Secure Income REIT — Update 19 September 2016

Secure Income REIT (Secure) is a specialist long-term income UK REIT. It listed in 2014 with an established portfolio with very long leases subject to annual fixed or RPI-linked uplifts. The portfolio had been previously managed and part-owned by Prestbury since 2007, within in a privately owned investment structure. Having optimised the balance sheet for its new listed REIT status during 2015, Secure broadened its ownership in March of this year by placing 61.4% of the existing shares. It has accompanied its predictably strong interim results with the announcement of an agreed acquisition and share placement, confirming the board’s view that there are opportunities to deliver growth through transactions that should increase shareholder total returns and at the same time diversify Secure’s exposure to various property subsectors, assets and tenant credits. We view the transaction as attractive and well timed, with the historical knowledge and experience of the investment adviser, Prestbury, playing a key role in sourcing and structuring this off-market transaction. Prestbury and the board will themselves add £5.4m to their investment in Secure, taking Prestbury’s holding to more than £104m (at the placing price). We provide a summary of the results and transaction below, and for investors less familiar with Secure we provide an in-depth look at the company in the pages that follow.

Secure has also agreed the acquisition of a portfolio of 55 Travelodge hotels, for £196.2m including property acquisition costs, conditional only on the placing of up to £140m of new ordinary shares at a price equivalent to the pro forma NAV per share of 298.6p. The balance of the consideration is to be financed by a new £60m seven-year, non-recourse secured debt facility for which the lender’s credit approval has been secured, with documentation at an advanced stage of negotiations. The assets to be acquired have a weighted average unexpired lease length of 27 years, are expected to immediately add £13.7m to rental income with future RPI uplifts, and are let to Travelodge Hotels, the UK’s second largest budget hotel brand, a substantial and growing privately owned business that has recently gone through a substantial investment programme. The transaction is expected to be immediately accretive with a 14% uplift to the distributions (from a yield of 3.9% on H116 EPRA NAV to 4.5% on the placing price), it will lower pro forma gearing (net LTV 56% versus 59.5%), and it will extend further the average unexpired lease length and diversify the tenant covenant profile.

Secure Income REIT (Secure) is a UK real estate investment trust (REIT) that specialises in investing for secure long-term income derived from real estate investments and offering inflation protection. In a tax-efficient REIT structure, it targets predictable cash flows from long leases and regular upward-only rent increases backed by high-quality tenants. Secure is externally managed by Prestbury Investments LLP (Prestbury).

UK commercial property lease lengths have reduced over a number of years and Secure is not unique in the UK REIT sector in seeking to meet investor demand for secure income streams and attractive returns, but, unlike some of the specialist REITs that similarly focus on long leases (eg primary healthcare properties or logistics properties), Secure adopts a sector-neutral position that management believes provides it with more flexibility to assess a wider range of long-term rental streams on the merits of the underlying real estate and tenant credit quality, and the ability to build a more diversified portfolio across a range of sectors over time.

Secure listed on the AIM market of the London Stock Exchange in June 2014 with an established portfolio of operating healthcare and leisure assets on very long leases, roughly two-thirds of which are subject to fixed annual rent increases, with the remainder indexed to upward-only, uncapped RPI increases. All of the properties are fully let by their nature, with the security that 100% of the rental income is guaranteed by financially strong, global, listed businesses (Ramsay Health Care, RHC; Merlin Entertainments, MERL; Orpea, ORP). We consider this portfolio to be highly attractive in current market conditions and the combination of upward-only rents, predictable administration costs and borrowing costs fixed at least until 2022 underwrite the almost inevitable likelihood of increasing shareholder distributions, even at zero RPI.

Since listing, Secure’s board has been clear in its belief that from the strong existing platform, there are opportunities to build a sizeable portfolio, further diversified by property subsector, assets and tenants, and capable of increasing total shareholder return. The agreed Travelodge hotel acquisition, subject only to the completion of the placing of up to £140m in new shares, is a significant first transaction, adding c 14% to investment property assets and more than 17% to rent roll, and meets all of Secure’s strategic and financial hurdles. We expect further acquisitions in the future, but their shape and timing are not easy to predict. We would identify pubs, healthcare, entertainment and student accommodation as specialist property sectors where there exists a reasonably deep pool of owner operators, with robust operating cash flows, but which may wish to liberate the capital employed for alternative growth projects but who welcome the security of long leases on key operating assets.

