We Don't Need No Stinkin' Rally: Eye on Hotel REITs

Sure, who wouldn’t like the market to show its true bottom and start a new climb to the stars? However, it’s not happening now. So, are there any lemonade recipes out there for the lemons we’re drowning in?

One such recipe may be presenting itself.

Good recipes usually have their roots in the concoctions of the master chefs. One of the aromas emanating from Chez Buffett lately has been preference shares. Now I’m as eager to follow him (and as battered by the Dow) as the next person, so I considered the idea of following his lead. But how? Picture the reaction from Goldman Sachs to my offer to invest $5,000 of my precious IRA in these preferred shares paying 15% per year. Yeah, right.

Sometimes small can be good, though. Bear with me as I share how I discovered where even better returns are to be had by ordinary investors who follow Chef Buffett’s cuisine nouveau. In my case, it started with the advice of that other icon of the small-time investor, Peter Lynch: invest in what you know and understand. It so happens that our company services the hotel industry. Not necessarily the most glamorous, but it’s what pays our rent (and gets us free vacations in Jamaica and Barbados) and therefore the one that’s most familiar. A good place to start, therefore.

As a normal part of our company’s due diligence, we keep track of our publicly traded customers’ fortunes. For those not familiar with how the hotel business works, there are three parties to a typical hotel: the owner, the manager and the brand. The Hilton you last stayed at is typically owned by an insurance company, REIT or some kind of institutional investor. The property likely is managed by Interstate Hotels (IHR) or a professional management company like it. Hilton’s only stake in the property is its branding. Of course, this is a generalization – the major brands (Marriott, Hilton, etc.) typically own a few flagship hotels in major centers, and manage those (and a few more) as operators. The party buying stuff usually is the owner, and the owners most likely to have a publicly traded presence are REITs. Therefore, we routinely monitor the earnings releases of publicly traded hospitality REITs every quarter.

It’s no news that the lodging industry suffered the last quarter of 2008. The outlook for 2009 is equally grim, grim enough that many common dividends have been suspended. Given that REITs have to distribute all their earnings as dividends, that is not a trivial indication of concern. A new refrain is emerging, and it goes something like this. “We’re suspending common dividends. We can meet our obligation to pay dividends by paying no more than our preferred dividends.”

That is when the aforementioned Buffett menu shift came to mind. What are these preferred dividends that HAVE to be paid, at the expense of the common dividend? In the past, preferred shares always had a connotation of boring, staid and uninteresting. They never go up and therefore they hold no interest to any red blooded investor. But in these trying times they seem to have something of value: a dividend regarded as holy. Holy and safe, because as a percentage of total cash flow, preferred dividends tend to be small and therefore much easier to maintain than the common dividend.

Safe is good, so my next question was, how much of a dividend are we talking about? At first, I had the hardest time tracking down these infernal preferred shares. None of the web sites I use respond to “preferred” or any known abbreviation. No stock screener seems to have a variable for stock type, and even when I specify a dividend yield as low as 0.1%, no preferred shares show up on the list. Most stock screeners seem to regard only common stocks.

There had to be another way to track these pesky and shy stocks down. We were just wrapping up a small job for LaSalle (LHO), so I looked to see if they had any preferred stock. A quick glance at their latest 10-Q showed they indeed do, four separate series’ worth, in fact. So I used the symbol lookup feature of my friendly online stock broker to see what would pop up under LaSalle. Sure enough, there they were, all four series of preferred stocks.

Now I was curious to see what the dividend yield was. My eyes popped open when I saw a yield of over 20%! Isn’t Warren Buffett’s benchmark 20% per year? At the risk of sounding like those late night television commercials: but wait, there’s more. For whatever reason, most preferred shares are issued at $25 per share, and that’s pretty much where they stay, year after year after year. However, these LHO preferreds were trading around $10, meaning that, when order is restored to the market, these stock prices will go back to their normal trading range around $25. That means not only does one get a 20% yield, but in a few years the price more than doubles on top of that. Sounds like the Buffett zone all right! Accessible by any patient investor, regardless of size.

Surely this was too good to be true. So I embarked upon a long and tedious study of all of the hotel REIT preferred stocks, and when that was done I looked at a few other similar stocks. Almost all seem to have the same variables, i.e., a $25 issue/redemption price, a dividend around $2 per share and almost all appear to be cumulative, meaning that if the company skips the dividend, it goes on the tab, and they can’t pay out any dividends to anyone else before clearing the tab. And if they make any money, they have to distribute it as dividends, so sooner or later those dividends are all going to get paid.

