DHC (2021 - Q4)

Good day and welcome to DHC Fourth Quarter 2021 Conference Call. All participants will be in a listen-only mode. Please note this event is being recorded. I would now like to turn the conference over to Michael Kodesch, Director of Investor Relations. Please go ahead. Michael

Good morning and welcome to Diversified Healthcare Trust call covering the fourth quarter 2021 results. Joining me on today's call are Jennifer Francis, President and Chief Executive 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. These forward-looking statements are based upon DHC's present beliefs and expectations as of today, Thursday, February 24, 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, 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. Good morning and thank you for joining us on today's call. I'd like to begin today's call by reflecting on the year where we focused on the foundational work necessary for DHC to emerge from the COVID-19 pandemic in a position of strength. While I would classify 2020 as a year of defensive measures taken to withstand the effects of COVID-19, 2021 was a year defined by our proactive steps taken to best position the company in terms of liquidity and future profitability. As vaccine acceptance and easing of pandemic related social restrictions helped curb deterioration across the senior living industry, we executed on a plan to refine operator mix, enhance liquidity and deploy capital to reposition a number of our properties. Since our last call, we completed three significant transactions that immediately improved our liquidity to enable us to unlock portfolio value and grow earnings. First, at the end of December, we sold a 35% equity interest in the existing joint venture that owns the two building life science complex in the Seaport district of Boston for approximately $378 million. As a reminder, this asset was purchased in 2014, for $1.1 million at a 7% cap rate and the recent sale was at $1.7 billion valuation or a 4.2% cap rate, a sizable appreciation in the value of this asset. Second in January, we completed a joint venture with 10 properties in our office portfolio segment that resulted in cash proceeds of approximately $653 million and we retained a 20% equity interest in the joint venture. The 10 property portfolio was sold at approximately $657 per square foot or at a 4.98% cap rate. And third, we announced yesterday an amendment to our credit agreement with our lenders that extends certain covenant waivers through the end of 2022 and extended the maturity date of our, of credit facility to January 2024, which Rick will discuss more thoroughly in his prepared remarks. The combination of these transactions created approximately a $1 billion of liquidity and flexibility as we continued to invest in our portfolio to drive operational performance and optimize returns. Following the deconsolidation of the assets related to the two joint venture sales, our office portfolio segment remains small -- nope, remains strong and well diversified. The $8.7 million square foot portfolio contains 104 high quality properties located across 24 states in Washington DC and represented approximately 85% of fourth quarter net operating income at DHC. As of December 31, 2021, this portfolio was approximately 91% occupied, which compares to the total portfolio inclusive of the JV assets of approximately 92% occupancy, both with a weighted average remaining lease term of just under six years. We're pleased with the remaining portfolio whose attributes closely resembled the portfolio prior to the joint venture transactions. Of our top 25 tenants, 22 of them are in our remaining portfolio and over 98% of this quarter's leasing was completed in the remaining portfolio. With properties like our Torrey Pines buildings, the Aurora Health Care buildings, our newly redeveloped properties in Washington, DC and Lexington Mass, and many others. We remain confident that this portfolio will continue to be the solid well occupied portfolio that the larger portfolio has always been. Turning to our results; leasing velocity was strong in our office portfolio segment for the fourth quarter and full year 2021. In the fourth quarter, we achieved the highest quarterly activity that we've had in over 10 years with 43 new and renewal leases, totalling close to 1.4 million square feet with average roll up and rents of 6.7%, a weighted average lease term of 9.3 years and with leasing costs of approximately $2.84 per square foot per year. We completed over 2.5 million square feet of leasing during the year at an average roll up in rents of 11.2%, a weighted average lease term of 9.2 years and leasing costs of approximately $5 per square foot per year. The annual results represent approximately the same square footage of leases that we executed in the prior two years combined. Same property occupancy during the fourth quarter increased 80 basis points from the previous quarter in our office portfolio segment, primarily driven by this strong