In this low interest rate environment, competition for secure longer-term income is understandably strong. Prestbury indicates that the restricted number of specialist UK REITs, combined with Secure’s sector-neutral approach, means that it commonly finds itself in competition for assets with institutions and, to a lesser extent, private investor-backed vehicles. Under these circumstances, Secure’s listed REIT status is likely to create a competitive advantage where the seller needs to manage capital gains tax liabilities on exit. Non-REIT purchasers may be unwilling or unable to take on inherent capital gains tax liabilities, whereas in most scenarios for Secure there would be no effective tax liability. As demonstrated by the Travelodge transaction, we also believe the knowledge and experience of Prestbury is an advantage in sourcing and structuring transactions, preferably less competitively, off-market.

Secure is advised on an exclusive basis by Prestbury, the majority of which is owned by Nick Leslau, Mike Brown, Sandy Gumm, Tim Evans and Ben Walford. The Prestbury team of property and finance professionals is very experienced in the UK real estate market, with a strong track record of successfully creating value for investors through previous cycles. Details of the Prestbury team’s investment track record can be found on page 36 of the presentation dated 8 September 2016 on the company website, www.SecureIncomeREIT.co.uk.

Prestbury is responsible for the day-to-day management of the portfolio and is a significant shareholder in Secure’s share capital, providing very strong alignment of the interests of the advisor and other shareholders. As noted above, Prestbury has pledged to invest an additional £5.3m in the proposed placing (and non-Prestbury board members an additional £0.1m), taking the post-transaction Prestbury holding in Secure to more than £104m (based on the placing price). Although the percentage ownership will decline from c 18% to c 15%, we are very encouraged by the additional investment and we also believe that this will continue to be among the largest management shareholdings in the quoted UK real estate sector.

Prior to listing Secure, Prestbury had an ownership interest in and managed the healthcare and leisure portfolios since their acquisition in 2007 through an investment fund established in 2006 with a 10-year life. Following the change in REIT rules in 2013, which eliminated the conversion charge and allowed closely held companies a three-year grace period within which to become widely held, a stock market listing as a REIT became the preferred “exit option” for investors in the fund. On listing, Secure issued a minimal (c 5%) of new equity, electing to materially extend the maturity profile of the group’s debt before widening the shareholder base. During 2015 the sale of Madame Tussauds in London for £332.4m (net initial yield [NIY] 4.5%) and New Hall Hospital in Salisbury for £49.8m (NIY: 5.3%) reduced gearing and a comprehensive debt refinancing extended the average debt maturity to more than eight years while reducing the average weighted cost of debt from 6.8% to 5.2%. Following the refinancing, with cash flows improved and distributions made possible, in March 2016, 110.7m existing shares (61.4% of the total) were made available in a co-ordinated placing. In addition to complying with the REIT rules, this created a broader shareholder base, better suited to support accretive expansion of the group, and improved liquidity in the shares.

As a REIT, Secure is required to distribute at least 90% of its qualifying profits, although as all of the leases are fully repairing and insuring, are not subject to voids, and have no capex requirement, a full dividend payout ratio is possible. Quarterly distributions began in August 2016 and the policy is to make distributions equal to the higher of this minimum REIT distribution or 1x adjusted EPRA EPS (as defined below) cover. The nature of the portfolio, with upward-only rental uplifts, a fixed cost of debt and predictable administrative expenses, should lead to annually increasing dividends, in line with geared earnings. At the same time, assuming an unchanged valuation yield, rental growth should translate into asset revaluation, excluded from the distributable earnings, reducing gearing/LTV over time.

A highly experienced board of seven, with extensive and relevant experience, is responsible for the overall leadership of the company. A majority of the board is independent of the investment adviser, with Prestbury represented by Mike Brown, Sandy Gumm and Nick Leslau. The Prestbury representatives receive no remuneration from Secure. Martin Moore, the independent non-executive chairman, is a chartered surveyor who served as CEO of M&G Real Estate (previously Prudential Property Investment Managers) for 16 years until 2012. He is an adviser to KKR and is also a non-executive director at Segro, F&C Commercial Property Trust and the M&G Asia Property Fund. The other independent non-executive directors are Leslie Ferrar, Jonathan Lane and Ian Marcus. Biographies for each of the directors are shown on page 19.

