Investors Chronicle - Patient property profits
Patient property profits
Far from the London world of luxury flats and phallic skyscrapers, doctors' surgeries occupy a sleepy corner of the British property market. Typically let on long leases to GPs, who are reimbursed by the NHS, their chief appeal for investors is that nothing much can happen. There are no development super-profits - yet at least the rent will always be paid.
But there is nothing sleepy about the three listed companies that specialise in the sector. The past month has been particularly hyperactive. On 17 May MedicX Fund (MXF) made an audacious unsolicited bid proposal for Assura Group (AGR), which fell through when it failed to receive the backing of Assura’s management. MedicX then announced the acquisition of 14 medical centres. Finally, the largest player, Primary Health Properties (PHP), last week raised £68.5m of equity.
The sector’s very sleepiness explains all this activity. In an investment environment bristling with risks, investors have seized on primary-care property as a high-yielding safe haven, bidding PHP and MedicX up to premia over their book values (as we will explain, Assura is viewed differently). For companies that have every incentive to grow - scale boosts stock-market liquidity and spreads management fees across a larger base - this has been an open invitation to issue more equity, take on more debt, and buy more property.
Care of the NHS
The safe-haven status of GP surgeries is founded on the long, government-backed leases that underpin the rents. But it also reflects the uniquely monopolistic nature of the underlying tenant, the NHS. Because there is no competition between rival medical practices, there is no speculative development and thus no risk of oversupply in a period of easy credit. At the same time, demand does not depend on the volatile process of corporate expansion and contraction. Rents are therefore not conventionally cyclical.
One might think that the NHS monopoly would be in a strong position to suppress the rents it pays to private landlords. But this is not the case. The health service is trying to shift care provision from hospitals to beefed-up GP practices, which are much cheaper and can deal with most routine ailments. Assura estimates that more than £10bn of investment is required to turn all existing surgeries into modern medical practices. The NHS depends on PHP, MedicX and Assura to fund the necessary development, and is therefore obliged to offer rents that justify the capital outlay. Market rents have tended to track development costs as a result.
This has earned the companies a reputation as inflation hedges. If commodity prices suddenly pick up, it should be mirrored in construction costs and therefore rents. Some leases are even explicitly linked to the retail-price index. With portfolios revalued in line with rental growth and debt costs fixed, landlords’ equity should balloon in an inflationary environment.
This is the safe-haven story, which PHP and MedicX have very successfully marketed to private investors. But two significant cracks in the story have emerged. No one doubts the solidity of the existing income-generating portfolios, but - except in the case of lower-yielding Assura - the scope for dividend growth now looks limited.
| Market value | Share price | Rental EPS | EPS growth | Div yield | Div cover | PE ratio | AdjustedNAV | Adj NAV growth | Premium or discount | Loan to value | |
|---|---|---|---|---|---|---|---|---|---|---|---|
| Primary Health Properties | 302 | 313 | 10.2 | -30% | 5.9% | 55% | 31 | 305 | -4% | 2% | 61% |
| MedicX Fund | 206 | 79 | 2.6 | 8% | 7.2% | 46% | 30 | 63 | -4% | 25% | 57% |
| Assura Group | 186 | 36 | 1.9 | 27% | 3.3% | 164% | 19 | 39 | 6% | -8% | 62% |
Source: company accounts
| |||||||||||
Unhealthy dividends?
One problem is uncovered dividends. PHP started to pay out more than it earned in rental profits back in 2010. Because it has increased dividends in each year since, while earnings per share have progressively fallen, rental profits now cover just 55 per cent of the payout. MedicX has never paid covered dividends, having been set up in 2006 with a strategy of funding the payout partly out of capital gains. But it has fallen short even of this target, mainly as a result of share issuance. In the absence of rapid capital growth, paying uncovered dividends erodes the equity value of the companies. Book value per share has been falling at both PHP and MedicX.
Assura operates in the same sector, but a rocky history has paradoxically left it with a more conventional approach to managing its balance sheet. Having diversified away from property into medical services and pharmacies - running up big debts in the process - the company ran into endless problems during the financial crisis (the company's shares proved a highly successful Investors Chronicle sell tipin late 2010). Yet the sale of its non-property businesses, a complete clean-out of the previous board and management team and a rights issue to pay off a £69m interest-rate swap have restored order in the past 18 months. Chief executive Graham Roberts took advantage of the general chaos to rebase dividends at a very cautious level - too cautious, perhaps, but at least there is now scope for growth in both the payout and the company’s equity value.
