Primary Health Properties — Resilient growth set to continue

In both the UK and Ireland, there is broad political will to reform healthcare provision, placing more emphasis on primary care to meet the increasing healthcare needs of growing and ageing populations. The requirement for larger, more flexible, higher-quality premises will provide significant investment opportunities in the coming years. PHP has a proven record of successfully investing in the sector since it was founded, and is now in its 25th year of unbroken dividend per share growth. The merger with MedicX in March 2019 was transformational for PHP, creating a group with increased scale and delivering operational and financial synergies. Management internalisation offers further efficiency savings, secures a strong investment platform and well-regarded management team, brings UK development activity in-house and should broaden the universe of potential investors, in particular those investors unable or unwilling to invest in externally managed vehicles. With its strong balance sheet, PHP is well placed to profitably address the substantial investment needs of the primary healthcare sectors in the UK and Ireland.

With c 90% of rents paid directly or indirectly by the UK and Irish governments, and most of the balance represented by co-located (not high street) pharmacies, rent collection was strong in FY20 and early FY21 and we expect this to continue. As at 17 February 2021, 2020 collection rates were more than 99% in both the UK and Ireland, and were 99% and 94% respectively in respect of Q121. PHP said it expected to soon receive the balance of Q121 rents due. With an end-FY20 annualised rent roll of £135.2m, the group has allowed £4.8m of annualised rents, predominantly pharmacies, to be paid by monthly instalments, and has given short-term rent deferrals of £1.2m and concessions of £0.5m. Valuations were similarly robust with net revaluation gains of £51.4m reflected in a continued tightening of the net initial yield (to 4.81% from 4.86% at end-FY19), driven by a flight to quality and continuing rental growth.

We expect further strong underlying growth in earnings in FY21 driven by acquisitions, development completions, and continuing like-for-like rent growth with an additional benefit from the expected c £4m cost savings related to the internalisation of management. We expect another year of above-inflation dividend growth (5.1%) with DPS fully covered by adjusted earnings. PHP has up to £243m of currently identified potential funding commitments over the next two to three years, comprising potential acquisitions (£129m), UK developments (£80m) and asset management opportunities (£34m), With end-FY20 funding headroom (cash plus undrawn debt) of £361.5m and gearing (loan to value (LTV) towards the low end of its target range (41.0%), PHP is well placed to capitalise on these opportunities and we have assumed c £120m pa of new investment commitments.

The valuation of PHP shares is driven very much by its prospects for continuing secure, long-term dividend growth, and this provides support for a continuing valuation premium to EPRA net tangible assets (NTA). At an expected 6.2p the FY21 dividend per share (DPS) represents a prospective yield of 4.1%, reflected in a P/NTA multiple of c 1.3x. Compared with its closest peers, PHP trades with a lower yield than the average and a higher P/NTA, reflecting the strength of tenant covenant and free cash flow, supported by a low cost ratio. Given the nature of PHP’s secure income stream it is tempting to draw comparison with the generic yield on 10-year gilts, which despite a recent rise remains clearly below 1.0%.

In early 2021, PHP completed the internalisation of the group’s management structure, with strong shareholder approval (99.95% of votes cast at the extraordinary general meeting in favour), and PHP expects to deliver immediate annualised cost savings of approximately £4.0m. The savings are around 25% of the FY20 EPRA cost base and we expect the EPRA cost ratio, already one of the lowest in the UK REIT sector at 11.9% in FY20, to fall to a little under 9% in FY21, including additional benefits from continued growth in the portfolio and like-for-like rents.

Internalisation was brought about by the acquisition of Nexus Tradeco Holdings, which through its subsidiary Nexus has acted as investment adviser to PHP since it was listed in 1996. Through the acquisition, PHP has secured the services of a well-regarded and experienced management team along with a fully operational platform, including systems, know-how and proprietary knowledge. Given the previous close relationship with Nexus, integration should be seamless, adding certainty to the cost savings that PHP expects. The savings result from PHP’s assumption of existing management and overhead costs from Nexus, which are anticipated to result in lower ongoing administrative costs compared with the previously agreed management fees. Shareholders will also now benefit fully from the expected future growth of the portfolio. The acquisition also included the Nexus primary care development business, Nexus Developments, with an £80m pipeline of direct development opportunities in the UK, which can now be undertaken on a pre-let basis, utilising PHP’s own substantial balance sheet, with the prospect of enhanced yields.