The majority of the group’s overheads are borne by the investment adviser and are compensated by way of advisory fees, as set out in an advisory agreement. The advisory agreement runs for eight years from admission in 2014, subject to certain conditions around staff and ownership continuity at Prestbury. The advisory fee is paid in cash and is calculated by reference to EPRA net assets on a sliding scale: 1.25% pa on the first £500m of net assets, plus 1% on net assets between £500m and £1bn, plus 0.75% on net assets above £1bn. There is also a performance fee, which is calculated as the lower of (a) 20% of annual shareholder returns over a 10% hurdle, reset each year to 10% over the previous year’s EPRA NAV, or (b) 20% of the excess shareholder returns over the high watermark (being the EPRA NAV as of the point of any previous performance fee being earned, plus 10%). Performance fees are payable in shares based on the year-end share price. One-third of these shares are locked in for 18 months, another third for 30 months and the rest for 42 months. Following the placing, NAV plus distributions of more than 311.6p per share would need to be exceeded at 31 December 2016 before generating an incentive fee for 2016, which is above our estimates. The independent non-executive directors will review the performance fee arrangements in the middle of 2017 to ensure that it remains an appropriate basis on which to incentivise the investment manager.

Secure operates in specialist areas of the UK commercial real estate market. The broader UK commercial real estate market has recovered strongly from the post-global financial crisis low in March 2009, of course with regional and sectoral differences. With economic recovery and steadily growing employment, occupier demand has increased, leading to lower vacancy, rental growth and fewer leasing incentives. Meanwhile, investor demand, most obviously in search of income in a low interest rate environment, had reached a new record level in 2015, driving prices higher and yields lower, in some areas of the market like prime central London, to record lows.

The unexpected EU referendum result came as quite a shock to investors, who feared that in its aftermath:

Subsequent readings on the economy have so far proved more encouraging than some had first feared, while the further cut in interest rates supports the investment proposition, reinforced for overseas investors by the weakness in sterling. It is too early to call the eventual Brexit impact on the broad commercial property market; the jury is still out.

The quoted specialist investors such as Secure or Primary Health Properties (a specialist investor in primary health facilities) have recently been clear beneficiaries of the volatility and uncertainty that has impacted the broader quoted real estate sector, and indeed some unquoted funds. Secure indicates in its interim statement that it has seen no evidence of a weakening in prices in its specialist sectors of the market. Some commentators expect the demand for secure long-term income to continue to drive growth in the investment share of the specialist sectors in the overall market, as has been the case in the US.

In any case, the post-Brexit experience to date underlines the historical volatility of commercial property returns and in that context it is significant that income represents c 78% of total property returns over the long term and has been very much more stable than capital values, which have displayed a high level of volatility.

Nevertheless, there is evidence that in broad terms, commercial property rents in the UK market have struggled to match inflation. This is particularly true of industrial and office rents, but even retail rents have generally fared better over longer term; the more recent trend has been negative.

A possible contributor to this lack of “pricing power” is the long-term trend to shorter lease lengths, making it harder for landlords to lock in income levels across business cycles but increasing their need to compete for lease renewals.

Secure’s investment proposition is thus built around the following pillars:

Exhibits 6 and 7 below show the split of passing rent according to the rent review terms, both for the existing portfolio as at 30 June 2016, and pro forma, assuming completion of the acquisition. Assuming RPI of 3%, the weighted average annual rental increase on the pro forma portfolio is 2.88%.

Secure’s existing portfolio (prior to acquiring the Travelodge assets) consists of 26 healthcare and leisure assets that were externally valued at 30 June 2016 at c £1.38bn. The healthcare assets comprise 20 freehold private hospitals; a portfolio of 19 located throughout England let to a subsidiary of Ramsay Health Care, a listed Australian healthcare company, and a single property located in central London and let to Groupe Sinoue, a French company specialising in mental health. The six leisure assets, four in the UK and two in Germany, comprise four well known visitor attractions and two hotels. The UK assets are the Alton Towers theme park and adjacent hotel, the Thorpe Park theme park and Warwick Castle. The German assets are Heide Park theme park (the largest in Northern Germany) and an adjacent hotel. The leisure assets are all let to operating subsidiaries of Merlin Entertainments. In each case the lease obligations are guaranteed by the parent companies of the operators, all profitable, global, listed businesses. Subject to completion, the agreed acquisition of the 55 Travelodge hotel assets will increase the existing contracted rental income (as at 30 June 2016) from £78.5m to a pro forma £92.4m at a pro forma portfolio value of £1.57bn. Completion of the hotel asset acquisition is expected before year-end and following a successful completion of the equity placing. We have included the assets from 1 October 2016 in our modelling.