In normal times, that’s not too bad, but not too exciting, either. When the stock price goes down, though, that’s when the numbers become downright generous. I observed a hierarchy among the hotel REIT ranks, with some stocks more depressed than others, the logical explanation appearing to be the relative risk. The biggest risks, of course, are (a) a skipped dividend and (b) the company going under. Dividend payment comes from EBITDA, as does the interest payment (which has to be paid before preferred dividends). So I tabulated the EBITDA coverage of both the interest and pref. dividends (in other words, how many times the company can afford to pay both interest and preferred dividends).

At the secure end of the spectrum, Host (HST), the granddaddy of hotel REITs, has a bulletproof forward looking (2009) coverage of over 2.5 times. The yield on their Series E prefs is “only” 15% per year and the stock, trading below $15, has an upside of “only” 50%. Not bad for a fairly risk-proof investment.

At the risky end of the spectrum lies Strategic Hotels and Resorts (BEE) with forward looking coverage of around 1.0. They have three series of preferreds, all priced under $3, and all therefore yielding over 60% per year, plus capital appreciation of over 700% (that’s gain, because the “normal” $25 price is 8 times the current price). However, they’ve already started skipping the preferred dividend.

Between these two extremes there are several alternative risk/return scenarios, all yielding more than 15% in cash per year, plus the prospect of a juicy price increase.

In order to gain perspective, let’s run the numbers for three years. Let’s assume that some semblance of order is restored in the market after three years and that the prices all return to $20, which is less than the normal $25, but let’s just be safe. Let’s further assume we don’t reinvest any dividends at all (a conservative assumption, but it makes comparisons simpler). In other words, we can take the numbers below and regard them as the very low end of return, assuming that all the companies survive (which is a separate exercise). The returns are simple average, over three years, assuming no returns on dividends received. (I know, how conservative can you get?):

These are rough numbers, but hopefully consistent. Everyone will please draw their own conclusions and do their own homework to refine the numbers. (Please share any improvements.)

From my knowledge of LaSalle and how they operate, I judged their risk as low enough for me to make their preferreds the cornerstone of my IRA portfolio. Of course, it may take more than three years for the stock prices to reach their normal level, but there are worse options than making 25% per year while waiting. There are bound to be good opportunities to invest those dividends somewhere in the meantime for an even better ultimate return. We also do business with Felcor (FCH) and I went out on a bit of limb, buying some in the belief that they have a good plan to weather an extended recession (for example, no significant debt maturities in 2009).

Is this bulletproof? Of course not. However, to assume that each and every hotel REIT is going to go under is not realistic, either. So sticking to the safe end of the spectrum sounds like an acceptable way to pass the time waiting for Mr. Bull to show.

The purpose of this exercise is to point out a segment of the market, often overlooked, where it’s possible for mere mortals to also breathe the great chef’s aroma of double digit cash returns while we wait, patiently (as he admonishes) for the rally’s inevitable arrival. America is indeed on sale.

Disclosure: Author holds long positions in LHO, AHT and FCH preferreds.

Comments

[biomedlives:]

Thanks for publishing your analysis of these attractive preferreds.

Mar 09 09:05 AM

[Chris B:]

Good analysis! However, in a scenerio where hotel REIT earnings are negative for 2-3 years, bankruptcy could come quick and the implied guarantees of cumulative preferred shares may go unfulfilled. After all, REIT's don't exactly sit on piles of cash, they distribute all their earnings. This tax requirement also means they could not hoard cash like a normal company even when they could forsee shortages of future earnings and refinancing options. When there are no earnings, how does anyone get paid? The carry-through nature of REITs means they could go bankrupt after a relatively short period of losses, and their heavy leverage means that the buildings themselves should not be considered collateral. Overall, these shares should be analyzed much as one would analyze junk bonds. The appearance of a bargain is there for a reason!

Also, in the event of a recovery in late 2009 or early 2010, the common shares are likely to appreciate faster than the preferreds. BEE common at $0.77, for example, might appreciate 600% within a month or two at the first whiff of even a mild recovery compared to "only" 400% total return per year for the preferreds. Sound unrealistic? It would only be a return to November 08 prices.

