Interview with Kenneth MacKenzie from Target Fund Managers

Hi, yeah, very well, thanks. And you?

Perfect, looking forward to doing that with you.

So, investing in care homes. What we do is buy brand new care homes, and we've been doing this as a fund manager for over 15 years. This particular fund, the listed fund Target Healthcare REIT, was founded in 2013, so we've been at this now for just over about 10 or 11 years. At the end of March, we had 98 care homes, about six and a half thousand beds, 60 million contracted rent. We're highly diversified in the source of that rent; the largest tenant only has 16 or 17% of the rent roll, and we have another 32 tenants giving ever smaller amounts than that. The rents are inflation-linked, so they go up linked to RPI year by year, with collars and caps typically at 2 and 4%. For a £250 million business, as I've said, 33 different sources of income. The portfolio value is around just under a billion, valued at a 6.2% yield effectively, and we're a very long-income fund, 26 years of income. When we started out, we planned to be a long, steady income fund with great total returns and also the mission of providing better physical quality for our seniors, because there's going to be a lot of seniors in the years to come, and that's one of the really positive tailwinds we have. You'll see that from this slide here: the number of over-85s doubles in the next 20 to 25 years, and on average, one in seven and a half of us, 13.4% of the over-85s, will require long-term residential care. So it's a really positive story in terms of our expectations for long-term demand for what we do, and we love to invest in the sector because of the kind of worthy nature of what it all is. Let's go on to the next slide.

And also within the sector, in terms of the quality of the real estate, it's important to speak about what kind of bedrooms are represented across the sector. When I started investing in the sector just over 15 years ago, about 9% of the bedrooms in the sector (and there are about 450,000 bedrooms in total) had wet rooms. When we launched Target Healthcare REIT, it had risen about 50% to 14% of the bedrooms having wet rooms. And last year, that number had gone up to 32%. So there's a very clear market shift to care homes where the bedrooms have wet rooms. In fact, you'll see that our portfolio, Target Healthcare REIT, is effectively 100% wet rooms. Why is that important? Well, the slightly indelicate answer is that if you're in a care home, about 70% of the residents are singly or doubly incontinent. There's actually a really good video on our fund manager's website and on the REIT website which is an animation video of the need for wet rooms. The issue is: do you want your toileting and cleaning up after toileting, if you're wearing a pad, done in the privacy of your own room, or do you want to be one of those poor folks who have to get that done in common bathrooms? You'll see that 68% of the beds in the sector are not compliant with best social practice, whereas this portfolio is in a remarkably better position. So that's part of the mission we're on: the mission of creating long-term income but also the mission of providing better quality places for our seniors. The portfolio also has a strong bias towards private pay, significantly ahead of the listed peer group in the UK. You'll see that 71% of the underlying residents in the care homes pay privately for their accommodation, and that is very different compared to our listed peers where it's down at 28%. Part of the mission for us there and the purpose for us is that regardless of which government is in place, we don't think there will be endless amounts of government money to fund this, so we have long felt that being in the private pay place was the long-term secure place for us to be. So we're miles ahead of the listed competition for that. Also, let's go on to the next slide.

A little bit of financial reporting for you. The net tangible asset per share rose in the first quarter of the year to 109p. Earnings per share rose just about 4%, and you'll see the dividend at the current share price is around 7%, just over 7% yield, and 110% cover for the quarter. So financially we're in a good place with certainty of rental income growth, rent collection robust greater than 98%, and I'll speak a little bit about the conservative balance sheet. We actually sold some more assets a week or two ago, so our net long-term debt is down to 22-23%, and it's got great waiting on it: £150 million of it is through to 32 and 36, and the balance of about £80 million is currently to November 25, with quite a number of banks keen and insurance companies keen to lend on to us. The final comment to make in relation to this slide: when I started the fund 10 or 11 years ago, we set out to create this long income for our shareholders, and I remember somebody saying to me in the early days, 'Of course, you really know if this works in about 10 years' time.' And a month or two ago, we discovered that in terms of the UK Healthcare Annual Property Index, the MSCI Index which has about 8.5 billion of assets in it, we were number one for the year and for the 10 years we are number two for total returns at a property level over the last 10 years. So we're thankful that the model has worked and what we do has worked in terms of providing longer stable returns. Let's go to the next slide.

