DHC’s share price closed on Thursday (4/9) at $3.51, down 58.4% year-to-date, worse than the peer group average of down 24.7%, but the stock is up from its bottom of $2.00. Most of the losses for DHC occurred during March. There is still considerable uncertainty about the near- to medium-term operating and financial performance for healthcare REITs, which could delay a full recovery of their shares. Even so, DHC’s share price has fallen to only 0.3 times book value, compared with the peer group average of 1.4 times. That gives the shares considerable upside potential, if DHC can cope successfully with COVID-19.
DHC’s share price losses accelerated at the end of March when it cut its quarterly distribution to $0.01 from $0.60. Officially, this is only a cut for the first quarter, but it is unlikely that DHC will be able to bring the distribution back to the $0.60 level before the end of the year and probably not until 2021. The Trust has pledged, however, that its distribution will be sufficient to allow it to maintain its REIT status. Therefore, it could conceivably raise the quarterly payment over the coming quarters to match its expected REIT distribution requirement.
The cut in the distribution will save $33.3 million of cash per quarter, $167.2 million for the year. In addition, DHC said that it would cut “non-essential” capital spending by $150 million. To my knowledge, management has not previously given guidance on 2020 capital expenditures. In 2019, capital spending totaled $236.6 million, including $60.8 million of recurring (or maintenance) capex. DHC had planned to spend $100 million to complete the renovation of its 3 building life sciences campus, Torrey Pines, in San Diego this year. While it can delay its capital spending, it will in doing so delay the completion of renovations and upgrades that would allow it to fill unoccupied buildings, raise rents and improve its competitive position.
DHC faces the maturity of $200 million of 6.75% Senior Notes on April 15 and a $250 million term loan in June. The senior notes will be repaid mostly from availability under its bank revolving credit facility. DHC also has the option to extend the term loan by six months. Besides these two debt issues, $300 million of 6.75% Senior Notes come due in December 2021.
The 6.75% Senior Notes due 2021 traded last week at 96 to yield 10.40%. Two other debt issues – the 4.75% Senior Notes due May 2024 and the 4.75% Senior Notes due Feb 2028 traded last week at 86 ( for a 9% yield) and 80 (8.3%), respectively. The two outstanding Trust Preferreds (DHCNI and DHCNL) traded at $16.27 (8.6% current yield) and $17.57 (8.9%), respectively. The yields are elevated, but not distressed.
On March 11, S&P downgraded DHC’s issuer rating to BB (from BB+) and the credit rating of its outstanding debt issues to BB+ (from BBB-). It has also assessed the outlook for DHC at stable.
At December 31, DHC had $37.4 million of unrestricted cash and $407 million of availability under its revolving credit facility. It has also announced the completion of $65 million in asset sales so far this year, including $56 million announced on April 2.
At year-end, DHC had $539 million of asset sales under agreement or in their first or second offer stages. It showed $209.5 million of assets as “held for sale” on its balance sheet. including assets for which it either had signed sales contracts or offers from third parties. Thus, $329.5 million of those pending asset sales were not under contract and have not received formal bids. Under current circumstances, while signed asset sale agreements may be completed on or close to schedule this year (assuming no material adverse change clauses), the remaining pending sales will likely be either delayed or cancelled.
As with the rest of the industry, DHC faces the challenges of COVID-19. On April 2, it disclosed that it had been notified of 41 confirmed cases of the coronavirus in its managed and leased properties, including 31 of its residents and tenants and 10 of its staff members. Several recent newspaper reports, including front page articles over the weekend in the WSJ and NYT, have highlighted the elevated death rates at nursing homes across the country. While it is difficult to know for sure just how DHC is faring in its efforts to protect its senior housing residents, the composition of its business suggest that the impact could be sufficiently contained, as long as its procedures are effective. About half of DHC’s net operating income comes from medical office/life sciences properties; it has very little exposure in the New York tri-state region; and its exposure in other potential hotspots like Florida and California is modest.
In response to COVID-19, DHC’s operating costs have increased due to greater overtime pay and measures taken to protect residents and tenants, including the purchase of protective gear, increased sanitation costs and increased security protocols. Consistent with the rest of the senior housing industry, its occupancy and move-out rates have not declined much as yet; but the Trust has suffered a drop in move-in rates, in large part because it has had to cancel in-person property tours.
As occupancy rates decline and operating costs remain high, DHCs profits will be squeezed over the next couple of quarters. Still, with the cut in the quarterly distribution to shareholders and capital spending, the Trust should not face a liquidity crisis, as long as COVID-19 does not run rampant through its properties. DHC will be able to meet its debt repayment obligations in 2020.
