Diversified Healthcare Trust
NASDAQ:DHC
Earnings Call Analysis
Q3-2023 Analysis
Diversified Healthcare Trust
Diversified Healthcare Trust (DHC) took decisive steps following the mutual termination of their merger agreement with OPI. With B. Riley Securities as a financial advisor, DHC explored various strategies to meet near-term capital needs such as asset sales, joint ventures, and innovative financing options like preferred equity or zero coupon bonds. They also commenced discussions with their banking group to extend credit facility maturity and adjust loan covenants thus providing flexibility to utilize proceeds from capital raising to address deferred projects and debt. This strategic pivot was reinforced by the Board's bylaws amendment to maintain the company's net operating losses, which offsets taxable gains and assists in DHC's asset-based liquidity strategy.
Third quarter reports showed that DHC's normalized FFO jumped to $0.03 per share from a negative $0.06 per share year-over-year, an encouraging sign given the $22.5 million increase from the prior year. This surge was largely attributed to the performance of their Senior Housing Operating Portfolio (SHOP), which experienced a notable rise in revenue by 13.2%, an increase in occupancy by 370 basis points to 78.4%, and a 7% uptick in average monthly rates. However, the SHOP segment did face challenges, such as a $2 million sequential decline this quarter and amplified operating costs. The office portfolio, while witnessing a slight revenue increase, saw a decrease in cash basis NOI by 2.7% and encountered higher seasonal expenses. Notwithstanding these hurdles, DHC posts strong leasing activity with 289,000 square feet of new and renewal leases, indicating robust demand for its properties.
DHC concluded the quarter with over $279 million in cash and restricted cash, providing ample liquidity in the short term. Despite this, the company faces $700 million in debt maturing in the first half of 2024 and currently does not comply with its debt incurrence covenant. This poses limitations on new debt issuances or refinancing options. However, the improved debt service coverage to 1.17x from 1.08x reflects a gradual enhancement in DHC's ability to service its obligations. To overcome the annual EBITDA shortfall of $61 million and align with the required covenant, the company is proactively assessing a spectrum of approaches, considering their substantial portfolio of unencumbered assets worth approximately $5.9 billion. These assets offer a foundation for DHC to engineer its path towards financial stability and future growth initiatives.
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Good morning, everyone, and welcome to the Diversified Healthcare Trust Third Quarter 2023 Earnings Conference Call. [Operator Instructions] Please also note today's event is being recorded. At this time, I'd like to turn the floor over to Melissa Mccarthy, Manager of Investor Relations. Ma'am, please go ahead.
Thank you, and good morning. Welcome to the Third quarter 2023 Conference Call for Diversified Healthcare Trust. Joining me on today's call are Jennifer Francis, President and Chief Executive Officer; and Matt Brown, Chief Financial Officer and Treasurer. Today's call includes a presentation by management, followed by a question-and-answer session with sell-side analysts. I would like to note that the recording and retransmission of today's conference call are strictly prohibited without the prior written consent of the company.
Today's conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and other securities laws. These forward-looking statements are based upon DHC's beliefs and expectations as of today, Thursday, November 2, 2023. The company undertakes no obligation to revise or publicly release the results of any revision to the forward-looking statements made in today's conference call other than through filings with the Securities and Exchange Commission, or SEC.
In addition, this call may contain non-GAAP numbers, including normalized funds from operations or normalized FFO, net operating income or NOI and cash basis net operating income or cash basis NOI. Reconciliations of net income or loss to these non-GAAP figures are available in our financial results package, which can be found on our website at www.dhcreit.com. Actual results may differ materially from those projected in any forward-looking statements. Additional information concerning factors that could cause those differences is contained in our filings with the SEC. Investors are cautioned not to place undue reliance upon any forward-looking statements. Now I'd like to turn the call over to Jennifer.