Triple digit returns are hard to imagine, for sure, but that's what always happens to the shares of the most speculative companies after the bottom of a stock market crash.

Mar 09 09:31 AM

[zorro6204:]

People make fun of the Yahoo chat boards, but we've been all over REIT preferreds since October. SHO is one of the most liquid REIT's in the market, and it flowed plenty of cash from operations even in a dismal Q4. HPT preferreds have become very cheap the last few weeks. BEE is a bad shape, no doubt, but it did just handle its credit line, and it flowed a little cash in Q4. It should make it so long as there is some recovery in the next year or two.

Hotels are not necessarily the most solvent REIT's out there, as pointed out above. Lending REIT's NRF and RAS have preferreds on sale, as does the apartment REIT AIV. None of these companies have any serious liquidity challenges coming up.

Mar 09 10:15 AM

[William Cowie:]

Chris, Zorro, good points, especially the possibility of the common to recover. However, the thing that gives me the most comfort is the scale of the amounts - it takes (comparatlively) only a small amount of money to service the preferreds. So even if a company barely squeaks by, it might still have enough for the preferred dividend.

Agreed on the risk of bankruptcy. However, I doubt that ALL will meet that fate. I think HST, AHT, LHO and SHO stand a better chance of making it than the others. Of course, for a return over 20% per year, one would expect at least some level of risk.

Speaking of which, there is another risk for the common, which is dilution. If I'm not mistaken, BEE has already filed a shelf registration for more stock. It is a rational way for REITs to weather the storm, and it could take some steam out of the common recovery. Preferreds, on the other hand, don't face the risk of dilution, because the dividend is fixed.

Zorro, thanks for pointing to those other stocks.

Mar 09 10:55 AM

[dave mckay:]

William, quantumonline.com is a great website to do research on preferreds. It's free, but I make a small contribution every year. Thanks for this analysis of yours.

Mar 09 05:29 PM

[dave mckay:]

William, on the balance sheet, could a quick and dirty way to look at these is to compare property,plant,equipme... versus long term debt? That comparison seems to end up being similar to your rankings.

Mar 09 05:44 PM

[User 139415:]

HPT preferred is by far the most secure as it has leases with third parties who have put up on average a security deposit equal to about 1 years rent. It is also an investment grade credit, unlike HST. Finally, it owns mostly limited service hotels that tend to narrower swings in performance thru the business cycles.

Mar 09 09:58 PM

[zorro6204:]

BEE's shelf registration will stay . . . on the shelf! It's hardly possible for it to issue any securities with a share price under a buck. It lives or dies with what's on the balance sheet now.

Mar 10 12:54 AM

[Panamax:]

yeah, I first found out about preferreds last summer and my analysis followed yours quite closely . . . until I realized that in the capital structure they come after the most subordinated junior junk bonds. GKK serves as a warning that the bondholders can shut off cash flowing to preferred holders if they so choose.

In my analysis of the implications of the $25 redemption value I found it odd that all things being equal that at these "insane" prices it is better to buy the nominally lower-yielding preferred series. eg. if XYZ-A with a 9% coupon is trading at 45% yield ($5) today vs. XYZ-B with an 8% coupon also trading at 45% yield ($4.44), for a $1000 buy, in the long run you're arguably better off with 225 shares of the -B instead of 200 shares of the -A, since the extra 25 shares you'll get will bring $625 (62.5% capital gain!) on redemption, if & when it comes.

Plus, with these yields all I want is my dividend payments, not redemption anyway, since where else am I going to find these yields.

GL all, we're going to need it.

Mar 15 07:50 PM

[dave mckay:]

Panamax, but don't forget that if the call dates are the same, the 9% coupon A shares will get called at par before the 8% B shares will. So there is the time value of money involved here as well.

Mar 20 11:10 AM

[logicalman:]

i was going to reply to the author....and then i read your reply...i couldn't have said it better myself..why would anyone in his right mind want to sell such a great deal to someone else...IF IT SOUNDS TOO GOOD TO BE TRUE!!!!!!!Too bad willy didn't write up his miraculous find before taking the plunge...oh,well,he can always sell his gems..check the wide bid/ask on these suckers he may get back 75 to 80% of his "investment" if he's real lucky and is very patient......hmmm.now let's see,a 20% loss in a two month timeframe =mucho % on a yearly basis..then again if he's patient for too long,he could be looking at a much greater loss..hope he didn't mortgage the farm and "invested" the whole wad in this terrible GAMBLE......