At the current price, the stock trades at 0.3 times book value, well below the industry average of 1.4 times book.
Considering all of the available information, I think that DHC’s share price is far below the level justified by current operating performance expectations. Although the Trust will be able to meet its financial obligations in 2020, it will not complete its asset sale program. Assuming the economy begins to climb out of its COVID-19 hole by the third quarter and COVID-19 does not decimate its resident population, I believe the stock will drift back to the $8-$10 level, as the market realizes that DHC is unlikely to go bust in 2020 and as it begins to restore its quarterly distribution payment. With the subsequent completion of the asset sale program probably in 2021, the stock would have upside to the low- to mid-teens, in my view.
I present here two looks at DHC’s valuation: the first based upon the carrying value of its net assets as reported at December 31, 2019 and the second by applying a capitalization rate to its annualized 2019 fourth quarter cash basis net operating income (NOI).
The Hidden Asset on DHC’s Balance Sheet. Before presenting these two valuation analyses, I offer an an estimate of the value and 2019 NOI of DHC’s Vertex Pharmaceutical’s property, which is located in the seaport district of Boston.
In March 2017, DHC sold a 45% joint venture interest to a third-party investor for $261 million. The price of the equity stake was based upon an assumed value of $1.2 billion for the property. The property was (and still is) financed by $620 million of secured debt. At the $1.2 billion valuation, DHC’s 55% stake was worth $319 million or about $1.34 per share.
By my estimates, the property generated NOI of $54 million in 2019, as shown in the table above, which represents 11.2% of the Trust’s estimated pro forma total cash basis NOI. At the $1.2 billion valuation, the property would have an implied cap rate of 4.5%.
The Vertex property is DHC’s most valuable. Although its 55% equity stake was valued at $319 million in 2017, I calculate that it was carried on DHC’s books at negative $35.8 million at year-end 2019. The value of the property was not written up when the joint venture was formed. Its aggregate net book value (gross book value minus accumulated depreciation) was $724.7 million at December 31, 2019, according to the Trust’s financial statement disclosures. Against that value, the property had $620 million of secured debt and a $140.5 million noncontrolling interest (i.e. the 45% joint venture interest).
Total debt outstanding. At December 31, 2019, DHC had total debt, including trust preferreds (which are classified as debt), of $3.5 billion, categorized as follows:
Valuation based upon book value: Based upon the carrying values on DHC’s balance sheet at December 31, 2019, I estimate DHC’s per share equity valuation as follows:
On a consolidated basis, DHC’s real estate properties and net lease intangibles had a combined net book value of $6.15 billion. Against that, I deduct the $140.5 million recorded value of the Vertex third party joint venture interest (classified as a noncontrolling interest on DHC’s balance sheet). I then add the $209 million carrying value of assets of properties held for sale.
From the resulting total of $6.22 billion of property values, I deduct the $3.5 billion of debt outstanding to arrive at an equity book value of $2.72 billion or $11.43 per share. Excluding net negative $35.8 million carrying value of the Vertex joint venture, the net book value, the net book value of DHC’s equity is $2.755 billion or $11.58 per share (as shown in the table in the column on the right).
At the 2017 valuation, the Vertex property is worth $475 million more than property’ net book value of $724.7 million and DHC’s 55% interest in the Vertex joint venture is worth $345 million more than its net equity book value of negative $35.8 million. The Vertex joint venture thus represents a “hidden” asset on DHC’s balance sheet.
I think that a strong case can be made that DHC should sell its 55% interest in the Vertex property, if it can do so near the 2017 valuation of $1.2 billion. This would allow it to pay down about $1 billion of debt (including the $620 million of debt secured by the property) and eliminate the noncontrolling interest with only a modest loss of net operating income.
Of course, investors are concerned that DHC’s other assets may be worth less than their carrying values. The market value of the remaining properties may not equal their net book value. Over the past three years, DHC has recorded total impairments of $181.5 million against the net proceeds of properties sold and classified as held-for-sale of $796.2 million, which represents 18.6% of their pre-sale carrying value. Applying the same percentage to the year-end 2019 $5.17 billion carrying value of DHC’s real estate properties (excluding Vertex) would result in $950 million of potential impairments.
It would be surprising indeed if potential impairments across the entire portfolio were that high. Still, potential impairments could be offset in part by the hidden $345 million gain on DHC’s 55% stake in the Vertex property. Under my valuation model, I calculate that a $950 million impairment offset partially by the Vertex hidden gain would still result in a per share equity value estimate of about $9 for DHC. That is well above the current share price of $3.51.