Thank you, Melissa, and good morning. Welcome to DHC's third quarter conference call. I'd like to begin by welcoming Matt Brown as our new Chief Financial Officer and Treasurer. Matt has extensive experience at the RMR Group, where he is responsible for the company's accounting function and he previously served as OPI's CFO for the past 4 years. Matt joined RMR in 2007 and for much of the time prior to becoming OPI's CFO, he was responsible for DHC's financial reporting. I've been working with Matt for years and welcome him to DHC.
In early September, we mutually agreed to terminate our merger agreement with OPI. Each company agreed to bear its own costs and expenses in connection with the terminated transaction and it was agreed that neither party would pay a termination fee. Beginning in late September, we took the following steps to move forward. First, we engaged B. Riley Securities as our financial adviser to help evaluate options to address our near-term capital needs, including upcoming debt maturities. These capital raising options may include asset sales, joint ventures and permissible financings that can include, but are not limited to, issuance of preferred equity or zero coupon bonds. This process may lead to and include other options before we're finished.
Second, we're in discussions with our bank group to possibly extend the maturity date of our credit facility and to amend certain covenants that would allow DHC additional flexibility to use proceeds from capital raising initiatives to pay off debt and fund the capital that we've recently deferred, which is an important part of the recovery in our SHOP communities. Third, in addition to the deferral of certain redevelopment capital, we've initiated a disposition strategy for a number of assets in order to increase liquidity at the company. Our goal is to pay off maturing debt and restart the capital projects we've deferred. The assets that we've selected for disposition come from each of our operating segments and are geographically diverse.
Finally, the DH Board of Trustees approved an amendment to our bylaws to reduce the allowed maximum percentage ownership of DHC common stock from 9.8% to 5%, in order to preserve cumulative net operating losses or NOLs. These NOLs are valuable to DHC and can be used to offset any taxable gains on asset sales in our disposition strategy as well as to offset other gains in the future. It's important to note that this new ownership limitation is applicable on a prospective basis and any owner of more than 5% of DHC's common shares as of November 1, 2023, is not required to reduce their ownership to meet this requirement. The sequencing and timing of our plan to address near-term debt maturities and return DHC to growth is still to be determined but we're working diligently to advance this plan on all fronts and look forward to updating the investment community when appropriate.
Moving on to our third quarter results. Yesterday, we reported normalized FFO of $0.03 per share, which is an increase from negative $0.06 per share in the prior year quarter. This improvement was driven largely by growth in our SHOP segment. The quarter was also highlighted by a 13.2% increase in revenue, a 370 basis point increase in occupancy to 78.4% and a 7% increase in average monthly rate over the prior year. The overall backdrop in the senior living industry continues to be supportive of a recovery. The new supply and construction starts both remained at their lowest levels in years. The overall labor market has become more favorable and there is evidence of decreasing labor costs across the industry. Evidence of the positive momentum in the labor market can be seen both on an industry level with wage pressures decreasing sequentially from Q2, and within DHC's SHOP segment with an $11.3 million decrease or a 64% reduction in contract labor from the prior year. Generally, SHOP progress can be attributable to strategic operational improvements, strong industry fundamentals and our capital investments into our communities.
During the quarter, we invested $49 million, bringing year-to-date SHOP spend to $128 million. However, cost for our SHOP operators remain elevated due to insurance premium increases, acquiring new staff and seasonal expenses such as the impact of heat waves across the United States this summer. While the SHOP recovery remains pressured by higher operating expenses and our deferral of capital, our operators continue to achieve rental rate growth and occupancy gains above the industry benchmark for comparable properties year-over-year.
Moving to our office portfolio. In our same property office portfolio rental income increased less than 1% and cash basis NOI decreased 2.7% compared to the third quarter of last year, which Matt will address shortly. We ended the quarter at 93% occupancy in this portfolio, which is an 80 basis point increase from a year ago. There was strong leasing activity in our office portfolio during the third quarter, as evidenced by 289,000 square feet of new and renewal leases signed with a 14.8% roll-up in rent and a weighted average lease term of 8.1 years. At the end of the quarter, we had a leasing pipeline of over 670,000 square feet. I'll now turn the call over to Matt to review our financial results. Matt?
