Hotel REITs: The Most Contrarian Idea I Have

Any reader of my blog recognizes that I generally have an affinity for consumer products and retail facing stocks. In this recession, I’ve also become quite the fan of dividends as manifested in my recent investments - General Electric (GE), detailed here, Valero Energy (VLO), detailed here, Altria Group (MO), detailed here, and Linn Energy (LINN), detailed here. As such, this investment idea probably comes as no surprise - Hotel REITS.

What are Hotel REITs?

Hotel REITs are a subcategory of Real Estate Investment Trusts. These are businesses which invest and (usually) operate income producing real estate. The benefit of this classification is that qualifying REITs do not need to pay corporate taxes on income which they distribute to shareholders in the form of dividends. As a result, there’s a particular incentive for these businesses to remit 100% of their earnings in the form of dividends. Hotel REITS focus on the purchase and operation of hotel (and other lodging) properties.

Any special considerations?

Researching hotel REITs is a significantly different animal than looking at more typical stock investments. Hotel REITs derive value in two ways - appreciation in the value of their underlying property and the cash flow/earnings power of the properties they operate. Which valuation dominates public market trading depends on the real estate market, consumer appetites with respect to travel and lodging, and a whole host of other things. With real estate markets in shambles, the focus for Hotel REITs is increasingly upon their cash flow power.

To assess this, get comfortable with two “novel” financial measurements often used by analysts and the companies themselves. Funds from Operations (FFO) or Adjusted Funds from Operations ((AFFO) and RevPAR.

Funds from operations is a statistic which attempts to correct for issues that arise from GAAP accounting (specifically, historical cost depreciation) and provide a “clean” number representing exactly the earnings power of a business stripping out depreciation costs (which, for these businesses, are more of a representation of investment). In simplest terms, basically net income minus depreciation. Adjusted funds from operations takes this one step further and subtracts capital expenditures. This allows you to get to a number which is closer to that of the Company’s distributable net income because the Company must allocate some of its earnings to pay for maintenance of its properties or invest in new ones.

RevPAR stands for Revenue per Available Room. This is the fundamental driver of operating cash flow/earnings at a hotel. It is basically a hotel’s occupancy rate multiplied by its average daily room rate which provides a metric for how well a Company is monetizing its rooms. Furthermore, this metric allows you to compare operational performance across different hotel operators which may charge differing average daily rates or have significantly different physical capacity.

Overall Perspective

Admittedly, this industry/asset class has done exceedingly well in the last month, but prices of several of stocks in this category remain greater than 50% below their 52-week highs. Many, despite reducing dividends to conserve capital during this unprecedented credit crisis, continue to pay significant dividends. A few particularly interesting stocks in the category might include: Hersha Hospitality Trust (HT), Starwood Hotels & Resorts (HOT), Ashford Hospitality Trust (AHT), and Sunstone Hotel Investors (SHO). These stocks all offer significant dividends and continue to trade at relative discounts and could be prime pickings when the current rally eventually corrects.

Full Disclosure: Author is long shares of GE, VLO, LINE, and MO at the time of writing. No positions in the Hotel REITs mentioned, though positions may change at any time.

Comments

[robert.b.fe...:]

Thanks, very informative.

May 07 10:22 AM

[toomuchgas:]

AHT and SHO eliminated their dividends and it may be a while before they are restored.

May 07 11:54 AM

[woodsey:]

I believed in Thornburg Mortgage. Very sound investments. Top quality management. The value of their collateral rapidly declined. I saw it, but I didn't believe it. Then JPM and Bear put the squeeze on. Now I believe: Stay away from those whose life blood is borrowed money.

May 07 01:04 PM

[Mike Dodge:]

1. RevPar is revenue per number of rooms available to rent, not occupancy rate (which is the number of rooms actually rented/number of rooms available).

2. Check the preferreds.....almost all are cumulative.

May 07 05:48 PM

[doubtful:]

Your timing could not be worse. Hotels are one of the most over leveraged classes of RE. Hotel Reits overpaid during the boom years by 50 to 100% of NAV. Not sustainable. Watch out below. RevPar still declining throughout the sector. Demand/Supply way out of balance.
No 'b lood in the streets' yet. But it'll come.

May 08 12:38 AM

[Living4Divi...:]

I agree with you "Doubtful". I do believe that REITs in general have been oversold. If an investor was going to buy a REIT today, I would stick to the less leveraged REITS that face less headwinds

May 08 06:36 AM

[Baboon:]

Living4Dividends,

Can you please explain why you think reits are oversold. With the average equity reits yield of about 6% I don't believe there is much of the upside either.

May 08 08:09 AM

[The Curious...:]

In the article, I described "RevPAR" as "occupancy rate MULTIPLIED BY AVERAGE DAILY ROOM RATE". You'll notice that this is a mathematical identity with what you describe as "revenue per number of rooms available to rent" which is actually rather redundant with the name - "RevPAR" or "REVenue Per Available Room."


On May 07 05:48 PM User 397226 wrote:

> 1. RevPar is revenue per number of rooms available to rent, not
> occupancy rate (which is the number of rooms actually rented/number
> of rooms available).
>
> 2. Check the preferreds.....almost all are cumulative.

May 08 09:31 AM

[Living4Divi...:]

VNQ - which represents a market-cap weighted portfolio of equity REITS is currently yielding 12.26%


On May 08 08:09 AM Baboon wrote:

> Living4Dividends,
>
> Can you please explain why you think reits are oversold. With the
> average equity reits yield of about 6% I don't believe there is much
> of the upside either.

May 08 03:40 PM

[Baboon:]

The current yield of VNQ is 5.73%.

https://personal.vangu...

According to the reit.com as of May 8 the avr. yield of equity reits is 6.64%:

www.reit.com/IndustryD...

May 09 09:10 AM

[Jonathan Ch...:]

If you want to invest in REITS at the present time, I suggest that you look at the cumulative preferred stocks of the REITS. These preferreds pay an amount based on the issue price, nominally 7% on a share issued at $25 . (Though the is a wide range of rates). With many preferreds depressed in price, the current rates are very nice. A specific example is AHT, mentioned earlier. AHT, in a director's meeting specifically voted to buy bck their AHT C and AHT D at market, a wise investment. Since the shares currently sell at about $12 per, and pay 8+ % based on a $25 share price, the annual return is about 18%, and it is cumulative. If the company does not pay it for a quarter, it accumulates and the accumulation pays interest at the same rate (18% based on current prices.).

At current low rates of interest, you can bet that AHT will eventually buy back all of them, and you can, if you hold on long enough, double your capital investment while earning 18% while you wait. Not a bad deal.

There are a lot of these Preferreds around, though you need to be sure the Company will be able to continue to fund the payments.

An example of one which has not is Impac Mortgage Properties. Though not in Bankruptcy (they came close and their shares sell for about $0.50 per share) their preferred shares have also collapsed in price, and do not pay a dividend. I mentioned this company specifically because they have good, tough managers, and may still survive. In which case this would end up being a 10 banger from the present price.

May 12 12:04 PM