Impact Healthcare REIT — Resolving sole underperforming tenant issue

Impact held extensive discussions with a number of alternative care providers before concluding that the transfer to MHL was the most attractive solution and in the best interests of all stakeholders. MHL’s acquisition of the Silverline tenant companies on a solvent basis (ie including its liabilities) avoids a period of uncertainty for home residents and the staff that care for them and commences a process of operational improvement immediately. It is unlikely this would have been possible had Impact sought a potentially lengthy lease reassignment or if the Silverline operating companies had been forced into default, and we believe that the turnaround experience provided by Minster has been secured in a cost-effective manner.

MHL is wholly owned by connected parties of Mahesh Patel, who is both the controlling shareholder of Minster and a principal in the investment adviser,1 making this a related-party transaction. It is however the case that the close relationship between Minster, the company, and its investment adviser that has facilitated Minster’s involvement on terms that have been scrutinised and benchmarked by the independent board and verified with a range of external advisers. Mahesh Patel has a 35-year track record of owning and managing care homes and, while Minster does not benefit directly transfer, other than its service fee, MHL is incentivised to turn around the homes and repay its liabilities, including drawn loan balances with Impact.

Free cash surpluses (after the Minster fees) pass directly to Impact in the form of loan repayments and accrued interest and, once the loan is repaid, variable rents. Of course, MHL/Minster may be unsuccessful in engineering a turnaround, reducing or even eliminating cash payments to Impact, but we think this an unlikely result. Rather, there is an upside opportunity for Impact, beyond restoration of the existing rents, which are set at a low level (c 60% of the portfolio average as per Exhibit 1). As any surplus in excess of the Minster fees (a fixed rate per bed) passes to Impact, this may in time exceed the previous rent level. If such a point is reached or in sight, we would expect the company to seek opportunities to revert to a normal lease structure or potentially dispose of some or all of the assets where these are deemed non-core.

In our May 2023 update, we focused on the strategic drivers of Impact’s strong performance since listing in 2017, amid a structurally supported sector, which has nonetheless been challenged by the pandemic and, more recently, high inflation.

We noted that Impact’s initial investment alongside Silverline, in turnaround assets, before the impact of COVID-19 had become apparent or the pandemic declared, was in contrast to its core focus on stabilised assets, with a consistently positive trading history and a good reputation in the local markets in which they operate, at affordable rents that can sustain high levels of rent cover.2 In retrospect, although this deviation from the core strategy was unfortunate, it is worth noting that this is the only rent collection problem experienced by Impact since listing. Rent collection for Q123 was 98% (96% excluding the £0.2m Silverline rent deposit release) and we expect a similar level for H123. Excluding Silverline, rent collection is 100%, as has been the case since listing, with no lease variations.

For the wider portfolio, strong fee growth and increased home-level occupancy have continued to offset inflationary impacts, maintaining average rent cover at a strong 1.8x.

Our revised forecasts assume a full repayment of lending to MHL by end FY24 and a full restoration of rents (at the previous level of £1.6m) from the beginning of FY25, forecast for the first time.

Impact has estimated that the rental default by Silverline, partly offset by rental deposits, and including the impact of the new arrangements agreed with MHL, will likely amount to a reduction in earnings versus its original FY23 budget of c £1m. Around half of this was reflected in our last published forecasts in May 2023, representing c £0.5m in our revised forecasts.

For FY24, we assume no rents are received from the homes operated by MHL (previously £1.6m), with any cash surplus used to repay MHL borrowings. For FY25, with all the debt repaid, we assume a sufficient cash surplus to support rental income of £1.6m. We also expect a first-time c £1m contribution from the Norwich forward-funded development, expected to reach practical completion by end FY24.

Any drawings on the MHL loan arrangement are covered in our previous cash projections, with no requirement for additional drawings on Impact’s own debt facilities.

The FY24 rent reduction arising from the MHL arrangements is partly offset by increased rent indexation (3.5% versus 3.0% previously) reflecting the stubbornness of inflation.

We understand that the lease variation, from a set rent to a variable rent, will reduce portfolio contractual income but correspondingly increase rent collection.

Although our forecast earnings are reduced, we continue to expect increased DPS to be fully covered by adjusted ‘cash’ earnings, 102% in both FY23 and FY24, increasing to 106% in FY25.

Impact has a clear and progressive dividend policy linked to rental growth. The FY23 DPS target represents an attractive yield of 7.0%. Meanwhile, the shares trade at a 14% discount to Q123 NAV per share of 112.6p. NAV increased from 110.17p at end FY22, with an increase in property values driven by like-for-like rental growth from its long, upward-only, index-linked leases.

Following detailed internal and independent assessment, Impact believes that the assets that were operated by Silverline are capable of providing an attractive and sustainable return with good levels of care, subject to enhanced stewardship, relating mainly to improvements in occupancy and staffing costs (with reduced reliance on expensive agency staffing).

Silverline became Impact’s 11th tenant in March 2020, as the new operator of three homes acquired in Bradford for £7.5m, with the initial rent of £630k pa reflecting a gross yield of 8.1%. The homes were all purpose-built to a high standard by the vendor, providing 182 rooms, all ensuite. Under previous management, the homes had been through a period of underperformance and were acquired as a turnaround opportunity, to be operated by Silverline. Silverline operated other homes in Yorkshire, including one in Bradford, and presented Impact with plans to generate the required operational improvement.

The unfolding pandemic, with its negative impact on occupancy and staffing costs,3 appears to have had a significantly negative impact on Silverline’s wider performance and its ability to turn around the Impact-owned homes in Bradford. During 2021, the withdrawal of lending facilities led to several Silverline-owned and operated homes being forced into administration, triggering a reassessment of its strategy, including a greater focus on nursing care.

In November 2021, Impact completed the acquisition of Springhill Nursing care home in Kilmarnock, Scotland, for £3.25m, in a sale and leaseback with Silverline, with the initial rent of £243k pa just under 2x covered and reflecting a gross yield 7.5%. For Impact, the acquisition was attractively priced and immediately accretive and had the added benefit of freeing up capital for Silverline, supporting its business repositioning. Springhill is a four-storey Georgian building with a substantial purpose-built extension offering a total of 61 beds with ensuite wet room facilities. It was acquired with an EPC rating of C531 with a strategy to achieve an equivalent EPC rating of B.

The acquisition of three further Scottish properties was agreed in March 2022 and completed in August 2022, adding 155 beds, all ensuite. The aggregate consideration of £8.1m and initial rents of £628k reflected a gross yield of 7.75%. The homes were acquired with EPC ratings of English-equivalent B on one home and English-equivalent C on two homes, with a strategy to bring these two homes to English-equivalent B.