The weighted average lease length of the Travelodge hotel assets is 27 years, taking the enlarged portfolio to 23.6 years (existing: 23.1 years) as at 30 June 2016. The hotel assets are expected to produce £13.7m of rental income annually, with upwards only RPI-linked rent reviews on a five-year rolling basis, and at a purchase price of £196.2m including acquisition costs this is a running yield of 7.0% (a net initial yield of c 6.5% compared with existing assets 5.3% at 30 June 2016). As detailed in the valuation section, the transaction promises to be immediately earnings enhancing, and in the exhibits above we show it also enhances the tenant and asset diversification of the portfolio.

In the sections that follow we discuss the components of the portfolio in more detail and also examine the quality of each tenant covenant.

The portfolio comprises 55 hotels across England and Scotland with 3,096 rooms with a weighted average unexpired lease term of 27 years, with no lease under 22 years and no break clauses. The passing rent at acquisition is expected to be £13.7m, representing a 7% yield on the £196.2m acquisition price, including costs. 68.6% of the leases by value are on freehold or 999-year leasehold properties. 7% of the portfolio by value has head leases of between 40 and 80 years duration, however we understand that this is reflected in the apportioned price on purchase with a net initial yield of c 10% for these properties. The portfolio’s staggered five-yearly rent reviews are upwards-only and RPI-linked. As a result of the timing of reviews it is expected that the portfolio will yield 7.3% on the purchase value by October 2017.

The tenant is Travelodge Hotels, the UK’s second largest budget hotelier (behind Premier Inn, owned by Whitbread), with a well-recognised brand and c 18 million customers. This is a substantial, privately owned business that has received significant investment and operates in a relatively defensive market.

The UK hotel market has grown revenues per available room (RevPAR) at a compound annual rate of 2.7% over the past decade (including the 2007-09 recession period) and international comparisons suggest room for the value branded sector, in which Travelodge operates, to grow further; in the UK the value branded sector of the hotel market accounts for 19% of all UK hotel supply, lower than France (24%) and the US (33%).

Travelodge was the first value brand to launch in the UK more than 30 years ago, but after the financial crisis the business struggled with a heavy burden of debt taken on as part of earlier expansion. It was acquired by the current owners, a consortium consisting of Goldman Sachs, GoldenTree Asset Management and Avenue Capital Group, in 2012. Travelodge management also owns a 10.4% stake. Since then, it has seen strong growth and has undertaken considerable investment. 2015 revenues of £560m were up from £497m in 2014 and EBITDA increased to £105m from £66m. 2015 also saw the completion of a £100m modernisation programme, which included the refurbishment of 35,000 out of 39,000 rooms, and importantly, all of the hotels in the portfolio to be acquired. Substantial investments were also made in yield management systems, online platforms, and marketing. The group recently refinanced its existing debt by issuing £390m of seven-year bonds and was given a credit rating of B3 by Moody’s and B- by S&P. Travelodge RevPAR has grown by 11.7% pa, like-for-like, since the change of ownership in 2012 and continues to grow, as shown in Exhibit 15. Over the same period, growth in the overall UK hotel market was 4.2%

The 19 private hospital portfolio was valued at £809.6m at 30 June 2016 with a passing rent of £45.6m. It is let to Ramsay Health Care UK, a subsidiary of Ramsay Health Care, an Australian company listed on the ASX with a market capitalisation of c A$15.8bn (c £9bn). Ramsay Health Care is guarantor to the leases. It is a very substantial business with growing earnings and a growing stock-market capitalisation. It is one of the top five hospital operators globally. The UK assets leased from Secure are a significant part of its UK business, which is a core part of the group.

The UK hospitals leased from Secure represent 61% of Ramsay UK’s 31 UK hospital locations. The UK is the Ramsay group’s third-largest geographical segment after Australia and France, generating A$782m in revenue and $75.6m in EBIT (c £420m and £40.5m respectively) in 2015, from total group revenues and EBIT in 2015 of A$7.4bn and A$804m (£3.94bn and £430m). The UK leases are fully repairing and insuring with a current term to expiry of 21 years with no breaks. Rents increase by a fixed 2.75% pa in May of each year although in 2017 for the first time (and at 5 year intervals thereafter) Secure has the option for an open market rent catch up. It is too early to determine whether it would be advantageous for Secure to trigger this option.