In addition to generating immediate cost savings and securing control of the Nexus development pipeline, other benefits of the transaction include:

The total fair value consideration of £35.7m included fees of £1.6m, and was satisfied by the payment of £16.6m in cash and the issue of c 11.5m new shares at 152.8p, equivalent to £17.5m. In our forecasts we allow for the intangible asset acquired in the transaction, as well as the transaction costs, to be fully written off in FY21, representing slight (2%) dilution of EPRA NTA.

Following the successful merger and integration of the MedicX portfolio and team in 2019, the board also reviewed its skills, experience and knowledge and considered its size and composition. As a result, the board was reduced from eight members to six, consisting of four independent non-executive directors and two executive directors, considered an appropriate size given the relative simplicity of the business. The two executive directors remain Harry Hyman, who becomes chief executive of PHP (having previously served in the role of managing director of Nexus), and Richard Howell, who becomes chief financial officer (having previously served in the role of finance director of Nexus). Mr Hyman has confirmed his continuing commitment to the group for at least five years from the MedicX merger in March 2019. The independent non-executive directors comprise Steven Owen (chair), Peter Cole, Laure Duhot and Ian Krieger. Biographies of the key members of the leadership team can be found at the back of this report, with further details available on the company website at www.phpgroup.co.uk/about-us/board-directors.

At 31 December 2020 (end-FY20) the portfolio consisted of 513 assets, externally valued at £2.58bn, and with a contracted rent roll of £135.2m reflecting a net initial yield of 4.81%. The £7.5m (or 5.9%) increase in contracted rent roll during the period predominantly reflected the acquisition of a portfolio of 23 UK assets for £58.8m, adding £3.1m, as well as four forward funding developments acquired (two in Ireland and two in the UK) with a total development commitment of £34.2m, which added a further £1.8m. Rental growth and asset management projects added £2.0m. The acquisitions and forward funding developments were contracted at an average c 5% net initial yield, above the existing portfolio average, and were also accretive of the portfolio weighted average unexpired lease term (WAULT), which ended the year at 12.1 years. Only 3.9% of the annualised rent roll expires in the next three years and PHP expects asset management opportunities for these assets over a similar time frame.

There are now 18 properties in Ireland with an aggregate valuation of £198m, just under 8% of the portfolio total. Reflecting a focus on purpose-built, larger, multi-disciplinary medical centres, the average lot size of the Irish assets is around double the £5.0m portfolio average, which continues to increase. Yields also remain higher in Ireland, although the premium has narrowed, with the valuation of PHP’s Irish assets reflecting a net initial yield of 5.1%.

With 90% of contracted rental income paid directly or indirectly by the UK and Irish governments, and the balance primarily by co-located pharmacies, covenant strength is exceptionally strong and, given the nature of the assets, vacancy is minimal.

The portfolio provides a stream of high-quality recurring income with good potential for further growth through acquisitions of standing assets and pre-let developments, development completions, asset management and rental growth.

During the year, four developments, all in Ireland (Athy in County Kildare; Bray, in County Wicklow; Rialto in Dublin; and Banagher in County Offaly), were completed on time with a net development cost of £46.3m (€51.8m). Including the four new commitments made during H120 (Arklow and Enniscorthy in Ireland, Eastbourne and Epsom) there continue to be six developments on site with a net development cost of £47.4m (of which £32.1m is remaining). All of the sites, in both the UK and Ireland, have continued to remain open and construction continues to progress.

PHP continues to have an active programme of incremental asset management projects such as property extensions, refurbishments and lease extensions/re-gears. Extensions and refurbishments enhance the quality of the portfolio, support the tenants in improving their healthcare delivery, generate additional rents and support lease extensions. Lease extensions extend both the WAULT and income visibility while enhancing valuation. During the year, 24 projects were either completed or continue on-site, with an aggregate investment requirement of £8.1m that will see £0.3m added to rental income and extend the WAULT back to an average 20 years. A further 80 projects have either been agreed or are in advanced negotiations, requiring an investment of c £34m, generating an additional £1.1m of rental income and similarly extending the WAULT on those premises back to an average of 21 years.