The second problem, which all three companies face, is a slowdown in rents. The coalition government’s plan to reorganise the NHS plays to the sector's advantage by biasing the system to general practitioners - thus making the poor quality of many old surgeries more problematic. But the upheaval caused in the NHS bureaucracy has also caused a hiatus in approvals for development. Since open-market rents are driven by the development process, this has allowed the old link between rental growth and inflation to break down. Rents are now growing at 1-2 per cent a year, judging by Assura’s annual results - down from the 3-4 per cent once considered normal.
IC VIEW:
Nobody knows how long it will take for the NHS’s new commissioning bodies to get back to business. Yet the reorganisation officially came into effect on 1 April, leaving scope for a recovery in rents as pent-up demand for new developments is gradually released. Certainly, the long-term prospects of the market look sound. The profit stream on offer will not propel anyone to sudden riches, but offers more security than virtually any other on the stock exchange. Sleepy investments ensure a good night’s sleep.
FAVOURITES:
Assura is arguably the most attractive company of the three - and its shares are certainly the most reasonably priced, on 19 times earnings. Unlike PHP and MedicX, it carries out its own developments. Since these are all entirely pre-let, this boosts profits without adding much risk. Moreover, Assura is not hamstrung by historical dividend commitments, so can afford to take the current market slowdown in its stride. Finally, the company is run by an internal team, which aligns the incentives of managers and shareholders more closely than the external-management model used by PHP and MedicX. Assura does retain some legacy assets from its days of over-expansion - but they are fast being flogged off and now account for less than 4 per cent of the portfolio.
OUTSIDERS:
The profile of PHP's earnings per share has been discouraging in recent years, falling from 18.4p in 2009 to 10.2p in 2012. This has been mainly the result of equity issuance. Assura develops on its own book, while MedicX sources developments directly from its management company. But PHP has no connection with a developer, leaving it to acquire assets on the open market. Even though chief executive Harry Hyman always boasts a large pipeline of targets, the delay between issuing new shares and buying the properties seems to create a cash drag on earnings, which has led to the gradual erosion of the company’s dividend cover. Last year the company’s earnings also fell in absolute terms, from £9.7m to £7.4m, as cheap pre-crisis debt was replaced with more expensive facilities, raising debt costs. The company’s shares have sunk back towards book value since the annual results in February, but remain expensive on 31 times last year’s recurring earnings per share. With a running yield of 5.5 per cent, the retail bonds have fallen below par and look better value.
BROKER VIEW:
The three quoted investors in UK primary care property, Assura,MedicX Fund and Primary Health Properties take similar investment approaches. Their rent is paid by GPs, reimbursed by the NHS and leased genuinely long term at 20-25 years. Unless our health improves dramatically, these will probably be extended as they approach expiry.
The core strategy is to leverage these secure revenues to ratchet up EPS and dividend growth, benefiting from economies of scale as portfolios grow and from underlying growth through rent reviews. Unlike other segments of the UK commercial property market, it is reasonable to expect some rental growth from leases subject to a mix of open market reviews, inflation adjustment and fixed annual increases.
All three groups are works in progress despite a combined portfolio value of over £1.5bn. Each targets a £1bn plus portfolio by acquiring completed properties and portfolios and funding developments. That makes a ready and predictable supply of new assets a key sensitivity. Assura has an in-house development arm and MedicX access to a project pipeline within a larger unquoted group.
Prospective dividend yields look attractive considering the revenue visibility. Currently, however, only Assura’s dividend is fully covered by cash earnings. We nonetheless expect MedicX and Primary Health to continue to increase distributions as they improve cover.
Plans to address the deficit pivot on portfolio growth. There appears to be no shortage of demand for new modern facilities; many GPs struggle to deliver satisfactory services from substandard surgeries. The completion of the latest NHS reforms should see approvals for new centres pick up over the next 18 months. The extent to which this will feed into earnings and dividend cover depends on the maintenance of a positive gap between rental yields at about 5.7 per cent and costs - notably that of new debt, currently available at 4.0-4.5 per cent.
Roger Leboff is an analyst for Edison Investment Research
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