To put it another way, asset write-downs would have to exceed $1.9 billion or about 37% of the current property net book value (excluding Vertex), to justify the current share price.
Valuation based on Cash Basis NOI. Alternatively (and more conventionally), DHC can be valued on its cash basis NOI. I estimate the current NOI run rate below:
My estimate starts with DHC’s 2019 fourth quarter NOI annualized (i.e. multiplied by four). I use the fourth quarter level because it incorporates fully the reduction in rent that DHC granted to Five Star in 2019 and is therefore closer to the income that DHC will earn from the properties going forward. The fourth quarter numbers also incorporate some of the loss of NOI from real estate properties sold during the year.
From that figure, I deduct the NOI on assets of properties held for sale and also certain non-cash income and expenses (e.g. straight-line rental income) to get an estimate of annualized cash basis NOI, excluding properties held for sale. Lastly, I deduct the estimated NOI from Vertex to get an estimate of annualized cash basis NOI for the remaining real estate properties.
Applying a range of capitalization rates to DHC’s annualized cash basis NOI provides a range of value estimates for its real estate properties, excluding Vertex. This estimate ranges from $3.9 billion (at an 11% cap rate) on the low end to $6.1 billion (at a 7% cap rate) on the high end. To this value, I add the estimated $319 million value for DHC’s 55% interest in the Vertex joint venture and the $209.6 million of properties held for sale and subtract out $2.9 billion of debt (excluding the $620 million of Vertex debt). This results in an equity value estimate for DHC that ranges from $1.53 billion or $6.45 per share to $3.75 billion or $15.78 per share.
There are several things to keep in mind about this analysis. First, the annualized cash basis NOI estimate of $427.5 million is optimistic for 2020. While the annualized run rate for 2020 first quarter NOI should be in line with that estimate, NOI for the remaining quarters of the year, especially the second and third quarters, will likely fall short as occupancy rates decline and operating expenses rise due to the impact of COVID-19. Assuming that COVID-19 does not become a catastrophe for DHC, the equity markets should begin to look through the 2020 profit decline later this year to improved performance in 2021 from the lifting of the lockdowns and normalization of economic activity.
Second, based upon DHC’s financial disclosures, I am comfortable with a capitalization rate at the lower end of the range, probably around 8% or so for now. Industry scuttlebutt suggests that the average cap rate across all properties is even lower currently, around 6%. DHC’s properties are not new and many still require upgrades to enhance their competitiveness, so its properties probably deserve a higher average cap rate. (As noted above, the Trust has been pursuing property upgrades, but since the arrival of COVID-19 it has announced that it will cut its capital expenditure budget by $150 million this year to conserve cash.)
Third, it is likely that DHC’s medical office/life sciences properties have an average market cap rate that is different from (and probably lower than) its senior housing properties. Thus, it may be useful to consider a blended rate.
For example, I estimate that, excluding Vertex and the properties held for sale, DHC’s medical office/life sciences segment accounted for 42% of cash basis NOI, senior living communities also accounted for 42% and non-segment properties, which are leased primarily to Life Fitness, accounted for the remaining 16%. If I apply cap rates of 7% to the medical office/life sciences NOI, 10% to senior housing and 8% to the rest, the blended rate is 8.4%, which produces a per share value estimate of about $11.50.
Obviously, it is important to take into consideration the potential downside risks of COVID-19 and the Trust’s relatively tight liquidity. By substantially reducing its quarterly distribution from $0.60 to $0.01 per share and scaling back capital expenditures, DHC should be able to cope with the likely squeeze on its profitability and meet its upcoming debt service requirements.
My optimism about DHC is based upon the assumption that the negative economic impact of COVID-19 will begin to subside in the third quarter and economic activity will return to normal in the fourth quarter or early in 2021. I also assume that DHC and Five Star will be able to minimize COVID-19 infections and deaths in their resident populations.
Accordingly, I think $11.50 is a reasonable 12-18 month price target today, but I believe that the stock will return to the $8-$10 level in the 2020 fourth quarter or early in 2021, if and when the national infection rate for COVID-19 falls back and probably when the Trust reinstates the $0.60 distribution (or raises it meaningfully so that investors will begin to anticipate a full restatement).
In my mind, a sustained rebound of DHC’s stock to $12 or above will require DHC to achieve substantial progress toward completing its $900 million asset program, which will reduce concerns about its ability to meet its debt repayment obligations in 2021 and beyond and provide support for the rating agencies to consider restoring the Trust’s credit rating to investment grade.
April 13, 2020
Stephen P. Percoco
Lark Research
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