Stockwatch: A lower-risk income play

Real Estate Investment Trust (REIT) Primary Health Properties has a long-term, modestly rising chart and a robust dividend yield over 5%, making it useful to bear in mind currently.

Jittery stockmarkets are explained by fears for global growth prompting a de-risking by investors, to prioritise security of capital and return. While it's hard to quantify capital upside prospects for this stock, it meets such essential criteria.

Keeping the NHS safe

Headlines suggesting Accident & Emergency facilities can't cope this winter reflect how important the health service is to public expectations.

No politician will get elected on a platform of spending cuts; David Cameron for example has pledged to ring-fence the NHS budget despite falling tax revenues.

So a business model of investing in UK primary healthcare property leased to GPs, NHS organisations and other healthcare users should be resilient. Demographics of an ageing population and inability to stem EU immigration will continue to strengthen demand for healthcare facilities. It's the number one, public spending priority. Within the NHS, a Five Year Forward Review states: "Over the next five years the NHS will invest more in primary care, while stabilising core funding for general practice nationally over the next two years."

Arbitraging the gap between returns and cost of capital

It's a typical business model for any property investor, pending good investments and managing liabilities well. This company has become the leading UK investor in its field with a portfolio of facilities now worth over £1 billion: its first-half rental income received went up by 50% to £29.4 million versus interest expense up 40% to £17.6 million, although management says it has reduced its average cost of debt to 4.6% against 5.5% last year.

The debt structure has been strengthened partly to make more acquisitions: an 11 November update cited consolidating loans into two tranches of 10-15 years with a fixed interest rate of 4.9% and reducing lending margins on other facilities. The group has net debt of about £625 million and total facilities of £786.4 million, relative to a net asset value (on European Public Real Estate Association measures) of £341.9 million or 308p a share. The end-June balance sheet had short-term debt of £3.5 million and £396.6 million long-term debt, mainly term loans, and £224.9 million bonds.

Notes regarding the debt facilities (including bonds) cite an average remaining term of 7.1 years and unsecured debt represents 25% of debt drawn. Of debt drawn, £396.1 million is fixed rate debt and £235.6 million is hedged by interest rate swaps or caps. These measures provide some security for what is a quite highly leveraged operation: management says only 18% of debt facilities would be exposed to interest rate changes, if fully drawn.

Increased dividend cover is a key objective

Prudent investors rightly want to see a company's earnings cover the dividend but here the annual cover dropped from a low 80% area in 2010/11 to 56% in 2012 and 2013; then in the first half of 2014 it increased to 76%. The last annual cash flow statement profiled quite a juggling act with £16.1 million paid in dividends relative to £18.3 million total interest paid and £195.7 million term loan repayments, in context of £58.7 million proceeds of a bond issue and £65.8 million from a share issue.

The complexity partly explains why the market prices the stock so as to exact a yield over 5%; however, the security and growth opportunities offered by healthcare property make this a reasonable target. "The continued portfolio expansion, rental growth and cost savings on both debt and management costs that will be evident in the second half of the year will ensure that dividend cover improves further in the remainder of 2014 and into 2015."

In drawing attention to the stock at 330p in October 2013 the expectation then was for a 2014 dividend of 19.5p a share, which has indeed been affirmed by the latest 11 November update. So it was possible to lock in a near 6% yield and management is delivering which augers well for their promise to improve dividend cover. Rental growth in the nine months to end-September was 1.9% against 2% in 2013 as a whole.

Yield strength hints at higher underlying asset value

At first sight the dividend is attractive, but why buy this stock at about 357p given it's a 16% premium to net asset value? Isn't that the real test for an asset-driven operation? Well the true asset value could be higher than the balance sheet value considering the yields management is achieving.

Ultimately an asset is worth the net present value of its future cash flows, which here involves a mix of dividends and (theoretically) a terminal value if the assets were sold. This is why some analysts entertain fair price targets of 400p and higher, although mind this kind of modelling can involve quite subjective inputs. Yet it has validity by way of the stock having persistently traded – over years – at a premium to balance sheet values.

Primary is therefore a sound stock to consider for income and capital protection – say if you are reducing equity exposure elsewhere and looking to substitute income. The chief risk would appear to be any issues arising with debt covenants although this seems unlikely as it would effectively require drastic cuts in NHS healthcare making GP practices unable to pay rents.

Another negative could be a downturn in property values should there be a serious recession. It being hard to envisage such a negative scenario, this stock should not be much affected by jittery markets.

For more information see phpgroup.co.uk

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.