Rental growth continued in FY20, although the 1.8% average uplift on completed rent reviews was slightly lower than in FY19 (1.9%), and management indicates that the outlook for pharmacy rents has become more muted during the pandemic. Relatively low overall rent growth in recent years is the result of lower rates of inflation and weak open market rent growth, both in contrast to land and building cost inflation. The past three years have seen stronger average growth and, importantly, the catch-up in open market rents (69% of the total for PHP) should have further to go.

Across the market there is evidence that open market rent reviews have failed to sufficiently capture the strong rise in land and build costs in recent years, in part the result of financial pressures and reorganisation within the NHS that slowed decision making on commissioning the development of new primary healthcare facilities. The dearth of new developments that this created restricted the opportunities for increased land and building costs to be adequately reflected in the rents set on newly developed assets, an important input into the rent review process for existing assets. As the NHS reforms have bedded down and healthcare plans have taken shape, development activity has begun to pick up, creating rent benchmarks at levels that are sufficient to encourage the much-needed private investment that will support modernisation of the primary healthcare estate. As this progresses, PHP anticipates that it will increasingly be reflected in market rent levels across the estate.

During FY20, 309 UK rent reviews were concluded and documented, with a combined value of £30m. Average uplifts of 2.3% and 2.9% were achieved on index-linked (25% of the total) and fixed uplift (6% of the total) reviews. For open market reviews (69% of the total), an average of 1.3% pa (FY19: 1.1% pa) was achieved on 159 reviews, including 48 where there was no uplift. In addition, a further 199 open market rent reviews were agreed in principle, which will add £1.1m to the contracted rent roll when concluded, representing an uplift of 1.2% pa. A very significant number of tenancies, 669 at end-FY20 and representing c £90m of passing rent, remain under negotiation, reflecting the requirement for all awards to be agreed with the District Valuer.

PHP continues to have a strong pipeline of potential acquisitions in both the UK and Ireland totalling £129m, including £59m that is under offer, while with Nexus Developments, a potential UK development pipeline of £80m was acquired including two projects (£10m) that are at an advanced stage and currently seeking planning consent. Including the £34m of asset management opportunities this amounts to up to £243m of currently identified potential funding commitments over the next two to three years. With end-FY20 funding headroom (cash plus undrawn debt) of £361.5m, PHP is well placed to capitalise on this opportunity.

PHP has never engaged in speculative development and this will continue to be the case. None of the Nexus pipeline projects will be progressed until they have been pre-let and de-risked. However, unlike the provision of forward funding, where the asset remains on the developer’s balance sheet until acquired at completion by PHP, these internal development projects will remain on the PHP balance sheet throughout. We would expect this to enhance the returns to PHP with limited additional risk.

Although valuation yields have continued to tighten, the accretive nature of continued acquisition-led growth has been maintained by continued reductions in marginal funding costs and administrative cost efficiencies.

FY20 showed further strong growth, driven by a full year contribution from the MedicX merger (March 2019), acquisitions and development asset completions, like-for-like rental growth, and expense and funding efficiencies, in part the result of increased scale.

In particular we note:

Despite the pandemic we made only minor changes to our FY20 forecasts following the interim results and the final outcome for the year was as expected.

Our FY21 forecasts are increased, primarily to reflect the cost savings related to management internalisation as well as finance cost savings relating to refinancing and continued low interest rates. The 1.55p DPS declared for Q121 was above our previous forecast and we have increased the FY21 forecast accordingly, fully covered by adjusted earnings. We expect further adjusted earnings growth and fully covered DPS growth in FY22, driven by portfolio growth and like-for-like rent growth. Our forecasts are shown in detail in Exhibit 11 at the back of this report and are summarised in Exhibit 5 below.

The key underlying assumptions driving our FY21 and FY22 forecasts include:

With a progressive dividend policy that sees recurring earnings effectively fully distributed, portfolio growth is funded by a balance of new equity and debt, locking in a positive spread between investment yields and funding costs and generating operational and financial economies of scale.