We wanted to speak a little bit about the portfolio itself, because the portfolio is obviously what creates the rental stream. We've spoken already about wet rooms compared to listed peers; we're almost at 100% of our bedrooms having wet rooms. In terms of environmental EPC ratings, 99% of the portfolio is A and B rated. A number of people have said to us that they doubt there's another portfolio in the UK with such good EPC ratings. And you'll see in terms of the age of the buildings compared again to our listed peers, it is vastly younger compared to product pre-1990 and many conversions. Part of that for us is that the seniors need to be in safe places, the carers need really good places to provide the service to our seniors, and modern purpose-built is as well has been environmentally more friendly, it's also socially more advantageous for the residents and with great surroundings around all of that. Let's go to the next slide.

I spoke a bit about the MSCI Healthcare Index here. You are seeing the index for the last 10 years, and you'll see that the dark blue line has beaten the index for every year over these last 10 years. So we're humbled and thankful for that, and obviously keen that we would be able to continue that stable path on into the future. Speaking a bit more about the portfolio, it's been interesting. Care homes were very much in the press through the pandemic, and in fact what's quite interesting about the portfolio is that we're not yet back up to the occupancy level. When I speak of occupancy, I mean here the percentage of the number of beds in each care home. Our homes as real estate are 100% occupied, but in terms of the residents within the care homes, pre-pandemic we were up about the 90% level, currently we're around 86-87% level. So you might think that was a little concern. In fact, if you look on the other side of this page, you'll see where portfolio rent cover has got to, and we're at an all-time high rent cover for the portfolio, up at 1.9 times, which for a modern portfolio is pretty, really rather good. And that of course follows through to great rent collection and underlying tenants making good money, so they can look after people well and look after your buildings really well. Also, let's go on to the next slide.

Another observation to make in terms of the pandemic is that when we entered the pandemic, because we buy brand new homes, we were in the situation where only 70% of the portfolio was mature. Typically it takes up to three years for a care home to get to maturity. There's a reason why people call it dementia: the resident has some level of dementedness, and you cannot just fill the home straight away with people who need a lot of personal care and tender loving attention. However, as we get into the first quarter of 2024, we're around the 91-92% level of maturity, and that speaks well to the ongoing profitability of the homes and the maturity of the homes. You'll see that I made reference at the beginning to how rent reviews are completed on an annual basis. Roughly 25% of the homes get uplifts in their rent levels on a quarterly basis, and you'll see that these rents have been rising by around about 4% level quarter by quarter as each individual home goes through to have its rent review. That's not a big discussion that we have; that happens quarter by quarter, so it's a very easy process for us. We're thankful to see that.

So, what's the outlook for the care home sector? Well, we're actually really positive about it all. The demographics are hugely in our favor, and because we have a premium portfolio with excellent private pay fee proportions, the profitability of the homes is robust. The other thing to remember in relation to care homes and to our homes in particular is that it is what we call needs-based care. In other words, it's not an optional purchase; the resident needs to be found a safe place. As families go back to work post-pandemic, they need a safe place for their loved one, and there is further opportunity especially as the new government potentially addresses the NHS issues with delayed discharges, which will create further demand. Rent cover in our portfolio has increased even while inflation was increasing and now easing. Wage inflation and National Minimum wage have obviously been important, but rent cover has improved through that because of good increases in the private pay fees, and energy costs have been well managed. Staffing is really important: for every hundred pounds of income in a care home, typically 50 to 55% of that income is paid out to staff. With the visa schemes that are in place, staffing is now much easier in our care homes, and I think that's partly also because we just have really good places to work, so staff would tend to choose a modern purpose-built home more than an old-fashioned one. There's a better understanding of the career of caring post-pandemic, so much more stable employment. In terms of the real estate itself, it's been great for us who are on a mission to improve the quality of care for our seniors. It's been great to see the quality improving with wet rooms now up to about a third compared to 10 or 15% when we started. Older homes and beds are leaving the market, though they're probably not yet being replaced quickly enough. Staff, as I say, favor modern homes. It's a great ESG story, and we don't really have EPC capex to spend because of the great place our portfolio is in. Demand for places in the longer term, as well as demographics, dementia is a reality. There is also the challenge of loneliness with people living more and more on their own, and as they get into older age, the real challenge of loneliness, and also the challenge of dual-income families leaving less time to care for their granny and grandpas. How is it all funded? If you're largely in private pay, well, the over-65s have £2.6 trillion of net worth. I was reflecting in the last month or two that when I did the IPO for this fund, that number was about £1.7 trillion. It's housing equity primarily, so great funding. In addition to the fact that even if they are cash-strapped, local authorities still have a statutory duty to fund social care for seniors. So we're in a good place in terms of the update and the outlook.

So, in summary, we've spoken about great real estate quality. This is absolutely a premium portfolio. In terms of the MSCI index, it has absolutely performed. A stable dividend with a yield of 6.2%, doing great social good. A conservative balance sheet with long-term fixed debt, and we see a significant gap between prime and non-prime real estate within care homes. So I hope that's been a useful introduction to the business. We love the privilege of being given money to do this, and we see lots of opportunity going forward as well. Thank you very much.

Yeah, that is true, and that is the reality of our current situation. However, we've evidenced to the market in recent weeks the ability to sell assets at above the NAV value, and that has freed up cash and headroom. And we already had some headroom, so there is some opportunity for us around that.

Yeah, so the macro view of elderly care homes in the UK is roughly 450,000 beds I mentioned. For the 15 years we've been doing this, about 200 care homes a year drop out of the market, but they're typically 20 or 30 beds. And about 100 new care homes are built on an annual basis, and they're typically 60, 65, 70 beds. So the absolute number of beds has slightly dropped over the 15 years we've been doing it, not significantly, but a little bit of drop. But everybody in the market is seeing increasingly tight demand because there are more and more elderly people coming through, and the reality of life and later living is increasing frailty and often dementia the longer we go. So we strongly believe there will be demand for further modern purpose-built homes, partly because the baby boomers went to the Mediterranean instead of little old bed-and-breakfasts of 30 or 40 years ago. They never stayed in a hotel which didn't have a shower or bathing facility. And that's one of the strange things in this sector: some people speak about their en suites, but the en suite is only a WC and a wash basin. But as I tried to describe earlier, we really believe it's fundamental, and the whole sector accepts today that any modern operator of care homes would accept that wet rooms are the only way to go forward for holistic personal care for residents. So we're in a great position in terms of the physical real estate we have to enable us to fill the ongoing demand and to work with our tenants to bring more homes to the market.

No, if anything, the opposite actually. It's quite interesting. One of our tenants, who now has four homes with us, I remember seven or eight years ago, so well before COVID, him saying to me, 'You know, I only operate old homes, Kenneth, with poor en suites, but I make good money out of them, and you're telling us that we need to go to modern purpose-built homes with wet rooms. He said my old homes are cash cows, it's a very difficult challenge for me.' And I said, 'Well, you know, if you're committed to the care for the elderly and holistic way, I would submit that you need to think about the kind of product that we are bringing to the market.' In the first six months of COVID, the same gentleman phoned me up and said, 'You're absolutely right. We realize that infection control in the old homes is really difficult, and we really need to move to modern purpose-built homes.' And they're in a whole plan and transition towards that. So to answer your question, it has confirmed to us the wisdom of the strategy we're on. And let's not pretend we're clever. If you're in America, of course, you would have this much better quality home. So we are strong supporters. Would you like to go to a common bathroom for your toileting needs, Richard, after another seven people have been in it in the previous half hour, or would you like to have that done in the privacy of your own bathroom? Yeah, that's the reality of this. It's sometimes our bankers tell me I'm a little bit indelicate in such matters, and probably the PR agents too, but it is the carers who provide the care to our seniors. We return to being babies in our old age; we need to get our nappies changed, and we'd like to have that done in the privacy of your own room. So I don't know how to say it other than by saying it. We've got that to look forward to.

Yeah, just over 16% for the largest, about 17% for the largest. We have three or four around the 7 to 9% range, and 27 or 28 less than 5%.

And that goes back to when I started this a dozen years ago. If you look, you seem old enough to remember Southern Cross, and you know the sector had a poorer reputation until we came and did what we're doing in these listed markets, showing that it can create long stable income. So we recognize that can be a risk, but let's diversify the risk away. If you have 100 care homes, you're never going to have every one of them working perfectly, but generally most of them are working very well.

Yeah, so we back, we have not many people from a private equity background companies. A couple who are private equity backed, generally we're backing stable family businesses of some scale, not tiny M&Ps. Generally it's usually kind of large SMEs, you might call it. So people with, as I mentioned earlier, somebody has 20 homes or 40 homes or 15 homes, that kind of scale. And each of these homes might be making half a million each, so you can do the math there. They're not insignificant.

Don't see why, yeah. We would expect our rental income to increase by this 2 to 4%, and so any dividend increase has to be tied to the rental increase obviously, so that's the kind of range we expect the rents to increase by.

Yeah, the recent portfolio sale was an interesting one because the challenge of a prime portfolio is how do you keep it prime. So we had the opportunity to sell four of the assets. One of the metrics that is interesting in a care home, just as it is for us all in our own homes, is bedroom sizes. The average square meter of the homes per bed per resident of the homes that we sold just a week or two ago was about 41-42 square meters, compared to a portfolio average of 47. So that tells you that they were homes that had less square meters per resident and therefore a bit more constrained, still good homes. And also they were homes that were amongst the oldest in our portfolio. Yet we got a very good price for them, whereby we were able to sell them at a premium to what we were holding them at in the balance sheet. So that has been, I think we hope that that gives some evidence that the NAV is real. Whether in the current market there will be much movement in the NAV, especially as we go into the summer, I think we have to be really realistic and perhaps pray for more buyers or something.

Everybody, that's the comment for everybody. We're actually very thankful that our core shareholder base is remarkably robust and stable, and they're very much communicating to us that they love what we do, they love the way we go about it, they see the manager as somebody who has a long-term commitment to it, and just be patient. You're paying a stable income, we're seeing it growing, it's doing great social good, all will be well. And I think that we would love to do more, but it's a portfolio of some scale, as you know.

They've handled it really well, and that's best evidenced ultimately by the fact that our rent cover is at an all-time high. But to explain a little bit more, the underlying nature of all of that is that it's a high preponderance of private fees. The private fee payer gets above inflation or at inflation increases, and by doing that, the significant increase in minimum wage rates can be paid to the carer. So we think there may be more difficulty in the public fee side, the local authority fee side, with government austerity, and there's good evidence that over the long term, that tends to get constrained. But the fees for the private fee payer continue to be above inflation. The other thing worth saying is the average length of stay in a care home for a resident is 18 months. So the challenge is for the family to get their head around that they're going to have to pay, or from the resident's estate, they're going to have to pay, say, £1,200 a week, that's the average fee in our portfolio. But typically it's only one inflationary increase that they will go through, and you know, 12 months after they come in. So that's the experience of the private fee payer.

Yeah, thanks for asking. 71% of the residents are private.

You know, there has been talk about changing the sector for about 20 years. And all of us know that the government is cash-constrained. Whatever they decide to do, we think the significant thing to be aware of is the net wealth of the over-65s, where there is £2.7 trillion of net worth. The sector typically spends, the income for the sector for the 450,000 beds is about 20 to 22 billion a year. So if that was to be totally funded out of the net worth of our seniors, that would still only come in the next 40 years to 900 billion or 2.6 trillion. So I think the government might be able to do that math as well as you and I. So I think the potential is for that to come more out of the private pay. And that, as well as wanting to have really good real estate to care for people, we think that is a long-term stable position. It's only one in seven and a half of us who end up in residential care, so it's not as if half the population over 85 ends up in residential care. It's only 13.4% of the over-85s.

Yes, we have two or three homes left to develop. If I'd been speaking to you last year, there were five, but three of them, two or three of them have opened. And they're homes that we've been able to influence the way the home is. I was in a home with some investors a few weeks ago in Dartford, and that was just a fabulous home. And actually the owners were saying to me, 'It's down to you that we have such fabulous outdoor spaces here with great balconies and so on.' So we have, because we've funded the development of 20 or 30 homes over the life of our fund management life, we have P&L accounts from every one of the homes, and we physically visit the homes continually. There's a team of four people who visit the homes regularly. We have a view on what a good care home looks like, and so the developments that we see and are brought to us, we're always happy to make some suggestions. We have two or three guys within the business who take great delight in tweaking the layout and trying to improve it in the light of what they've seen work really well over the years.

Yeah, we can either forward fund or we forward commit. Quite often we forward fund. And they're always on a pre-let basis. We've done no speculative development.