leasing activity. Leasing in the fourth quarter included the renewal of Aurora Health Care, now DHC's largest tenant in this portfolio, following the deconsolidation of the assets included in the joint venture transactions. This 631,000 square foot eight building renewal was at a 4.2% roll up in rent with a new lease term of approximately 10 years and with leasing costs of $2.36 per square foot per year. Tenant retention in the fourth quarter was 91% based on annualized revenues, bringing total retention for the year to 83%. Our leasing pipeline is now approximately 875,000 square feet following the large leasing volume completed in the fourth quarter. Approximately half of the pipeline is for new tenants that could absorb close to 400,000 square feet of space. Additionally, subsequent to quarter end, we executed a lease in our newly developed Tempe Arizona property for 82,000 square feet or a 100% of the building for an 11-year term at a 20.3% roll up in rent. We're pleased with the leasing success at our recent redevelopment properties and are excited to continue to pursue redevelopment opportunities in our portfolio where appropriate. For instance, I've spoken in past calls about a property in Decatur, Georgia that is being vacated by its full building tenant this month. Redevelopment plans have been finalized and construction will begin as soon as the tenant vacates. We also have a tenant outside of Boston downsizing from two buildings to one and plans are advancing toward a potential redevelopment of the building that is being vacated into lab-ready space. Turning to our shop segment, in the fourth quarter and while ahead of schedule, we completed the management transition of 107 senior living communities from five star senior living to 10 new third party operators. As our new operators have started settling in, we're already seeing the benefits of utilizing regional operators for these communities. They're leveraging their local market presence and referral source relationships to drive occupancy increases in previously challenged assets and are utilizing regional labor networks to limit costly agencies. Operationally, despite expected seasonal weakness and another rise in COVID case counts across the United States in the fourth quarter, due to the Omicron variant, our shop segments experienced occupancy growth. In our same property shop segment, which is comprised of 120 communities managed by five star, occupancy increased approximately 70 basis points on average from the third quarter. total shop occupancy this quarter increased 120 basis points from the third quarter as the transitioned portfolio is more heavily weighted toward higher acuity needs based care, which continues to outperform choice based care in our portfolio, as it does in the broader senior living recovery. While we're encouraged by occupancy growth in our senior living properties and are now seeing the aggressive concessions that we're being offered earlier in the year subside due to those concession packages offered in 2021 in our same property portfolio, rate was down 2.6% from the third quarter and same property revenues decreased approximately 170 basis points sequentially. Looking ahead, we're seeing signs that we're reaching an inflection point for rate recovery in continued occupancy growth. Our operators are increasing asking rents 5% to 10% in the first quarter in reaction to increased expenses and wage inflation, which all of our operators believe is realistic and achievable. We've also seen some operators begin to increase community fees, which should help drive margins. While we're hopeful that many of these tailwinds continue, the biggest challenge now facing the senior living industry is labor. While dealing with labor issues is not new to our operators and prior to the pandemic, they were already experts at dealing with wage pressure and labor shortages, these issues have accelerated. Same property wages and benefits increased $3.4 million or 4.1% from the three third quarter, largely driven by a sharp up uptick in agency use. Agency cost increases rec represented approximately 65% of the same property wages and benefits increase due to staffing shortages driven by the Omicron variant and the holiday season. Looking forward, we expect agency costs to moderate as the effects from the Omicron variant subsides, but expect wage inflation to persist with same property wages expected to grow 10% to 12% in 2022. We believe our operators can price a portion of increased wages and benefits into resident rent and community fees while also implementing more efficient labor models that can adjust to varying acuity and occupancy levels. The senior living industry is well positioned for recovery. The sector is benefiting from outpaced absorption and a strong supply-demand environment and we're actively positioning our communities for success through a balanced operator mix and capital investment. I'll now turn the call over to Rick to provide details on our financial results.

