Primary Health Properties — Strong 2017 with good growth prospects

PHP is a UK real estate investment trust (REIT) and a leading long-term investor in modern, flexible, purpose-built, primary healthcare facilities located across the UK and, more recently, in the Republic of Ireland. The majority of these are leased to general practitioners (GPs), government health service organisations (the UK NHS or Irish HSE) and other associated healthcare providers, such as pharmacies and dentists. Investment is targeted at assets that can generate long-term rental income with scope for capital gains.

The company was founded by the current managing director, Harry Hyman, in 1995. It floated on the AIM market of the London Stock Exchange (LSE) in 1996, moved to the Main Market of the LSE two years later and converted to REIT status in 2007. PHP has a proven record of successfully investing in the sector. The portfolio has reached 306 properties valued at £1.4bn and PHP is now in its 22nd year of unbroken dividend growth since launch, targeting 5.4p for FY18. Dividend cover is high, averaging 98.7% over the past three years (98.6% in FY17 and fully covered, excluding investment adviser performance fees).

The primary healthcare property sector is a specialist sector alongside the broader mainstream commercial property subsectors (offices, retail, industrial). As well as having good growth prospects – driven by an ageing population with increasing healthcare needs – that are effectively immune to the economic cycle, the key factors that differentiate it from the broad commercial property sector are as follows:

PHP is externally managed, with the board (biographies on page 14) appointing Nexus Tradeco (Nexus) to provide property advisory and management services, including the services of the managing director and finance director, Harry Hyman and Richard Howell, as well as administrative and accounting services. Nexus receives a property advisory fee payable based on the gross net assets of PHP’s portfolio, calculated on a sliding scale, which with incremental asset growth lowers the average fee. In addition, Nexus receives a fixed annual fee for administrative and accounting services, and is entitled to a performance incentive fee (PIF) that gives Nexus 11.25% of the EPRA NAV total return (change in NAV plus dividends paid) above a hurdle rate of 8%, on a cumulative basis, with annual payments subject to caps.

2017 saw continuing growth in assets, earnings, NAV and dividends, generating a 16.4% EPRA NAV total return for the year. The prospects for further growth are good. PHP enters 2018 with a strong pipeline of investment opportunities, a reduced LTV and average cost of debt, and substantial undrawn borrowing facilities. We comment briefly on the results below:

PHP has a long-term strategy to grow its portfolio through asset management of the existing assets and selected acquisitions, at all times ensuring that the portfolio remains fit for purpose and suitable for satisfying evolving healthcare needs over time. Acquisitions include a mix of let standing properties as well as new developments, generally providing funding to the developer with an agreement to acquire the pre-let assets at completion. PHP itself is not a developer, but works with a range of experienced development partners, healthcare bodies and health professionals to source and procure newly built premises. Over the past 10 years, the portfolio value, including investment commitments, has increased from £354m to £1,362m, with the number of properties increasing from 112 to 306 and the average value per property from £3.2m to £4.5m (Exhibit 3). Over the same period, the annualised rent roll has increased from £19.6m to £72.3m.

With investor interest in the secure long-term income provided by primary healthcare assets remaining strong, prices have increased and valuation yields have tightened across the sector. Exhibit 4 tracks the NIY reflected in PHP’s portfolio, along with the 10-year UK gilt yield. Yields in the healthcare sector have historically shown much less volatility than has the general commercial property sector, but from a recent high of c 6.0% in 2009, PHP’s NIY, in common with the market and quoted peers, has steadily tightened to 4.91% as of December 2017.

In such an environment, it is necessary to remained disciplined in selecting investments. Management believes that it has achieved this and notes that, in its view, the market in general is not differentiating sufficiently on the quality of the assets and their ability to generate growing rents and attractive returns over the long term and not just in the immediate future. It is not easy for investors to assess the quality of the assets in the portfolio, but we would suggest that larger, more modern assets, and assets with the flexibility to adapt and change over time, are more likely to provide superior long-term rental growth.

Exhibit 5 shows a summary of the 10 assets acquired during the year. At the time of acquisition, eight of the assets were completed and let, and two were pre-let development assets for which PHP provided pre-acquisition funding. The asset in Carrigaline completed in August 2017 and opened to patients in September, while the Churchdown asset remains on-site and is due to complete in March 2018. The rent roll at completion added by these 10 assets was £3.7m (or c 5.1% of the acquisition price before costs), adding 5.4% to the total rent roll. The average lot size is large, at £7.2m, and well ahead of the portfolio average of £4.5m, although this is skewed somewhat by the Low Grange asset with an acquisition cost of £25.4m. That said, eight of the 10 have a lot size of more than £3m. Low Grange is a high-quality asset, serving four GP practices (12 doctors) in addition to NHS property services, a pharmacy, and optician. It benefits from a fixed 3% pa rental uplift and a WAULT of 17.3 years. In February 2018, PHP completed the acquisition of a third Irish asset: a large, modern 6,500sqm healthcare facility in County Cork, at a cost of €20m.

Exhibit 6 provides an analysis of the overall portfolio by lot size. 78.9% of the total portfolio has a lot size of £3m or more and there are just two assets (excluding £1.3m in land assets) that have a value of less than £1m.

Lease terms are long in the primary healthcare sector, typically 20-25 years at inception, providing considerable durability of income. PHP has an average unexpired term of 13.2 years across its portfolio, with less than 1% of rent roll coming from 12 properties where the remaining lease length is less than three years. In each case, the company is in advanced negotiation to renew the lease, in some cases as part of an asset management programme.

Asset management initiatives that enhance and extend the existing assets are a useful way to continue to meet the evolving needs of tenants, increase rents, extend/re-gear leases and increase the property valuation. In 2017, PHP committed to nine asset management projects, investing £4.4m and re-gearing leases back to 20 years. It has seven further projects approved by the NHS and a pipeline of 16 further projects that are being progressed.

UK rental agreements can only be instigated by the landlord and are effectively upwards-only, based on lease terms that may include fixed uplifts (c 7% of PHP rents), RPI-linked (c 19%) and open market (at the option of the landlord, c 74%). The majority of reviews (more than three-quarters) are on a three-year basis, with the balance on either one- or five-year cycles. In Ireland, the HSE leases are also of 20- to 25-year durations, with five-yearly reviews that are all set by reference to CPI, and rents may go down as well as up.

Low rates of RPI 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. Although the total weighted average rent increase on completed rent reviews in 2017 increased on 2016, it was still just 1.1% pa.

The weighted average increase on fixed uplift lease reviews completed in 2017 was 3.4% pa, while RPI-linked uplifts averaged 2.3% pa. Open market reviews saw an average 0.3% pa uplift but this included a number of instances where there was no increase at all; excluding these the increase was an average 1.3% pa. In addition, a further 10 open market reviews were agreed in principle, which will add another £0.1m to the contracted rent roll and represent an uplift of 1.4% per annum.

Open-market reviews aim to set the rent at current market level, defined as what would be paid by a free and willing tenant to a landlord in that area. As a result of the NHS rent reimbursement mechanism, the decision is that of the district surveyor, seeking to allow for a range of factors including the size, condition, amenity and location of the premises as well as terms of the lease itself. However, 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 has slowed decision-making of the commissioning of the development of new primary healthcare facilities. This dearth of new developments has restricted the opportunities for increased land and building costs to be adequately reflected in the rent reviews for existing assets and threatens to restrict the flow of much-needed private investment to support modernisation of the primary healthcare estate. There is a growing optimism that this is beginning to change, with developers reporting that they expect increased levels of activity.

We have previously written at length about the strong medium- to long-term growth outlook for investment in primary care health facilities in both the UK and Ireland, as governments and health authorities strive to meet the challenge of ageing populations with growing healthcare needs. In both, there is a general acceptance of the critical role of primary healthcare in meeting growing demands, but also of the advantages for healthcare services to be more integrated within the community as the NHS and HSE strive to improve levels of care and efficiency. To make this happen, the under-invested healthcare estate needs significant resources and requires modern, purpose-built, flexible premises of the type in which PHP invests. The direction of travel has been clear for some time now, but progress in getting needed developments underway has been painfully slow in the UK. Signs of acceleration are apparent, however, and PHP notes that every one of the developers with which it works expects to have more developments on site this year than next.

NHS plans for primary care provision were set out in broad terms in the NHS Five-Year Forward View (FYFV) in late 2014. In late 2016, sustainability and transformation plans (STPs), which include plans for the primary care premises that will be required to deliver care objectives, were published by all 44 STP areas in England. This was followed in March 2017 by publication of the independent report on NHS Property and Estates by Sir Robert Naylor. The report highlighted the importance of primary care premises and of the recently created NHS Property Board in supporting the visions of the FYFV and STPs, and in helping to create affordable and efficient estates, as well as the role of the private sector in delivering these objectives. The UK government’s spring and autumn budgets both announced additional funding for the NHS, to provide support for the 15 strongest STPs, increase funding for frontline NHS services and upgrade NHS buildings and facilities. An additional £6.3bn, including £3.5bn for capital investment, will be made available to the NHS by 2020-21.

Early this year, the government published a response to the Naylor Review that acknowledges the importance of land and property to the transformation of NHS health services and how the NHS will be able to supplement public capital with finance from the private sector, which has provided a source of valuable investment and innovation in primary and community care in the past.

PHP, like all of the main investors, continues to work closely with GPs, stakeholders and key influencers within the NHS, HSE and governments in both the UK and Ireland, to demonstrate the benefits of the third-party development model and its differences to private finance initiatives.

As primary healthcare property prices have increased in recent years, reducing the amount of income immediately available on new acquisitions, PHP has continued to work hard on the liability side of its balance sheet; reducing the average cost of borrowing while maintaining a broad range of funding options, and managing duration and interest rate risk.

The weighted average cost of debt fell by an additional 56bp to 4.09% in 2017, while the weighted average maturity of the debt facilities increased to 6.3 years from 5.1 years, above the four-year average of 5.9 years. The marginal cost of debt, reflecting the current cost of utilising the floating rate revolving debt facilities is c 2.3%. There were 10 secured debt facilities in place at end-2017, from a range of lenders, and two unsecured debt facilities, issues of convertible and retail bonds. Total available loan facilities amounted to £844m (2016: £749m), of which £724m had been drawn. After allowing for cash balances and committed investment, £101m of undrawn facilities remained available to the group to fund ongoing investment. 90% of the drawn debt is either fixed rate or hedged using interest rate swaps.

PHP continued to extend and diversify its sources of funding in 2017, including its first private placement (to a range of insurance companies) of £100m in 10-year senior secured notes at an attractive fixed coupon of 2.83%. The proceeds were partially used to refinance drawings on its £115m revolving ‘club facility’ with RBS and Santander, which was due to mature in August 2017. The club facility itself has been replaced with a bilateral loan for £50m from RBS, which was extended in November to £100m, while early in 2018 the initial four-year term was extended to five years. In December 2017, PHP agreed another long-term (11-year) secured loan facility with Aviva; the £75m loan at a fixed rate of 3.1% replaced a similar facility (at a fixed 4.0%) due to mature in late 2018, saving £0.7m pa in interest.

PHP also cancelled a relatively expensive 4.76% fixed-rate swap with a nominal value of £20m during the year, in return for a one-off payment of £6.2m. The swap would have become effective from H217 and cancellation resulted in an annualised interest saving of c £800k pa.

Continuing favourable borrowing conditions are maintaining a positive spread between marginal income on acquired assets less costs and marginal borrowing costs, although the gap has narrowed. In the UK, the 1.4% positive spread shown in Exhibit 11 compares with 1.86% at H117, since when the 10-year LIOBOR swap rate has increased. In Ireland (Exhibit 12), the spread remains much wider, but there too it has tightened, to 3.0% from 3.70% at H117, as a result of asset yield contraction (increasing competition for Irish assets) and an increase in the 10-year EURIBOR swap rate. The Irish spread remains particularly attractive and we expect Irish assets to represent a significant share of portfolio growth in the next couple of years. Our estimates assume 30% of all commitments. Over the medium term, we would anticipate that accelerating rental growth should mitigate the impacts of a turn in the interest rate cycle. Meanwhile, PHP has an opportunity to further reduce its average cost of borrowing over the next two years.

There are no debt maturities during 2018, but in 2019 the £75m retail bond issue and the outstanding convertible bonds will mature. The unsecured retail bonds pay a coupon of 5.375%, which appears high in current market conditions, providing an opportunity for refinancing at lower cost. The convertible bonds may be converted at 97.5p per share, below the EPRA NAV per share and well below the current share price, at any time up to May 2019. We now assume full conversion in our forecasts. The immediate effect is to slightly dilute EPS per share (c 3%) but the conversion of debt to equity will reduce LTV (c 5%) and provide an opportunity to re-gear the balance sheet, most likely utilising debt at lower cost. We have not assumed lower borrowing cost in our forecasts.

The 2017 results were closely in line with our expectations, apart from the gain on revaluation of investment properties. We include an allowance for the impact of rent increases in our forecast but not for changes in the valuation yield, which continued to tighten in H217. EPRA NAV per share was 4.2% above our forecast as a result.

Our forecasts for 2018 and (new) 2019 continue to be driven off the following key assumptions:

The majority of the administrative cost is accounted for by the investment adviser fees that are determined by a set, scaled schedule, with a marginal rate of 0.30% of gross portfolio value up to £1.5bn and 0.275% thereafter. The assumption of full conversion of the convertible bonds is slightly dilutive of EPS in 2018 and 2019, as we have made no change to the forecast rate of investment; the LTV falls by c 5 percentage points as a result. We look for further growth in DPS and for this to be broadly covered by EPRA earnings.

In an environment of continuing low interest rates and in a sector where income returns represent a substantial share of long-term total returns, the security and length of PHP’s lease portfolio are attractive to investors. Our forecast FY18 dividend of 5.40p represents a 4.7% dividend yield on the current share price, with growth potential, and is covered by forecast cash earnings off a secure, long-term income stream. With 90% of the rent roll funded directly or indirectly by the NHS in the UK or HSE in Ireland, it is tempting to draw comparison with the c 1.6% yield on 10-year gilts. This secure and growing dividend return on PHP shares provides support for the continuing premium to EPRA NAV.

Between the end of 2012 and the end of 2017, PHP generated an EPRA NAV total return of 64.8% or a compound 13.3% pa. Dividends paid have accounted for 50% of the return, with capital values benefiting from yield tightening and modest rental growth.

At some point, we are likely to enter a market environment in which valuation yields stop tightening, and may even increase again, although this is only likely in the context of a broad property market yield shift. This would have no impact on the rental income from existing assets and would have no material impact on funding costs. It would increase the cash yield available on acquisitions, but whether this would be a net benefit would depend on marginal funding costs at the time. However, with the prospects for rental growth improving, it seems likely that in such an environment, the balance of total return contribution would shift further in favour of income returns and away from capital returns. In our near-term estimates, by assuming capital value growth in line with 2.0% assumed rent growth over the next two years, our forecast EPRA NAV total returns are 9.7% and 9.1% respectively, with dividends contributing 5.1% and 5.0% respectively, or c 55%.

As a long-term investor (not developer) operating in a sector with long leases, predominantly government-backed, with minimal vacancy and (in the UK) upwards-only lease adjustments, supported by predominantly fixed-cost debt, we view PHP as relatively low operational risk. 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, general economic and monetary conditions, and operational performance.