Description

Diversified Healthcare Trust (DHC) has two series of senior unsecured baby bonds that offer good yields and are well protected by the asset base. The capital structure features a large stack of unsecured debt and minimal mortgages except for a large mortgage on a flagship office property. The company has strong liquidity and enjoyed stellar rent collection in April and May. 

DHCNI is the symbol for 5.625% senior notes due 2042. DHCNL is the symbol for 6.25% senior notes due 2046. Currently, there are $350 mm of DHCNI and $250 mm of DHCNL outstanding. As of this writing, DHCNI trades at $18 (70 cents on the dollar), offering 7.8% current yield and 8% yield to maturity. DHCNL trades at $19, offering current yield and YTM of 8.2%. Both are illiquid, trading only ~$600k a day, so they are suitable for PAs and small funds. This write up will use DHCNI for valuation math. Before the March market crash, both traded at a premium to $25 as investors chased yield. 

After the $1 bn 2025 bond offering which was used to retire $450 mm of 2020 maturities and pay down the revolver, DHC has $200 mm unsecured term loan and $2,650 mm of unsecured bonds outstanding. Face and market values of unsecured debt are $2.9 bn and $2.1 bn respectively. 

Boston JV

DHC also has $695 mm of mortgages, but $620 mm of them is secured by two life science buildings in Boston’s Seaport District (11 Fan Pier and 50 Northern Avenue) in which DHC owns 55% (and fully consolidates the results) and a sovereign wealth fund owns 45%. 

The two 15-story Class A office buildings are fully leased by Vertex Pharmaceuticals until 2028, a $80 bn market cap biopharmaceutical company. In 2017, DHC sold the 45% stake at $1.2 bn valuation. Net of $620 mm of mortgages, DHC’s stake is worth $319 mm. 

NOI of the joint venture has not been disclosed, but annual distributions to NCI is $21 mm, implying $47 mm of total distributions. Distribution yield on the $580 mm of equity is 8.1%, which is reasonable or even cheap. Assuming 100% distribution of FFO and no G&A load, I estimate NOI of the JV is $70 mm, implying a 5.8% cap rate at 2017’s $1.2 bn transaction value. Again, this seems reasonable given the location and tenant quality.

Life sciences and MOB portfolio

Excluding the Boston JV, DHC generates $180 mm of cash NOI from a portfolio of life science and medical office buildings, encumbered by only $24 mm of mortgages. These office buildings are 92% leased, and have well staggered lease expirations (only 30% expiring in the next 4 years) and a well diversified tenant base (other than Vertex, only 5 tenants represent >1% of annual rental income). MOB comps (DOC, HTA and HR) trade at 5~6% cap. Applying a 7% cap rate to DHC’s assets gets us $2.55 bn (net of $24 mm mortgages).

For April, DHC collected 99% of rent due for its office portfolio. For the first 3 business days of May, DHC collected 86% of May rent due, in line with historical patterns. Competitors reported similar results. MOB REITs’ recent collection numbers are probably the highest among all real estate asset classes. 

So, DHC’s 55% stake in the Boston JV ($319 mm) and its life sciences/MOB portfolio ($2.55 bn) are worth almost $2.9 bn, covering the unsecured debt at face and market values. 

SHOP

DHC also owns a senior housing operating portfolio (SHOP). The SHOP portfolio has 30,000 units among 240 properties, with gross asset value of $4.2 bn, encumbered by only $43 mm of mortgages on 3 properties. 

All properties were previously either leased or managed by Five Star Senior Living (FVE). Due to FVE’s poor results, DHC restructured its arrangement with FVE whereby FVE would be managing the 20,000 units it previously leased from DHC (this change became effective on Jan 1, 2020). Under the new management agreements, DHC would be operating the SHOP portfolio under the RIDEA structure, meaning DHC will be directly exposed to the revenues and opex of the assets, instead of being a passive rent collector. FVE would be managing the operations and receive a management fee equal to 5% of revenues. 

Annualized Q120 NOI for this segment is $200 mm. As of April 30, SHOP had 350 confirmed cases (1.5% of resident population) across 46 properties. Management disclosed on the Q1 call that occupancy is declining at 40~50 bps per week due to covid-19, representing $6 mm/week of lost revenues. Obviously occupancy will find a bottom somewhere, but near term results are not going to be great due to lower occupancy and higher labor costs. However, you don’t need this portfolio to be worth anything for the bonds to be covered, and the negligible asset level leverage offers staying power into a post-covid world. 

Other assets

DHC has $45 mm NOI from “non-segment” assets consisting of senior housing properties not managed by FVE and wellness centers. In addition, DHC owns 10 mm FVE shares valued at $43 mm. 

Liquidity and covenants

DHC issued $1 bn of 2025 notes and used the proceeds to pay down $450 mm of 2020 maturities and the revolver. Now DHC has an unused $1 bn revolver maturing in Jan 2022. 

The revolver’s covenants are copied below. Due to the large unencumbered pool, I don’t expect unencumbered asset related covenants to be a problem. 

The leverage ratio is calculated with asset values assuming 7% cap rate for senior housing and 6.5% for all other assets. Currently, this ratio is at 42%. For leverage ratio to increase to 60%, NOI of the SHOP segment has to decrease by $170 mm from the current $200 mm level. 

The office portfolio generates $250 mm of NOI (assuming 100% contribution of the Boston JV). Annual interest expense is $170 mm. Just the office portfolio provides almost 1.5x EBITDA/interest coverage. 

While industry occupancy levels continue to decline, some leading indicators (customer leads, move-ins) are encouraging. For example, through June 8th VTR’s SHOP move-in trend already recovered to 73% of last year, rebounding from 30%s in April. 

RMR 

DHC is externally managed by RMR, whose management fee is based on the lower of DHC's EV or historical asset value. Due to decline in DHC's share price, currently management fee is calculated using market value. RMR has an incentive to boost performance/share price of DHC, as well as to keep this as a going concern to receive the fee stream.

In addition, DHC's G&A load is below peer average.

Appendix A: Valuation

Appendix B: Comparable bonds

VTR 5.7% notes 2043: $110/4.9%. Debt/EBITDA: 5.7x

HTA 3.1% notes due 2030: $102/2.9%. Debt/EBITDA: 5.6x

HR 2.4% notes due 2030: $96/$2.8%. Debt/EBITDA: 5.3x

Appendix C: Debt outstanding

Risks:

Sustained outbreaks in the SHOP portfolio

Legal liabilities from covid-related deaths in the SHOP portfolio

Permanent reduction in demand for MOB space due to adoption of online/phone visits

Recent offering of 9.75% notes due 2025 may indicate that debt market isn't accommodative to SHOP exposure. However this bond now trades at 109. 

Catalyst

SHOP portfolio stabilization

Extension of revolver