Diversified Healthcare Trust: Time To Buy The 50% NAV Discount And 7.5% Yield

Jan. 07, 2020 8:15 AM ETDiversified Healthcare Trust (DHC)ALR, RMR, EQC34 Comments14 Likes
The Boy Plunger profile picture
The Boy Plunger
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Summary

  • Following a major tenant restructuring and dividend cut, stock has been punished, trading at a 20-year low and a 50% discount to NAV, providing a compelling risk-reward proposition.
  • Senior housing industry fundamentals may be at a positive inflection point, which would be a significant positive catalyst for the stock.
  • We think the recent destruction of value and discounted valuation could bring an activist investor to push for a sale of the company and or termination of the RMR agreements.
  • Following the dividend reduction, the stock now offers a well-covered 7.5% dividend yield, compensating investors while they wait for the NAV gap to narrow.

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Thesis

Following a major tenant restructuring and dividend cut (details here), DHC (formerly SNH) (NASDAQ:DHC) stock has been punished, trading at a 20-year low and a 50% discount to NAV, providing a compelling risk-reward proposition for risk-tolerant value investors. Investor sentiment towards the name is incredibly negative due to an external management structure and negative fundamentals in the senior housing industry. However, due to share price decline, the fee structure is much more favorable and it appears senior housing industry fundamentals may be at a positive inflection point, which would be a significant catalyst for the stock.

As part of the company’s restructuring, leverage will be reduced to moderate levels through the sale of approximately $900 million of non-core assets, leaving the company with a healthy, investment grade rated balance sheet. Following the dividend reduction, the stock now offers a well-covered 7.5% dividend yield, with an AFFO payout ratio projected to be roughly 80%. We think the recent restructuring and resultant destruction of shareholder value, coupled with the current extremely discounted valuation could bring an activist investor to the fray to push for a sale of the company and or termination of the RMR management agreements, either of which would be additional catalysts for the stock.

Overview

DHC owns a portfolio of 436 healthcare-oriented properties across the country, which are roughly evenly split between medical office and senior housing. A snapshot of the portfolio is seen in the following tables. As one would expect, the geographic concentration of the portfolio is focused on the sunbelt and the life science hub of Boston.

Source: Diversified Healthcare Trust.

Source: Diversified Healthcare Trust.

Senior Housing Portfolio

Source: Diversified Healthcare Trust.

Senior Housing

DHC’s senior housing portfolio consists of 32,410 units and is predominantly private-pay, i.e. not reliant on reimbursement from Medicare/Medicaid. The company states that 97% of NOI comes from properties where a majority of the NOI is private pay. The makeup of the senior housing segment by NOI is 50% independent living, 43% assisted living, and 7% skilled nursing. The company’s senior housing exposure has been the major issue at hand for DHC for several years, owing to weak industry fundamentals and their exposure to Five Star Senior Living Inc. (FVE), an RMR-owned operator of senior housing facilities and DHC's largest tenant. Five Star was created by RMR as a subsidiary of DHC (formerly SNH) in 2000 following the devastation inflicted on the senior living industry (particularly nursing homes) by the Balanced Budget Act of 1997, which cut reimbursement rates for nursing homes.

These changes resulted in widespread industry bankruptcies of operators and forced RMR to create an entity to manage assets where operators had become insolvent. Subsequent to this formation of necessity, RMR decided to spin off Five Star as a public company in 2004 and go on an acquisition binge of independent and senior living facilities, financed principally through sale-leaseback transactions with DHC. This led DHC’s exposure to FVE to balloon to over 50%, roughly where it still stands today. Five Star’s financial health had been unstable for a long time, and it was clear for the past several years that something had to give. The challenged supply/demand environment, coupled with rents with DHC that seemed too high, meant that the prospects for FVE to be a viable profit-making enterprise were slim.

Finally, in April of this year, the long-awaited restructuring was announced, where DHC dramatically reduced Five Star’s rent and changed the formerly triple net leases to a RIDEA structure (REIT Investment Diversification and Empowerment Act). Now, instead of fixed rents with nominal annual escalators, DHC will effectively participate in the upside in NOI growth (and potentially downside) as well as fund capital expenditures at the properties. It remains to be seen if DHC will be able to recoup the lost NOI over time, but more importantly, this restructuring assures the ongoing financial viability of their largest tenant for the foreseeable future.