Thanks, Jennifer and good morning, everyone. For the fourth quarter of 2021, we reported net income attributable to common shareholders of $365.6 million or a $1.54 per share, which included a $461.4 million gain on the deconsolidation of our Boston Seaport joint venture assets following our sale of 35% of the venture. We retained a 20% ownership interest in the venture. We also reported normalized FFO of negative $16.5 million, which was $7 million lower than we reported for the third quarter, due to the decline in our consolidated cash basis NOI. This decline was primarily attributable to the $9 million decrease in our shop segment, including $4.7 million related to our same property pool, which decreased to 120 communities following the completion of the community transitions that Jennifer mentioned earlier. The decline in our shop cash basis NOI compared to the third quarter was primarily due to increased wages and benefit expense related to labor shortages, wage inflation and agency usage. Within our office portfolio segment, same property cash basis NOI increased 90 basis points from the third quarter, primarily due to the 80 basis point increase in occupancy this quarter. As we do each year during the fourth quarter, we recognized approximately $2 million of percentage rent from our triple net lease senior living tenants this quarter. Percentage rent is calculated annually based on revenues in the communities and included in our non-segment NOI. During the quarter, we recognized approximately $600,000 of Cares Act funds within interest and other income, which is excluded from our reported cash basis NOI bringing year to date Cares Act income to approximately $20 million. Also excluded from our reported cash basis NOI is $2.3 million transition related expenses. Our general administrative expenses decreased approximately 4% from the third quarter to $8.5 million for the fourth quarter, as a result of lower share based compensation, expense and business management fees paid to our manager. Turning to our balance sheet and liquidity, as Jennifer mentioned in her prepared remarks, there were three significant transactions that occurred during this and subsequent quarter end, that substantially enhanced our liquidity. The two JV transactions generated over a $1 billion of liquidity, and we have amended our revolving credit facility. The amendment extends the waiver of the fixed charge coverage ratio through December 31, 2022, and provides increased flexibility to fund investments in our portfolio. In exchange for these changes, our credit facility capacity was reduced by $100 million to $700 million and the interest rate premium increased by 15 basis points. Following the amendment, we exercised our option to extend the maturity date of our revolving credit facility by one year to January of 2024. On a pro forma basis, our cash balance at year end factoring in both the credit amendment and the JV transaction completed subsequent quarter end was approximately $1.6 billion, which is available to be used for repaying debt and making portfolio investments. As a reminder, our next senior notes maturity is not until May 2024, but our 9.75% senior notes become callable in June of this year. In the fourth quarter, we spent $112.1 on capital expenditures across our portfolio despite continued supply chain disruptions and shortages of certain materials and labor. These expenditures included approximately $80 million of CapEx within the shop segment, an increase of approximately $54 million from the third quarter. $32.4 million of capital was deployed in the office portfolio, an increase of approximately $16.4 million from the third quarter. Some of this acceleration in capital deployment can be attributed to improvements in project management in terms of scope and execution. We continue to review and prioritize our capital spend on a property by property basis for overall potential NOI impact. I'll now turn it back over to Jennifer for closing remark.

Thank you, Rick. We're eager to move forward following the transition of certain shop communities to new operators and the continued investment in our portfolio and we remain confident in this strategy. Utilizing the solid foundation we built in 2021, we believe that we're on track to optimize portfolio performance, deliver earnings growth and maximize long term shareholder returns. That concludes our prepared remarks. Operator, please open the line for questions.

We will now begin the question-and-answer session. The first question comes from Bryan Maher from B. Riley Securities. Please go ahead.

Good morning, Jennifer and Rick. I was hoping we can drill down a little bit more and you gave some information on this, on the wage increases you're expecting for this year. I think you said 10% to 12% and I think you also said that you were expecting rate increases at the shop facilities to possibly go up 5% to 10%. So that captures a decent amount of the labor increase but what other inflationary pressures are you seeing that could weigh on results in 2022

