Primary Health Properties — Sustaining dividend growth

Organic rental uplifts have reached the highest level in the past 10 years but have the potential to increase much further.

UK rent reviews are typically on a three-year revolving basis and effectively upward only, at the option of the landlord. Irish rents (c 8% of the total) are linked to Irish CPI and are reviewed every five years. The recent acceleration in uplifts has been led by inflation-linked reviews, accounting for 25% of rent roll. Although inflation shows signs of moderating, recent high levels are yet to fully feed through the UK three-year review cycle. From a medium-term perspective, the firmer tone in open market rent reviews, 69% of rent roll, is the key development. Open market reviews have shown very modest uplifts for many years, in stark contrast to land and building cost inflation. To justify the new development that is needed to support modernisation of the primary healthcare estate, this cost inflation needs to be reflected in rent levels, in turn creating benchmarks for the review of rents on existing assets.

Rent reviews added £2.2m to annualised contracted rent roll in H123 which, allowing for asset management schemes and FX movements on the Irish portfolio, increased 1.4% to £147.4m. Management expects rent reviews will add more than £4m in FY23 as a whole.

We forecast rent review settlements will continue to grow rent roll and generate additional passing rent in future years.

With inflation remaining stubbornly high and interest rates volatile, PHP made no new acquisitions or development commitments during H123. Although we expect it to maintain a highly selective approach to investment, PHP nonetheless identifies accretive opportunities in Ireland, UK developments and asset management schemes. The existing pipeline has a potential funding requirement of c £80m over a two-year period, although most immediately there is one Irish forward-funding scheme and a number of asset management projects in legals.

In the current environment, Ireland continues to be PHP’s preferred area of future investment activity. The dynamics of the healthcare system and market are very similar to those of the UK, while benefiting from a lower cost of capital and higher property yields. PHP’s existing assets are valued at £219m or c €255m (c 8% of the portfolio total) and the company has set a target of increasing this to c €500m or c 15% of the portfolio, for which the January 2023 acquisition of Axis will provide meaningful support.

PHP has one UK development on site currently and has, for now, paused an advanced pipeline of three projects with a total expected cost of £15.2m. In each case, negotiations with the NHS, integrated care boards and the district valuer continue with the aim of increasing rents to a level at which it is economically viable to proceed. The company is hopeful that previously agreed rents will be increased by around 20–30%.

Asset management projects such as physical extensions or refurbishments help to avoid obsolescence, including by improving energy efficiency, and are key to maintaining the longevity and security of income through long-term occupier retention, increased rental income and extended occupational lease terms, adding to both earnings and capital value. PHP estimates c £24m of asset management capex over the next one to two years.

Our forecasts include the asset management projects, about which there is the greatest visibility. Given the time to completion, additional forward-funding and/or development projects would have a modest impact on near-term earnings or leverage.

Alongside the acquisition of Axis, an Irish property management business, PHP signed a long-term agreement providing access to a pipeline of future primary care development projects in Ireland. While the acquisition was modestly valued1 and we expect it to be accretive to earnings, of greater significance is the support that Axis and the pipeline agreement provide for the further growth of PHP’s Irish business.

Axis provides a permanent local platform from which to manage PHP’s 20 existing Irish assets2, strengthens its position in the market and deepens its relationship with the HSE3. For the HSE, Axis provides fit-out, property and facilities management.

Adjusted earnings increased by £1.2m or 2.7% versus H122. This included £4.4m growth in net rental income and a £0.5m first contribution from January’s Axis acquisition, partly offset by a £3.1m increase in financing costs and an increase in administrative costs. Compared with H222, adjusted earnings increased by c £1.9m or 4.3%.

In addition to the £3.4m uplift from reviews settled in the period, net rental income included £0.8m from acquisitions, disposals and development completions, and benefited from a reduction in property costs.

The EPRA cost ratio was 10.1% (H122: 10.5%) and remains one of the lowest in the sector despite an increase in staff costs and costs assumed on the Axis acquisition.

Increased net financing expense primarily reflects increased average debt and the impact of higher interest rates on the small amount of floating rate debt.

H123 DPS of 3.35p (+6.9%) covered 1.02x by adjusted EPS of 3.4p. A third quarter dividend has been paid and the company is well on track to pay a fully covered 6.7p aggregate DPS for the year. We forecast further growth in DPS in FY24, again driven by rental growth, substantially fixed/hedged borrowing costs (97% at end-H123) and well controlled costs.

Portfolio valuations stabilised considerably compared with H222, and although the net initial yield (NIY) expanded to 4.90% from 4.82%, the negative c £45m impact was significantly offset by £33m benefit from rental growth. The net revaluation loss was £11.9m or c 0.9p per share and including a 0.5p reduction from the acquisition of Axis4, adjusted NAV per share was 111.1p compared with 112.6p at end-FY22. Including DPS paid, the NAV total return was 1.6%. Our forecasts assume no net revaluation movements, which implies a further c 25bp widening of the NIY by end-FY24.

PHP has a long average debt maturity (6.9 years at end-H123) and with the cost of 97% of drawn debt either fixed or hedged, it is very well protected from interest rate volatility. The end-H123 net loan to value ratio (LTV) of 45.6% (end-FY22: 45.1%) was in the middle of the company’s target range of 40–50%. The higher leverage than is customary for many quoted investors in mainstream commercial property sectors reflects the highly resilient nature of primary healthcare property cash flows. The average cost of drawn debt is 3.2% and at end-H123 net rental income covered interest costs 3.2x. PHP guides that every 50bp increase in the SONIA benchmark borrowing rate would increase this by just 2bp. LTV covenant headroom on the lending facilities was £1.2bn at end-H123, equivalent to a 42% reduction in portfolio values, a valuation that would imply a NIY of 8.6%.

Total debt facilities amount to c £1.6bn, of which c £1.3bn was drawn at end-H122. Allowing for cash and capital commitments, PHP has c £0.3bn of borrowing headroom. Its fixed cost debt is mostly long term and its floating rate debt is shorter term. The interest rate hedging matures at the end of 2024 and there are debt maturities amounting to c £670m in 2025, including a £150m unsecured convertible bond with a coupon of 2.88%. Of the unsecured debt maturities, PHP has options to extend c £350m, subject to lender approval.

While access to funding is not an issue for PHP, at current market interest rates, the average cost of borrowing will increase in 2025 although management is confident that rental growth in the intervening period will provide an offset.

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 the strong fundamental backing for healthcare property, in turn generating secure and more resilient income, and less pronounced yield shifts through the property cycle. PHP is well into its 27th year of unbroken dividend growth and is on track towards its targeted FY23 aggregate DPS of 6.7p, which we expect to again be fully covered by adjusted earnings.

Despite the dividend performance, the trailing yield of c 7% and trailing P/NAV of c 0.8x are approaching levels not seen since the global financial crisis (c 7.5% and c 0.6x, respectively). The scope for a re-rating as and when interest rates can be seen to approach a peak is clear.

In Exhibit 9 we show a comparison of PHP with close peer Assura and other companies invested in healthcare and supported social housing assets. While PHP (and its primary healthcare peer Assura) trade at a lower yield and higher P/NAV than the peer group average, the gap has narrowed considerably over the past 18 months. This is despite the exceptional security and visibility of income that PHP enjoys and the fact that its achieved rent growth compares increasingly favourably with those peers where indexed rent uplifts are typically capped at c 4%.