At the start of 2019 Senior Housing Properties Trust (NASDAQ:DHC) was paying a dividend of $0.39 per share per quarter. But just one quarter later it dropped its quarterly disbursement to $0.15 per share, a massive 60% dividend cut. That was a tough call, since management is well aware that dividend investors don't appreciate dividend cuts.
Even with the cut, though, the yield here is still elevated at around 8% (roughly four times the yield of an S&P 500 Index fund). If Senior Housing has regrouped and positioned itself for better days, as management contends, investors might be missing an opportunity here. But what's really going on?
The big, bad cut
Senior Housing Properties Trust is a healthcare real estate investment trust (REIT). It owns a diversified portfolio of assets, including senior housing (around 50% of rent), medical research facilities (27%), and medical office buildings (23%). This isn't materially different from many of the industry's largest players, including Ventas and Healthpeak Properties. So from a portfolio-diversification perspective, Senior Housing Properties is right in-line with peers. In fact, one of the biggest positives here is that medical office and research properties make up roughly half the portfolio. These assets are in high demand right now, and management expects that to remain the case for years to come.
The other half of the portfolio, however, isn't doing quite as well. The good news is that most of Senior Housing's rent is largely direct pay, so it avoids the issue of Medicare and Medicaid reimbursement changes (which are known as third-party payers). But it hasn't been able to sidestep the overbuilding that has taken place in the senior housing space. And the pain has been widespread.
There are two buckets on the senior housing side of the business: net-lease assets, and what is known as a senior housing operating portfolio (or "SHOP"). Net-lease assets are rented out by other companies under long-term leases. SHOP assets are owned and operated by Senior Housing Properties, though it really hires other companies to do the day-to-day work. The key difference is that the REIT benefits from the operating upside in the SHOP portfolio during good years, while also feeling the pain of the downside in bad years. It just collects rent from a net-lease tenant, though, meaning the tenant takes on all of the operating risks.
The problem today is that there's been a lot of bad news in senior housing, most of which ties back to overbuilding. The long-term story is that the giant baby boomer generation is cresting into retirement, and that will eventually lead to increasing demand for senior housing assets like Senior Housing Properties owns. That's just demographics. But everyone is well aware of the trend, and that predictably led to a material increase in construction in the senior housing space.
That construction is currently starting to come online, increasing competitive pressures in the industry. It has been particularly bad for Senior Housing Properties, whose SHOP portfolio saw net operating income (NOI) fall 17.5% year-over-year in the third quarter. That's much worse than at its larger peers, where declines were closer to 5%. Still, in a difficult market, investors would expect the SHOP portfolio to take a hit. The real concern is that Senior Housing Properties' net lease portfolio saw NOI drop even further, declining 30% year-over-year.
There's a story behind that number, and it helps explain both the dividend cut at the start of the year and the concerns that investors still appear to have about Senior Housing Properties' future.
Helping out a troubled tenant
A large portion of Senior Housing's net-lease assets are run by a company called Five Star Senior Living. It was having a particularly hard time dealing with the supply/demand imbalance from overbuilding, and Senior Housing Properties effectively ended up recapitalizing the company. In a complex deal, Senior Housing provided rent concessions and a cash infusion. That helps explain the massive year-over-year NOI decline in the net-lease portfolio in the third quarter, and why Senior Housing had to cut its dividend.
The deal, however, gets even more complicated. Five Star is giving equity to Senior Housing Properties, increasing its ownership of Five Star, and also issuing shares to Senior Housing Properties' shareholders. As if that weren't enough, the assets Five Star leased will no longer be net-lease assets, and will instead shift into the SHOP portfolio when all is said and done. There are a lot of moving parts in this complicated agreement, but the end result is that Senior Housing's SHOP portfolio will expand from 77 properties out of 286 senior housing assets (27%) to 243 out of 286 (85%).
The deal won't be fully complete until early 2020, but this is a material change. And even at that point there will be more work ahead, because Senior Housing plans to sell off nearly $1 billion worth of poorly performing assets. But the big story is that this move, while perhaps necessary to avoid the bankruptcy of a key lessor, materially increases the risk for Senior Housing Properties. It will now be participating a lot more in the performance of its senior housing assets. Right now that seems like a bad thing, since the industry is facing a supply/demand imbalance caused by overbuilding. As long as that imbalance continues, near-term results here aren't likely to be very good.
That said, with the dividend cut Senior Housing Properties now has one of the lowest payout ratios in the industry, and its dividend is arguably in a strong position to weather the current market headwinds. And while supply and demand are out of whack right now, the long-term demographics haven't materially changed, so increased demand is still coming. Meanwhile, the current industry headwinds have led to a drop in construction, which should further help to alleviate the supply/demand imbalance over time. So there's a reason to buy into the idea that Senior Housing Properties has made the hard call, and once it's through this rough patch the future looks much brighter.
However, until the dust settles on this complex deal, most investors are still probably better off sitting on the sidelines. There's just too much going on. That includes the not-so-subtle fact that the same company that struggled to operate properties profitably as a net-lease tenant is now going to be operating those same properties under contract for Senior Housing's SHOP portfolio. Maybe Five Star can turn things around, but until there's proof that this plan is more than a band-aid, it is way too early to call it a successful resolution.
Too many questions, not enough answers
Senior Housing Properties has made a bold move to deal with a very big issue. That decision has resulted in investors having to swallow a huge dividend cut, and what appears to be a material increase in risk, as the SHOP portfolio expands. Until its efforts to help right Five Star play out for a little while, most investors should probably avoid Senior Housing Properties. Yes, the 8% yield is enticing, but it comes with a lot of risk. The trade-off just doesn't seem worthwhile at this juncture.