23Q2 GAAP loss was $0.30 per share and normalized FFO was $0.05 per share, an improvement over 22Q2’s loss of $0.46 and FFO of -$0.14. The GAAP net loss was higher than the $0.24 loss that I projected, but normalized FFO was $0.02 better than my estimate of $0.03. The Office Portfolio posted a decline in operating income both sequentially and YOY due to higher property operating expenses and declining rental income. Senior Housing Operating Portfolio (SHOP) net operating income (NOI) was up sharply, due to gains in occupancy and rental rates.
The Trust faces a vote by shareholders on its proposed merger with Office Properties Income Trust (OPI) on August 30. Three proxy advisory firms – ISS, Glass Lewis and Egan-Jones – are recommending a vote against the merger. Since DHC’s stock is currently trading just under $3, which is well above the merger’s estimated implied value of $1.06 (equal to OPI’s share price of $7.24 times the proposed consideration of 0.147 shares of OPI for each share of DHC), the market is apparently betting the merger will not be approved by DHC shareholders.
If that proves to be correct, it seems most likely that DHC and OPI will enter then into negotiations over the merger consideration with Flat Footed LLC, the activist investor that has led the fight against the merger, and perhaps others. At the current price of DHC shares, the market is apparently betting that the consideration will be raised to 0.38 shares of DHC (equal to DHC’s share price of $2.75 divided by OPI’s $7.24) or higher.
That would be a surprise to me. An offer of 0.38 shares would give DHC shareholders a 65% ownership stake in the merged OPI/DHC. It would be highly unusual if the acquirer, which is providing the capital to allow DHC to follow through on its turnaround, were to cede control to the acquiree. In my view, the most that DHC shareholders should expect is 50% control, which would equate to 0.203 shares of OPI, currently valued at $1.47 per DHC share.
It is possible that Flat Footed, and the other DHC shareholders who are leading the charge, have other plans. Perhaps they can sell DHC to a different buyer – maybe a large healthcare REIT or private equity investor – for more than the current price of $2.75. If that is not possible, it seems likely to me that DHC will require a significant equity capital investment over the next two years.
The Trust has issued a going concern warning due its debt service coverage covenant violation and says that it is unlikely that it will be able to get that ratio above the required 1.5 times minimum before its $450 million revolving credit facility expires in January 2024. (My projections support that assertion.) Even so, barring a meaningful deterioration in DHC’s financial performance, I think that it is a pretty good bet that the banks will ultimately renew their credit facility; but they may require a further reduction, perhaps $50 million or more, in the amount outstanding, and will probably extend the debt service coverage default waiver, as well.
Assuming that the revolver is renewed, DHC then faces a $250 million repayment of its 4.75% Senior Notes on May 1, 2024. Given current market conditions and the ongoing bank waiver and without a more significant improvement in DHC’s financial performance, it is questionable whether the Trust will be able to refinance these Notes for less than an 8.0% coupon rate (if not 10.0%). Ditto for the $500 million of 9.75% Senior Notes that mature on June 15, 2025.
As a result of the proposed merger, S&P placed DHC’s debt on Credit Watch with a positive outlook and Moody’s placed the debt under review for a possible upgrade. If the merger is scuttled, DHC’s unsecured debt ratings will remain at CCC+ (for S&P) and Ca (for Moody’s).
If DHC is unable to tap the capital markets to refinance the maturing debt issues, it will then probably have to enter into negotiations with bondholders to extend the maturities (probably for five or ten years). In exchange, it will most likely have to raise the coupon rate on the Notes and/or convert some of them into equity, which would be dilutive to existing shareholders.
At this time, the current yields and spreads on DHC’s debt are high, but not at distressed levels (typically defined as a spread of 1000 basis points or more). The betting then at this time is that a deal will eventually be reached, paving the way for a bank credit facility renewal and an eventual refinancing of the 4.75s and 9.75s. If a deal is not reached, however, it seems likely that prices of DHC’s bonds and stock will decline.
This is a summary of my recent report on Diversified Healthcare Trust (DHC), which was published on August 28, 2023. To obtain a copy of the full report, please reach out to me using the contact information provided below.
August 28, 2023
Stephen P. Percoco
Lark Research
839 Dewitt Street
Linden, New Jersey 07036
(908) 975-0250
admin@larkresearch.com
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