Good morning, Brian? It's a good question and it's a question we've spent a lot of time with our asset management team and our operators talking about and trying to make sure we understand, I think we all see what's happening at gas pumps and at the grocery store and there is certainly some other inflationary costs that the employees in our communities are seeing as well. For the most part though, we've actually been pretty successful. One of the larger initiatives, five star move towards outsourcing some of the dining and that's actually resulted in some savings. So, while you might expect some inflationary pressure there, we actually expect a little bit of savings and other expenses are kind of similar. We're making sure that we're centralizing, purchasing where we can. We're making sure the we've selected operators that are very focused on individual markets and have the ability to avoid some of the national pressure if they can find a better price on it with a regional supplier. So there is a lot of work being done on that, but really the story in the shop portfolio is wage pressure, but even more so the labor shortage. So again, I think we're doing, I think our operators are doing all the right things to manage that and to try to create environments where employees want to be and it is meaningful work and a lot of the folks that work in the industry do have a calling beyond on just needing a paycheck. So we are -- we obviously need to pay the market and I think our thinking on that has shifted a little bit over the last few months as we've continued to see inflation pickup where, I think early on in the budget cycle, we were probably high single digits and now we're thinking it's in that 10% to 12% range. So, it's something we're going to continue to keep an eye on, but we are hopeful that the customers and the residents are going to understand the inflationary pressures and be willing to accept the rate increases.

From a timing standpoint and maybe for Jennifer more on a macro basis, how do you think that the labor situation and the ability to simply get people in the door, kind of forget for a second, the dollar amount per hour, how do you think that that plays out in 2022?

I think that all of our operators, Brian are very focused on building a strong employee experience. One of the issues that they've had when it comes to labor is not only, or the result of the shortage of labor is the costly use of the agency. And so focusing on that employee experience, understanding what their needs are, the employees, needs addressing their desire for flexibility, this is something that we're hearing an awful lot in senior living, but across all industries as well, is this growing demand for employees to have flexibility. And the agency -- working for the agencies has given them that flexibility. I think that operators are now starting to see that they need to be less rigid with the schedules and providing that flexibility, but also reviewing benefit structures and building that sense of community to bring people back to senior living. There, there was a great deal of burnout due to COVID-19 over the past couple of years, where there are people who just left the industry and so I think the operators are working very hard to reach back out to those folks to try to bring them back now that things have settled down a bit.

Thanks. And last for me, can you talk about maybe for Rick, how the credit facility amendment and the signal significant amount of cash you're sitting on now impacts your ability to address the billion dollar 9.75% senior notes in the middle of the year, and has management kind of formulated a view on what they want to do there. Thank you.

Thanks, Bryan. It is a great point. We are sitting on a significant amount of cash. As I mentioned in prepared remarks, it's $1.6 billion on a pro forma basis for the JV transaction and our pay down of our credit facility from $800 million down to $700 million. So, we think we're well positioned. There is still a significant amount of capital that we're excited to get deployed into the communities. One of the big changes in the creditor agreement was to increase the basket that we can spend on CapEx up to $400 million. I don't think we've ever gotten close to that number in the past, but we are excited about the opportunities that we're seeing in the portfolio, both on the senior living side, but also on the office side, because some of the redevelopments that we've done in the office portfolio have really generated some incredible results. So we're going to continue to look to deploy capital where we can and as you mentioned, we do have some 9.75% senior notes out there that become callable in June. So we are certainly looking forward to reducing our debt as well.

The next question comes from Michael Carroll with RBC Capital Markets. Please go ahead.

Yeah, thanks. Rick, can you talk a little bit about your CapEx plans that you just mentioned, how much of that would be considered revenue generating CapEx and how much of that is maintenance CapEx that would kind of hit you on the AFFO line?

It's a good question, Mike and it's interesting, right? We've talked in the past about deferred capital that needed to be as we converted from leases to management contracts there, there was certainly some deferred capital and then we because of COVID, we weren't really able to get our asset managers and some of our project managers into the buildings to kind of get some of that started. So now that, that is behind us, we are actively working on addressing of that. So, it's a fine line between recurring and non-recurring capital. In a lot of cases, I think repositioning an asset that's been capital starved for a while is revenue enhancing. It may be things that would typically be classified as recurring capital and when our accountants actually get the invoices and process through, it's going to wind up in that recurring bucket. But I think we're really thinking more in total CapEx and again in the prepared remarks, I mentioned that we spent, $80 million of capital in our shop portfolio. Most of that was allocated to recurring because they are things of a recurring nature, but a lot of it was kind of one time. We're not going to have this every single year. So I would look towards total CapEx versus the split for now until things are more normalized and we increase dividends and things like that. So I think we're going to continue to look to deploy capital and that split is a bit challenging, but I think on a normal basis, in the shop portfolio, for example, it's probably appropriate to think about it as about 1500 per unit per year. And we're obviously exceeding that right now, but it's a really an investment in our portfolio.

So how long will the elevated CapEx expenditures persist? Should we assume that the run rate that you did in the fourth quarter continues through '22? Should we also consider that going through '23 also?

Well, we can't quite maintain the run rate. We were just at $112 million this quarter. We are limited to no more than $400 million in a year. I can tell you that we are planning to get as close to that as possible. In '23, our model has it coming down a bit. We are really trying to be proactive and take care of everything we can to well position the portfolio for a recovery from COVID. So our model does have it coming down in '23, but I think this year is a big year for CapEx.

Okay. Can you talk a little bit about what type of expenditures you're spending within the seniors housing portfolio? What have the prospective residents responses been to that? And I guess maybe how disruptive are those, or should we expect there's going to be more seniors housing disruption in '22 as you kind of address these needs?

I would say a great deal of what has been spent to date. Mike is what I call the low hanging fruit CapEx, paint and carpet replacement, lobby refreshes, things like that, unit turns what I would call more disruptive capital. We're going to do a lot of this year and I'm not sure it's going to be very disruptive. I think that we're -- our project management group is planning to do some of this repositioning capital this year and next in a way that impacts residents as little as possible. They'll be working very closely with the EDS and the residents to meet with them on a regular basis to actually try to have them feel like they're part of the project as opposed to being bothered by the project. So we don't expect that there will be a great deal of disruption as a result of the work.

Okay, great. And then, can you lastly talk about the transition assets? I know NOI dropped pretty significantly in that bucket. Was that just the disruption related to the transition and how can we think about the recovery within that portfolio?

I think there was certainly some disruption from the transition. We tried to minimize the impact on the employees in the communities, but having your employer change is always somewhat disruptive. So we certainly saw the results deteriorate in the fourth quarter and I think as we look at the short term kind of action plans and what the new operators were focused on, we're excited. And we do expect to see that recover pretty quickly. Again, I think they're getting a really good feel for the buildings right now and we should start to -- we should start to see some recovery in the first quarter but really, through the latter half of the year, we really expect it to be humming along.

Okay, great. Thank you.

The next question comes from David Toti with Colliers International. Please go ahead.

Good morning. Thanks for taking my question. Just a quick question, can we expect other joint ventures or other asset sales, or are there still plans to continue to liquidate portions of the portfolio to raise capital or is that the bulk of that completely your mind?

I would say the bulk of it is complete David. We have no portfolio dispositions or joint ventures planned going forward.

Okay. That's a simple answer. I appreciate it. And then lastly what do you think, obviously we don't know the answer to the reversal of performance in the shop portfolio, but when do you think the company will be back in growth mode? What's your expectation for more aggressive strategy deployment?

Growth mode, as far as NOI growth

Either external growth -- external growth strategies, portfolio expansion, anything on the more expansionary side.

Sure. We do have some redevelopments planned in our office portfolio segment and so I think that that will, investing capital in our existing portfolio is our goal this year. And so I think most of our growth will be focused on growth within our existing portfolio capital deployment and repositioning our senior living assets and then a number of our office portfolio segment properties. So I would say most of our growth will be focused on internal growth.

Excellent. Thank you.

Thank you.

This concludes our question-and-answer session. I would like to turn the conference back over to Jennifer Francis for any closing remarks.

Thank you. And thank you all for joining our call today. Operator, that concludes our call.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.