Thanks, Jennifer, and good morning, everyone. Normalized FFO for the third quarter was $8.3 million or $0.03 per share, an increase of $22.5 million from negative $14 million in the prior year. While we are pleased with this improvement, sequentially normalized FFO declined $3.8 million, mainly driven by a $2 million decline in our SHOP segment that I'll address shortly, and an increase in interest expense as a result of continued increases in SOFR. Our consolidated same-property cash basis NOI was $56.2 million which is a $22.1 million or 64.6% year-over-year improvement. The changes by segment are as follows: Office same-property cash basis NOI was $27.6 million, representing a year-over-year decline of $754,000, mainly driven by increased expenses due to a tenant contraction. On a sequential quarter basis, cash basis NOI declined $1.9 million in line with expectations based on higher cooling costs in the summer months.
SHOP same-property cash basis NOI was $21 million, representing a significant year-over-year increase of $22.8 million. On a sequential quarter basis, cash basis NOI declined $2 million made up of the following: an increase in expenses of $9.8 million, most notably $5.3 million in wages, payroll taxes and benefits $2.6 million in insurance premium increases and $2.3 million from seasonal cooling costs in the summer months. These expense increases were partially offset by an increase in revenue of $7.8 million, driven by a 100 basis point increase in occupancy.
Turning to the balance sheet. We ended the quarter with over $279 million in cash and restricted cash. As a reminder, we have $700 million of debt maturing in the first half of 2024 and are not currently in compliance with our debt incurrence covenant which prevents us from issuing any new debt or refinancing existing debt. Our consolidated income available for debt service to annual debt service coverage grew to 1.17x from 1.08x last quarter below the 1.5x minimum requirement. The annual EBITDA shortfall to achieve compliance is $61 million. As we look forward, we believe we have several viable options available to us to address our near-term capital needs and as Jennifer outlined, we are pursuing all of these options concurrently. We have a significant pool of unencumbered assets with a gross book value of approximately $5.9 billion available to pursue various strategies.
Regarding our credit facility, we have added a property in Hawaii to satisfy the aggregate appraised value of the collateral properties requirement following notice of a nonmonetary default in June 2023. We are currently engaging in discussions to possibly extend the maturity date of the credit facility and to amend certain covenants to provide DHC additional flexibility to use proceeds from capital raising initiatives. As we are in ongoing negotiations, we will not provide detail on specific terms, but look forward to disclosing more information when available.
As part of our liquidity management and financing strategies, we have begun to defer certain redevelopment capital across our portfolio. As a result, we currently expect aggregate capital expenditures to total $240 million to $260 million in 2023 from an initial forecast of approximately $315 million and $200 million to $220 million in 2024 from an initial forecast of approximately $330 million. Based on the execution of our financing strategies, the path to covenant compliance will impact the timing of restarting these deferred projects to continue to drive the SHOP recovery.
In closing, we are actively evaluating all strategies to strengthen DHC's balance sheet regain debt covenant compliance, source additional capital to fund our ongoing SHOP recovery and best position the company for long-term growth. We currently expect to regain debt compliance by the end of 2024 and based on the execution of certain financing strategies being contemplated, it could lead to covenant compliance sooner. That concludes our prepared remarks. Operator, please open the line for questions.
[Operator Instructions] Our first question today comes from Bryan Maher from B. Riley FBR.
A couple for me this morning. Let's start with the covenant compliance. I think you're at 1.17, our model had you at 1.22 for the quarter. So we're not too far off. I think the prior commentary from management was by mid-year 2024. And I think, Matt, you just said by year-end 2024, barring some changes in dispositions and what have you. What's pushing that back? Again, we're kind of getting to it in the second quarter of 2024.
