Turkey of the week: Reit at risk of running out of cash

published 3 April 2009

Primary Health Properties is a landlord that, under long-term leases, rents out 113 modernised premises to GPs (78% of sales), pharmacists (9%), dentists, and the government. In 2007 it converted into a real estate investment trust (Reit) and now pays out most of its £19.6m rental income in the form of a juicy 6.9% yield. According to most analysts, Primary Health Properties can do this because it operates a low-risk business model with 90% of revenues underpinned by NHS funding, coupled with high occupancy rates.

Primary Health Properties (LSE:PHP), rated a BUY by Numis

But don't be lulled into a false sense of security. Secure cash flow is the life-blood of Reits, but Ithink Primary Health Properties is at risk of running dry. At the last count, its gearing had ballooned to 250%, equating to debt of £203m against net assets of just £79m. After factoring in new facilities coming on stream, it only has £25m of headroom under its £265m in banking facilities. This limited capacity will crimp future growth, especially as the government wants another 150 centres to be built in the next two years.

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Property values could drop further, triggering a breach in Primary Health Properties' covenants. For example, one of its terms stipulates that its loans must not exceed 75% of the market value of its sites (tightening further to 70% in March 2010). If this was to occur, the company would need a hefty slug of painful medicine. The dividend would probably be cancelled and an emergency rights issue launched, hammering the shares. To make matters worse, I suspect its much-vaunted 'near guaranteed' rental income could also disappoint. As mainstream commercial property prices soften, it may be impossible for Primary Health Properties to continue its 'upward-only price reviews' without losing tenants a problem that has already hit retail landlords hard.

This niche sector is also becoming surprisingly cut-throat. Already, Boots, Sainsbury's, Tesco and Virgin have piled in and currently operate GP and pharmacy practices within their stores. If these chains ever decided to treat the services as loss-leaders to attract more punters, that could send Primary Health Properties' profit margins into a tailspin.

There is also an outside chance that the NHS could reverse part of its much-criticised decision in 2005 to hike payments to GP surgeries hitting the wallets of Primary Health Properties's core end-users. So while the share price has fallen 55% over the past two years, if property values keep falling and/or interest rates climb again, the firm could be soon heading towards the sick-bay.

Recommendation: SELL at 240p

Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments

Paul gained a degree in electrical engineering and went on to qualify as a chartered management accountant. He has extensive corporate finance and investment experience and is a member of the Securities Institute.

Over the past 16 years Paul has held top-level financial management and M&A roles for blue-chip companies such as O2, GKN and Unilever. He is now director of his own capital investment and consultancy firm, PMH Capital Limited.

Paul is an expert at analysing companies in new, fast-growing markets, and is an extremely shrewd stock-picker.