Primary Health Properties — Robust and resilient growth

As may be expected with 90% of rental income funded by government bodies, PHP delivered a strong and robust operational and financial performance in H120 despite the COVID-19 pandemic. With more than 99% of Q220 rents collected and 96% in Q320, to the date of the interim report, with the balance expected shortly, DPS payments have been unaffected and PHP is now in its 24th year of uninterrupted DPS growth. PHP has been actively working with the health services and general practitioner (GP) tenants to help them better utilise group properties for deployment in the front line of the current health crisis and has meanwhile continued to actively deploy capital, in many cases bringing additional new-build, high-quality facilities to the sector. The highlights of the interim results were:

Post the H120 period end, in July, PHP completed the oversubscribed placing of 96.6m new shares (c 8% of the outstanding) at 145p to raise additional equity of £140m (or £136.9m net of issue expenses). With the new shares placed at a c 33% premium to adjusted EPRA NTA per share, the issue is accretive to NTA but slightly dilutes EPS until fully deployed.

At 30 June 2020, PHP’s 510 assets were externally valued at £2.51bn with a contracted rent roll of £133.3m reflecting a net initial yield of 4.86%. The £5.6m (or 4.4%) increase in contracted rent roll during the period predominantly reflected the acquisition of a portfolio of 22 UK assets for £54m, adding £2.9m, as well as three forward funding developments acquired (one in Ireland and two in the UK) with a total development commitment of £29.3m, which added a further £1.2m. Rental growth and asset management projects added £0.9m.

The 17 assets in Ireland now account for more than 8% of the total by valuation, and enhance the overall portfolio average lot size of £4.9m, which reflects a focus on purpose-built, larger, multi-disciplinary medical centres.

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. Given the nature of the assets, vacancy is de minimis, and the weighted average unexpired lease term (WAULT) is 12.5 years, subject to upwards rent increases. Only £3.0m (2.3%) of annualised rent roll expires in the next three years. Of this, £2.6m is subject to a planned asset management initiative or terms have been agreed to renew the lease.

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.

PHP continues to have a strong pipeline of potential acquisitions both in the UK and Ireland totalling £92m, including £44m that is under offer, with an additional pipeline of asset management opportunities totalling £36m (see below). The key drivers of medium-term demand for investment in primary healthcare properties are demographic, including a growing population of elderly with increasingly complex medical needs, combined with the drive to shift healthcare delivery out of expensive and inflexible hospitals. The COVID-19 pandemic has increased the numbers of delayed and deferred hospital appointments, accelerating the migration out of hospitals, and increasing the demand for primary healthcare services despite the use by GPs of internet and telephone for initial consultations.

PHP is not a developer and does not engage in speculative development, but it does forward fund the development of new, pre-let healthcare facilities, acquiring the assets on completion. Three developments in Ireland (Athy in County Kildare, Bray, in County Wicklow and Rialto in Dublin) completed during H120, on time and with a net development cost of £43.8m (€48.3m). Including the three new commitments made during H120 (Arklow in County Wicklow, Ireland, Eastbourne and Epsom) there continue to be six developments on site with a net development cost of £41.5m (of which £30.9m remaining).

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 H120, 12 projects were either completed or continue on-site with an aggregate investment of requirement of £4.1m that will see £0.12m added to rental income and extend WAULT back to an average 21 years. A further 80 projects have either been agreed or are in advanced negotiations, requiring an investment of c £36m, generating an additional £1.1m of rental income and similarly extending WAULT on those premises back to an average 21 years.

Low rates of inflation (in contrast to land and building cost inflation) and low open market rent review increases in recent years have resulted in low overall levels of rent growth. However, the trend of the past three years has moved positively upwards, with an average uplift on review of 2.2% achieved by PHP in H120 (FY19: 1.9% and FY18: 1.4%). While the current economic weakness is being reflected in lower rates of inflation, 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 rent reviews for existing assets. As the NHS reforms have bedded down and plans take shape, development activity has begun to pick up and the rents required to encourage the flow of much-needed private investment that will support modernisation of the primary healthcare estate should increasingly be reflected in market rent levels across the estate.