The hospitals are well spread across the country where Ramsay UK treats self-insured patients and an increasing number referred by the NHS; admissions of the latter showing double-digit growth in 2015. Underpinned by demographic trends of an increasing and ageing population living longer with medical conditions requiring treatment, conditions appear favourable to continued growth. With the NHS underpinning a growing share of its UK revenue and insurance companies paying most of the rest, its income sources are also reliable. Ramsay has performed well both in terms of revenue and EBIT, with 18% and 18.7% CAGR since 2007 respectively.

The other healthcare asset is Central London’s only private a psychiatric hospital on Lisson Grove in Marylebone, let to Groupe Sinoue, which is 45% owned by Orpea SA, a French healthcare company listed in Paris. Its value at 30 June 2016 was £40m with a passing rent of £1.9m. Rents increase by a fixed 3.0% pa in May of each year. Orpea SA is guarantor for the lease.

Orpea is a major European healthcare provider specialising in nursing homes, post-acute and psychiatric care. It is listed on Euronext with a €4.8bn market capitalisation. Its financial performance has been strong, with revenue and EBIT growing at compound annual rates of 20.3% and 20.5% respectively since 2007, and over 23% each since 2002.

The leisure portfolio was valued at £528.1m at 30 June 2016 with a passing rent of £31.2m. The assets are all let directly to Merlin Entertainments or guaranteed by Merlin. Merlin, the world’s second largest visitor attractions company, is a constituent of the FTSE100 with a market capitalisation of c £4.8bn.

The UK assets (Alton Towers Park and Hotel, Thorpe Park, and Warwick Castle), with a passing rent of £25.4m, are subject to upwards only uncapped RPI-linked rent reviews every June. The lease runs for 35 years from 5 July 2007 with the option for Merlin to renew for two further terms of 35 years at expiry. The German assets (Heide Park attractions and hotel), are let to Heide Park Soltau and Tussauds Heide-Metropole respectively and are guaranteed by Merlin, with a passing rent of £5.5m. The leases run until 2042 with options to extend for two further terms of the same length. The rent on the German assets is subject to a fixed annual uplift of 3.34.

The UK assets are among the country’s best-known tourist attractions, Alton Towers and Thorpe Park are the second and third most-visited theme parks in the UK with combined admissions of 3.775m people in 2015; Heide Park had 1.525m visitors (source: The Themed Entertainment Association). Worldwide, Merlin’s assets attracted 62.9m visitors in 2015 generating £1,278m in revenue, 2.3% above the 2014 figure of £1,249m.

Merlin runs 114 tourist attractions in 23 countries around the world including the Madame Tussauds, Legoland and Sea Life brands. It is the third-largest attraction operator by revenue in the world after Disney and Universal Studios and second by number of visitors. The top ten attraction operators have attracted over 420 million visits in 2015, 9.8% higher than 2014 and a number which has increased at a 5.1% CAGR since 2007. Merlin has a strong track record of growth and profitability and is highly diversified within its sector.

Given the annual fixed or RPI linked rent review profile, long leases and a lack of vacancy, costs that are substantially driven by a predictable and formulaic management fee structure, and debt costs that are fixed at least until October 2022, medium-term forecasting for Secure requires relatively little judgement. With few assumptions (future RPI, the valuation yield and non-advisory fee costs), dividend growth and total return can be reasonably forecast for several years. Prior to the acquisition of the hotel assets, the distribution formula described above indicated a cash dividend distribution potential equivalent to 3.9% of the H116 EPRA NAV per share or an annualised 11.75p. Following completion of the placing and acquisition, the same formula indicates headroom for the distribution to increase to an annualised 13.3p per share, with the first enhanced payment in Q117. By following the current market expectations for future RPI (c 3% pa) management illustrates the potential for 6.5% pa compound annual growth in dividends (2016-2022). Our own analysis supports this illustration. Further, by assuming an unchanged valuation yield, such that rent growth can be expected to translate into revaluation gains and NAV uplift, management has illustrated, again supported by our analysis, the potential for an annual compound EPRA NAV total return (the change in EPRA NAV plus dividends paid) of 10.9% pa, based on the base case assumptions discussions outlined below.

