Description

2023.10.23 DHCNL 6.25% Baby Bonds due 2/1/46

I believe the Diversified Healthcare Trust 6.25% Baby Bonds due 2/1/46 are an attractive long (ticker: DHCNL).  These bonds currently trade ~53 cents on the dollar and sport a YTM of 12.8%.  The current yield is 11.8%.

DHC is a healthcare REIT that owns medical office, life science buildings, and senior housing communities. 

Here’s a summary of DHC’s capitalization:

Next is a look at DHC’s debt stack:

And a quick snapshot of its real estate assets:

Why does the opportunity exist? 

The medical office, life science, and triple net assets are performing well. 

But the bulk of the portfolio by assets – the senior housing or SHOP portfolio  – is operating at margins massively below historical and normalized levels.  Covid crushed demand and the revenue side while labor shortages and cost inflation sharply increased the cost side. 

The bonds were issued pre-Covid with 4 primary covenants.  DHC has substantial headroom on the first 3 bond covenants: (i) Unencumbered Assets / Unsecured Debt; (ii) Debt / Adj Assets; and (iii) Secured Debt / Adj Assets.

But Debt Service Coverage incurrence covenant is problematic today.

The drop in senior housing NOI after Covid pushed the DSCR below the threshold of 1.5x (troughed at 0.79x in Q3’22 and up to 1.08x as of Q2’23).

So DHC is prohibited from incurring additional debt.  This prohibition applies not just to incremental debt, but it also prevents refinancing in the ordinary course.

So DHC is in a purgatory of sorts where it theoretically has $5+ billion of unencumbered assets and total debt capacity almost double the current net debt.  Yet it is prohibited from simply refinancing in the ordinary course until NOI rebounds or other actions are taken.

That explains why DHC’s standard corporate bonds are all trading with YTWs in the teens. 

In terms of dollar price and convexity, the baby bonds are cheaper still, at 53% of par.  We are creating the company for ~$1.82 billion through the DHCNL baby bonds.

Despite their lower price, the baby bonds are bona fide senior unsecured credit instruments that are pari passu to and operate under the same indentures as the standard DHC corporate bonds due 2024 and 2028.  (They are structurally subordinated to the 2025 and 2031 DHC corporate bonds that have the benefit of certain subsidiary guarantees).

While Covid clobbered the senior housing industry, there are promising supply / demand tailwinds driving the industry’s rebound.  The key 80+ age cohort is seeing accelerating growth.  New supply of senior housing is down sharply as well.

The industry rebound can be seen clearly in recent numbers reported in industry association data and by competitor REITs Welltower and Ventas – the 2 largest owners of senior housing in America.

Occupancy growth is driving dramatic increases in rents, re-leasing spreads, and therefore NOI. 

DHC’s rebound off the trough is lagging Ventas and Welltower but is clearly underway – rents, occupancy, and NOI are also increasing.  Further increases in occupancy should drive better fixed cost leverage and rental pricing power, which should combine to drive NOI improvement that DHC needs. 

DHC has $338mm of unrestricted cash on the balance sheet as of its last quarterly report.

First, DHC must secure the extension of its $450mm revolver which matures in January.  Given the amount of excess collateral, top position in the capital stack, and long term relationships with not only DHC but all of the RMR platform broadly ($37 billion in total assets on the platform), I am not terribly concerned about the revolver being extended once again.

Next, the 2024 unsecured bonds mature 5/1/24 in the amount of $250mm.

After that, the next maturity is not until June of 2025.

It seems quite likely DHC will be on the right side of the DSCR covenant prior to June of 2025.  In fact, there is a decent chance DHC will be on the right side of that covenant prior to the 2024 bond maturity if targeted asset sales are concluded in the interim.  So I’d expect the 2025 bonds will ultimately be taken care of with an ordinary course refinancing prior to their maturity.  And with essentially only the $450mm revolver secured at this point, there is tremendous secured capacity if necessary.

Assuming the revolver is indeed extended at the current size, then cash on the balance sheet today slightly exceeds the 2024 bond maturity.