It's typically the same yield on cost as you get for the long-term lease that's put in place, because the 35-year lease is part of the pre-let. In the early days, there might have been 50 or 75 basis points of premium, but as more and more people have seen the stability of what we've been able to do with this fund, we have seen other people come into the market and compete, and therefore that has been less remunerative than we might have liked.

Yes, yeah, there is. And one of the great things about having 32 different tenants is that often a few of them will always have an idea about the next home, and so there are ongoing discussions about further developments.

So there are four healthcare REITs really in the UK: the two GP surgery funds and Impact and ourselves, and then there's a European REIT that has some UK assets. So when in the presentation I made reference to listed peers, I was referring to that European REIT plus Impact. It's just really different stock. Our en suite wet rooms, as I say, almost 100%. Impact, I think I'm not sure exactly what the numbers are, but it's less than 30% of their beds have wet rooms. Whereas 97% of our product has been built in the last 15-20 years. Their percentage is more like 70% is older than the 2000s. So it's just really different, more of the older product versus modern product. And the difference in wet rooms, I think, is a great way of thinking of the difference between the two. And then it's for us all to make a conscious decision as to whether you want your residents to follow into all that I described earlier, Richard. So it's just really different. And the other interesting question in the whole sector is where net initial yields are for the secondhand stock as some might hold compared to the prime portfolios. So the American REITs are currently buying secondhand stocks at around about 10% initial yield. So it's just really quite different.

We bought brand new homes. Brand new homes tend to be quite well insulated, especially for seniors. It's just everything's new in what we do. When we set out originally, I always remember a panel I was sitting on about four or five years ago, and I was introduced as the founder of the first social impact fund in the UK. And I kind of looked at the chair of the panel, saying, 'Oh, thank you, I'm not sure that I realized I created that.' When we set out, we decided that we would buy really good new buildings, and we are of course 100% in the social care space. If you're serious about social care, you'll provide good privacy for your residents in terms of personal care, which is the indelicate thing I spoke about, and you'll also have best practice governance so that as a manager we're not involved with the operating of any of the homes ourselves. The result of that is the first social impact fund. We didn't know we were going to create the first social impact fund, but it just seemed like good practice to create that kind of product and to invest in that kind of product.

Obviously now, yeah, so RPI is higher than that, so the rental growth will be whatever RPI is. It's all predicated on RPI, not CPI. So who knows, three and a half or 4%? I guess that's where it'll be.

Yeah, a little, and also other product. In fact, we're probably glad that we didn't diversify. So, for example, the whole kind of sheltered housing stuff that other REITs have done and they're kind of allied to this, I remember we looked in great detail at a scheme in the area 10 years ago, and we just said to ourselves, 'I don't get how all of this works over the long term.' We couldn't get the housing associations buying, paying, committing to the rental levels. So we know this really well. Our tenants send us monthly P&L accounts for every one of the homes. Every night I'll know occupancy across our portfolio. And we have four people who physically visit the homes on a minimum of two or three times a year. If we're concerned about a home, we'll probably be in it every 30 months. So we just have a lot of visibility of what our underlying tenants do. In fact, our tenants find our interaction with them really enabling. We've just completed some independent research for some of the sustainability stuff that we report on, and we're just in a really good place in terms of the perception of our tenants to what this landlord is like and how we compare to others. In the past, we've done that direct with them, but we thought this year we would get an independent body to ask all the awkward questions. You'll be glad to know that when I think I just read on Tuesday or Wednesday this week, it's been a satisfactory, very satisfactory response.

Obviously, yeah, yeah. No, if you want long stable income, 26 years of income in front of you that will have some inflationary increase, with an underlying portfolio that has got tailwinds that are just, you know, 40 years hence there's an awful lot of elderly people. And the other thing to remember is at the moment there are 4 and a half working age people for everybody over 65, and that drops to two and a half. There's going to be a lot of elderly people. You won't be able to do it by domiciliary care; they will have to be housed together. You better have the right real estate for 40 years of growth. So, yeah, absolutely. It was really cool. We love what we do. It's a great mission. We love to visit homes, see people living well in their later years. They can live really well in their later years. So it's a most favorable mission. We love it.

Thank you very much. Thanks a lot. Have a good day. Bye.