I think, Bryan, it really relates to the growth in our SHOP segment, we do expect to see that continue to improve. But as you saw in this quarter's results, we did have some negative impact from operating expenses. Some of those are seasonal. However, some of those are going to continue such as wages and insurance costs. So we think realistically, by the end of '24 makes sense. However, if the SHOP growth is in excess of forecast, it could be closer to the middle of the year.
I just want to add to that, Bryan, that we -- Matt talked about the deferral of capital in his prepared remarks and we have deferred capital and that capital deferral will have an impact on our operators' ability to grow rate and to grow occupancy. I mean, obviously, we are still projecting real growth in the SHOP segment. But as soon as we can start redeploying that deferred capital, we'll be able to -- our operators will be able to push results.
Yes. And I can understand and agree with deferring some capital. That being said, at properties where you might have previously done a deep dive and a refresh instead maybe changing carpet and putting pain on it, maybe a capital improvement light, but still something that refreshes the property. Is that something that's being considered?
Without a doubt, I mean, we're still expecting in '24 million $200 million to $220 million of capital spend. So we've deferred capital and we haven't suspended capital. So there is still -- there are still improvements going on, and we will see the results from those improvements.
Okay. Moving on to the bylaws changes. I found that to be interesting specifically as it relates to the NOLs. Matt, can you share with us what the current NOLs available are?
Sure. At DHC, they're currently in excess of $300 million. And for our TRS entity, they're in excess of $100 million. So over $400 million in the aggregate.
Great. And then we noticed that the other operators within SHOP did a little bit better than our expectations and the 5-star stuff was a little lighter than we had thought. Is there anything going on there particularly in the other operators that can further juice the NOI coming out of those properties?
They're just really having positive results, growing occupancy, pushing rate. I think there's still a great deal of opportunity with our other operators and with Aleris to push rate and continue to push the rate associated with level of care and making sure that residents are at the appropriate level of care. And so they're just -- they're for the most part, doing a really good job.
Shifting gears to the asset sales. And I know you probably don't want to get into too much detail on that. But can you give us any more color as to if they're more along the lines of one-offs or if they're portfolios? I think you talked about in your prepared comments across segments and across geographies. Can you give us any more color, level of magnitude of proceeds, et cetera?
Yes. So they are -- it is across -- the properties are across all of our operating segments. It's a pretty challenging time right now to sell assets. We feel pretty positive about the properties that we've picked. We picked the assets that we believe have the most desirable characteristics for buyers. Yes, it's really not a market for large portfolio sales. So I think that these dispositions will be in small bite-size dispositions, 1, 2, 3 assets maybe some much smaller portfolios, but it's certainly not 1 or 2 or 3 large portfolios. It's a pretty -- like I said, it's a challenging time to sell assets, but because of the quality of these assets, we think that we'll be successful. We're out with -- I would -- close to $1 billion in assets that we've -- that we're engaging brokers with.
That's good color. And we've come across articles saying that entities like Bain Capital have an over $2 billion fund looking to buy assets in your world. And I suspect that Ventas and Welltower might be interested as well. But I'll leave that up to you guys and your brokers. Last for me on -- and I know you didn't really want to go too far down this road on the credit facility. But would you say that the bank group is receptive to your overtures? And if you were to look for an extension, are you kind of thinking 6 months or a year? Just any broad strokes there would be really helpful.
Yes, Bryan, it's tough to provide too much color because we are in ongoing negotiations. Thus far, we've been dealing with the admin agent. And we believe we've reached terms with them. And now it's really engaging in the rest of the bank group, and we need approval from 100% as it relates to a maturity extension, we'd love to get a year, but it's too early to really definitively say at this point.
[Operator Instructions] And ladies and gentlemen, I'm showing no additional questions. I'd like to turn the floor back over to management for any closing remarks.
Thank you, and thank you all for joining our call today. Operator, that concludes our call.
And ladies and gentlemen, with that, we'll conclude today's conference call and presentation. We thank you for joining. You may now disconnect your lines.