Source: Diversified Healthcare Trust (3Q Supplemental Data)

As seen in the following table, rent coverages by operator are pretty healthy by healthcare sector standards, and the Five Star coverage is much improved following the restructuring.

Source: Diversified Healthcare Trust.

The National Investment Center for Seniors Housing & Care ("NIC") is the leading provider of data and analytics for the senior housing industry and is relied upon by healthcare investors and Wall Street analysts. NIC publishes a monthly newsletter that provides a comprehensive compendium of national supply and demand data. Below are excerpts from the most recent newsletter, which seems to present a landscape in which supply growth is moderating and occupancy is stabilizing or improving. To be clear the following bullet points are from NIC, not us.

  • During the third quarter, seniors housing net absorption totaled 4,977 units for the NIC MAP® 31 Primary Markets, the greatest number of units absorbed on a net basis in a single quarter since NIC began reporting the data in 2006.
  • At the same time, the quarterly change in the number of units added to inventory slowed to 3,832 units, the second fewest units added to the stock since mid-2016.
  • Combined, these factors supported a 30 basis-point increase in the seniors housing occupancy to 88.0% in the third quarter from 87.7% in the second quarter when it had fallen to its lowest level in 8 years.
  • This placed occupancy 1.1 percentage points above its cyclical low (of 86.9%) reached during the first quarter of 2010 and 2.2 percentage point below its most recent high (of 90.2%) in the fourth quarter of 2014.

Source: NIC

Source: NIC

  • During the third quarter, assisted living properties’ occupancy moved off its record low rate of 85.1% for the past three quarters to 85.4%, as relatively robust demand outpaced new inventory growth. Indeed, net absorption totaled 3,128 units in the third quarter, the most of any quarter except the Q4 2018.
  • The occupancy rate for independent living properties inched up 20 basis points to 90.2% in the third quarter, 10 basis points higher than year-earlier levels, but below its rate earlier in 2019.
  • Construction as a share of inventory for majority assisted living properties decelerated in the third quarter and equaled 7.3% or 22,000 units. This includes all properties under construction from start to completion. This was the lowest rate of construction since 2015 and down from a peak of 10% in late 2017.
  • The same pattern is not yet evident in independent living properties as the following exhibit shows. In the third quarter, construction as a share of the independent living inventory totaled 6.2%, where it has been hovering for the past year.

Source: NIC

While it is always difficult to identify inflection points with certainty, the data suggests a turnaround in senior housing fundamentals may indeed be at hand following a five-year malaise. We think this backdrop should be supportive for owners of senior housing assets such as DHC for the near-intermediate term.

Medical Office Portfolio

Source: Diversified Healthcare Trust.

Medical Office

The company’s medical office portfolio is well-occupied at 92.3% as of September 30th, 2019 and is comprised of 140 assets, of which 54% of NOI is derived from life science assets (35 assets) and 46% traditional medical office buildings (105 assets). According to the Centers for Medicaid & Medicare Services, spending on outpatient and physician services, a key driver of medical office demand, is projected to grow in excess of 5% annually through 2027 and reach $1.2 trillion.

Source: Diversified Healthcare Trust (11/19 Investor Presentation), CMS.

As can be seen in the following table of same-property results for the medical office building segment, strength in the life science portion of the portfolio has been offset by less impressive results in the traditional medical office building portion of the portfolio. The weakness in Q3 results for the traditional MOB segment was a function of a large termination fee paid in the prior year and the associated vacancy in the current period according to the company. The results are expected to return to positive same-store NOI growth going forward according to management on the Q3 conference call.

Source: Diversified Healthcare Trust.

Balance sheet

In spite of its operational/tenant challenges, DHC has managed to maintain an investment grade-rated balance sheet that boasts pretty healthy metrics, other than the slightly elevated debt/EBITDA ratio as of Q3. Following the Five Star restructuring and associated sales of $900 million of non-core assets, the company’s leverage will tick down to around 6x in order to secure its investment grade status. On a debt-to-gross assets basis, leverage is pretty conservative at just 42.5%, with healthy EBITDA/interest coverage at 2.7x. The company’s debt maturity schedule appears manageable over the next several years, with moderate annual maturities over 2020-2021.

Source: Diversified Healthcare Trust.

Source: Diversified Healthcare Trust.