Should the revolver somehow not get extended, then I’d expect the revolver and 2024 bond maturities to be satisfied by a combination of the cash on the balance sheet and targeted asset sales.

DHC could also pursue a preferred equity issuance (the incurrence covenant prohibiting new debt does not prohibit preferred equity) instead of asset sales.  The EBITDA / Interest covenant is calculated on a pro forma basis.  A preferred equity issuance would improve the covenant calculation by eliminating interest from the debt paid off while the new preferred dividends wouldn’t count as interest.

DHC could also issue a (short dated) zero coupon bond to refinance debt so long as the pro forma calculation for EBITDA / Interest would exceed 1.5x.

I am confident that once the maturities through 2025 are handled, then our baby bonds should trade at a significantly tighter spread and yield than today, driving substantial upside beyond the current yield of 11.8%.  We may see this happen even in advance of the 2025 bonds being refinanced – once both the revolver and 2024 bonds have been handled and assuming that the operating metrics at DHC continue to improve.

Here is a summary table of a base case outcome in which the baby bonds trade to 9.5% YTM in 2 years from now:

On a 2 year time frame, we’d be looking at a 29% IRR.  Trading to a 9.5% YTM in 12 months from now would mean ~49% IRR.  Even if it were to take 5 years, we’d still be looking at an 18% IRR.

An upside case in which they trade to an 8% YTM in 2 years would imply a 38% IRR as shown in the following table:

A “fundamental” downside case seems priced in in part already as shown below:

Trading to a 17% YTM in 1 year (to a price of 40% of face) or to a 20% YTM in 2 years (to a price of 33% of face) both imply total downside of ~13%.   

(Of course, trading down immediately without the benefit of collecting the 12% annual cash yield is more painful – a 17% YTM today implies 26% price downside to a dollar price of 39% of face).

Ultimately, I believe the low dollar price provides significant downside protection through the previously mentioned low creation value.  The create value represents only 26% of gross Real Estate Asset Value as shown below:

While the present time is not opportune for selling assets, I still expect ample asset sales could be consummated.  First, essentially all the SHOP assets are unencumbered.  In theory, SHOP assets are easy to package either in very small bite sizes or in larger portfolios.  Similarly, SHOP assets for sale could be comprised mostly of the best performing, stabilized and largely recovered ones to maximize valuation per unit; or, SHOP assets for sale could be comprised mostly of the worst performing assets in which a buyer could pay a dramatic discount to replacement cost yet DHC wouldn’t be losing current NOI.

In addition, the triple net assets in particular ought to be readily financeable today.  And while life science and medical office would not get the peak pricing of 18 months ago, they should be saleable.

Beyond the quantitative elements of the investment case here, I see significant qualitative reasons for the baby bonds to do well.  DHC is externally managed by RMR.  While RMR’s involvement has historically translated into equity dilution for DHC, I believe it is a credit positive.  I don’t see RMR jeopardizing its exceedingly lucrative perpetual management fee and incentive fee stream with a DHC default.  I also don’t believe RMR is ready to risk tainting the rest of its $37B empire with a DHC default.

RMR has historically proven a willingness to take credit positive actions at its managed REITs, even at the expense of the REIT equities.  Most recently, it attempted to merge OPI with DHC – ostensibly a play to prop up OPI’s longer term secular issues with the benefit of DHC’s longer term SHOP recovery, but also with the carrot to DHC to immediately solve DHC’s covenant issue and enable an ordinary course refinancing.

An activist agitating against that transaction (apparently from the perspective of DHC equity initially, and partially from the perspective of the bonds later on) successfully scuttled that transaction.  The proxy statement has lots of interesting details.  The activist materials also do an excellent job of laying out the upside at DHC (from an equity perspective).  Suffice to say, if the equity is indeed worth multiples of the current share price, that only solidifies the case that our bonds should be many times covered.

I’d also note that several other holders filed materials not only blasting the potential merger with OPI, but discussing their desire, prior attempts, and current and offers to assist DHC in refinancing and dealing with its near dated maturities. 

