SIF Folio: Can Target Healthcare REIT provide a safe 6% yield?

UK markets delivered a bumpy ride last week. While the FTSE 100 has been propped up by exceptional gains for Big Oil and a few other heavyweights, the FTSE 250 is down by 20% so far this year:

While I want to protect the SIF folio’s capital in this uncertain period, I’m conscious that the portfolio is 39% in cash.

Being out of the market carries both an opportunity and an opportunity cost. I’m not sure that having this much cash in the portfolio is the right balance between the two:

Fortunately, a new opportunity has arisen which I think has the potential to provide SIF with a stable capital value and a useful 6% income. The company in question is FTSE 250 member Target Healthcare Reit (LON:THRL) which owns 99 care home properties around the UK.

Target Healthcare has been drawn from the relaxed version of my stock-buying screen. I’m now able to use this to look for new buys, as I haven’t added a stock to SIF for over four weeks.

The only differences between the relaxed screen and my standard screen are that the valuation and growth criteria are relaxed slightly, in order to widen the choice of stocks on offer.

Target Healthcare Reit (LON:THRL)

Target Healthcare REIT floated on the London market in 2013. It was promoted to the FTSE 250 in the latest quarterly reshuffle. This REIT has outperformed the FTSE 250 so far this year, aiding its promotion:

Portfolio: Target Healthcare has a portfolio of 99 care home properties that are rented to 33 tenants. They are described as modern, with 96% having en-suite wet rooms. According to management, this contrasts with a UK national average of 29%.

Long leases are another attraction. The portfolio had a weighted average unexpired lease term (WAULT) of 27.3 years at the end of March.

Such long leases are typical of healthcare properties and should provide excellent visibility on cash flow. However, there is some tenant solvency risk. The recent quarterly update mentions re-tenanting homes operated by two tenants “whose resilience has been stretched” during the pandemic.

Rental collection for the quarter to 31 March was 92% on 5 May, while the previous half-year results cited rental collection of 96% 2.5 months after the quarter end. These figures seem acceptable but highlight some ongoing risk, in my view.

Valuation & returns: Target Healthcare’s portfolio was valued at £886.8m at the end of March, with an EPRA topped-up net initial yield of 5.8% (useful definition here). According to the trust’s most recent accounts, the portfolio has generated an annualised total return of 10.5% over the last five years.

For shareholders, the majority of this has come from Target Healthcare’s dividend yield, which has hovered around 6% throughout its time on the stock market.

According to this chart on the REIT’s website, these returns compare well to those delivered by most other asset types in recent years. However, I’d note that the seven-year period ended in 2020, so the timing may have favoured healthcare compared to some other asset classes:

Dividend income: as a REIT, Target Healthcare’s main focus is on generating shareholder returns through income. The stock pays a quarterly dividend.

Although Target Healthcare has a progressive dividend policy, shareholders probably shouldn’t expect too much growth. The annual payout started at 6p per share in 2014 and has now reached 6.76p. I make that an annualised growth rate of 1.7%.

Source: Target Healthcare REIT

A closer look: Stockopedia’s algorithms have a cautiously optimistic view on Target Healthcare, awarding it Neutral status and a StockRank of 73:

I think this stock has the potential to be a useful addition to the SIF folio. I’ll now take a closer look at the stock’s value, quality and momentum factors.

Value: fair

ValueRank: 47

At first glance, Target Healthcare’s valuation metrics do not seem encouraging:

However, I think much of this is due to the industry-specific accounting that applies to property businesses, and to REITs specifically. For example, reported (IFRS) earnings include unrealised property revaluation gains and losses.

I usually use book value and dividend yield to get an idea of a property stock’s valuation.

Here’s how these metrics look up for Target Healthcare:

• EPRA net asset value per share (31 March 22): 111.8p
• Share price (20/06/22): 113p
• Price/book value: 1.0
• Trailing 12-month dividend yield: 5.9%

How safe are these numbers?

Dividend cover: According to management, last year’s dividend was covered 1.05x by EPRA earnings. This industry-standard measure excludes revaluation and disposal gains.

This level of cover is expected to improve as the REIT deploys cash that was sitting on its balance sheet at the end of last year, following an equity raise.

Slim dividend cover is the norm for REITs, which are required to pay out 90% of their rental profits to shareholders each year. I’m reasonably comfortable with this situation.

Debt risk? Like most specialist REITs, Target Healthcare issues equity to help new property purchases. This dilution limits the potential for capital gains, as book value per share tends to stay flat:

However, equity issuance also limits debt use. From the StockReport, we can see that Target Healthcare’s net debt is low relative to its book value:

These numbers correlate reasonably well with the company’s last-reported loan-to-value ratio of 20%.

This level of leverage seems comfortable enough to me. At the end of March, this debt had an interest rate of 3.2% and a weighted average time to maturity of 7.2 years, reducing any near-term refinancing risk.

My view: Like many UK-listed REITs, Target Healthcare has not previously had to operate in a rising interest rate environment.

A portion of Target Healthcare’s debt has a variable interest rate, so interest costs are rising. This could put pressure on the dividend. However, 96% of the trust’s leases are said to have inflation-linked rent reviews, so I’d hope this would help to offset higher interest costs.

More generally, rising interest rates could also put pressure on property valuations, as investors demand higher yields. While this might not affect dividends, it could lead to REIT stocks trading at a discount to NAV (i.e. below current levels).

Notwithstanding these risks, I’d be comfortable buying Target Healthcare at book value with a near-6% yield.

Quality: steady returns

QualityRank: 74

Target Healthcare’s high QualityRank suggests this could be a decent business.

Although operating margin is not really a meaningful metric with REITs, due to their minimal operating costs, I am broadly reassured by the stock’s history of stable returns:

I’m also happy with Target Healthcare’s fundamental health score, which highlights profitability, cash generation and modest leverage:

My view: On balance, I’m comfortable with the quality of this business.

Momentum: positive

MomentumRank: 74

Economic headwinds do not yet seem to have dampened Target Healthcare’s momentum, which remains positive.

Price momentum: The stock boasts a surprisingly strong set of technical indicators. My guess is that investors are happy with the yield on offer here and have been moving out of riskier assets into REITs such as Target Healthcare:

Earnings estimates: City analysts also appear to have remained positive on this stock. While earnings estimates for the year ending 30 June dipped during the latter part of 2021, the outlook for 2022/23 has remained stable:

These estimates reflect management guidance that properties recently added to the REIT’s portfolio will add an extra £9.3m of annualised rental income to the portfolio, supporting higher earnings next year.

This is also expected to lead to improved dividend cover:

My view: Target Healthcare appears to have positive momentum. Spending on care home services is generally non-discretionary and often backed by insurance policies or public sector funding.

The main risk I can see is that the level of financial distress among Target Healthcare’s tenants (care home operators) could rise due to the impact of wage and cost inflation.

My decision

I’m comfortable with the valuation of Target Healthcare and the apparent outlook for the stock. In my view the downside risks are fairly limited and this REIT provides me with the opportunity to generate some useful income for SIF.

I’m going to add Target Healthcare Reit (LON:THRL) shares to SIF and my personal holdings this week, after this article has been published.