RMR Management Issues

One of the most obvious objections to an investment in DHC is the external management structure and the external manager, RMR Group. While RMR tries to pitch its management as beneficial to its managed companies, clearly this arrangement is sub-optimal and creates glaring conflicts of interest. RMR is incentivized to grow the managed companies’ asset bases, and the easiest and fastest way to do this is to utilize excessive leverage to go on a buying spree. This is predictably what has happened at almost all the RMR companies, and they have almost all had to endure some form of value-destroying restructuring.

That said, RMR also earns management fees based on market capitalization and incentive fees based on stock outperformance versus a peer index, so these fees have been obliterated to RMR’s detriment due to the fall in market capitalization and relative performance. There has always been a reluctance by activists to challenge RMR in trying to wrestle portfolio companies away from them, given the steep termination fees that would be due; 10-20 years of future fees in most cases. However, the agreements do provide the ability for the companies to terminate the management agreements for cause. This element of the agreements is highlighted in RMR’s S1 (link), an excerpt from which is below.

Our management agreements with our Client Companies are subject to termination, and any such terminations could have a material adverse effect on our business, results of operations and financial condition.

Our management agreements with our Client Companies may be terminated by a Client Company or by us in certain circumstances. Depending upon the circumstances of a termination, we may or may not be entitled to receive a termination fee.

Clearly the company’s legal team felt termination for cause was a real risk, at least real enough to need to include it as a risk factor. The agreement prescribes some very specific definitions of what constitutes cause as it relates to termination as included below. We think the sections highlighted in bold could be relevant potentially.

(2) Cause” shall mean: (i) the Manager engages in any act that constitutes bad faith, fraud, willful misconduct or gross negligence in the performance of its obligations under this Agreement; (ii) a default by the Manager in the performance or observance of any material term, condition or covenant contained in this Agreement to be performed by the Manager, the consequence of which is a Material Adverse Effect;

As we contemplate the potential for breaches of the agreement, we also want to look at what the obligations of the manager are per the agreement. Again, we have highlighted in bold the relevant sections that could pertain to thinking about where RMR may be vulnerable.

General Duties of the Manager. The Manager shall use its reasonable best efforts to present to the Company a continuing and suitable real estate investment program consistent with the real estate investment policies and objectives of the Company. Subject to the management, direction and oversight of the Company’s Board of Trustees (the “ Trustees”), the Manager shall conduct and perform all corporate office functions for the Company, including, but not limited to, the following:

(a) provide research and economic and statistical data in connection with the Company’s real estate investments and recommend changes in the Company’s real estate investment policies when appropriate; (b)(i) investigate and evaluate investments in, or acquisitions or dispositions of, real estate and related interests, and financing and refinancing opportunities, (ii) make recommendations concerning specific investments to the Trustees and (iii) evaluate and negotiate contracts with respect to the foregoing; in each case, on behalf of the Company and in the furtherance of the Company’s strategic objectives;

(h) advise and assist with the Company’s risk management functions;

As we evaluate the history of recent events at DHC, the evidence suggests that the company had (and continues to have) too much exposure to a single tenant in Five Star in our view. How is willfully creating a massive exposure (50%+) to a single tenant helping the company in fulfilling its risk management function? This raises questions of the diligence performed in the evaluation of investments in properties acquired to be operated by Five Star, which is owned by RMR. Was the underwriting arms-length, at prevailing market terms? Additionally, given the incentives for RMR, could this be considered willful misconduct or gross negligence?

In terms of advising on risk management and financing, how did RMR fulfill its obligations by advising the company ramp up its leverage in excess of 7x debt/EBITDA in order to go on a buying spree of assets to be managed by Five Star? As far as the mismanagement of the company leading to a material adverse effect for the company and its stockholders, there is zero question in our minds. We are not lawyers and activist involvement is not the base case, but we believe there could be an opening in the wake of recent events for an experienced activist to make a move here. We would note that following a battle with activist investor Corvex, Commonwealth REIT (Now Equity Commonwealth EQC) terminated its agreement with RMR in 2014 (press release).

But would RMR ever let go of one of their portfolio companies willingly? We think this answer historically would have been a resounding “no,” but given the recent restructuring, we think it is something that could be on the table. The reasoning behind this is as follows. The company’s annual base management fee is 50 basis points of the lower of historical cost or market capitalization, so today about ~$9.5 million. After our estimate of public company costs of roughly $5 million, the margin for RMR isn’t anywhere near what it used to be.

The company’s additional fees consist of property management fees of 3% of rents at the company’s MOB portfolio, on which there is likely little to no margin and 5% fee on construction projects, which again there is likely little to no margin. Finally, the biggest source of fee income for RMR historically has been the incentive fees based on stock outperformance. These incentive fees from DHC, which totaled almost $100 million in 2017-2018 combined, are unlikely to be earned again for a very, very long time given the stock has lost 60% of its value over the past couple years.

Lastly, Adam Portnoy, the head of RMR owns 2.7 million shares of the company’s stock and would probably earn more from selling the company than he would through the RMR management agreement over the next several years in our view. A termination fee would likely not be payable to RMR in the event of a change of control at DHC (see p. 65). In summary, we think the incentives for RMR to keep a death grip on this portfolio company are dramatically diminished relative to history, which could open the door for an activist or a sale transaction in our view.

Valuation

The company estimates that the new annual dividend rate of $0.60/share will approximate a payout ratio of 80% of AFFO, implying a baseline run rate of $0.75/share of AFFO annually. With the stock currently trading at approximately ~10.5x 2020 estimated AFFO, the market appears to be pricing in zero growth for the foreseeable future. We think this is overly pessimistic, given what appears to be an improving backdrop in senior housing fundamentals. On consensus FFO estimates, the stock is trading at just 6.9x compared to the peer group at 15.6x. At a 7.5% dividend yield, DHC offers one of the highest yields in healthcare and should be sustainable for the foreseeable future at an 80% AFFO payout ratio. The risk to the dividend would be if operations do not stabilize and capex requirements move higher, but even if that scenario unfolded, the current level of payout should provide sufficient cushion.

Source: S&P Global.

As seen in the following table of REIT-land’s biggest losers, DHC trades at a massive 52% discount to the consensus NAV of ~$15/share. We have applied what we believe to be somewhat more conservative assumptions in calculating our estimate of NAV, but we still arrive at a per share value of just over $14/share. Given the RMR blemish associated with this company, we don’t think NAV is a realistic target in the absence of a sale, but we think a 15% discount is appropriately applicable, which gets us to a $12 target and is still extremely compelling in our view relative to the current stock price. Our estimate includes current in place NOI as of Q3 and assumes no growth and assigns no value to any fee income. If industry fundamentals are in fact beginning to turn, there could be upside to our estimated NAV in the form of NOI growth as well as cap rate compression. It is also worth noting that the stock trades some 36% below tangible book value per share of roughly $12.50.

Source: S&P Global.

Source: The Boy Plunger

Ownership

In analyzing the ownership of the company, it is comprised predominantly indexers, given that there are few fundamental managers who would want to own this company without a huge discount. That said, we can see in the most recent quarter there have been a few value investors beginning to take positions near the lows. This is typically the beginning of the ownership daisy chain. We can also see in the second chart below what appears to be a lot of mutual fund sellers in the most recent quarter, which has probably continued into Q4 to harvest tax losses. In addition, sell-side analysts rate the stock mostly "hold" or "sell." We think this provides a supportive backdrop for a long investment.

Source: Bloomberg.

Conclusion

In summary, we think DHC presents a compelling risk/reward opportunity at current levels. There are clearly risks related to operational improvements at Five Star as well as the RMR management overhang, but sentiment is about as negative as it gets, and fundamentals appear to be on the cusp of improving after several years of malaise in the senior housing industry. The company’s balance sheet has been de-levered and the dividend has been reset to a level that should be well covered for the foreseeable future and provides an attractive 7.5% yield while you wait for the ~50% gap between the current stock price and NAV to be narrowed.

We think that a positive turn in senior housing fundamentals presents the most likely catalyst for the stock in the near term. Additionally, the recent Five Star restructuring and resultant destruction of shareholder value, coupled with the current extremely discounted valuation could bring an activist investor to the fray to push for a sale of the company and or termination of the RMR management agreements in our view, either of which would be incremental positive catalysts for the stock.

This article was written by

The Boy Plunger profile picture
126 Followers
Hedge fund manager and 20-year veteran of Wall Street.
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Disclosure: I am/we are long DHC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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