Our analysis similarly assumes that asset values follow rent increases with no structural shift in valuation yields; we assume that there is no change in the rate of exchange between sterling and the euro, although the impacts are modest; we assume no change in the rate of tax payable on the German business that remains subject to corporate taxation; and we have similarly relied on the consensus for future changes in RPI to drive the 42% of the pro forma rents that are RPI-linked. We have applied similar indexation to the small amount of non-management fee costs (corporate costs, other administration costs, c 15% of total costs) that are not formulaic investment advisory fees, and therefore potentially “variable”. The investment management fee structure is detailed on page 5, and this covers the majority of the group’s overheads. All overheads, including the fees, are subject to VAT, which Secure cannot fully recover currently due to the fact that VAT is not chargeable or recoverable on its healthcare assets. Disallowable VAT currently averages at c 60% but should reduce to c 50% following the Travelodge acquisition. Corporate costs include directors’ fees and other costs of being listed. Other administration expenses include items such as audit fees and tax compliance costs. The cost ratio (recurring administrative expenses/gross profit) was a sector competitive 13.2% in 2015 and 9.3% in H116.

Under an agreement entered into prior to listing, until 10 July of this year the cash required to satisfy the advisory fees was subsidised by pre-listing shareholders. During H116, Secure received a final cash contribution covering £2.8m of the £3.6m investment advisory fees.

There is a difference between EPRA earnings, which primarily adjust reported earnings for non-cash revaluation movements, and “adjusted EPRA earnings” which further adjusts for “rent smoothing” and other non-recurring costs. In H116 there was a £2.1m adjustment relating to the costs of the secondary placing, and a £1.4m adjustment for acquisition feasibility costs incurred in relation to Travelodge.

IFRS accounting requires that where future lease income, including uplifts, is known with certainty (as is the case with Secure’s fixed rent uplift leases), it must be reported on a straight line basis; the average periodic “known” rent over the whole lease term is reported as income in each period. To avoid overstating the value of the portfolio, the positive rent smoothing adjustment (the difference between actual cash rent received and the smoothed rent reported) is offset against any property revaluation gains, thus being taken back out of net income through the revaluation line. The balance sheet recognises it as a receivable asset, which grows during the first half of the lease term and shrinks back to zero by the end. Secure helpfully publishes details of future smoothing adjustments, although the German assets will generate modest changes in the schedule from one period to another according to the £/€ exchange rate. German rents represent c 7% of the pro forma group passing rent and c £2.1m of the expected FY16 smoothing adjustment of £12.6m. The key point is that the fully repairing and insuring nature of the lease structures, and no capex requirement means that cash flow and future dividend paying capacity effectively tracks adjusted EPRA earnings. Our forecasts assume a 100% pay-out of adjusted EPRA earnings in line with management’s guidance.

We have assumed completion of both the placing (to raise £140m gross) and the acquisition in our forecasts, published for the first time. We have also included the £60m new seven-year non-recourse debt facility that is at an advanced stage of negotiation, at an assumed fixed cost of 2.75% pa. This is below the average fixed cost of the existing debt facilities of 5.2%. Management has indicated that the earnings accretion from the transaction feeds through to a 14% uplift in the expected dividend which, under the policy described above, is equivalent to a similar increase in annualised adjusted EPRA EPS. Management expects the dividend yield on EPRA NAV to represent 4.5% of NAV post the transaction compared with 3.9% before, and this is supported by our analysis.

We have assumed RPI of 2% for FY16 and, in line with the current UK RPI interest rate swap curve (source: Thomson Reuters), we have assumed 2.8% in 2017 and 2.9% in 2018. Within the predictable earnings framework outlined above it remains interesting to flex our central assumptions for alternative changes in RPI, which we do so in the Valuation section that follows.

As noted above, Secure came to market in 2014 with relatively high gearing (net LTV of 69.7% at 31 December 2014), although we would not describe this as excessive given the secure nature of its income. When run as a private fund prior to listing there was no expectation of dividend payments, allowing higher gearing and faster amortisation of debt. The net LTV had declined to 59.5% by 30 June 2016 and will decline further, to a pro forma 56%, when the equity placing and acquisition of the hotel portfolio has completed. We have allowed for ongoing debt amortisation of £4m pa which sees the substantial cash position (£89.6m at 30 June 2016) decline modestly and net LTV hit c 50% in 2020.