On Mar 09 09:31 AM Chris B wrote:

> Good analysis! However, in a scenerio where hotel REIT earnings are
> negative for 2-3 years, bankruptcy could come quick and the implied
> guarantees of cumulative preferred shares may go unfulfilled. After
> all, REIT's don't exactly sit on piles of cash, they distribute all
> their earnings. This tax requirement also means they could not hoard
> cash like a normal company even when they could forsee shortages
> of future earnings and refinancing options. When there are no earnings,
> how does anyone get paid? The carry-through nature of REITs means
> they could go bankrupt after a relatively short period of losses,
> and their heavy leverage means that the buildings themselves should
> not be considered collateral. Overall, these shares should be analyzed
> much as one would analyze junk bonds. The appearance of a bargain
> is there for a reason!
>
> Also, in the event of a recovery in late 2009 or early 2010, the
> common shares are likely to appreciate faster than the preferreds.
> BEE common at $0.77, for example, might appreciate 600% within a
> month or two at the first whiff of even a mild recovery compared
> to "only" 400% total return per year for the preferreds. Sound unrealistic?
> It would only be a return to November 08 prices.
>
> Triple digit returns are hard to imagine, for sure, but that's what
> always happens to the shares of the most speculative companies after
> the bottom of a stock market crash.
>

Mar 29 08:27 PM

[Mad Hedge F...:]

Many hotel investors not only lost their hearts in San Francisco, they lost their wallets too. The New York Times highlighted the dire condition of the city’s hotel market. The occupancy rate in February plunged to 57.7%, the lowest since 9-11, with many luxury rooms going for less than $100 a night. The collapse in pricing has been exacerbated by the Internet, and first and foremost by the William Shatner inspired priceline.com, whose competitive offering system unleashes avalanches of cheap rooms dumped on the market. As a result, the average price of a room has dropped from $156.16 to $127.59 in a year. Many hotels acquired at the market top in 2004 and 2005 have cash burn rates so severe that they are in imminent threat of defaulting on loans.

Apr 09 06:34 AM

[andrewsdad:]

Zorro6204,

I'm a stock investor and haven't bought preferred. What is the ticker (if that's the correct terminology) for SHO? Thanks.

Gman


On Mar 09 10:15 AM zorro6204 wrote:

> People make fun of the Yahoo chat boards, but we've been all over
> REIT preferreds since October. SHO is one of the most liquid REIT's
> in the market, and it flowed plenty of cash from operations even
> in a dismal Q4. HPT preferreds have become very cheap the last few
> weeks. BEE is a bad shape, no doubt, but it did just handle its credit
> line, and it flowed a little cash in Q4. It should make it so long
> as there is some recovery in the next year or two.
>
> Hotels are not necessarily the most solvent REIT's out there, as
> pointed out above. Lending REIT's NRF and RAS have preferreds on
> sale, as does the apartment REIT AIV. None of these companies have
> any serious liquidity challenges coming up.

Apr 20 09:26 PM

[andrewsdad:]

Hello,

I'm a long term stock investor. Never bought preferred stocks. What is the ticker for SHO? Thanks.

Andrewsdad


On Mar 09 10:55 AM William Cowie wrote:

> Chris, Zorro, good points, especially the possibility of the common
> to recover. However, the thing that gives me the most comfort is
> the scale of the amounts - it takes (comparatlively) only a small
> amount of money to service the preferreds. So even if a company barely
> squeaks by, it might still have enough for the preferred dividend.
>
>
> Agreed on the risk of bankruptcy. However, I doubt that ALL will
> meet that fate. I think HST, AHT, LHO and SHO stand a better chance
> of making it than the others. Of course, for a return over 20% per
> year, one would expect at least some level of risk.
>
> Speaking of which, there is another risk for the common, which is
> dilution. If I'm not mistaken, BEE has already filed a shelf registration
> for more stock. It is a rational way for REITs to weather the storm,
> and it could take some steam out of the common recovery. Preferreds,
> on the other hand, don't face the risk of dilution, because the dividend
> is fixed.
>
> Zorro, thanks for pointing to those other stocks.
>
>

Apr 20 09:29 PM