The overlap of property & powerful long term thematics: 2 quality stocks for your watchlist
Earlier this year, we reviewed some of the key factors driving the ongoing strength in the property sector. At that time, we noted: ‘despite the hysteria surrounding the US lifting interest rates for the first time in years, rates remain at historically low levels across the globe. We continue to view this as a protracted and grinding cycle: one that provides a degree of support for good quality, high yielding assets.’
A few months and one further domestic rate cut later, Australian Real Estate Investment Trusts (AREITs) have rallied further, supported by a global wave of capital seeking a relatively high yielding home. For instance, the flow of capital from Japan, whose 10 year government bond yields now offer negative yields, is suggested to represent a large portion of substantial offshore buying of AREITs of late. In aggregate, capitalisation rates have tightened further, thus increasing asset pricing while concurrently price to book ratios have expanded.
While we did share a small-cap REIT idea recently (read research note), the purpose of this paper is not to once again specifically review the AREIT sector. Rather, we aim to introduce companies that encompass property as well as operations that are benefitting from other powerful tailwinds.
Property and the Ageing Population
As illustrated below, the population of those over 65 years of age in Australia is expected to more than double in the next 25 years. Further, the Australian population aged 85 and over is projected to double by 2032 and triple by 2045.
Source: ABS, Stockland
Source: Japara Healthcare, Aged Care Financing Authority
It is our view that this demographic trend will drive an increasing level of opportunity for accommodation services right across the spectrum of retirement village living, home and community care, residential aged care and acute hospital care. Two companies that we are closely following are Japara Healthcare (ASX: JHC) and Ingenia Communities (ASX: INA), both of which we believe are well placed to benefit over the long term.
Japara Healthcare (JHC) is one of Australia’s largest enterprises in the aged care and retirement industry. JHC own and operate 43 aged care facilities and 4 retirement complexes across Victoria, Queensland, South Australia, New South Wales and Tasmania.
JHC, like its listed peers Regis (REG) and Estia (EHE), is in effect comprised of a property trust and an aged care operating business. Upon listing in 2014, JHC illustrated its business structure as follows:
Source: Japara Healthcare PDS
As such, JHC directly owns substantial tracts of land in predominantly metropolitan and coastal areas. Beyond that, in the course of normal operations, JHC add and create value through the provision of high quality aged care services.
More specifically, JHC provides accommodation and care to people who can no longer live independently (either at home or in retirement village accommodation) due to health reasons, but who do not require acute hospital care. The average resident tenure is between 24 and 30 months and generally speaking, the higher the level of care required, the higher the revenue per resident generated.
JHC has two key sources of funding:
- Operating revenue: relates to the provision of care and additional services, which constitutes resident fees & government funded care subsidies
- Accommodation bonds: a unique and interest-free source of capital funding, payable in either a lump sum (called a refundable accommodation deposit, or RAD) and/or daily payments (called a daily accommodation payment, or DAP) by incoming residents.
Accommodation bonds effectively provide a float of capital that funds growth and augments cash flow. JHC includes its net RAD cash flows within financing cash flow (a stance we agree with), whereas its peers include this item within operating cash flow. So for those poring over the cash flow statement in an effort to compare across the sector, this is a nuance worth noting.
Importantly, the Aged Care Act stipulates that capital provided by accommodation bonds must only be utilised for approved purposes, which include capital works, retiring bank debt & the purchase of additional aged care facilities. As a result, JHC can sensibly utilise this interest free RAD capital to expand its footprint over time. When projects are completed, sales of accommodation bonds to incoming residents more than recoup this outlay and the capital is thus recycled into subsequent opportunities. The operator has an obligation to repay the bond balance to the resident when they depart, and normally receives a new bond from an incoming resident, typically of a higher amount.
Source: Japara PDS
“JHC’s growth strategy centres around increasing the size of its aged care portfolio through the acquisition of additional aged care facilities and the development of brownfield projects.”
The residential aged care sector is highly fragmented with approximately 63% of companies operating single facilities, 29% between two and six facilities and 8% operating seven or more facilities. The residential aged care sector comprises approximately 190,000 places, more than double the size of the hospital sector, with ~90,000 beds. This number is forecast to increase by approximately 82,000 beds by 2025, representing a compound annual growth rate (CAGR) of about 4%.
Hence the long term opportunity for (and likelihood of) consolidation is immense. JHC will almost certainly play its part in industry consolidation over time and in doing so will likely generate further gains in efficiency.
In terms of the near to mid-term growth potential, we believe JHC has the ability to expand its business from an existing footprint of 4750 beds by between 40% and 50% over the coming 3 years. Management already have an existing brownfield development program (‘brownfield’ means to add capacity to existing owned facilities, a strategy effectively employed by Ramsay Health Care for many years) that will deliver in excess of 900 beds by 2019.
We also believe JHC has the capacity to acquire a further 300 to 400 beds annually over the same time frame, of course dependent on pricing and opportunity. As a result, it is our view that JHC are capable of delivering double digit growth in earnings and thus dividends over the medium term.
