Diversified Healthcare Trust (NASDAQ:DHC) is currently trading around $1. Six years back, it was trading around $22. During the same time, the quarterly dividend decreased from $0.39 to $0.01. DHC generated an average yield of 2 percent in 2022, and 1.2 percent in 2021. The gradual decrease in price and dividend is a testimony of how poorly the stock has performed.
In an earlier report, published in March 2022, I suggested a “HOLD” and commented that:
“[S]elling off the life science and medical office properties will surely put pressure on already thin top line growth in the immediate term. The SHOP segment despite having growth potential doesn’t seem to be in a position to generate significant revenue growth as the properties are being operated by third parties under fixed operating fees, but without any guaranteed revenue commitment.”
Similarly, during May 2022, I expected a further price loss, and recommended a “SELL.” I was particularly concerned about liquidation of stakes by financial institutions. I mentioned that:
“This REIT has an extremely high institutional ownership at 81 percent. However it has come down from 84 percent when I last covered this REIT on 9th March, 2022. As time passes by, I expect more and more institutions to liquidate their stakes in Diversified Healthcare Trust. And if that happens, existing investors should liquidate their stakes as early as possible.”
On March 9th, the stock was trading at $3.05 and on May 16th, it was trading at $2.2. Investing in this stock did not make any sense to me. However, the current extreme low price makes me want to ask: is there any scope of generating returns in the near future, or is the company moving along a path towards bankruptcy?
A Close Look at Diversified Healthcare Trust & its Financials
Diversified Healthcare Trust is a real estate investment trust (“REIT”) that focuses on the Senior Housing Operating Portfolio (“SHOP”), and Life Science Estates. It earlier had a significant presence in the Medical Business Office (“MBO”) segment, but has now sold off many of its assets. The SHOP segment runs communities that offer multiple types of residential care, including independent living services, assisted living services and skilled nursing facilities (“SNF”). Once a major player in healthcare REIT, DHC has a presence across the United States and derives majority of its revenue from the SHOP segment. DHC is managed by the operating subsidiary of Massachusetts based RMR Group Inc., which is an alternative asset management company.
Diversified Healthcare Trust has always been held or owned by renowned financial institutions (“FI”) and hedge fund managers. Off late, these financial institutes liquidated their stakes. Still, 84 percent of this REIT is owned by FIs and hedge fund managers, and 10 of the renowned FIs own 40 percent of DHC. These FIs are Vanguard Group Inc, Flat Footed LLC, State Street Corporation (STT), H/2 Credit Manager LP, Geode Capital Management, LLC, JPMorgan Chase & Co (JPM), Charles Schwab Investment Management Inc (SCHW), Zimmer Partners LP, The Bank of New York Mellon Corp (BK), and Morgan Stanley (MS) – Brokerage Accounts. In short, the situation is not as bad as I expected during May, 2022.
Diversified Healthcare Trust is trading at an all time low price $1.1. The price multiples are extremely low. Price/Book (P/B) of 0.09 and Price/Sales (P/S) of 0.19 is hard to justify. Financial health of this REIT is reasonably under control. A quick ratio of almost 1, and current ratio of 1.2, suggest that DHC is not under pressure of running its operation. At the same time, the solvency ratios also stand good, if not strong. Debt/Equity ratio of 1.1, and interest coverage ratio of 2.68 suggests that the company is safe from default risk. The company also generated a return on equity (“ROE”) of almost 16 percent, and return on invested capital (“ROC”) of 10.2 percent. A 3-year annualized sales growth of 7.4 percent also worked in its favor. In my opinion, there is nothing substantially wrong with this REIT that can justify its current valuation, and it has taken all the corrective measures required to overcome the crisis in hand.
Going forward, a determining factor will be the rising interest rates. Despite the company witnessing gradual decline of its long term debt, the interest expenses kept on increasing. Interest expenses have surpassed operating income since 2020. However, DHC has been able to generate net income on the basis of gains made from sale of its assets in the MBO segment. This surely hasn’t gone down well with investors. But, that is the need of the hour. Now, If the interest rate keeps on increasing, then it may lead to severe trouble for Diversified Healthcare Trust. This is a risk, a macroeconomic phenomena, that perhaps DHC will not be able to overcome. Thus, there lies a scope of DHC going bankrupt. Investors should be cautious about this aspect.
Is There any Scope of Turnaround?
Earlier I found a fundamental problem with the business model of Diversified Healthcare Trust’s SHOP portfolio. I repeatedly stressed the point that “Diversified Healthcare Trust pays fees to Five Star Senior Living Inc. (FVE) for managing almost two-third of DHC’s SHOP portfolio, and the earnings from such properties are transferred to DHC. However, till 2025, DHC cannot terminate Five Star or close down any center without paying a termination fee, even if Five Star fails to generate steady revenue. As a result, DHC can’t sell up to $682 million worth of senior living communities without the payment of termination fee.” Thus, DHC is unable to make efficient use of 2/3rd of its SHOP portfolio.
However, this situation throws up some opportunities too. Once this contract with FVE is over, Diversified Healthcare Trust will be able to operate those assets on its own, or enter into a sound operating contract. Fundamentally, there is nothing drastically wrong with this company that can justify this depressed and ever decreasing price. It is mostly the result of a market panic, correlation, beta, stake sales by financial institutions, that has pushed this stock to such a low. Investors can take this as an opportunity to accumulate some units of DHC. By another 2 years, the stock will probably overcome most of the hindrances that are pulling back the market price of this healthcare REIT.
Funds from operations (FFO), a key metrics for analyzing the financial condition of REITs, also is indicative of a turnaround. In Q3, 2017, i.e., almost 5 years ago, the FFO stood at $0.44. It gradually declined since then, and turned negative during Q3, 2021. For the past 4 quarters, FFO has been negative, but has started improving from Q2, 2022. Seeking Alpha has been optimistic about DHC’s future FFOs, and has estimated a $0.29 FFO for 2023, on the back of an estimated revenue of $1.37 billion. This, if materialized, will be a huge turnaround for Diversified Healthcare Trust. Having said that, the primary objective of DHC will be to sail through this crisis period – which has resulted from higher interest rates, lower revenue from SHOP portfolio, negative operating income, and most importantly negative FFO.
Clearly, DHC is neither an alpha producing stock nor a value stock. The FFO has been gradually worsening and has turned negative since Q3, 2021. This surely is a serious concern for this SHOP focused REIT. But, a company holding real estate assets in the healthcare sector should not trade at 9 percent of its book value, no matter how adverse the current market situation is. Not to forget that the financial stability, and repayment capability of DHC is high enough, and the company has not defaulted on its debt obligations. Moreover, the way this healthcare REIT has approached its problems, I am quite hopeful that it will be able to overcome this crisis. The book value is 11 times its market capitalization and the financial soundness provides a scope for price to shoot up anytime in the future.
Even a modest improvement in profitability and resulting pay-out can make this stock a big winner in the coming years. In my opinion, Diversified Healthcare Trust is definitely worth a gamble at the current price level of $1.1.
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