I see multiple ways to win with the baby bonds.  Besides tightening spreads following a refinancing of the nearer dated debt maturities, I could envision a potential sale of the company.  To date, DHC has not mentioned that possibility in connection with the failed merger of OPI, but rather has mentioned asset sales, potential preferred financing, and the hiring of B. Riley as a debt restructuring advirsor.  Nevertheless, the 2 largest owners of SHOP assets in WELL and VTR have both talked at length about how bullish they are relating to SHOP NOI recovery.  They have also both acquired SHOP assets/portfolios and alluded to the potential for further inorganic growth. 

Both WELL and VTR have equity market caps multiples the size of DHC’s enterprise value, not to mention investment-grade rated unsecured bond issuances of ~$18B and $9B, respectively, with even 10 year maturities trading inside 7% YTWs.  Either one could conceivably acquire DHC in its entirety, in which case the baby bonds would likely trade up 75% overnight.  That blue sky scenario may sound far fetched considering RMR’s historical misalignment of incentives. 

However, I believe that a sale of DHC could be a best case scenario for RMR too.  RMR would earn a massive termination fee of ~$300 million.  Depending on the takeout price, RMR may even earn an incentive fee.  The Chairman and CEO of RMR atop the RMR empire owns 52% of RMR personally.  He also owns 100% of ALR, which manages the bulk of the SHOP portfolio at DHC.  Presumably, he would use that as leverage to demand a massive termination fee at ALR so that a buyer of DHC could swap out the management of the SHOP portfolio.  On top of that, he personally spent $47mm out of pocket in a 2 week period several months back to acquire 9.8% of DHC common stock, paying an average of $2.26 per share of DHC.  A sale of DHC at fair value could easily net him a quick multi-bagger on that investment.  I could envision him personally clearing $300-500mm+ in a sale of DHC to a WELL or VTR.

Moreover, the sale of DHC at a value maximizing price could go a long way toward improving the reputation of RMR, along with the “governance discounts” at the other RMR entities, not to mention dramatically improve the valuation at RMR itself.

Perhaps a more likely outcome could be Adam Portnoy acquiring DHC himself in a takeunder, as he did earlier this year with ALR.  While such an event would be ugly and abusive, I believe our bonds would be more likely to trade up than down.  After all, nearer dated debt maturities would need to be handled in such a scenario.

While there would certainly be risk of the baby bonds getting primed over time in such a takeunder, I expect that would take time and our basis continues to be bought down in time with the payment of the 11.8% current yield annually.  I also suspect that the activists involved in DHC equity would not step away silently.

Another risk is that RMR throws out its historical playbook and files DHC for Chapter 11 despite the risk that would entail to the perpetual fee streams (not to mention the personal risks from the likely UCC / US Trustee investigation / litigation surrounding insider dealings that would almost certainly ensue). 

Even so, I would view a “normal” Chapter 11 of DHC as a positive catalyst for our bonds.  DHC is pretty clearly a solvent debtor, the low dollar price of our bonds would put us in great position relative to the pari passu bonds, and a shorter term Chapter 11 would prevent our bonds from being primed prior to bankruptcy.  The main risk in a Chapter 11 would seemingly be the type of creditor on creditor violence seen in certain larger bankruptcies.  But given how discounted our create value is, it isn’t exactly clear to me how that would work in this case (seemingly obviously solvent debtor).

In short, while the DHC baby bonds have hair, I believe they offer a juicy current coupon, significant capital appreciation upside in time, with the potential for a home run if WELL and/or VTR decide to acquire it.  And while MTM downside can always be nastier than seems reasonable, I believe that fundamental downside over time is quite limited.

Catalysts

Asset sales

Preferred equity issuance

Continued operating improvement at SHOP segment

Paydown or refinancing of near term debt maturities

Regaining covenant compliance

Sale of the company

Catalyst

Asset sales

Preferred equity issuance

Continued operating improvement at SHOP segment

Paydown or refinancing of near term debt maturities

Regaining covenant compliance

Sale of the company