 2.5% increase on 2015, a yield of 4.8% at the current share price. This remains an attractive (FTSE 100 c 5.3% at the time of writing) but also very secure yield.

We forecast dividend cover of 102% for the 2016 year as a whole, driven by continued asset growth at yields higher than the cost of debt (helped at the margin by investments in Ireland) and a management fee structure that ensures relatively lower costs as the portfolio grows. PHP’s EPRA cost ratio remains the lowest of its peer group by some way at 11.5% and we expect it to further reduce with continued asset growth.

Net asset value per share rose to 77.4p on an IFRS basis and 87.7p on an EPRA basis in 2015, against 69.5p and 79.7p respectively at the end of 2014. EPRA adjusts for the fair value liability of interest rate swaps and changes in the fair value of the convertible bond. At the current share price of 106.25p the EPRA P/NAV ratio is 1.20x.

As discussed above, the net valuation yield on the portfolio continued to contract during the year, from 5.52% at the end of 2014 to 5.39% at mid-year and 5.32% at the 2015 year-end. This compression is driven by investor interest in the attractive yields and secure income streams offered by the sector, particularly compared with gilt yields of c 1.5%. We have not forecast a further tightening in valuation yields and the revaluation gains included in the 2016 and 2017 forecasts simply reflect the impact of anticipated rental growth. However, further compression is entirely possible and we estimate that a 10bp tightening in the net valuation yield (to 5.22%) when applied to the 2015 year-end portfolio would add c 5p to EPRA NAV per share, while a movement in the yield to 5.0% would add c 16p.

During 2015 PHP generated a total return on its property assets (net rental income plus valuation movements) of 9.7% (2014 9.2%) and with the benefit of gearing the NAV total return was 16.3% (2014 12.8%).

Exhibit 3 compares the total property returns for various periods to 31 December 2015 for PHP and for the overall commercial property sector.

Net rental income is a significant element of commercial (and healthcare) property returns over time. However, because healthcare property is less economically sensitive, displays consistently high levels of occupancy and is less susceptible to speculative development, returns tend to show much less volatility than the commercial sector as a whole. The broad sector saw values decline by c 42% from the pre-financial crisis peak to the trough in March 2009, and has seen a significant upswing since. As expected, healthcare property values were much more defensive in the downturn and have therefore lagged the broader sector in the current upswing.

On an underlying basis the strong 2015 results were slightly better than we had forecast, in terms of revenues, EBITDA, and dividend cover (98% for the year but 107% in H2). EPRA NAV per share also exceeded our forecasts, having benefitted from higher than expected revaluation gains, driven by a further compression in yields, explicitly not allowed for.

In an environment of increasing competition for attractive properties, PHP’s selectiveness meant that 2015 property acquisitions were lower than we had forecast and this will have an impact on 2016 rental income and EBITDA. However, lower acquisitions also mean lower debt and lower funding costs, even though through H216 and 2017 additional swap protection against a rise in interest rates comes into effect resulting in expected increases in swap costs. Our underlying, EPRA PBT and EPS forecasts are slightly lower than before and we have introduced 2017 estimates for the first time.

.

In 2015 PHP committed c £44m to property acquisitions compared with the £55m that we had forecast. We have also reduced our 2016 forecast for new commitments to £65m (was £95m) and forecast £95m in 2017. Within this we have allowed for £30m of commitments a year in Ireland at a 200bp higher debt adjusted yield. This would take the Irish share of the portfolio to c 5% compared with management’s intention to lift it towards 10%.

We have allowed for average rent increases of 1.0% in 2016 and 1.5% in 2017. The 2017 increase reflects the expectation of accelerated NHS development, also evident in our forecast commitments. Our forecast revaluation gains only capture rent increases and we do not factor in further possible valuation yield contraction.

Our forecast property acquisitions imply an increase in net debt to £852.9m in 2017 from £694.9m at the end of 2015. This represents 66% of the projected investment portfolio value in 2017, which is approaching the upper limit of management’s gearing range (70%). If property acquisitions were to be materially ahead of the level we forecast, we would expect PHP to seek additional equity funding, not included in our estimates.

The weighted average maturity of PHP’s debt is 5.9 years and the interest cost on over 70% of the debt is fixed or hedged out to 2020. PHP maintains a wide range of funding sources and 23% of debt is unsecured (the retail and convertible bonds), which provides room to keep LTVs on the secured facilities lower than they would be otherwise, and provides PHP with more flexibility in acquisition funding.