At a market cap of just $750m and an existing footprint that equates to about 2% market share, we believe the long term growth runway for JHC is exceptional. Better yet, the company has a strong balance sheet, is a healthy generator of free cash, pays out a sound level of franked dividends (forecast dividend yield of ~5%) and is guided by a highly competent and aligned management team.
To that end, JHC is led by an experienced and focused CEO in Andrew Sudholz, a man who balances the desire to deliver exceptional care in high quality facilities with the need to generate a sound return for capital providers. Sudholz is also a substantial personal holder of JHC stock, a factor we believe assists in aligning interests with minority holders.
Ultimately, we believe JHC will grow market share in a growing market. Equally as importantly, we also believe much of this growth will be self-funded, which in turn should drive substantial growth in per share value over the long term.
Looking at a slightly younger cohort yet related opportunity, we are also positive about the prospects of Ingenia Communities (ASX:INA).
INA is a leading Australian property group that owns, operates and develops a growing portfolio of affordable senior’s communities across key urban & coastal markets.
Source: INA presentation, May 2016
Initially established in 2004 as an externally managed retirement focused REIT, INA was internalised in 2012 and is today exclusively focused on owning, managing and developing a diversified portfolio of retirement communities and lifestyle parks across Australia.
INA’s vision is to be “a leading Australian provider of affordable long-term and short-term rental accommodation with a focus on the seniors demographic.”
INA currently has three core operating divisions:
- Active Lifestyle Estates (ALE, note this term is used interchangeably with manufactured home estates, or MHEs)
This is the growth engine for INA and is comprised of 26 lifestyle parks (and growing) around Australia. This provides an affordable yield focused housing alternative for seniors and short-term residents. Housing types are mixed and include both long-term and short-term accommodation within lifestyle parks, with earnings augmented by the development and sale of manufactured homes. The MHE business model is best described as follows:
While the permanent resident of the MHEs form the core of the annuity like income rental streams, this division also offers exposure to a degree of development and tourism revenue streams.
- Garden Villages (wholly owned rental villages)
The Garden villages division is a strong cash generator for INA. This division is comprised of 31 rental villages located on Eastern seaboard and in Western Australia. The existing portfolio is considered core to the business and generates over over $24 million in rental income annually from stable, recurring cash flows underpinned by Government payments (pension and rent assistance). INA’s portfolio is valued at a 10.2% cap rate and $77,000 per unit. This compares favourably with recent transactional evidence and suggests this portfolio is valued conservatively on INA’s books.
- Settlers Lifestyle (deferred management fee villages, considered non-core)
Settlers Lifestyle is comprised of eight deferred management fee villages. These villages are located in Queensland, New South Wales and Western Australia and accommodate more than 800 residents generating income from accrued deferred management fees, rental income from villages which are not yet fully converted and development income from unit conversions/village expansion. The carrying value of these assets at 30 June 2015, net of resident loans and lease liabilities is $62.9 million. INA is currently looking to divest these assets.
At its core, we believe the value proposition offered by Ingenia to its target ‘value’ market of retiring Australians is compelling. In considering this statement, firstly it’s worthwhile reviewing what each cohort of Australia’s ageing demographic currently has in terms of superannuation funding. As per the below chart, a significant percentage of Australians aged over 50 have superannuation account balances of less than $100,000. As it stands, the typical retiree has just $140,000 in super (though admittedly this figure is incrementally rising as the SGC incrementally takes greater effect). This further supports our view that, on average, the family home accounts for most of our ageing population’s net wealth.
Source: INA presentation, May 2016
In addition, adding further weight to this trend is the fact that Australians are on average living longer.
Sources. ABS; Australian Institute of Health & Welfare
In aggregate, this provides a greatly supportive environment for retiring Australians to unlock some of the value stored in the family home to in part fund their retirement. Ingenia provides the following example that we believe effectively illustrates the significant value proposition offered by such a strategy.
Source: INA presentation (appendices)
In our view, INA’s business model is attractive as it provides a sound mix of recurring rental income and development profit. In effect, INA has several thousand residents paying fortnightly rent, with revenues complemented by a capital light, relatively low risk development program and co-located tourism.
INA’s strategic asset allocation, both existing and target, is presented below:
Source: INA presentation, April 2016
Like JHC, Ingenia is also currently forecast to grow operating earnings (i.e. profit excluding property revaluations) at double digit rates over the medium term. When you consider this in conjunction with what appears to be an improving ROE profile and a forward P/E of about 13x, we believe INA presents as reasonable value for those with a longer term investment time horizon. When compared with peers such as Gateway Communities (GTY) and Lifestyle Communities (LIC), INA also trades at a comparatively modest price to book ratio.
In summing up, we believe INA is solid value and is well placed to take advantage of attractive industry dynamics. We see industry growth being fuelled by the ageing population, a national shortage of affordable housing and a significant opportunity to monetise equity in the family home.
The following paper is a multi-part research series.
Read Part 2: The overlap of property & tourism
Written by Adrian Ezquerro, Senior Analyst.
Disclosures: Clime Asset Management owns shares in JHC, RHC for and on behalf of various mandates for which it acts as investment manager.