Exhibit 22 below illustrates the potential growth in annual distributions to September 2022 according to a range of assumptions for RPI, and based on the general assumptions outlined above. As our model is based on annual forecasts, we have shown management data from its recent presentation so as to avoid confusion. We note that our own distribution and EPRA NAV estimates are very similar to management’s illustration, being based on similar assumptions. The current RPI swap curve indicates an average 3.1% pa RPI increase over the period (to October 2016, the date of the first debt maturity), generating a potential compound annual growth in distributions of 6.5% pa. Even at zero RPI increase, the 58% of rents that are subject to fixed annual uplifts, combined with operational and financial gearing, are capable of generating a potential 4.3% under this scenario. Higher RPI growth should generate higher income and distribution potential; if RPI were to be 1% pa higher over the period, the potential annual growth rate increases to 7.0% pa.

Working with the assumption of a constant valuation yield (a pro forma 5.4% on the enlarged portfolio at 30 June 2016) it is possible to similarly illustrate how rent growth may translate into asset and NAV growth, and therefore to illustrate the potential NAV total return.

Using the consensus RPI expectation detailed above, and leaving the valuation yield unchanged, suggests a potential IRR of c 11% pa on the growth of the current pro forma NAV to the potential September 2022 NAV with dividends added back. In simple terms, the compound annual growth rate from the current EPRA NAV of 298.6p to the illustrative 527.9p (including cumulative distributions) in September 2022 is 10% pa.

Combining possible outcomes for RPI with alternative valuation yield assumptions (both higher or lower), provides the range of potential IRRs shown in Exhibit 24.

At a 297.5p share price, Secure is prospectively yielding c 4.8% (Edison FY17e DPS of 14.3p) and is trading just below pro forma EPRA NAV per share. These ratios position the group around the peer group median on both measures. Closer comparators, other specialist REITs whose portfolios have similarly long leases, are all on noticeably higher P/NAV ratios (Exhibit 25). For example, the three primary healthcare REITs/investment companies (Assura, Primary Health Properties, MedicX Fund) are all in the top five ranked by P/NAV, reflecting the long, secure income streams from their portfolios, largely underpinned by the NHS (either directly as tenant or indirectly through rent reimbursement to the GP tenants). Secure has the longest WAULT in the group with strong visibility of medium-term rental income growth. Open market rent increases for primary healthcare assets are currently quite modest, but should increase as NHS investment leads to more development projects upon which to base rent reviews. Secure’s rents are less directly underpinned by government than is the case for many primary care assets (although a significant share of Ramsay UK’s revenues are generated from the provision of treatment to NHS patients), but as we discuss above, we believe the quality of the tenant covenants are very strong and quite sufficient to support an increased valuation.

Any prospective P/NAV revaluation would have the potential to additionally gear up the illustrative NAV total return potential discussed above. What we consider to be the closest peers to Secure (the healthcare REITs/investment companies and Tritax Big Box, shown in grey in the charts) trade at an average c P/B of 1.2x, at the same rating Secure’s share price total return over the period to 2022 could increase from the base case to c 14% pa.

The agreed £196.2m acquisition of the Travelodge hotel assets is subject to the placing of up to 46.9m new shares to raise gross proceeds of up to £140m (137.5m net of issuance cost) by way of part-funding. The new shares represent 26.0% of the current issued share capital and are being offered at 298.6p, equivalent to the pro forma EPRA NAV per share (and compared with the 30 June 2016 reported EPRA NAV per share of 300.2p.

Prestbury will invest c £5.3m in the placing resulting in a post-acquisition shareholding of more than £104m at the placing price. Non-Prestbury members of the board will also invest c £0.1m. This further commitment to the company will maintain Prestbury’s position as one of the largest management shareholdings within the UK quoted real estate sector. The expected timetable of the main events is as follows:

If for some reason the transaction to acquire the hotel portfolio should not proceed, the vendor is due a payment of £3.0m while management suggests that additional costs of c £1.0m would likely be incurred.

Secure is insulated to some extent against short-term movements in the wider property market by the length and structure of its leases, the financial strength of it tenants and guarantors of the leases and the sectors it operates in, healthcare in particular. As noted above, movements in RPI affect the level of rental income on 42% of the rents of the enlarged portfolio and therefore potential distributions. In the current low inflation environment, the 58% of rents that are subject to annual fixed uplifts are a distinct advantage. The annual RPI linked uplifts are uncapped, providing protection should inflation accelerate noticeably, while in the case of the Ramsay assets (£45.6m of the total £53.1m of passing rents with fixed uplifts) the leases contain the periodic landlord option to elect for a market rental value. Other risks include: