Last year at this time, when I last wrote about DHC, the Trust had proposed to merge with another RMR Group affiliate, Office Properties Income Trust (OPI). That merger proposal was scuttled by opposing DHC shareholders.
Since that time, the Trust has worked on improving its profitability. It has sought to reduce operating costs, upgrade its properties to boost occupancy and revenue per available room (RevPAR) and pursue the sale of marginally profitable, non strategic properties.
It has also changed its management team. Christopher J. Bilotto, formerly President and CEO of OPI, has taken the same role at DHC (replacing Jennifer F. Francis) and Matthew C. Brown, formerly CFO and Treasurer of OPI, now holds the same positions at DHC (replacing Richard W. Siedel Jr.).
In December 2023, the Trust issued $941 million of Zero Coupon Senior Secured Notes due January 15, 2026 (with a 12 month extension option). It received $750 million in gross proceeds before estimated issuance costs of $19.6 million. The annualized interest rate on the Notes is 11.25%. Estimated net proceeds of $730.4 million were used to repay in full DHC’s $450 million Secured Credit Facility and redeem its $250 million of Senior Unsecured Notes that were due to mature in May 2024. This financing has bought the company an addition year (or two) and given it greater financial flexibility to pursue its operational and financial turnaround.
In May, the Trust issued a $120 million mortgage loan secured by eight MOLS properties. $60 million of the proceeds were used to retire a portion of its 9.75% Senior Notes due in June 2025.
The company has shown improvement in its overall financial performance. On a trailing 12 month basis (through June 30), revenues increased 8.0%, with a 10.3% rise in senior living resident fees and services partially offset by a 1.8% decrease in rental income (almost all of which is generated by its medical office and life sciences portfolio (OP)). Occupancy in senior housing operating portfolio (SHOP) has improved 120 bp to 79.0% over the past year, while OP occupancy has fallen by 430 bp to 81.5%. DHC’s normalized funds from operation has improved 43.8% to $26.8 million over that time and its net operating income (NOI) has risen 20% to $246.7 million.
While the improvement in financial performance is impressive, most of it was achieved in 23H2. Thus, the Trust’s performance has stalled somewhat this year. 24Q1 results were below 23Q1’s, but 24Q2 results showed a solid gain. Yet, OP occupancy has fallen 440 bp since the beginning of the year, while SHOP occupancy is down 30 bp. In a hopeful sign, management said that the pace of SHOP move-ins improved in July.
Besides seeking to raise occupancy at all of its properties through marketing initiatives and upgraded amenities, the Trust is also looking to raise the occupancy rates in both OP and SHOP by divesting underperforming properties. DHC currently has $44.0 million of properties classified as available for sale, $21.3 million of which were sold in July. The Trust is currently marketing for sale 1,100 underperforming SHOP units with a combined negative NOI and an average occupancy rate of 72%. It hopes to receive $80-$100 million in the sale.
The Trust is also looking to sell its 186,000 sq. ft. Torrey Pines life sciences complex located in San Diego. It continues to pursue sales of the smaller senior living communities (SLCs) included in its SHOP portfolio that are managed by third-party operators.
Improved portfolio performance, low interest rates and steady economic performance are all essential to a successful turnaround. The Trust has $440 million of 9.75% Senior Notes coming due on June 15, 2025. It is working to obtain additional financing secured by its SHOP properties to repay this outstanding debt. At current rates, it is hopeful that it can accomplish this refinancing at an interest cost of 6%-6.50%, which would reduce its annual interest expense payments by $14.3-$16.5.
After that, the Trust will need to turn its attention to repaying the recently issued $941 million of Zero Coupon Senior Secured Notes due January 15, 2026. It has the option of extending the maturity on that debt by 12 months. However, it is imperative to reduce the interest expense burden on this tranche of debt as much and as quickly as possible. The Trust is very highly leveraged, so it ideally should issue at least some equity to reduce its outstanding debt. If that is not possible, the combination of improved financial performance and hopefully lower interest rates could reduce its debt burden sufficiently to allow the Trust to continue to operate.
At this point, there are many key variables that can shape the outcome for DHC shareholders. First, it is not clear how much and how quickly SHOP occupancy can improve. Portfolio tweaks and property upgrades can raise occupancy at the margin, but DHC’s SHOP occupancy rate has been hovering just below 80% for three quarters now, still well below pre-COVID levels of around 84%. (Since professional staffing levels must be maintained to serve patients adequately, a substantial portion of property operating costs are fixed, so increasing occupancy even by a modest percentage can boost profitability meaningfully.) By now, pent-up demand arising from move-in delays attributable to the pandemic has presumably been satisfied. Since the onset of the pandemic, seniors have become more inclined to remain in their homes for as long as possible. Yet, demographics are favorable as baby boomers age will boost the seniors population. My projections assume that DHC will be able to achieve steady but modest quarterly gains in SHOP occupancy, so that occupancy through 2025 remains well below pre-COVID levels.
OP occupancy is another wild card. Although the Trust has been recording double-digit gains on new and renewal leases, occupancy in this portfolio has dropped steadily for the past two-and-a-half years from around 92% to 81.5%. There are no clear signs that it has yet bottomed. Changing work dynamics and tenant cost cutting may inhibit a rebound in occupancy. Even so, my projections assume (probably optimistically) that OP occupancy bottoms at 80% at year-end 2024 and recovers to 84% by the end of 2025.
Overall, my projections show that DHC’s normalized FFO improves from $34.5 million in 2024 to $67.0 million in 2025. On a per share basis, projected normalized FFO is $0.14 in 2024 and $0.28 in 2025. Net operating income under my projections improves from $276.5 million in 2024 to $320.4 million in 2025. (On a preliminary basis, with further modest gains in occupancy and a successful refinancing of the zero coupon senior secured notes, my projections indicate that normalized FFO per share could rise to $0.44 in 2026).
Since my previous report one year ago, DHC’s stock has risen 21.9% in price, modestly better than the S&P SmallCap 600’s 17.4% gain. Year-to-date, it is down 3.2%, underperforming the S&P 600’s 6.4% gain. Most of the underperformance occurred up until May. DHC has outperformed its benchmark since the beginning of June. Sentiment on the stock improved noticeably after the merger proposal was cancelled a year ago. In recent months, the stock has reacted positively (and noticeably) to market optimism about lower interest rates.
DHC’s stock remains unrated (and is not formally covered at this time). I believe that a reasonable price target for the stock, assuming that my projections are on target, would be $4.00. The target price equates to a forward multiple of 14.3 (below the current peer group average of 15.5) times projected 2025 normalized FFO per share of $0.28.
Steady improvement in financial performance from net operating income gains and lower interest costs is essential to both the forecast and price target. If DHC is unable to meet or exceed these projections, whether due to an inability to improve occupancy rates and reduce operating costs, continued high interest rates or deteriorating general economic conditions, there is a high probability that it will eventually have to restructure its debt obligations to reduce its leverage.
This is a summary of my recent follow up report on Diversified Healthcare Trust (DHC). To obtain a copy of the report, please reach out to me using the contact information provided below.
Stephen P. Percoco
Lark Research
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