Diversified Healthcare Trust (DHC) 2010 Q2 法說會逐字稿

Good day, and welcome to the Senior Housing Properties Trust second-quarter 2010 financial results conference call. This call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to Vice President of Investor Relations, Mr. Tim Bonang. Please go ahead, sir.

Thank you and good afternoon, everyone. Joining me on today's call are David Hegarty, President and Chief Operating Officer; and Rick Doyle, Chief Financial Officer.

Today's call includes a presentation by management, followed by a question-and-answer session. I would also note that the recording and retransmission of today's conference call is strictly prohibited without prior written consent of SNH.

Before we begin today's call, I would like to state that today's conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and federal securities laws. These forward-looking statements are based on Senior Housing's present beliefs and expectations as of today, August 2, 2010.

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, regarding this reporting period.

In addition, this call may contain non-GAAP numbers, including funds from operations or FFO. A reconciliation of FFO to net income, as well as components to calculate AFFO, CAD or FAD, are available on pages 11 and 14 in our Q2 supplemental operating and financial data package, found on our website at www.snhreit.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 Q2 2010 Form 10-Q, to be filed with the SEC later today. Investors are cautioned not to place undue reliance upon any forward-looking statements.

With that, I would like to turn the call over to Dave Hegarty.

Thank you, Tim, and good afternoon, everyone, and thank you for joining us. We have a lot of positive news to report today. The company had an excellent quarter and is in solid financial condition. We also feel optimistic about the investment opportunities going forward.

Maybe the most significant news to report is that our unsecured senior bonds were just upgraded to investment grade this past Thursday by Moody's Investor Services. As stated in their press release, "this rating action reflects the substantial progress made by Senior Housing in terms of growth and diversity, as well as its maintenance of consistently sound credit metrics."

By design, over the past two years, we have diversified our real estate investment portfolio, primarily through the addition of medical office buildings. We've expanded the size of our real estate investment portfolio to approximately $3.5 billion, while maintaining our historically conservative balance sheet. As many of you know, our unsecured bonds are already considered investment-grade rated by Standard & Poor's.

The second quarter of 2010, we reported $0.42 per share funds from operations, which was consistent with the consensus expectations. We continue to have a high cash balance and full capacity on our $550 million revolving credit facility, with no near-term debt maturities.

As usual, the company has a solid balance sheet, excellent liquidity, a well-performing portfolio and is consistently evaluating growth opportunities.

During the quarter, we closed on two medical office buildings mentioned in our last earnings call that totaled $16.6 million, and we funded $9.6 million of capital improvements and expansions at our senior living properties and are optimistic that we will have ample investment opportunities to consider in the second half 2010.

We have had excellent access to capital, as evidenced by the $200 million debt issuance we did in April, and we have plenty of capacity to invest. Before I get into the details of our portfolio, the acquisition environment and the outlook, Rick will review our results for the quarter.

Thank you, Dave, and good afternoon, everyone. Rental income for the second quarter increased by $11 million to $81 million or 16% compared to the second quarter of 2009. General and administrative expense increased $357,000 or 7% to $5.4 million, which is one of the lowest in the healthcare REIT industry at 6.7% of revenues.

Depreciation expense increased by $3.7 million or 20% to $22 million compared to the second quarter of 2009. Year-over-year quarterly increase in rental income, G&A and depreciation expense reflects properties acquired since April 2009, partially offset by the sale of four properties in 2009.

Property operating expenses increased by $925,000 to $4 million, primarily due to acquisitions of several medical office buildings since April 2009. In most cases, these operating expenses are recovered from the tenants.

Percentage rent revenue from our senior living tenants for the second quarter 2010 increased 4.2% to $2.5 million versus the second quarter of 2009.

Interest expense for the second quarter 2010 was $9.8 million higher versus the 2009 period, due to the interest and amortization of deferred financing fees relating to our agency debt with Fannie Mae that closed in August 2009, offset by lesser amounts outstanding under our revolving credit facility. As discussed in our last call in April, we issued $200 million of senior unsecured notes due in 2020 at a rate of 6.75% per annum. Approximately half of the proceeds were used to redeem our $97.5 million of our Senior Notes due 2015.

Due to the 30 day notice on the redemption, we incurred approximately $640,000 of extra interest charges during the quarter. Additionally, we recorded a loss on early extinguishment of debt of $2.4 million, consisting of approximately $1.3 million of debt prepayment premium and a write-off of unamortized deferred financing fees of $1.1 million.

On a quarterly basis, we evaluate our portfolio for impairments and performance. During the quarter, we recognized impairment charges of $1.1 million on five senior living facilities leased to Five Star, and classified these facilities as held-for-sale in our financial statement. Effective August 1, we sold four of these facilities for their approximate net book value of $1.5 million. This transaction will reduce the annual rent paid by Five Star by 10% of the net proceeds of the sale.

We recognized acquisition costs of $404,000 compared to $1.3 million for the same quarter last year, and that is solely a function of transaction volume.

For the second quarter of 2010, our FFO was $53.3 million or $0.42 per share compared to $52.8 million or $0.44 per share for the same period in 2009. FFO for the second quarter was negatively impacted by $0.01 to $0.02 per share due to the timing to redeem our Senior Notes and having access proceeds until they are fully invested.

In July we declared a dividend of $0.36 per share, which represents a payout ratio of 86% of our second-quarter FFO.

On April 1, we acquired one medical office building for $4.5 million. In early June, we acquired another medical office building for $12.2 million, and we invested $9.6 million into revenue-producing capital improvements. We funded these investments with cash on hand and by assuming a mortgage loan totaling $2.5 million, with an interest rate of 6.7% per annum.

As a reminder, our leases with most of our tenants provide an option for the tenant to finance long-term capital improvements at our properties. Five Star and some of our other tenants take advantage of this provision. Recently, Five Star added 38 units to two properties, as well funded major improvements at the rehabilitation hospitals with this type of funding. This may result in about $30 million to $40 million of new investments for SNH in 2010.

At the end of the quarter, we had nothing outstanding on our revolving credit facility, unrestricted cash on hand of over $25 million through a series of unsecured senior notes of $423 million in aggregate and mortgage loans and capital leases totaling $658 million.

We currently have $225 million of senior notes due in 2012 with a high interest rate of 8 5/8%. Although onerous yield maintenance penalties on the 2012 senior notes have discouraged us from prepayment, we continue to look for opportunities to prepay these notes.

On June 30, our total debt was approximately $1.1 billion, and our equity was $1.9 billion, for the ratio of debt to total book capital of 37%. On a market basis, our debt to total market capitalization was 30%. Other than the 2012 Senior notes, we have little debt due until 2019 or later.

Today, we have the entire $550 million credit facility available to fund future investments. Our revolving credit facility expires on December 31, 2010. However, at our option, we can extend the maturity date one year until December 31, 2011. We continue to monitor banking market conditions, and at this time, have not yet made a decision to either pursue a new revolving credit facility this year or exercise our one-year extension option.

Now that we have investment grade rating from both agencies, this should assist us in our effort to obtain a new revolving credit facility and potentially enhance pricing.

Now I will turn it back to Dave for a discussion about the performance of the portfolio and the investment environment.

Thank you, Rick. As you can hear from Rick's comments, our operating performance was solid, the dividend is well covered, and the balance sheet is well-positioned for several years. And the performance of our tenants and their management of the properties leased to them reflect on the quality of our cash flows and, ultimately, the security and growth of our dividends.

Our existing portfolio continues to perform well in this difficult environment. Our largest tenant, Five Star, reported its earnings last Wednesday. They reported excellent earnings, with normalized income from continuing operations of $0.21 per diluted share, generated significant cash flows from operations, have their $35 million revolving credit facility completely available and have little capital needs for several years. As a reminder, Five Star received a net cash increase of approximately $35 million from the UBS Put Right on their auction rate securities, which occurred on July 1.

As Five Star noted on their call last week, of the four largest publicly-traded operators, they are the only operator to be profitable in each of the past six quarters.

With regards to properties we own and lease to Five Star, for the 12 months ended March 31, 2010, the cash flows covered their rental obligations by a strong 1.34 times, and that is computed on an EBITDA basis, or a cushion of approximately $60 million.

The occupancy for two of the leases with Five Star ticked down by a percent for the 12 months ended March 31, 2010 compared to the same period December 31, 2009, while the other two leases remained flat for the same period. But as Five Star reported last week, occupancies have stabilized over the past few quarters, and more notably, for the first time in four years, occupancy at their independent and assisted-living properties is up on a comparative basis to 86.6% in the second quarter 2010 from 86.4% in the second quarter a year ago.

Now, the 14 high-end retirement communities that we lease to Sunrise, whose obligations are guaranteed by Marriott International, also performed well. We continue to monitor Sunrise the company, but the facilities are being operated well and the occupancy and rent coverage are holding up. The rent coverage was 1.4 times and occupancies averaged 89%.

The Brookdale properties continue to be stable, with 91% occupancy and over 2 times coverage. Our smaller, private operators continue to perform at about 2 times coverage as a group. Additionally, the two wellness tenants cover their rental obligations over 2 times and have been holding up well in this difficult economy.

On the medical office building portfolio, occupancy was 97% at March 31, 2010 and at June 30, 2010. We currently own 58 properties and the majority of these are long-term lease with strong credit tenants. Even our multitenant buildings are performing extremely well. There has been little turnover in the medical office suites, but renewals and new leases have approximated existing rents. And tenant improvement leasing commissions for the quarter ended June 30, 2010 were $430,000, with leasing commissions accounting for the majority of this figure.

On April 1, we acquired a 15,000-square-foot medical office building; that's a surgery center built in 2007 located in Colorado, for $4.5 million. It's leased to a physicians' group for 10 years on a triple-net basis.

And in early June, we acquired a Class A 56,000-square-foot medical office building leased to a high-investment-grade health system in Texas for $12.2 million. This building was built in 2009 and the lease expires in 2024, and the cap rate on these investments was 9.7%.

Moving on to our acquisition pipeline, we are seeing several individual assets and small portfolios to consider in both the senior housing and medical office property space. I am optimistic that we will acquire properties in the 8% to 10% cap range over the second half of the year. We will continue to exercise discipline and not chase transactions for the sake of putting money to work.

Before we wrap up our discussion for the quarter, I want to update you on the outcome of discussions that occurred during the quarter between Senior Housing's Board of Trustees and Five Star's Board of Directors regarding long-term strategies. The independent trustees and directors of each company discussed a range of strategic options, including the possibility of Senior Housing acquiring Five Star in a taxable REIT subsidiary structure, or TRS.

During the discussion, each company differed on their valuation of Five Star, including their ancillary businesses, as well as their net operating loss carryforwards that exceeded $100 million. It was evident that the boards were too far apart in their valuations to continue the conversation further, although as a positive exercise, the gaps between the interests of both companies were too big to bridge. As we went through the process, a significant number of SNH's investors expressed concern over our risk profile changing as a result of that transaction.

Ultimately, the boards agreed to consider the TRS structure for certain future acquisitions of senior living communities under the right circumstances.

Subsequent to quarter-end, our Board declared a cash dividend of $0.36 per share, which is a payout ratio of 86% of the second quarter's FFO. Our Board evaluates the dividend on a quarterly basis and looks for opportunities to prudently raise the dividend. Based on our current payout ratio, we are generating $60 million to $65 million of excess cash flow per year to provide a cushion for the dividend, should any operator experience difficulties or any unforeseen needs. This surplus cash flow is currently used to fund improvement financings, make new investments or prepay debt.

In conclusion, we will continue as always to closely monitor the portfolio, seek excellent investment opportunities, while prudently managing our liquidity and focusing on growing cash flow to ultimately increase the dividend.

With that, we will turn it over for questions.

(Operator Instructions) Kevin Ellich, RBC Capital Markets.

Good afternoon. Thanks for taking my questions, guys. Starting off with the upgrade, congratulations. Just wanted to -- how do you guys think we should think about that, in terms of renegotiating your revolver and the cost of debt? What do you guys expect and how do you think we should think about this?

Well, this was certainly an important milestone for us, and now with both agencies considering our debt investment-grade, that certainly helps us going forward.

We will be looking at doing our revolving line of credit over again this year. We'll see whether or not it makes sense to go to the market in the fall or wait until early next year, but -- because we definitely have attractive pricing on our line right now, and it is going to go up even with the upgrade.

But it definitely should save us some basis points. You don't really know how much it's going to save you until you actually have a live deal, and you know what the market conditions are. I think we got -- our last debt issuance in April was very attractively priced. I think most people have told us that we achieved pricing almost as if we were investment-grade. So to be -- I assume we would improve on that somewhat, but it's very difficult to determine how much. It could be 10 basis points, 25 or more.

But I would say don't -- just read into it that it is a positive that we have this, and that going forward it should benefit us. Again, we have no immediate needs for capital right now. So the first use would be to help us with doing the line of credit.

Sure, and then does that also change your thinking on the refinancing of the Senior Notes due 2012? I believe that is the notes that are due right on January 1. Is that right?

They are due on January 1, and there is still a make-whole provision on that, Kevin that is pretty onerous right now. So we are looking at how we are going to fund that, and over time, I think we will just look at different options that we will have.

Got you. Okay, that's helpful.

And that's very expensive debt, so whatever we refinance it for, it should be accretive.

To what we are paying now on that debt.

You guys are paying -- what -- a little bit over 8.5% on that?

8 5/8%, yes.

8 5/8%, okay, got it. And then on the Five Star call, they mentioned, I think, there are some nursing homes that are being sold in Q3 in Nebraska. I was just wondering what are you guys going to do with those properties.

Those four properties closed today; in fact, effective August 1. So the net proceeds are a little less than $1.5 million. So the way it works under our lease is we get the proceeds, we reduce their rent by 10% -- on those particular properties, we reduce the rent by 10% of the net proceeds. And essentially, that money probably will go back into other properties as capital investments down the road. And we raise the rent at that time.

Okay, so wait now -- just so I understand it -- are you switching operators or did you actually divest those properties?

We've divested them.

Okay. And you said the proceeds was $1.5 million. Got it.

Okay, and then Dave, you were talking a little bit about the cap rates. I think you said the two MOBs -- was that 9.7%?

Correct.

Okay. Well, it seems like the acquisition pace has been a little bit slower. Are the deals just more expensive or are you just being more diligent in the process?

What has happened is we've seen a material increase in opportunities to consider since about the first of July. And on the medical office building front, more so, but also on the senior living side, we are seeing many more opportunities to consider.

So it is difficult to point out as to what the catalyst is. Some people say it is the fact that capital gains rates are likely to go up after this year, so people want to close on deals before year-end. Some of it is debt maturities. Some of it lenders are encouraging the sales. There are a number of factors at work, but we've definitely noticed a material uptick in opportunities to consider.

Got it. And then the valuations, has that changed much, in terms of how we should think about the pace?

I would say the senior living cap rates haven't changed that much from where they were last quarter. As far as the medical office buildings, they may have come down a little bit. And I think you still have situations where large portfolios of Class A properties would go for a premium cap rate or a better cap rate than the one-off transactions.

Got it. Okay. That's good. Thanks, guys.

Jerry Doctrow, Stifel Nicolaus.

Just a couple things. Speaking on the cap rates and the MOBs, so the two that you bought, one was kind of small and the cap rate seemed very high to me, just compared to market even kind of one-off. Can you give us a little more color on those, maybe what drove the cap rates as high as they were?

I think in the two cases, one case was a marketed deal through a major brokerage firm, national brokerage firm. And I think it was on the smaller side, so you probably didn't have a number of the major players chasing it. And there was a function of debt. I think -- I don't know, maybe we were the better-qualified buyer at that pricing level of that size transaction. But it made sense for us, given we had a presence in the market anyway. And so that was in that 7, 9, 8 range.

And the other one was a one-off property, an off-market deal. And I think that we're finding more and more transactions that are off-market. And I think what is key is that the actual cash cap rate is lower, but each of these leases contain some fixed increases over the life of the lease and their long-term leases.

Okay, so the straight line too. Can you give us a sense of maybe where the cash cap rates are?

Maybe in the mid to high 8s.

Okay. So on that basis, they are at least -- a little closer to where at least I think the market is. So, okay.

On the TRS, I guess I was curious as to whether -- is there a type of transaction that you would use that for. Are we likely to see those? Is TRS something you would do only with Five Star or with somebody else? Just trying to get a little color on what's the likelihood that we will see it and if there's a criteria maybe for using it.

Sure. I mean, I think it is still something -- I think that many people in the industry are trying to get their arms around whether -- how valuable the TRS structure is. In our case, we've seen a few transactions that we've debated about what to use it for.

I think the optimal use for it is a situation where a property may be, say, 60% or 70% occupied. But in fill-up -- and it might be a very nice, attractive property, but you can't ask an operator to take on the lease without the cash flows being there.

So we would look at doing a TRS structure in that case, and we could be breakeven for a year or lose money a little bit for a year if we saw a tremendous upside once we got stabilized.

There have been a few turnaround situations, too, that would qualify. So it is definitely something that we are looking at and have actively discussed in certain situations. As far as -- frankly, we have not had any discussions yet with other operators, and I guess it depends on what the terms are and so on. But maybe -- certainly should be a hot topic for this upcoming NIC Conference.

Okay. And how about just any more asset sales. I mean, you wound down four underperforming assets. Was that sort of a Five Star-initiated deal because they were losing money, or is there any more of that that we might see coming down the pike?

In most cases, they are initiated by the tenant, and they are operations they are losing money that help them and help us. In fact, under our leases, there is no mechanism for somebody to initiate a sales process without getting our approval first.

But secondly, it has to meet the criteria of being an underperforming property and less than a temporary underperformance. So like maybe -- in those particular cases, a local operator may be able to do better with them. So they are rural Midwest nursing homes.

So I think we have targeted some nursing homes for sale, and will continue to prove the portfolio in that sense.

Okay.

As you can see from the last several quarters, it has been a challenge to put money to work [at] the higher-end assets. So there is not a lot of incentive to sell our best-performing properties, even if there is a big built-in gain.

Okay. And just on the purchase side, you are sounding more optimistic, but it is still -- you also were saying, I think, it was sort of onesie twosies and sort of small portfolios, rather than -- are you looking at any larger transactions that would seemingly move the needle between now and year-end?

There is always a couple transactions out there that we evaluate that might be in the (inaudible) of, say, $100 million or so. But as far as much larger than that, at the moment, we are not conserving any, and have nothing out there of that magnitude.

Okay. And then just one modeling question and I'll jump off. As you said, you've got cash, you've got unused credit line, that sort of thing. So should we be thinking about -- and then you just termed out some debt. Should we be thinking about, as you are buying, say, properties on the scale that you did this quarter, of just putting them on the line, which, obviously, is a lot lower interest rate than term debt or certainly using equities (inaudible).

Right. I would say we are sitting on probably about $15 million to $20 million of excess cash that could go right into a real estate investment. And then we would utilize the cash, and you really need enough critical mass to look at the capital markets to do anything.

So the line could run up to 50 or 100 or something before you might have to go back to term debt?

Oh, yes, easily, yes.

Okay. All right. Thanks.

(Operator Instructions) Tayo Okusanya, Jefferies & Company.

A couple of quick questions. With the TRS and your recent conversations with Five Star, is the idea if you actually did end up using this at some point that Five Star would just be the manager of the assets? Is that the idea behind if you do that?

That's correct. Going forward, if we use the TRS transaction, they would be just the manager.

Okay, that makes sense. And I guess again, just around the TRS, you've talked about it; some of your other payors have talked about it. But no one -- and (inaudible) kind of talking about the same idea of when it is best to use it.

But it is just interesting to me that up until now, you haven't really seen anyone press the button and actually try to do this. And I was just wondering is it just like it is a really complex thing to do? Or what are the reasons why you kind of think at this point, just given the general idea that fundamentals are expected to start turning around in assisted living and independent living in particular, why someone hasn't made the move yet.

Well, it is a balancing act that people are a little bit nervous to take the dive in and do it. One thing is that there have not been many transactions to utilize it for. But also, most managers who want to manage the properties are insisting on long-term 20-, 30-year contracts, with very little ability to terminate them, like your typical, say, hotel management contracts.

And that is a vastly different situations than a lease arrangement. It totally shifts the balance between the manager and the landlord or owner of the property. And so I think the REITs are very reluctant to do that very long-term management contract arrangement without some ability to cancel it with reasonable terms.

But that is a -- just to confirm -- but that is a standard on the hotel side?

Usually it is, yes. So I think many of the operators who would be willing to do it on the operating side want that security of a long-term contract, and the REITs are less willing to dive in and take all the risk of ownership without having any ability to remove the manager if they don't like what is happening.

That's helpful. And then from an acquisition perspective, just following up on Jerry's question, just as you mentioned, a bunch of onesies and twosies and things like that you see out there. But have you ever given consideration to maybe trying to buy one of the smaller public healthcare REITs out there, especially since you do have an interest in increasing your MOB exposure?

Right. From time to time, we consider looking at them. I guess it depends on when we are looking and what is going on. I think there are several that still want a significant premium to be acquired. We won't do a hostile transaction.

Were you involved in Lillibridge at all, in any way?

No, we did not pursue that.

Okay, all right. Appreciate the time.

With no further questions, I will turn the call back to Dave Hegarty for closing remarks.

Thank you, everyone, for joining us today. We will be presenting at several conferences in New York City in September. We will also be at the NIC Conference in Chicago, and we hope to see you at one of those conferences. Thank you.

Thank you. That does conclude today's conference. We thank you all for your participation.