During H120, uplifts of 2.7% and 2.9% were achieved on RPI-based and fixed uplift reviews. For open market reviews (69% of the total), an average of 1.1% was achieved on 44 reviews including 20 where there was no uplift. In addition, a further 134 open market rent reviews were agreed in principle, which will add £0.8m to the contracted rent roll when concluded, representing an uplift of 1.4% pa.

Following the H120 results, other than to update for the recent share placing, we have made only minor changes to our FY20 and FY21 forecasts that were first published in our March 2020 outlook note, before the extent of the COVID-19 pandemic had become apparent.

The key underlying assumptions we make relate to asset growth and funding:

Our forecasts are shown in detail in Exhibit 10 at the back of this report and are summarised in Exhibit 5 below. As a result of the capital increase, we forecast slightly lower debt and borrowing costs in FY21 with a corresponding slight increase in adjusted EPRA earnings. However, because of the increased average number of shares in issue there is a slight reduction in adjusted EPRA EPS and dividend cover. We still expect dividends to be fully covered in FY20 and very substantially covered in FY21 and meanwhile our adjusted EPRA net tangible assets per share is slightly increased. Given its substantial capital resources, faster investment than we have assumed is possible and we would expect this to have a positive impact on EPS and dividend cover.

With a progressive dividend policy that sees recurring earnings more or less 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.

By the end of H120, the £100m (gross) proceeds of the September 2019 equity raise had been deployed and although £266.7m of headroom (undrawn debt facilities and cash) remained, to have deployed this in full would have taken the loan to value (LTV) to c 51%. With a continuing strong pipeline of investment opportunities, and against an uncertain economic and financial market background, PHP decided in July to raise an additional £140m (£136.9m net of issue expenses) of equity capital. On a pro-forma basis the H120 LTV was reduced from 45.8% to 40.3% and would fall further to 34.3% assuming conversion of the £150m nominal value of convertible bonds outstanding (conversion price 149.3p). On the pro-forma basis the funding headroom (cash plus undrawn debt) increased to £403.6m. Looking ahead, PHP has also lowered its target gearing range with the maximum targeted LTV reduced from 55% to 50%. We estimate that full deployment of the increased headroom would result in a c 49% LTV. 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 H120 interest cover ratio of 2.9 times.

The average cost of debt was unchanged during H120, with a significant reduction from 4.0% having been achieved in FY19 following completion of the MedicX merger. The marginal cost of debt funding is 2.2%.

There are no significant near-term debt maturities but a little more than £400m of revolving debt facilities will mature during FY21 and FY22, providing an opportunity to realise further funding cost efficiencies. PHP says that it is already engaged in positive discussions with lenders and that it hopes to be able to make positive announcements later in the year.

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.

Over the past five and a half years (from end-FY14 to end-H120) PHP generated an EPRA NAV total return of 73.8% or a compound 10.6% pa (dividends added back but not reinvested). Dividends paid have accounted for around half of the return, with capital returns contributing the balance including the impact of asset management, rental growth and yield tightening.

The targeted FY20 DPS of 5.90p (for which the first three quarterly payments have been made or declared) represents a prospective 3.8% dividend yield and we forecast dividends to be fully covered by adjusted EPRA earnings, with good potential for further growth.

Importantly, PHP’s income and dividend paying capacity is backed by a secure, upwards only rent profile, c 90% funded directly or indirectly by the NHS in the UK or HSE in Ireland. Given the nature of this income stream it is tempting to draw comparison with the generic yield on 10-year gilts at little less than 0.2%, and it is this secure and growing income profile that provides support for a continuing valuation premium to EPRA NAV (currently 1.5x)

In Exhibit 9 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 supported housing investors (Civitas and Triple Point).