With the £100m (gross) proceeds of the September 2019 equity raise deployed during H120, in July 2020 PHP raised an additional £140m (£136.9m net of issue expenses) of equity capital to take advantage of the continuing strong pipeline of investment opportunities. End-FY20 LTV of 41.0% (or 35.2% assuming conversion of the outstanding convertible bonds) was comfortably within the target gearing range with an upper limit of 50% (reduced during the year from 55%). Compared with the more cyclical mainstream commercial property sector, LTVs for primary healthcare investment are typically higher, recognising the highly secure, long-term nature of the cash flows, and reflected in the FY20 interest cover ratio of 2.9 times.

The debt portfolio is very broadly diversified, provides significant borrowing headroom from which to fund portfolio growth, and contains medium-term opportunities to benefit from debt maturities and enhance the overall cost of debt. End-FY20 funding headroom (cash plus undrawn debt) was £361.5m and although the weighted average maturity of the debt portfolio is a long 7.6 years, there are certain facilities that mature by end 2023 where, based on current market conditions, PHP is hopeful of reducing the average cost of debt further. PHP is already engaged in positive discussions with lenders and it may be able to realise funding cost efficiencies well before the actual maturities. Significant debt refinancing activity occurred in FY19, following the MedicX merger, reducing the average cost of drawn debt from 4.0% to 3.5%. The average was unchanged in FY20 although on a fully drawn basis the average reduced from 3.4% at end-FY19 to 3.1%, reflecting the low marginal cost of debt of 1.7%.

Interest rate risk is well managed, with 100% either fixed rate or hedged for an average maturity of 7.4% (just slightly shorter than the overall average maturity). Unfettered assets of £88.4m at end-FY20 provide significant flexibility in the utilisation of the debt facilities.

Historical returns on primary healthcare assets have been higher than other sectors of the UK commercial property market, with a lower level of volatility. This has been a function of strong healthcare fundamentals, secure and more resilient income, and more muted yield shifts through the property cycle.

PHP is in its 25th year of unbroken dividend growth, having already declared a Q121 DPS of 1.55p, 5.1% ahead of the FY20 quarterly rate. The annualised rate of 6.2p represents a prospective 4.1% dividend yield. We expect further growth in FY22 with continuing full cover by adjusted earnings.

DPS paid represents 52% of the cumulative NAV total return generated over the past five years, with capital returns contributing the balance including the impact of asset management, rental growth and yield tightening. In the five years to end-FY20, the aggregate NAV total return was 59.8% or a compound annual average return of 9.8%. With valuation yields for primary healthcare having tightened over a number of years, we would expect income returns to represent a greater share of total returns in the coming years.

The valuation of the PHP shares is very much driven by PHP’s prospects for continuing secure, long-term dividend growth and this provides support for a continuing valuation premium to EPRA NAV. At c 1.3x this is in line with the five-year average but down from the peak of c 1.6x. Given the nature of this income stream, 90% government backed, it is tempting to draw comparison with the generic yield on 10-year gilts, which despite a significant rise in recent weeks is still below 1%.

In Exhibit 10 we show the key valuation and performance metrics for PHP and a group of its closest peers, including Assura, another investor in primary healthcare assets, care home investors (Impact and Target) and social housing investors (Civitas, Secure Residential Income and Triple Point). Compared with the average of the group, PHP continues to trade with a lower dividend yield and higher P/NAV, reflecting investor perceptions of the strength of the tenant covenant as well the strength of free cash flow, supported by a low cost ratio.

In our view PHP has low operational risk within the context of the UK property sector. This reflects its position as a long-term investor in a specialist sector of the commercial property market characterised by long leases, predominantly government backed, with minimal vacancy and (in the UK) upwards-only lease adjustments supported by long-term fixed or hedged debt. Occupational demand in the primary healthcare sector is driven by demographics (ageing, growing and sicker populations) and the need to upgrade the existing primary care estate rather than general economic conditions. There are nevertheless a range of factors that could affect the business, especially over the longer term, including structural changes in the markets in which the group operates, changes to government health and fiscal policies, funding conditions and operational performance. In terms of our forecasts we note: