Earnings Call Transcript - DHC Q4 2021

Operator, Operator

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 Kodesch, Director of Investor Relations

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.

Jennifer Francis, President and CEO

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 a $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 credit facility to January 2024, which Rick will discuss more thoroughly in his prepared remarks. The combination of these transactions created approximately $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 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 joint venture 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, totaling 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 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 were 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 third quarter, largely driven by a sharp uptick in agency use. Agency cost increases 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 subside, 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.

Rick Siedel, CFO

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 $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 $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 to 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 million 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 remarks.

Jennifer Francis, President and CEO

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.

Operator, Operator

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

Bryan Maher, Analyst

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?

Rick Siedel, CFO

Good morning, Bryan. That's a great question and one we've discussed extensively with our asset management team and operators to ensure we have a clear understanding. We can all observe the rising costs at gas stations and grocery stores, along with other inflationary pressures that our community employees are experiencing. However, we've actually managed to maintain some success. One significant step has been Five Star's move towards outsourcing certain dining services, which has yielded some savings. While we might anticipate inflationary pressures, we actually foresee a slight reduction in expenses, which are largely consistent. We're centralizing our purchasing efforts where possible and selecting operators who are focused on specific markets, enabling them to find better prices with regional suppliers to alleviate national pressures. A considerable challenge in the shop portfolio is the pressure from wages, particularly due to the labor shortage. Our operators are taking the right actions to create appealing environments for employees, who often seek meaningful work beyond just earning a paycheck. We need to stay competitive with market wages, and we’ve recently adjusted our expectations; early in the budgeting process, we projected wage increases in the high single digits, but now it looks like it's in the 10% to 12% range. We will continue to monitor this closely, but we are optimistic that customers and residents will recognize the inflationary challenges and be open to rate increases.

Bryan Maher, Analyst

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?

Jennifer Francis, President and CEO

I believe our operators are very committed to enhancing the employee experience. One challenge related to labor is the expensive reliance on agency staff due to a shortage of workers. There is a strong emphasis on understanding employee needs and addressing their desire for flexibility, which is a growing trend not just in senior living but across various industries. Working with agencies has provided some flexibility, and operators are beginning to recognize the importance of being more adaptable with schedules and benefits while fostering a sense of community to attract workers back to senior living. Many employees left the industry during the significant burnout caused by COVID-19 over the past couple of years, and now operators are making efforts to reconnect with those individuals as conditions improve.

Bryan Maher, Analyst

Thanks. And last for me, can you talk about maybe for Rick, how the credit facility amendment and the 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.

Rick Siedel, CFO

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 and 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.

Operator, Operator

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

Michael Carroll, Analyst

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?

Rick Siedel, CFO

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 was certainly some deferred capital and 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 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 $1,500 per unit per year. And we're obviously exceeding that right now, but it's really an investment in our portfolio.

Michael Carroll, Analyst

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?

Rick Siedel, CFO

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.

Michael Carroll, Analyst

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?

Jennifer Francis, President and CEO

I would say a significant portion of our spending to date has focused on what I consider essential capital expenditures, like painting, replacing carpets, and refreshing lobbies. These are less disruptive tasks compared to unit renovations. We plan to undertake a lot of this work this year, and I don't anticipate it will cause major disruptions. Our project management team is coordinating the repositioning capital efforts for this year and next, aiming to minimize impact on residents. They will engage closely with the residents regularly to ensure they feel involved in the project rather than inconvenienced by it. Therefore, we do not expect substantial disruption from this work.

Michael Carroll, Analyst

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?

Jennifer Francis, President and CEO

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 see some recovery in the first quarter but really, through the latter half of the year, we expect it to be humming along.

Operator, Operator

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

David Toti, Analyst

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 complete in your mind?

Jennifer Francis, President and CEO

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

David Toti, Analyst

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?

Jennifer Francis, President and CEO

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. Most of our growth will be focused on internal growth. Excellent. Thank you.

Operator, Operator

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

Jennifer Francis, President and CEO

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

Operator, Operator

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