2023-11-09 23:20:55 ET
Summary
- Diversified Healthcare Trust's poor performance and credit downgrades have caused its debt yields to jump, with its 2024 maturing debt trading at yields nearing 20%.
- The company's violation of debt covenants has led to an inability to refinance upcoming debt maturities, putting it at risk of default.
- The company's senior housing segment is dragging down its overall performance, and it may take a long time for the segment to recover.
Diversified Healthcare Trust ( DHC ) is an embattled senior living and office REIT. The company’s poor performance and credit downgrades have caused its debt yields to jump. The company’s 2024 maturing debt is currently trading at yields nearing 20%, while the longer end of the company’s debt is trading closer to its credit peers. After last week’s earnings announcement and recent developments, I believe time is quickly running out for the company and holders of the company notes and shares need to brace themselves.
Prior to the earnings report, Diversified Healthcare Trust and Office Properties Trust ( OPI ) mutually agreed to terminate their controversial merger proposal . Following the merger termination, the company announced it had hired a financial advisor to help address its capital needs as its violation of debt covenants has led to an inability to refinance its upcoming debt maturities.
Diversified Healthcare Trust’s operating results have shown improvement in 2023, but not enough to be considered transformational. On a year-to-date basis, revenues grew by more than $100 million or nearly 11%. Expenses did grow by less than revenue growth with $18 million being noncash related impairments. Yet, revenue less expenses came in at a loss, even before accounting for the $142 million in interest expenses.
While depreciation is a big part of Diversified Healthcare’s loss, it’s important to note that depreciation typically indicates the level of capital expenditures that the company needs to invest in its assets. With the company having a large senior housing component, capital expenditures are a big part of their operations. When looking at the cash flow statement, the company’s free cash flow remains negative at $150 million year to date.
While free cash flow is better than last year, it still shows that Diversified Healthcare’s operation needs to burn cash to support its operations and assets. After starting with a cash balance of $688 million, the company has had to pay $266 million towards debt reduction and $150 million towards free cash flow burn and now has $279 million cash on hand. In addition to refinancing, Diversified Healthcare is going to need access to additional liquidity soon.
With $450 million in secured credit facility coming due in January, and $250 million in unsecured notes coming due in May, the shift is being made towards figuring out how to address these maturities. In the earnings call, Diversified Healthcare’s CEO made note that the company is in talks with brokers regarding approximately $1 billion in asset sales, but there’s no indication of sales and closing in the next 60 days, therefore the company is hoping to extend the maturity of its credit facility.
Due to the immediate need for capital, and a clear or timely solution not in place, Diversified Healthcare Trust issued a going concern. A going concern is a regulatory statement saying that the company has doubts about its ability to avoid a debt default over the next twelve months. Interestingly, the issuance of the going concern and the immediate maturities of debt has not sent debt prices into distressed territory.
When it comes to opportunities for new financing, there is a silver lining for Diversified Healthcare Trust. The company’s balance sheet shows nearly $2.5 billion in shareholder equity. Since real estate assets depreciate, there should be significant unencumbered assets that the company can tap into for new financing. This is also verified when looking at the company’s debt covenants, which show plenty of room under the total debt and secured debt ratios.
The trouble comes from the company’s inability to generate meaningful income. Lenders do not want to lend into a hole and unsecured creditors receiving principal payments in May creates a problem for any interested secured lender. Diversified Healthcare needs to find a way to divest nonperforming assets and consequently improve its operating results.
I’m concerned that the entire senior housing portion of the portfolio may be driving the company down. Senior housing comprises of nearly two thirds of the total portfolio, but only one third of the net operating income (NOI). The inverse is true about the company’s office holdings. In fact, the NOI margins for Diversified Healthcare’s office holdings are just under 60% compared to less than 10% for senior housing.
The senior housing segment could take a long time to recover, too. While occupancy levels are slowly improving in senior living, investors should note that 75% of the triple net leases are signed through at least 2032. If Diversified Healthcare is underwater on these leases, it will take awhile for them to get out from below break-even revenue levels.
There’s no real solution for Diversified Healthcare Trust that can bypass the company’s profitability problems. If restructuring in the court system is to be avoided, I believe it will be because debt holders have agreed to take a haircut via a distressed debt exchange. Until a path to profitability is found, and the debt issues are mitigated, I am avoiding the company’s shares and debt offerings.
For further details see:
Diversified Healthcare Trust: Time Is Running Out