DHC (2021 - Q1)

Good morning, and welcome to the Diversified Healthcare Trust First Quarter 2021 Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Mr. Michael Kodesch, Director of Investor Relations. Please go ahead. Michael

Good morning, and welcome to Diversified Healthcare Trust Call covering the first quarter of 2021 results. Joining me on today's call are Jennifer Francis, President and Chief Operating Officer; and Rick Siedel, Chief Financial Officer and Treasurer. Today's call includes a presentation by management followed by a question-and-answer session. I would like to note that the transcription recording and retransmission of today's conference call are strictly prohibited without the prior written consent of Diversified Healthcare Trust, or DHC. Today's conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and other securities laws. The forward-looking statements are based upon the DHC's present beliefs and expectations as of today, Thursday, May 6, 2021. 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, EBITDA, EBITDAR, net operating income or NOI and cash basis net operating income or cash basis NOI. Reconciliations of net income or loss attributable to common shareholders to these non-GAAP figures and the components to calculate AFFO, CAD or FAD are available in our Supplemental Operating and Financial Data package 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, Michael, and good morning. Welcome to our first quarter 2021 earnings call. To begin today's call, I'll provide detailed commentary on the current operating environment and some of the recent actions we've taken to meet our long-term goal of maximizing shareholder returns. We believe the country is beginning to recover from the pandemic as we're seeing a marked decrease in confirmed COVID-19 cases and hospitalizations across the United States, since these metrics surged at the start of '21. We believe these trends have been and will continue to be supported by the vaccine rollout, which is progressing at various time lines across each state. Within our own portfolio, COVID-19 vaccination clinics at our shop communities are complete, which we believe is a critical step toward improving resident competence in senior living and growing the profitability of our shop segment. Upon completion of the vaccination clinics, over 96% of residents and almost half of the employees within our shop segment were vaccinated. Although we expect this number to fluctuate with move-ins and move-outs, Five Star Senior Living continues to work to educate employees about the benefits of being vaccinated. And we hope that will encourage higher acceptance. Vaccinations have also had an impact on the number of active COVID cases in our communities. As of May 1, only 11 residents in our managed communities had active cases of COVID-19. All of these communities in our shop segment are accepting new residents. Move-ins in our shop segment accelerated in the first quarter of 24% relative to the fourth quarter of 2020 and leads have increased substantially. Five Star continues to focus on generating more professional and resident referrals, as these two sources of prospects tend to result in higher conversion rates and covering a lower cost than third-party referral sources. Five Star is increasing investment in its digital marketing platform as it mirrors the quantity of leads received from third-party referral sources, but it is expected to result in greater conversion rates and longer lengths of stay. Finally, senior living construction activity across the country has slowed, both in construction starts and units under construction, which will of course result in reduced new supply. As a result of these trends and Five Star's efforts, we've seen shop occupancy began to stabilize in February, March, and in April, and we're cautiously optimistic that these trends will continue through the balance of the year. While same property shop average occupancy declined to 69.5% in the first quarter of 2021, down 320 basis points from the fourth quarter of 2020, March occupancy increased 30 basis points from February lows. Excluding the approximate 1,500 skilled nursing units that we've announced that we're closing, March occupancy increased 10 basis points from February to 70.5% and increased another 30 basis points to 70.8% in April. We believe the fastest path to DHC stock price recovery is a rejuvenation of our shop segment. Following strategic discussions with Five Star, we recently announced our plan to transition management of 108 communities with approximately 7,500 units to a diverse group of best in class operators, without paying a termination fee to Five Star. Discussions are well underway with a number of operators, most of whom have a regional focus, which we believe is important for the types and size of communities that we're transitioning. Our interviews in person meetings and community tours with potential new operators have gone very well. And we're aiming to be finished with these management transitions by year end. Additionally, we're supportive of Five Star's strategic plan to reposition its business, to focus on managing larger communities with residents that require a lower level of care. To support that strategy, we've begun to close the skilled nursing units in our Five Star managed CCRC's and repurpose them to complement the needs and requirements of the communities. Finally, the RMR group will assume control of major renovations and repositioning activities at all of our Five Star managed senior living communities. In exchange for these and other negotiated changes to our relationship with Five Star, we agreed to amend the calculation of incentive management fees Five Star can earn. We want Five Star to have the incentive to maximize performance. So it will continue to have the potential to earn 15% above a base year of 2021, budgeted EBITDA. Going forward though, no incentive fee will be paid on senior living communities undergoing major renovations or repositionings until the end of the first full calendar year, following the disruption in operation. And that year's EBITDA will become the new base year over which the fee is calculated. There will no longer be a cap on the potential incentive fee Five Star can earn. For the 120 communities, Five Star will continue to manage for us, the target EBITDA or budget for 2021 is approximately $100 million. Based on first quarter performance and our forecast for the remainder of 2021, we do not expect to pay an incentive fee this year. Due to our planned capital spend in the portfolio, we expect nearly 60% of the base years to be reset over the next few years as we execute on that capital. Our goal is for Five Star to improve operations, to a point where they are earning incentive fees because if they're successful, we're successful. Turning to our office portfolio segment, as of the first quarter, same property occupancy and DHC's office portfolio was 93.6%, a 10 basis point decrease from both the sequential and year over year quarters. On a consolidated basis though occupancy increased, 90 basis points sequentially. During the first quarter, we executed 26 new and renewal leases, totaling approximately 213,000 square feet at a weighted average lease term of 10.6 years, roll up and rents of 18.7%, and with leasing costs of approximately $14.57 per square foot per year. This quarter's leasing results were heavily influenced by two leases signed for a total of approximately 122,000 square feet at the recently redeveloped Torrey Pines Life Sciences asset. Subsequent to quarter end, we signed another lease for close to 10,000 square feet at Torrey Pines, bringing the project to approximately 85% leased. The asset managers and real estate services professionals that are responsible for leasing our portfolio have seen a notable increase in leasing activity this year, both in increased renewal discussions with our existing tenants and new prospect tour activity. Our leasing pipeline across our portfolio was healthy at 1.6 million square feet, which is slightly higher than our pipeline in the fourth quarter of 2020, and above the 2019 average of 1.2 million square feet. Approximately, 60% of this 1.6 million square foot pipeline is for lease renewals and 40% is for leasing vacant space. Additionally, more than 40% of this pipeline is at the signed LOI stage with lease documents being negotiated. Rent referrals remained largely unchanged since our last call and represent just four tenths of a percent of DHC's total annualized rental income. Rent collections continue to be strong in our office portfolio as approximately 99% of our contractual rents due were collected during the first quarter and in April. Our triple-net senior living communities and wellness centers represent 8% and 4% first quarter NOI respectively. All of our triple-net senior living and wellness tenants are current. And the portfolio of triple-net senior living properties had rent coverage of 1.48x for the trailing 12 months ended December 31, 2020. Before I turn the call over to Rick, I wanted to highlight the RMR groups recently published sustainability report. This report provides insights, accomplishments, and data regarding our manager's commitment to long-term environmental goals, investment in the platforms workforce, and social and governance performance over the last year. You can find links to the report on our website at dhcreit.com. I'll now turn the call over to Rick to provide details on our financial results.

Thanks, Jennifer and good morning, everyone. As Jennifer said, we believe the country is now beginning to recover from the COVID-19 pandemic, but our first quarter results are reflective of what has been an unprecedented 12 months in the senior living business. This extraordinary time of declining occupancies and expense pressure in our shop segment, along with steps, we took to shore up our balance sheet and think longer term about our liquidity needs have resulted in normalized FFO attributable to common shareholders of $0.02 per share and adjusted EBITDA $73.2 million for the first quarter of 2021. As the shop segment has now experienced several quarters of pandemic impacted results. Much of my commentary will compare the first quarter's results with the fourth quarter of 2020 or sequential quarters to provide more meaningful comparisons than year over year changes. Sequentially same property cash basis NOI in our shop segment was down $8.3 million from the fourth quarter. Same property revenues in our shop segment, we're down 4.5% from the fourth quarter driven by lower occupancy. Same property average monthly fees however, we're up approximately 2.3% compared to the fourth quarter. And we're up 1.3% compared to the prior year. Same property expenses in the shop segment decreased 1.5% from the fourth quarter or approximately $3.9 million, primarily as a result of lower wages and benefits partially offset by approximately $2 million in costs related to the severe weather experienced in Texas and several other states in February. Looking at sequential office portfolio results, same property cash basis NOI was up 90 basis points, largely driven by lower repairs and maintenance expense in the first quarter. Interest and other income was $2.8 million for the first quarter of 2021, a decrease of $7.4 million compared to the fourth quarter due to lower CARES Act income recognized. Interest expense was $60.1 million for the first quarter of 2021, an increase of $2.3 million compared to the fourth quarter, primarily due to the $500 million of 4.375% senior notes issued in February partially offset by lower interest on the $200 million term loan we prepaid in February. In the first quarter, we spent $51.9 million on capital improvements, a decrease of $12.8 million compared to the fourth quarter of 2020. Approximately, $33.1 million of our first quarter spend was considered recurring while the remaining portion of our capital expenditures or $18.8 million was spent on redevelopment capital projects. We remain committed to investing capital into our portfolio to improve future results. With senior living operator transitions plans, we currently expect 2021 capital expenditures to be between $250 million and $290 million, of which approximately $90 million to $120 million relates to redevelopment capital projects and includes the $19.6 million acquisition of a property physically connected to one of our existing medical office properties in Silver Spring, Maryland, that we believe will provide flexibility as we evaluate several potential redevelopment opportunities for the combined site. I'd also liked a brief update on our liquidity position. At the end of the first quarter, we had approximately $310 million of cash set aside to redeem our 6.75% senior notes in June when they can be redeemed without a prepayment penalty. We also had an additional $843 million of cash on hand. While we're cautiously optimistic about the recovery of our shop segment, out of an abundance of caution we drew the $800 million that was available on our revolving credit facility as a precautionary measure to preserve our liquidity. As previously disclosed, we expect to be out of compliance with one of the incurrence covenants contained in our debt agreements that will prohibit us from incurring additional debt until we are back in compliance. This had been anticipated when we amended our credit facility in January, and we are confident that we will be able to utilize cash on hand for all of our liquidity needs until we can reduce our debt service costs by refinancing a portion of the 9.75% senior notes that become callable in June of 2022. The credit facility amendment also provides for waivers for most of our financial covenants through June of 2022 and added an additional option to extend the maturity of the revolving credit facility into January of 2024. Other than the previously mentioned early redemption of the $300 million of senior notes in June, our next senior notes would charity is not until may of 2024. That concludes our prepared remarks. Operator, please open up the line for questions.

[Operator Instructions] The first question today comes from Bryan Maher with B. Riley Securities. Please go ahead.

There are a couple of questions from me. When we think about the transitioning of the 108 senior living facilities, have you identified any in there that you are just planning on selling and not transitioning? Or is the goal to transition all 108, see how they go and then make a sell decision? And if so, how long are you going to give those properties to show some improvement?

So we have not identified any predisposition at this point, Bryan. We feel very positive about the operators that we've met with. We're in varying stages of transition. We've talked to dozens of, of operators and then issued RFPs to probably more than 20 operators. We've interviewed 10, but are expecting to interview another 10 and we've even started touring some of those operators and doing some diligence. So we're pretty far along in the process. And at this point, we're in discussions on all of the communities that we're transitioning and the operators that we've been speaking to are pretty excited about the prospect of managing these communities.

Great. And how should we think about the new contracts on those properties? Will they be similar to the Five Star contracts or will they vary in some degree that we should be thinking about?

It's early to tell. I think they'll be pretty similar to Five Stars. At this point where we're just starting to, as I said, we've issued RFPs, we've received proposals. So we're starting the stage of negotiation of those, but they will all be management contracts and five stars contractors at market. So I think they'll be pretty similar.

Okay. And then on the property that you bought next to the MOB in Maryland, you've been a little vague on what you might do with that property. Can you give us a little color as to maybe two or three options that you might convert that to?

Sure. So I think it's important to note that the properties that's under agreement and we're currently in diligence is one unit of a two unit condo building. The second unit is the 92,000 square foot MOB that we currently own. And this is a situation where the whole is greater than the sum of the parts. So while the MOB that we own is a good building, it will be better when it's combined and put back together with this hotel. This is a market. Silver Spring is a great market. This building is close to the metro. It has many nearby retail amenities. It's about a 20 minute metro ride to Union Station in DC. So this is a market where there are a few life sciences tenants in the market. And then the existing building is a hotel. So on its own, it's a strong investment, but together -- our redevelopment group is looking at it during this diligence period, and they're looking at it as, should the whole thing be converted to a hotel, should the whole thing be converted to life sciences. And so we have a couple of good, strong options that we'll get further along in our diligence and determine what the best step, the path forward is.

Great. That's some good color. First of all, thank you for the shop occupancy per month in your release. That goes through March, where we see the uptick, sequentially. And I think you made some comment in your prepared remarks regarding April, but I didn't catch that. What would that number for occupancy be in April?

Let's see. For April, our spot occupancy at the end of April -- I'm sorry, the occupancy was 71.8%.

Does that 71.8% compare to the 69.5% in March? So 130 bp increase month-to-month?

No, Bryan. We have to -- on a go-forward basis, we made the announcement of the restructuring with Five Star on April 9. And as you can imagine, once we announced that they were exiting the skilled nursing space and that we were shutting those units down, we haven't had a lot of sniff move-ins in those units, and we have been placing residents elsewhere. So April forward, and we did look at what March would look like, and February on a comparative basis. But we're generally starting to strip out that 1,500 SNF units out of the Five Star retained portfolio, just to make it more meaningful comparisons. So if we look at the entire portfolio, this is the Five Star retain, excluding the sniff and the transition communities. We did see occupancy increase from February to March 10 basis points on average, and from March to April, another 30 basis points. And then, I don't know if Jennifer said it, but we ended April with spot occupancy at 71.8% in that portfolio. And then just to provide a little bit more color, there is a difference between the properties. Five Star is looking to retain, or is retaining and the transition properties, the ones they're retaining are generally the properties they believe they're better at operating and have more confidence in. Those properties ended with spot occupancy of 73.8% while the transition properties ended at 67.1% at the end of April. So there's still some work to do, but as Jennifer said, the operators we've been talking to are really excited. And frankly, our team's been touring all of these assets and we're excited about the possibilities as well.

Right. So there's a lot to unpack in what you just said.but to dumb it down a little bit; would you say that no matter how you sliced it, March to April was positive?

Without a doubt, Bryan. In addition to that, this activity, leads activity, activity, tour activity has been very strong. We had 400 move-ins in our shop portfolio in the week beginning, April 25. And that's the most move-ins that we've had in the portfolio in 14 months. So occupancy is growing, move-ins are growing. The increase in leads has been substantial. As I said, we had close to a 30% increase in leads in the first quarter. Over the fourth quarter of '20 more than 40% increase in web leads. So we're really starting to feel a change. Our increase in tours has been substantial. And then, close to an 80% increase in repeat tours in the shop portfolio. And those are people who are coming back for a second tour. So we're really feeling like things are turning.

The next question comes from Jason Idoine with RBC. Please go ahead.

I just wanted to ask about how you went about selecting the 108 properties that you're going to be transitioning. So based off of your comments to Bryan's questions, sounds like those might have been some of the weaker operating properties. So I guess, what gives you confidence that a new operator will be able to come in and improve results and that those transitions won't ultimately be overly disruptive?

Yes. Thanks for your question, Jason. I would say that they're not weak communities. We've spent a good deal of time with Five Star talking about their strengths. They've obviously spent a long time or a lot of time thinking about where they can excel, and what the determination was is they're better at managing larger communities that have residents who have a lower level of care. And I think that determination plays out when you look at the buildings that we're transitioning. They tend to be smaller. They tend to, and I'm talking generalizations, but they tend to have residents who require a higher level of care. And so it became pretty obvious when we and Five Star and Senior Living Asset Management went through each asset, asset by asset, to determine which Five Star would continue to manage and which we would transition over. Just based on that criteria; larger, independent assisted living, independent and assisted living buildings, Five Star's better at managing those.

Got it. Okay. And then, what would slow down those transitions? It seems like, I think previously when you guys were transitioning some assets there was some delays with licensing switches. So just what are your thoughts on any potential administrative delays that could be caused by COVID or anything along those lines that could maybe slow down those transitions?

Yes. We've got a team of folks that have been working on that for some time, and these are managed communities. When we transitioned from a leased to managed relationship with Five Star, when Five Star leased communities from us, they held the license. And when we transitioned, it took that year to transition over, really because of the change in who held the license. And now DHC is licensed in all of these communities because Five Star is our manager. So transitioning managers is much easier than transitioning from leased to managed, because we do not have to transition the licenses. So that should not hold us up at all. Because it's just not a requirement. I don't know that there's -- It's a lot of communities to transition.but we have a team both at Five Star and at Senior Living Asset Management that are going to be focused on that transition. And as part of our interview process with operators, we spend a good deal of time talking about their transition expertise and how they're going to do it. And it's part of what we're looking for in new operators, is operators who have done this and are expert at it.

Got it. Okay. And then my last question is, how did you guys think about the new management agreement, obviously when taking the incentive fee cap off and at a point where we're at a trough in the business? And then also not having to pay the termination fee and having a stake in Five Star's business. So I guess, with those puts and takes, how did you guys weigh those?

There were a lot of puts and takes. And so this was -- we spent a good deal of time coming up with the changes to the management agreement. With the negotiation of any agreement there are gives and takes and this is where we settled, and we think that both parties gained and both parties settled at some point, but we're pretty happy. We do strongly believe that an incentive fee is important. We want our manager to be motivated, to continue to grow NOI, to grow EBITDA. And so that's where the incentive fee comes into play, and so we think it's pretty important.

Okay. Sorry. And then I do have one other one. So did you mention what the 2020 for the targeted EBITDA level was going to be? I think you did in your prepared remarks. But I would just be curious, I guess, how did you guys come to that number?

Yes, it was based on budget. The budget process works is the senior living asset management and Five Star work closely together on establishing a budget for the coming year. So in the late spring, early summer of last year, they met and talked about every community. And so the target for the 2021 budget, or the target EBITDA, is about a $100 million in the retained communities. Again, we don't think that EBITDA will come close to that number. So I think we will not pay an incentive fee this year.

Your next question comes from Jonathan Hughes with Raymond James. Please go ahead.

We've seen some recent public to public M&A activity across the REIT space, and a few of those were scenarios where the target is a company that just hasn't worked or had structural headwinds and a merger was a win-win for both shareholder basis. So as I look at DHC where the 10-year total return CAGR has been negative 10% versus the health care REIT average of positive 7, it seems like things just aren't working here and haven't for a while. So Jennifer, you mentioned a focus on maximizing value in your first report prepared remarks. And I know the last year has been very difficult. But has the Board or RMR explored all ways to maximize value at DHC, including a sale of the Company, or at least announcement of a review of strategic alternatives and not just transitions and more cap ex investment?

I mean, the Board, I think has conversations and ways all options on a regular basis. Our focus is to stabilize our portfolio and we feel -- Obviously our MOB life sciences portfolio is pretty strong. And in some instances we put capital into those buildings to reposition them. We're really focused on stabilizing our senior living portfolio as a way to maximize shareholder value. So that's our strategy.

I mean, I hear the comment. But I mean the same store NOI in life science and MOBs has been negative for a couple of times now. And we haven't seen that at any of the peers. So maybe this is a question for the Board. Where's the accountability for the performance, and frankly under-performance, of DHC over the past decade? I mean, every Board member, with the exception of one, has served for an average of 11 years and is on another RMR managed REIT Board. Mean do shareholders' voice, this accountability concern to you and the Board? And if so what do you tell them?

Jonathan, I'm struggling a little bit with the 10 year period. I mean if you look back there have been a number of actions taken to try to be more shareholder friendly and to enhance returns for our shareholders. The 10 year number is -- If you look back, it was a very different business 10 years ago. Starting with, in 2015, there was a significant restructuring in order to make RMR the manager that was previously private public and be more transparent. And we actually distributed those shares out to shareholders. And then, obviously, the senior living business has changed since 10 years ago. So there was a significant restructuring from leases to management contracts. And essentially the entire industry did that. Maybe we were a little late, because again, there is a certain amount of related party transaction that we don't want to do something like that unless we absolutely have to, because it could be disruptive to shareholders. COVID was not expected. And we have repositioned the portfolio more towards medical office and life science. If you look at our more recent redevelopment activity, I mean, the team is hitting home runs on that stuff. And again, if we've got some long-term leased assets that are finally rolling after a 15 year term, you're going to have some vacancy and we're going to reposition those portfolios. So if other peers have been out buying brand new buildings with 2% rent steps, if different than what was in our portfolio. But we are doing everything we can to maximize value in our portfolio.

What is the breakup fee payable to RMR if they were to be terminated as manager of DHC and a change of control transaction?

Again, we are focused on the business and moving it forward. That stuff is disclosed in the SEC filings if you want to dig through it. But that is not what we're focused on.

As there are no further questions at this time, I would like to turn the conference back over to Ms. Francis for closing remarks.

Thank you. And thank you for joining our call today. We look forward to seeing many of you at the upcoming REIT week, NAREIT 2021 Investor Conference. Operator, that concludes our call.

That does conclude our conference for today. Thank you all for participating. You may now disconnect your lines.