Lowering Estimates for 2022 and Adding 2023, Lowering Price Target to $5.00
DHC reported 21Q4 normalized FFO of –$0.09 per share, compared with 21Q3’s ‑$0.05 and 20Q4’s +$0.09. Although the Office portfolio posted another solid quarter and the Senior Housing Operating Portfolio (SHOP) occupancy improved by 120 bp, SHOP operating costs were high, due mostly to the tight labor market. On a positive note, management says that its operators have been able to begin raising rental rates to help cover higher operating costs.
Despite the FFO loss, DHC recorded GAAP net income $1.54 in the quarter, as a result of a $461.4 million gain from the sale of a 35% joint venture interest in the Vertex headquarters complex. The Trust netted $367 million in cash from the sale, ending the year with $1.01 billion of cash and restricted cash. In January, DHC sold an 80% joint venture interest in 10 medical office/life sciences properties, taking in $652.8 million of proceeds and booking an estimated $320 gain. I project that DHC will end 22Q1 with $1.47 billion in cash, giving it the means to retire a substantial portion of the 9.75% Senior Notes when they become callable in June 2022.
In February, the Trust amended its revolving credit agreement, agreeing to pay down $100 million of the facility immediately and another $113.6 million in January 2023. With those debt payments and its plans to spend possibly up to $400 million annually to upgrade its properties, DHC will probably call less than the total $1 billion outstanding of 9.75% Senior Notes. That may have been a factor in Moody’s downgrade of DHC’s unsecured debt from B1 to B3. My analysis suggests that the Trust can pay down $700 million of the Notes in June and still maintain adequate liquidity. Over time, when the business is clearly on the path to recovery from the COVID-19 pandemic, DHC will hopefully repay more of the 9.75s.
My projections assume that SHOP operating costs will remain high throughout 2022, reflecting management’s expectations that labor costs will be 10%-12% above 2021 levels. With steady projected increases in occupancy and rental rates and hopefully as the Trust finds ways to lower its labor costs, I expect that operating costs as a percent of revenues will begin to ease in the second half of 2022 and more rapidly in 2023. I anticipate that SHOP will show a steady 100 basis point quarterly improvement in occupancy in 2022, but the improvement slows in 2023, leaving occupancy 400 bp below pre-pandemic levels at the end of 2023. I also expect that revenue per occupied room (RevPOR) will bottom in the 22H1 and increase at a 3.6% annual rate thereafter. Altogether, I project that SHOP’s net operating income (NOI) will decline in 2022 to ‑$2.0 million from $10.1 million in 2021; but then recover to $47 million in 2023. The projected 2023 improvement represents an NOI margin of 4.5%, still substantially below the pre-pandemic 37.6% NOI margin reported by DHC in 2019.
Besides the expected improvement in SHOP, my projections anticipate significant savings in interest from repaying $700 million of the 9.75% Senior Notes. That, along with sustained solid performance in DHC’s Office portfolio and Non-Segment operations should position the Trust to increase its normalized FFO (my definition) from $0.02 in 2022 and to $0.41 in 2023.
Although improved performance during the forecast period looks like a reasonable bet, DHC’s stock continues to trade just above its early pandemic, March 2020 lows. The stock managed to stage a couple of rallies late in the spring of 2020 and from November 2020 to March 2021, but it has been on a fairly steady slide since its March 2021 peak. Despite positive news – the completion of its strategic repositioning in SHOP, increases in SHOP occupancy over the past two quarters, solid performance in the Office portfolio, including strong leasing activity, and now the raising of $1.0 billion in cash and booking of $782 million of gains from the joint venture transactions – the stock has continued to trade lower.
While some of the decline may be due to general market weakness, the failure of the stock to respond positively to recent developments may be a sign of deeper problems at DHC. Management’s disclosure that it will probably not call the entire $1.0 billion of 9.75% Senior Notes in June seems to support that view. It is understandable that the Trust has some other uses for the cash: DHC repaid $100 million of its revolving credit facility in February and will repay another $113.6 million at year-end. It also has some catch up capital spending required to improve the competitiveness of its properties, especially in SHOP. However, management’s stated intention to incur as much as $400 million of capital expenditures annually seems excessive. It is hard to imagine that the entire $400 million of capital projects will offer a better return than the 9.75% savings that would be guaranteed by retiring the Senior Notes.
For that reason and also because the recovery in SHOP has been delayed further by the Omicron variant and rise in operating costs, I am reducing my 6-12 month price target from $6.50 to $5.00. The revised target price represents a forward multiple of 12.2 times projected 2023 normalized FFO of $0.41. If the Trust’s financial performance recovery begins to take hold and especially if it retires 9.75% Senior Notes at or above my estimate of $700 million, I will consider raising my price target. On the other hand, if the Trust retires significantly less than the projected $700 million, I may be inclined to lower my price target again. Since my revised price target of $5.00 is 77% above where the stock is currently trading (as of March 2, 2022, I am maintaining my outperform rating on DHC’s stock.
This is a summary of my update report on Diversified Healthcare Trust (DHC) published on March 2, 2022. To obtain a copy of the full report, reach out to me.
March 8, 2022
Stephen P. Percoco
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Linden, New Jersey 07036
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